Opinion ID: 383816
Heading Depth: 2
Heading Rank: 3

Heading: Revenue/Cost Presumption

Text: 82 Under the revenue/cost presumption, market dominance is presumed to exist where the rate in issue exceeds the variable cost of providing the service by 60 percent or more. 49 C.F.R. § 1109.1(g)(3). The crucial concept is that of variable costs. All the petitioners allege one or more mistakes by the Commission in calculating the railroads' variable costs for CP&L's traffic. Because this is such a technical subject, a review of the Commission's rules and practices for determining costs will be beneficial before discussion of the substance of the petitioners' objections. 83 In proposing the revenue/cost presumption in Ex parte No. 320, Interim Report, the Commission stated that variable costs are expenses which over a long-term period, fluctuate with the volume of traffic handled. 353 I.C.C. at 911. The Commission noted that such costs include operating expenses, rents, taxes, and an allowance for the cost (apparently to be calculated at the imputed interest level) 40 of equity capital invested in transportation property, plus interest on borrowed capital invested in such property. 353 I.C.C. at 911, n. 44. The Commission has indicated that in establishing variable costs for the revenue/cost presumption, shippers with the responsibility of providing evidence of costs may rely upon a formula known as Rail Form A. 41 Ex parte No. 320, Interim Report, 353 I.C.C. at 913. In justifying the 60% figure used in the presumption, the Commission itself relied upon Rail Form A variable costs. Ex parte No. 320, Clarification, 359 I.C.C. at 738. 84 Rail Form A is a formula by which various levels of carrier costs for a movement may be determined. It can be utilized both to determine the variable cost associated with a particular movement and to allocate a portion of constant costs to a movement. 42 The variable cost incurred by a movement is calculated by Rail Form A on the basis of historical systemwide averages and the volume of the movement in question. It projects an increase in operating expense as well as an increase in fixed plant investment and equipment investment incurred by a movement. Fifty percent of this incremental fixed plant investment and one hundred percent of this incremental equipment investment is deemed variable by Rail Form A. Accordingly, the return on the capital (at the imputed interest level) justified by fifty percent of the incremental fixed plant investment and one hundred percent of the incremental equipment investment is deemed a variable cost and is included in the total variable cost derived by Rail Form A. 85 With respect to unit coal train cases, the Commission has consistently modified Rail Form A in calculating costs for the purposes of rate-making. 43 I & S, No. 9199, Unit Train Rates on Coal-Burlington Northern, Inc., Decided July 13, 1979 (unprinted) (BN-Iowa); Arkansas Power & Light Co. v. Burlington Northern, Inc., 361 I.C.C. 504 (1979) (Arkansas Power), petition for review pending; San Antonio, Texas v. Burlington Northern, Inc., 361 I.C.C. 482 (1979) (San Antonio I ), vacated and remanded sub nom. San Antonio v. United States, 631 F.2d 831 (D.C.Cir. 1980) (San Antonio II ); Annual Volume Rates on Coal-Wyoming to Flint Creek, Arkansas, Docket No. 36970 and Southwestern Electric Power Company v. Burlington Northern, Inc., Docket No. 36980, combined, Decision Served May 25, 1979 (unprinted) (Flint Creek); Kings Mill, supra; Smithers Lake, supra. This modification has taken the form of the use of additives, one for additional equipment and the other for incremental fixed plant investment necessitated by unit coal train movements. These additives are added to the figure derived by Rail Form A to give what the Commission considers to be a more accurate projection of costs. These additives are not based upon systemwide historical averages, but are based upon actual incremental investments necessitated by a movement. These additives calculate both an operating expense portion associated with a movement and an allowance for the cost of the capital investment necessitated by a movement. These costs are directly allocated to a given movement by means of the additive. (J.A. III, pp. 2050-1). Thus, for example, instead of relying on Rail Form A's averages, the additive takes the actual capital investment in fixed plant necessitated by a movement, calculates the cost of that capital investment and directly allocates this cost to the movement. (J.A. III, pp. 2050-1). In order to eliminate a double count on the elements included within the additives, the Commission purportedly removes from the Rail Form A calculation the incremental fixed plant and equipment investments associated with the movement under consideration. 86 The petitioners make several objections to the Commission's modification to Rail Form A, but primarily complain that the Commission's method of removing incremental fixed plant investment from Rail Form A is defective and that a double count of this element remains. Although CP&L objected to the use of the additives, it calculated a cost figure adding the additives to its Rail Form A calculation to arrive at a variable cost figure of $12.12 per ton. 44 (J.A. III, p. 1724). This gives a revenue/cost ratio of 172%, well above the threshold level of the presumption. The Commission, though, rejected CP&L's estimates of some of the inputs into the Rail Form A formula and also rejected CP&L's calculation of the incremental fixed plant investment additive to arrive at an estimate of variable costs of $13.90 per ton. This amount yields a revenue/cost ratio of 150%, a ratio insufficient to establish the presumption. 87 (i) Use of Additives 88 CP&L and Justice argue that any use of additives violates the Commission's rules for determining variable costs in applying the revenue/cost presumption. They contend that both Rules to Govern Assembling & Presenting Cost Evidence, 337 I.C.C. 298 (1970) (Rules for Costs) and Ex parte No. 320, Interim Report, mandate strict adherence to Rail Form A methodology without modification. We believe neither of these proceedings requires such rigid methodology in deriving costs. 89 Rules for Costs was a proceeding in which the Commission discussed methods for determining variable costs in various transportation modes. It explained and noted that parties could rely on the use of Rail Form A to determine variable costs for rail carriers. 337 I.C.C. at 324. The Commission in Rules for Costs, however, was careful to preserve flexibility in the formula to derive variable costs, indicating that circumstances can exist in which the usual methodology for determining costs might be inadequate. The Commission left open the possibility of adapting the usual procedure to a special situation. The Commission emphasized: 90 (T)his proceeding (Rules for Costs) would not determine whether any particular costs are more valid in certain cases than others, and that the parties would still be free to employ other methods of estimating costs. 337 I.C.C. at 300. 45 91 In Ex parte No. 320, Interim Report, the Commission noted that while shippers could rely on Rail Form A, this formula could be adjusted to fit the traffic or movement to which the rate in issue applies. 353 I.C.C. at 913. Thus, Ex parte No. 320, Interim Report, as does Rules for Costs, indicates that flexibility is the watchword in determining the costs of a movement. 92 We conclude that in Rules for Costs and Ex parte No. 320, Interim Report the Commission clearly indicated that Rail Form A could be modified when necessary to determine variable costs. Accordingly, CP&L's and Justice's argument must fail. However, we do not endorse the use of the particular modifications used by the Commission in this case for the reasons stated below. 93 (ii) Rate of Return on Incremental Fixed Plant Investment Additive 94 The incremental fixed plant investment additive is calculated as an annuity spread over a series of equal future payments during the service life of the new investment. (J.A. III, p. 2090). The Commission here, as in prior unit coal train cases, calculated the incremental fixed plant investment additive at what is called the revenue need level, utilizing a weighted average of the cost of equity capital as well as debt capital to determine the cost of capital associated with this additive. 46 (J.A. III, pp. 1968, n.8, and 2090-99). Thus the Commission figured the cost of equity capital at a level somewhere between the traditional return on equity, which includes a profit or incentive for risk of ownership element, and a level we have referred to as the imputed interest level, i. e., the level similar to the cost of debt capital. CP&L and Texas object to the Commission's treatment of the return-on-equity factor in calculating this additive, but for different reasons. We think both objections are valid; we conclude that the Commission erred to the extent it used a return-on-equity factor in excess of the cost of debt capital. 95 CP&L objects that the Commission's calculation of the return-on-equity factor in the additive at the revenue need level violates the Rules for Costs. While we have noted above that the Rules for Costs provides for flexibility in cost methodology, it clearly states that, in determining variable costs, the risk of ownership element in the return on equity is not appropriate, and that a return on equity is an appropriate element of variable costs only to the extent of imputed interest similar to that charged for borrowed capital: 96 Allowances for return on investment ... to the extent that they are admittedly intended to serve as an encouragement and incentive for continued or risk-bearing ownership, are in the nature of so-called pure economic profits and should not be taken into account as an element falling within the restrictive construction given here to costs. This is not to say, however, that such an allowance for profit is not to be considered as a factor in ratemaking-it should if transportation is to remain under private ownership and control ... However, this so-called pure profit should be clearly distinguished from opportunity costs. The latter does include a return on investment, simple, in the sense of, and as the equivalent to, cost of capital, but in no way connected with the risk or incentive of ownership. It is with respect to this limited effect to be given to return on investment as an element of cost that the examiner generally agrees ... as to why equity capital invested in carrier facilities should be treated in the same manner as similar debt capital. Such equity capital is then entitled to receive imputed interest, similar to that charged for borrowed money .... 97 337 I.C.C. at 393. The Commission has repeatedly stated that an allowance for the traditional return on equity investment is not appropriate in determining the variable costs of a service. Flint Creek at pp. 20-21; BN-Iowa at p. 46. When it has utilized a traditional return on equity, it has been careful to emphasize that such an inclusion has been to calculate revenue need costs in the context of rate-making, and not in determination of variable costs. Flint Creek at pp. 20-21; BN-Iowa at p. 46. 47 Because we believe this principle to be well-founded in Commission cases, we conclude that the Commission has acted unreasonably in deviating from this principle of determining variable cost, at least in the absence of full explanation of the reasons for deviating. In light of the Commission's prior norms, we hold that the Commission erred in calculating the cost of equity capital at the revenue need level, rather than at the proper cost of debt capital level. 98 Texas complains that inclusion of a return-on-equity 47a factor was improper in light of the reasoning the Commission used in establishing the 160% ratio in the revenue/cost presumption. Texas rightly notes that the traditional notion of return on equity capital constitutes profit. It notes that in justifying the 160% ratio, the Commission included a factor for profit in estimating the level that would trigger the revenue/cost presumption. 99 We assumed that any percentage test would have to account for both a railroad's constant costs and its variable costs. We first determined from the best available evidence that nationwide railroad fully allocated costs approximated 129 percent of variable costs. Subsequent publications show this as 127 percent at variable costs. 100 We then increased this figure to take into account all railroad expenses and a reasonable profit, as well as to provide a wide margin for error. 101 359 I.C.C. at 737. (footnote omitted). Since a profit factor was incorporated in determining the maximum appropriate spread between variable costs and revenue, we believe it imperative that the Commission adhere to the methodology presupposed by the revenue/cost presumption. That methodology requires the Commission to determine variable costs without incorporating a traditional return on equity in applying the revenue/cost presumption. We do not imply by this holding, however, that the Commission may not impute a return on equity capital similar to the return on debt capital in calculating variable costs for the presumption. We have noted above that Rules for Costs indicates that equity capital is entitled to receive imputed interest similar to that charged for borrowed money. 337 I.C.C. at 393. See also § 202, Staggers Rail Act of 1980. 102 We conclude, both for the reason asserted by CP&L and the reason asserted by Texas, that the Commission, in calculating variable costs for purposes of the revenue/cost presumption, has acted unreasonably to the extent that it utilized a return-on-equity factor in excess of the cost of debt capital. Should the Commission on remand wish to continue utilizing a return-on-equity factor in excess of the cost of debt capital, it must explain why it is deviating from its well-established norm announced in Rules for Costs. Accordingly, we vacate and remand. 103 (iii) Double Count 104 Because with any new movement Rail Form A normally projects an increment in fixed plant investment based on system averages, the inclusion of the incremental fixed plant investment additive would result in a double count unless appropriate adjustments are made to Rail Form A. A recurring argument before the Commission has been the proper methodology for eliminating this double count. See BN-Iowa, Arkansas Power, San Antonio I, Flint Creek, Kings Mill, Smithers Lake. Shippers have consistently maintained unsuccessfully before the Commission that its modifications to Rail Form A calculations are not adequate to alleviate this problem. 105 The Commission in this case admitted that the use of the additives resulted in a slight overstatement of costs to an unknown degree, but added that it believed the overstatement not to be significant because, adopting the methodology of the railroads, it had excluded the incremental fixed plant investment related exclusively to coal traffic from its Rail Form A calculations. It noted that while some remaining system investment is left in Rail Form A, such investment allocated to CP&L is small and CP&L would, in any event, utilize a portion of existing fixed plant. (J.A. III, pp. 1942 and 2050-51). This is essentially the same justification the Commission has given to its methodology in the rate-making context. BN-Iowa, Arkansas Power, San Antonio I, Flint Creek, Kings Mill, Smithers Lake. 106 We are unable to ascertain from the Commission's opinion whether the overstatement it admits results from a double count of incremental fixed plant investment or whether it results for some other reason. 48 Whatever the case, we vacate and remand because we are unable to discern the reasoning of the Commission. 107 A reason sufficient unto itself for our decision is that the Commission admits that its method results in a slight overstatement of variable costs, meaning that the actual revenue/cost ratio is slightly higher than the 150% the Commission calculated. Although we appreciate the fact that it may be difficult or even impossible to precisely calculate the overstatement, 49 we believe that it is possible to provide a better explanation than that now before us. We also hope that the balance of our discussion in this paragraph (iii) will provide guidance as to some of the specifics that can be clarified. Accordingly, the Commission on remand should explain the duplication (including a discussion of the items or categories that are duplicated, and a discussion of how appropriate costs are eliminated from Rail Form A to eliminate the duplication), why it believes the duplication to be insignificant, and why it believes the 160% ratio not to have been exceeded. 108 Our second reason for vacating and remanding on this point is that the Commission has failed to adequately address the serious arguments raised by CP& L that the Commission's methodology results in a double count. To better understand these objections, we need to explain more fully how Rail Form A predicts incremental fixed plant investment, and how the Commission modified Rail Form A in this case. 109 We understand Rail Form A to predict incremental fixed plant investment in essentially the following manner. An average of incremental fixed plant investment per increase in volume of traffic is first established on the basis of historical systemwide data. Then, for a movement in question, a prediction of incremental fixed plant investment is derived by multiplying the projected increase in volume for that movement by the historical average incremental fixed plant investment per volume. Fifty percent of the total predicted incremental fixed plant investment is then deemed to be a variable cost. 110 Because of the Commission's brevity in its explanation of why it rejects CP&L's double count objection, 50 we are not certain that the following accurately describes the modifications to Rail Form A which the Commission adopted. 51 As we understand it, the Commission made a distinction between (i) the incremental fixed plant investment that is occasioned solely by unit coal trains, such as heavier than normal rail, or the addition of ties and ballast necessitated to upgrade a line solely because of CP&L's movement, and (ii) the incremental fixed plant investment necessitated by system traffic, including unit coal trains. (J.A. II, p. 1380). In other words, an attempt is made to segregate incremental fixed plant into that which would not occur but for the special characteristics of coal trains and that which would occur merely because of the increase in volume resulting from the coal train traffic considered as normal traffic. 52 The latter incremental fixed plant investment is that which can be considered to be appropriate for normal traffic. This distinction is thought necessary by the railroads because unit coal trains require capital outlays heavier than the average capital outlay normally resulting from volume increase. By segregating the incremental fixed plant investment necessitated solely by CP&L's movement, the railroads attempt to segregate this heavier than average increment and to attribute it directly to CP&L's movement. Within the additive is included the incremental fixed plant investment occasioned solely by the unit coal train movement, directly calculated without use of Rail Form A, while the Rail Form A calculation would include that incremental investment attributable to the volume increase occasioned by normal traffic, including CP&L's traffic. Because the additive includes incremental fixed plant investment which is greater than average, an adjustment is made to the factor normally used in Rail Form A determining the portion of incremental fixed plant investment which is deemed variable. In this case, the railroads reduced the percentage from 50% to 47.4%. (J.A. II, p. 1382). This reduction in the percentage of incremental fixed plant investment deemed variable by Rail Form A is the only modification to the Rail Form A formula specified in the record. It is presumably this modification the Commission relies upon when it states that the railroads removed the incremental fixed plant investment related exclusively to coal traffic from the Rail Form A calculation. 53 111 Having explained the adjustment to Rail Form A, we can more clearly state CP& L's objection to the Commission's methodology. First, CP&L objected below that in all the prior cases in which the Commission has modified Rail Form A methodology, it has failed to come to grips with the fact that Rail Form A predicts an increment in fixed plant investment for a specific movement on the basis of volume output. 54 The significance of this is that the Rail Form A measurement of increment in fixed plant is proportional to the volume increase of a movement. CP&L maintains that because Rail Form A averages include historical cases of heavier than average outlays, the Rail Form A calculation, by itself and without any additive, is sufficient to predict accurately the increment incurred, even in cases of greater than average investment, as in the instant coal traffic. The thrust of this objection is that because historical averages include cases of greater than average incremental fixed plant investment, Rail Form A's calculation without modification is the most meaningful and representative determination of true incremental fixed plant costs. While the Commission may have a ready answer to this argument, we believe it merits consideration and answering. 112 A second objection by CP&L, and one more directly to the point of a double count, is that the distinction between incremental fixed plant occasioned solely by CP&L's movement and incremental fixed plant occasioned by traffic increase, including CP&L's traffic, is not a workable distinction to eliminate the double count and is a distinction which has not been made. It argues for example that there are no workable criteria to separate ties and ballast utilized on a line which are occasioned solely by a unit coal train and that which is occasioned by volume increase of normal traffic including CP&L's lines. We are not as certain as CP&L that this distinction is meaningless or can never be made to work, but we perceive in the Commission's opinion no reasons as to why it believes the distinction utilized by the railroads, and which it adopted without comment, is appropriate. 55 In adopting the railroads' methodology without addressing this concern of CP&L, the Commission has made it impossible for us to adequately review its findings. 113 We are also concerned that the distinction, if meaningful, was not applied in this case to eliminate a double count. This can be seen, for example, in the handling of the increment along a portion of SP's line from Flatonia to Coleto Creek. Within the additive was included all the ties and ballast necessary to upgrade this line because this line was apparently scheduled for abandonment before CP&L's movement. (J.A. II, pp. 1357 and 1415 and J.A. III, pp. 1717 and 1973). Since all of the cost of the ties and ballast was included in the additive, it would seem that a proper modification of Rail Form A would exclude all the incremental fixed plant investment relating to ties and ballast attributable to the volume increase along SP's line from Flatonia to Coleto Creek. We are unable to determine whether the modification of Rail Form A approved by the Commission accomplished this. On remand, the Commission shall address this point, as well as a similar discussion of other costs included in the additive and a demonstration that Rail Form A has been modified to eliminate any double count with respect to such costs. 114 In Celanese Chemical Co., Inc. v. United States, supra, we recently quoted from San Antonio II and held that the Commission's procedure-adding a fixed plant investment additive to the Rail Form A costs-constituted a double count and, therefore, was erroneous. 56 We follow Celanese and hold that the Commission on remand shall be required to eliminate any double count. We do not require at this time that the Commission abandon its use of additives. It very well may be that additives are necessary to calculate accurate estimates of variable costs with respect to unit coal trains. Instead, on remand, the Commission should explain more fully its methodology, address CP&L's objections so that we may rationally assess the propriety of its method, eliminate the double count, and demonstrate how the elimination has been accomplished.