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Parties Involved:
Federal Energy Regulatory Commission
Respondent
Kansas Corporation Commission
Intervenor
Missouri Public Service Commission
Intervenor
Williams Gas Pipelines Central, Inc.
Petitioner

Document Text:

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United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued May 15, 2000 Decided June 27, 2000

No. 99-1169

Missouri Public Service Commission,

Petitioner

v.

Federal Energy Regulatory Commission,

Respondent

Kansas Corporation Commission, et al.,

Intervenors

Consolidated with

99-1171, 99-1241

On Petitions for Review of Orders of the

Federal Energy Regulatory Commission

Charles F. Wheatley, Jr. and David D'Alessandro argued

the cause and filed the briefs for petitioners Kansas Cities

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and the Missouri Public Service Commission. Kelly A. Daly

entered an appearance.

Gary W. Boyle argued the cause and filed the briefs for

petitioner/intervenor Williams Gas Pipelines Central, Inc.

Beverly H. Griffith, Gregory Grady and Joseph S. Koury

entered appearances.

Andrew K. Soto, Attorney, Federal Energy Regulatory

Commission, argued the cause for respondent. With him on

the brief were John H. Conway, Deputy Solicitor and Susan

J. Court, Acting Deputy Solicitor. Jay L. Witkin, Solicitor,

entered an appearance.

Before: Williams, Henderson and Rogers, Circuit Judges.

Opinion for the Court filed by Circuit Judge Williams.

Williams, Circuit Judge: In 1993 Williams Natural Gas

Company,1 a natural gas pipeline company within the jurisdiction of the Federal Energy Regulatory Commission, filed for

a general rate increase under s 4 of the Natural Gas Act, 15

U.S.C. s 717c. The proceeding closed in 1999 with the

Commission's third rehearing order. Williams Natural Gas

Co., 86 FERC p 61,323 (1999) ("Third Rehearing"). That and

the underlying orders are attacked from two sides. A host of

Kansas cities, the Missouri Public Service Commission and

others, which we will collectively call the "Public Service

Commission," attack the allowed rate of return. They argue

that the Commission wrongly refused (a) to impute to

Williams the capital structure of its corporate parent, or

alternatively, (b) to adjust Williams's return on equity downward to reflect its subsidiary status and the "thickness" of its

equity ratio in comparison to that of firms in the proxy group

used by the Commission to calculate the return on equity.

The pipeline itself attacks on an unrelated issue, objecting to

__________

1 In the course of the proceedings Williams Natural Gas Company became Williams Gas Pipelines Central, Inc. We use "Williams"

as shorthand.

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the Commission's method of projecting the costs for cleaning

up PCB (polychlorinated biphenyl).

We cannot say that the Commission's use of Williams's

capital structure and the median return on equity for the

proxy group was arbitrary and capricious. As to clean-up

costs, the Commission no longer defends the $1.4 million

annual cost recovery as a figure representative of actual cost,

and its decision does not purport to rely on any procedural

default by Williams; we therefore grant Williams's petition

and remand for further proceedings.

Capital structure and rate of return on equity

The Public Service Commission's brief offers a nonexhaustive, but here uncontested, explanation of the role of

capital structure and equity rate of return. It points out that

a firm's return on equity must be higher than the return on

debt because (1) any dividends are paid out of after-tax

earnings, whereas the firm can deduct interest on debt, and

(2) equity is riskier. Because the overall cost of equity is the

product of the equity share of capital and the equity rate of

return, these factors imply that an increase in the equity-debt

ratio tends to increase a firm's allowable overall rate of

return. But there is an offset: Because debt service has

priority, the higher the proportion of equity capital, the lower

the financial risk for the firm's stock, and thus, in this

respect, the lower the necessary rate of return. See also

Richard J. Pierce, Jr. & Ernest Gellhorn, Regulated Industries 136-37 (3d ed. 1994).

Williams is a wholly owned subsidiary of The Williams

Companies ("TWC"). Williams's own capital structure is

35.71% debt and 64.29% equity, while TWC's is 50% debt, 3%

preferred equity, and 47% common equity. Assuming use of

the same equity rate of return, FERC's use of TWC's ratio

would be an advantage for Williams's customers.

In calculating the equity rate of return of a wholly owned

subsidiary, the Commission has a special problem. Since its

shares are not traded in the market, they have no market

price from which to infer their rate of return. So the

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Commission looks instead to a proxy group of supposedly

similar firms whose stock is traded, calculates their return on

equity with the "DCF" or "discounted cash flow" method, and

then tacks the resulting number onto the equity of the

subsidiary. See generally Williston Basin Inter. Pipeline

Co. v. FERC, 165 F.3d 54, 56-57 (D.C. Cir. 1999); North

Carolina Utilities Comm'n v. FERC, 42 F.3d 659, 661 (D.C.

Cir. 1994).

Here the Commission used Williams's capital structure. It

found the company's business risk average, and, though not

explicitly so labelling its financial risk, held that its overall

risk (the amalgam of the two) was not outside the "broad

middle range of average risk." Third Rehearing, 86 FERC

p 61,323, at 61,860-61. It thus allowed Williams the median

rate of return of the proxy group. In doing so, it made no

adjustment to reflect the fact that Williams's equity ratio was

a good deal thicker than the average of the proxy group (and

therefore presumably less risky). Indeed, Williams's ratio

was higher than the highest equity ratio of the proxy group--

64%, compared with 42% and 62% for the average and

highest ratio of the proxy group, respectively.2

We review the challenge under the arbitrary and capricious

standard of the Administrative Procedure Act. 5 U.S.C.

s 706(2)(A). The Commission must consider the relevant

factors and draw "a rational connection between the facts

found and the choice made." Williston Basin, 165 F.3d at 60

(citation and quotation marks omitted). On the technical

aspects of ratemaking FERC's decisions necessarily enjoy

considerable deference. Public Service Comm'n v. FERC,

813 F.2d 448, 451 (D.C. Cir. 1987).

The attack on the Commission's refusal to use TWC's

capital structure opens with the "double leveraging" theory.

The theory's basic concept is that the true cost of a subsidiary's equity capital is the overall cost of the parent's capital.

Accordingly, the cost of the subsidiary's equity should be

computed as the weighted average of the parent's debt and

equity costs. Otherwise, says the theory, shareholders of the

__________

2 The proxy companies and their equity ratios were: Sonat, Inc.

(62%), TWC (47%), Enron Corporation (43%), Panhandle Eastern

Corporation (45%), Coastal Corporation (39%), and Transcontinental Energy Corporation (16%).

parent receive not only the higher equity returns associated

with the parent's equity, but an artificial (doubly leveraged)

return on the subsidiary's equity.

Although the Commission in the first rehearing order opted

in favor of using TWC's capital structure, Williams Natural

Gas Co., 80 FERC p 61,158 (1997) ("First Rehearing"), even

then it rejected double leveraging as a rationale: "The rate of

return to a pipeline should not depend on who owns the

pipeline, nor on how that owner, whether a holding company

or individual stockholders, financed its investment." Id. at

61,682; see also Third Rehearing, 86 FERC p 61,323, at

61,858-59. The double leveraging theory would in principle

be applicable to a pipeline owned by a single individual, or by

a group of investors, requiring the Commission to pursue its

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inquiry into these owners' finances. Further, an expert

quoted by the Commission makes the point that the pipeline

investment's true opportunity cost does not depend on the

capital structure of the investor, but rather on the foregone

risk-adjusted returns of alternative investments. See James

E. Brown, "Double Leverage: Indisputable Fact or Precarious Theory," Public Utilities Fortnightly 26, 29 (May 9, 1974),

cited at First Rehearing, 80 FERC p 61,158, at 61,682 n.21.

It is not for us to say whether these arguments have put

the kibosh on the double leverage theory. We can, however,

say that the Public Service Commission's quick response--

individual investors would never directly own a FERCregulated pipeline, and if they did, they would not stand for

such high equity ratios--is not a serious intellectual answer to

them. On this record we have no basis to disturb FERC's

refusal to apply the double leveraging theory.

The Commission nevertheless briefly flirted with the idea

of using TWC's capital structure. First Rehearing, 80 FERC

p 61,158, at 61,683. But on the next lap it dropped that

approach, with the reasoning stated in a chronologically connected case:

Traditionally, the Commission has preferred to utilize the

applicant's own capital structure and will continue to do

so if the applicant issues its own non-guaranteed debt

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and has its own bond rating. But the Commission will

utilize an imputed capital structure (most often that of

the corporate parent) if the record in a particular case

reveals that the pipeline's own equity ratio is so far

outside the range of other equity ratios approved by the

Commission and the range of proxy company equity

ratios that it is unreasonable.

Transcontinental Gas Pipe Line Corp., 84 FERC p 61,084, at

61,413 (1998) ("Order 414-A"), affirmed North Carolina Utilities Comm'n v. FERC, No. 99-1037 (D.C. Cir. Feb. 7, 2000)

(unpublished opinion). The Commission applied this policy to

Williams on the second rehearing. Williams Natural Gas

Company, 84 FERC p 61,080, at 61,356 (1998) ("Second Rehearing"). As Williams issued its own non-guaranteed debt

and had its own bond rating, the normal pre-conditions for

using Williams's own capital structure were satisfied.

We now turn to the Public Service Commission's argument

that Williams's equity ratio is so out of line that the Commission should either have applied the caveat in the excerpt

quoted above (calling for use of an imputed capital structure

in cases of anomalous equity ratios), or should have adjusted

Williams's equity rate of return down from that of the proxy

group. The common sense of this attack is clear. Given that

a high equity ratio reduces financial risk (everything else

being equal), it would make no sense for the Commission to

use a rate of return inferred from the market experience of a

proxy group with much thinner equity ratios.

But how thick is "too thick," and how much difference in

thickness is too much? Here the issue is whether 64% equity

is "anomalous," bearing in mind that it is 22% above the

proxy average but only 2% above the highest in the proxy

group. See supra note 2. Judges are hardly in a position to

play this numbers game. Such numerical limits cannot readily be derived by judicial reasoning, Hoctor v. USDA, 82 F.3d

165, 170 (7th Cir. 1996), though to be sure courts are driven

to it occasionally, as in enforcement of the Administrative

Procedure Act's mandate to ensure that agency action is not

"unreasonably delayed." 5 U.S.C. s 706(1). The ultimate

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choice may partake of arbitrariness--not in the sense of being

"arbitrary and capricious," but in the sense that, while numerical lines sometimes must be drawn, it is impossible to

give a reasoned distinction between numbers just a hair on

the OK side of the line and ones just a hair on the not-OK

side.

Here, it seems clear at the outset that the Commission was

on firm ground in rejecting the idea that an equity ratio

outside the bounds of the proxy group must automatically

require an adjustment. See Second Rehearing, 84 FERC

p 61,080, at 61,355. Assume a proxy group with ratios varying from 40% to 44%. Insisting on an adjustment for a firm

with one of 45% would surely impute an improbable refinement to the rough inferences derived from capital markets, as

well as raising the question just how great the adjustment

should be.

The Public Service Commission suggests in its brief that

Commission precedent can provide some guidance. In

Transcontinental Gas Pipeline Corp., 60 FERC p 61,246

(1992), reh'g denied 64 FERC p 61,039 (1993), FERC found

that Transco Energy Corporation's equity ratio (the pipeline

proposed using its parent's equity ratio) was 22% below the

proxy average and required a different imputed capital structure to boost pipeline returns. See North Carolina Utilities

Comm'n, 42 F.3d at 661, 663. FERC does not really respond

to this argument, although it did observe in the Second

Rehearing that the proxy group average here is brought

down by the 16% equity ratio for one of the proxy firms

(Transco, interestingly). 84 FERC p 61,080, at 61,358 n.31.

Indeed, Transco's presence lowered the proxy group average

over 5% (47.4% to 42.2%). But as petitioners point out, if one

outlier is to be removed, why not another (Sonat, at 62%)?

And the double removal would put the average at 43.8%,

which would leave Williams still well above the average and

even more above the new top (48%). Further, the Commission gives no explanation as to why any outlier should be

removed, see United States Telephone Assn. v. FCC, 188 F.3d

521, 525 (D.C. Cir. 1999) (agency eliminating outlying data

points must explain "why the outliers were unreliable or their

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use inappropriate"), much less why a low outlier should be

removed and a high one retained. Had the Transco precedent been properly raised, FERC's failure to offer a distinction might well have required a remand. See Greater Boston

Television Corp. v. FCC, 444 F.2d 841, 852 (D.C. Cir. 1970)

("[I]f an agency glosses over or swerves from prior precedents without discussion it may cross the line from the

tolerably terse to the intolerably mute."). But petitioners'

exceptions before the Commission did not cite the North

Carolina Utilities Comm'n case or make such precedentbased arguments.3

Nor is there much force to petitioners' argument that

creeping stare decisis will inch equity ratios ever-higher, as

each new peak in equity ratio will justify another, still higher

peak. The Commission swears off any such progression, see,

e.g., Second Rehearing, 86 FERC p 61,232, at 61,858, and

petitioners can identify nothing in the record to undercut its

commitment. A slippery slope argument is almost always

available. "Judges and lawyers live on the slippery slope of

analogies; they are not supposed to ski it to the bottom."

Robert H. Bork, The Tempting of America: The Political

Seduction of the Law 169 (1990). Especially with the Commission's explicit pledge, the slope risk provides no basis for

us to upset the Commission's judgment.

Petitioners also claim that in looking in part to pipeline

companies outside the proxy group in determining the reasonableness of Williams's equity ratio, the Commission failed

to provide adequate notice and thus failed to allow them an

opportunity to offer evidence distinguishing the companies

outside the proxy group. But after the Commission considered pipelines outside the proxy group in the Second Rehearing, petitioners made no request to supplement the record.

__________

3 Petitioners have not been punctilious in their use of precedent,

mistaking in their brief the facts of North Carolina Utilities

Comm'n, 42 F.3d at 663, for those of Public Service Comm'n v.

FERC, 642 F.2d 1335 (D.C. Cir. 1980). See Petitioners' Opening

Br. at 32.

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All that said, this case is somewhat puzzling. No one

contests the Public Service Commission's point that a thick

equity ratio implies less risk and thus a lower rate of return,

everything else being equal. Yet the Commission selected a

proxy group with widely dispersed equity ratios, from 16% to

62%, as opposed to a proxy group nearer to Williams's capital

structure. Further, it is unclear why the Commission has

taken such an interest, both in its orders and in its brief here,

in explaining that Williams's 64% ratio is in the mainstream of

ratios in the pipeline industry generally. The rate of return

is inferred from the rate of return of the proxy group, so the

non-anomalous character of Williams's equity ratio by the

standards of the industry generally is not self-evidently pertinent.

But there are also gaps in the petitioners' attacks, which

undermine any inference that FERC's looking to the industry

generally had any material effect. Given the supposed relation between equity ratio, risk, and rate of return, we should

expect to see some effort to show it at work within the proxy

group, or broadly among publicly traded companies generally.

Yet petitioners offer no such analysis. We know the direction

of the effect of equity thickness on equity rate of return (as

no one contests it), but we have nothing on the degree.

Accordingly, we have no basis for thinking that relationship

to be so strong as to make a material difference, business risk

being held constant. On this record, then, we cannot find

anything arbitrary and capricious in the Commission's use of

Williams's capital structure and the proxy group's median

return on equity.

PCB removal cost estimates

Before the administrative law judge Williams presented

evidence of $4.2 million in past unamortized costs for cleaning

up PCB (polychlorinated biphenyl), plus projections of future

costs. The ALJ allowed the company to amortize the $4.2

million over three years, with a procedure for refunding any

amounts Williams recovered from third parties responsible

for the PCB. ALJ Opinion, 73 FERC p 63,015, at 65,074-75.

Because Williams made a new s 4 rate filing in 1995, the

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issue of PCB cost recovery in the present case became

"locked in" for the period of November 1, 1993 through July

31, 1995.

For this locked-in period, the Commission rejected amortization in favor of the "test period" method. Williams Natural Gas Co., 77 FERC p 61,277, at 62,182 (1996) ("First

Order"); see generally Southwestern Public Service Co. v.

FERC, 952 F.2d 555 (D.C. Cir. 1992). This method takes

actual costs of the most recent 12-month period (the "base

period"), subject under some circumstances to adjustment on

the basis of data from a nine-month period following the base

period (the "adjustment period"), and absent some anomaly

projects them into the period covered by the rate filing. See

18 CFR s 154.303.

Without looking to whether Williams had offered such test

period figures, the Commission declared that "the $1.4 million

annual amount the participants and the ALJ arrived at using

an amortization method is a reasonable equivalent of WNG's

actual PCB-related test period costs." First Order, 77 FERC

p 61,277, at 62,182. It also asserted that Williams had projected 10-year costs of $20 million; "this averages to $2

million a year which is reasonably close to the $1.4 million

annual amount the ALJ permitted [Williams] to recover." Id.

at 62,183.

Williams did not object to use of the test period method.

But on rehearing it did strenuously argue that the Commission was wrong to convert the amortization figures into test

period figures. Williams pointed to Exhibit 216 in the record,

which stated "Test Period Actuals" and a total of

"$3,990,768." The Commission rejected the $3.9 million figure, however, claiming it inappropriately covered a 22-month

period; but in so doing the Commission cited Exhibit 24 not

Exhibit 216. First Rehearing, 80 FERC p 61,158, at 61,680 &

n.11. As for Exhibit 216, the Commission stated it provided

"no distinct record evidence" of the level of PCB costs

"incurred over any annual period during the test period." Id.

at 61,680 & n.13. The Commission offered no explanation as

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to the precise flaw in Exhibit 216's statement of "Test Period

Actuals."

Sticking by $1.4 million as "representative of annual PCB

cost figures," the Commission chastised Williams for disputing the figure, saying that this was the figure initially proposed by Williams (albeit as a figure for amortization). Id. at

61,679-80.

At oral argument the Commission abandoned any claim of

equivalence between the $1.4 million accepted by Williams

under the amortization theory and imposed by the Commission as a "representative" test period amount. Clearly a

number that emerges from taking past aggregate costs and

amortizing them over an arbitrarily chosen future period is

not necessarily useful for applying past experience to project

future expenses--the basic principle of the test period method. It could hardly satisfy the Natural Gas Act's requirement of substantial evidence for facts found by the Commission, 15 U.S.C. s 717r(b). See also Public Service Comm'n,

813 F.2d at 451.

Instead, the Commission at oral argument seemed to defend the use of $1.4 million as a response to what it claimed

was Williams's failure to place correct test period figures into

the record. The Commission's brief points out that $3.2

million of the total test period $3.9 million were incurred in

two months, proving (in its current view) that Williams's test

period figures were "unrepresentative." And for the very

first time in this seven-year saga, the Commission at oral

argument claimed that Williams's data failed to satisfy a

regulatory requirement of monthly cost figures during the

test period.

Williams maintains that Exhibit 216's "Test Period Actuals"

was sufficient evidence. Nothing said by the Commission up

until oral argument has supplied a reason to believe that that

was inadequate. That $3.2 million in costs were incurred

during two months of the test period may show that PCB

removal costs come in lumps. But it hardly shows that the

$3.9 million annual aggregate figure was unrepresentative, a

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theory in any event never invoked in the Commission's orders.

When the Commission at oral argument asserted a requirement of monthly data, Williams questioned the existence of

any such requirement and said that in fact it had supplied

such data. The new Commission theory is in any event the

purest form of "appellate counsel's post hoc rationalization,"

which in the usual case we do not accept. North Carolina

Utilities Comm'n, 42 F.3d at 663. Since the Commission no

longer defends the $1.4 million figure as representative, and

in its orders never sought to justify it as a solution to some

procedural default by Williams, we grant the petition and

remand the case for the Commission to address this issue.

* * *

The petitions of Public Service Commission are denied; the

petition of Williams is granted, that part of the order is

vacated, and the case is remanded to the Commission.

So ordered.

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