Opinion ID: 2268472
Heading Depth: 2
Heading Rank: 7

Heading: The Rate of Return

Text: The rate of return allowed to a utility company is the percentage by which that company's rate base is multiplied in order to determine the revenues needed to pay expenses and to acquire investment capital. To calculate the rate of return, the costs of each component of capital, viz., debt, preferred stock and common equity, are weighted according to the ratio that each bears to the total capital structure of the company, and the resultant figures are added together to yield a sum which is the rate of return. [11] This rate must be reasonable and just and must look toward the immediate future as well as to the moment. Thus, a utility is permitted an opportunity to earn a return on the value of property utilized for the public convenience equal to returns generally achieved at the same time and in the same general part of the country on investments in other enterprises having corresponding risks and uncertainties. Rhode Island Consumers' Council v. Smith, 111 R.I. 271, 292-93, 302 A.2d 757, 770 (1973). This court has also adopted the standard for reviewing the reasonableness of an allowed return as promulgated by the United States Supreme Court in the Permian Basin Area Rate Cases, 390 U.S. 747, 88 S.Ct. 1344, 20 L.Ed.2d 312 (1968), that a return should be sufficient to permit the utility    to maintain financial integrity, attract necessary capital, and fairly compensate [its] investors for the risks they have assumed, and yet provide appropriate protection to the relevant public interests, both existing and foreseeable. Id. at 792, 88 S.Ct. at 1373, 20 L.Ed.2d at 350. Because the returns to investors in preferred stock and debt are contractually fixed at predetermined levels, the most controversial element of the rate of return is, in most cases, the return on equity. Narragansett Elec. Co. v. Kennelly, 88 R.I. 56, 83-84, 143 A.2d 709, 725 (1958). This arises, of course, from the fact that common stock pays no fixed yield but only dividends which, if they are paid at all, are paid in an amount and at a time specified by the company's management. Nichols and Welch, Ruling Principles of Utility Regulation, Rate of Return, Supp. A at 222-23 (1964). The instant case presents no exception to this general pattern in that the only dispute with regard to the rate of return herein centers around the cost of equity. The company's witnesses at the hearing below calculated an overall rate of return of 9.68% based in part on a proposed return on equity of 15.3%. This latter figure was derived from a complicated statistical analysis which compared the company's performance with that of some 90 other companies on the basis of 49 correlated variables. We will make no attempt to evaluate the utility of the company's approach but note only that the commission discarded it as being nonpredictive and without theoretical basis. The commission opted instead for the so-called Discounted Cash Flow method employed by its own witness which yielded a return on equity of 12.0% assuming no need in the near term future for equity financing or 13.5% if such financing were to become necessary. Since the record contained testimony by company witnesses that neither the company nor NEES [12] would require equity financing in the near future, the commission chose the 12.0% figure. Citing what it regarded as fairness to the company's existing or captive investors, the return on equity was finally pegged at 12.5%, the rate which had been allowed since the previous rate case. While the report and order contains a statement to the effect that the choice of a 12.0% cost of equity was based upon evidence that no new equity financing was necessary in the near future, the true basis of the conclusion reached in this respect was somewhat obscured by the inclusion of an addendum of sorts which sets forth additional reasons for minimizing the allowed return on equity. Responding to its duty under the Hope [13] and Bluefield [14] decisions, the commission claimed to have reviewed all the relevant evidence and to have taken into consideration, all the interests it is [its] duty to guard. Specifically, the commission took notice of the fact that construction of new plant has brought the company to a point where it has an excess capacity of 20 to 40%. The commission thereupon decried the alleged need for construction financing. The commission also seized this opportunity to unburden itself of its adamant opposition to unnecessary growth of utilities. Secondly, the commission noted that the state of the economy and the resultant inability of some consumers to pay increased rates are such that any upward pressure on the rate of return should be resisted. Lastly, the commission stated that after a rather poor performance during 1974, the company has resumed a normal growth-in-earnings pattern and that this fact supports its conclusion that the existing return on equity of 12.5% is just and reasonable. The company's objections to this facet of the decision are twofold. First, the company strenuously objects to any reliance whatsoever upon the consumer's ability to pay for services rendered, echoing the bynow familiar expression that utility companies are not eleemosynary institutions. Second, the company argues that to differentiate between enterprises that will require equity financing and those that will not has the effect of luring investors in only to penalize them when they have done so ; and that any on-going enterprise has a continuing need to raise capital to support its construction program. The rate of return allowed by the commission in a given rate case is entitled to a presumption of reasonableness until the company comes forth with clear and convincing evidence that it is clearly, palpably and grossly unreasonable. Rhode Island Consumers' Council v. Smith, 111 R.I. 271, 295, 302 A.2d 757, 772 (1973). So too, the commission is permitted broad discretion in its choice of methodology and that choice will not be disturbed as long as the end result is fair and reasonable. New England Tel. & Tel. Co. v. Public Util. Comm'n, R.I., 358 A.2d 1, 19 (1976). Applying these standards of review to the instant matter, we will not, as we have not in the past, second-guess the commission's choice of the Discounted Cash Flow method of fixing a return on equity. Thus, insofar as the 12.5% return reflects the proper considerations which that method imports and insofar as that figure represents a reasonable return on equity, it will not be disturbed. While we can appreciate the relevance in determining the cost of equity of excess plant, see Ex Parte Reserve Tel. Co., 16 P.U.R.3d 197, 201 (La.P.S.C.1956), and the recent resumption of normal earnings growth, we are troubled by the commission's reliance, in this narrow sphere, upon the consumers' ability to pay for services rendered. It is indeed true that the commission's work is affected with a public interest, G.L.1956 (1969 Reenactment) § 39-1-1, and that the commission is entrusted with a broad charter to be ever mindful of the needs of the consumer as well of the investor. Permian Basin Area Rate Cases, supra, 390 U.S. at 792, 88 S.Ct. at 1373, 20 L.Ed.2d at 350; Rhode Island Consumers' Council v. Smith, 111 R.I. 271, 293, 302 A. 2d 757, 770 (1973). However, it is well settled that, with regard to fixing a rate of return, the appropriate manner in which to protect consumer interests is for the commission to assure that the utility company is permitted to earn a return no greater than is necessary to maintain the financial health of the company. That is, the consumer is treated fairly if he pays no more than the cost of the service that has been rendered to him including a reasonable profit. Re Potomac Elec. Power Co., 83 P.U.R.3d 113, 143 (D.C.P.S.C.1970). The foremost expression of the law in this respect was provided by the Washington Supreme Court in 1934, a time at which consumers were in more dire straits than today's electric power consumers. That court stated that    public service companies are not eleemosynary institutions, and they cannot be compelled to devote their property to a public use except upon the well-recognized basis of a fair and reasonable return therefor. Through general taxation only, in common with all taxpayers, can they be compelled to contribute to the relief of the distressed. State ex rel. Puget Sound Power & Light Co. v. Department of Pub. Works, 179 Wash. 461, 468, 38 P.2d 350, 353, 7 P.U.R. (n.s.) 14, 19 (1934). We agree with these principles and hold that, in this case, the commission has erred in relying upon the ability of consumers to pay for services in setting a cost of equity. However, as we stated earlier, the report and order is somewhat vague in specifying the exact extent to which each of the named factors influenced the ultimate choice of 12.5% as a cost of equity. Inasmuch as the inability of consumers to pay the cost of service is the only criterion suffering a fatal infirmity, the matter of the return on equity is remanded for a clarification of the commission's position in this respect and, if necessary, an appropriate adjustment in the cost-of-equity figure. This holding should not be read to import that local economic conditions do not have a bearing in establishing an appropriate return on equity. We have already stated that the process of fixing a return on equity is a process of comparing the company being examined with other similar enterprises having similar risks. Thus, the cost of equity is very much a measure of the desirability of the company's stock as an investment opportunity and local economic conditions, including employment, population and standard of living, have a significant impact on investor confidence. Re Diamond State Tel. Co., 21 P.U.R.3d 417, 436 (Del.P.S.C.1958). Our only statement in this case with regard to local conditions is that specific reliance by the commission on the consumers' ability to pay is error.