Opinion ID: 436086
Heading Depth: 1
Heading Rank: 5

Heading: ferc's decision lacks a reasoned basis

Text: 87 In the foregoing analysis, we found the general ratemaking principles that guided FERC in the Williams opinion to be in excess of statutory jurisdiction, authority, or limitations, 5 U.S.C. Sec. 706(2)(C), and not in accordance with law, id. Sec. 706(2)(A). Because an agency's action must be upheld, if at all, on the basis articulated by the agency itself, we would remand this case to FERC on the basis of the foregoing considerations alone. Motor Vehicle Manufacturers Association, 103 S.Ct. at 2870; see SEC v. Chenery Corp., 332 U.S. 194, 196, 67 S.Ct. 1575, 1577, 91 L.Ed. 1995 (1947). As independent grounds for our decision today, however, and in light of the apparent need for judicial guidance in this case, 52 we further hold that the Williams opinion was not the product of reasoned thought and based upon a consideration of relevant factors. Specialty Equipment Market Association v. Ruckelshaus, 720 F.2d 124, 132 (D.C.Cir.1983). Accordingly, we now turn to examine the particulars of FERC's oil pipeline ratemaking formula.
88 In Williams, FERC decided to adhere to the rate base formula it inherited from the ICC. See 21 FERC at 61,632. It gave no rational justification for doing so, however. FERC acknowledged that rigorous logic and Euclidean consistency are not the system's most striking features, and that the formula is much too blunt and much too clumsy for close work. It nevertheless concluded that the ICC method is usable because oil pipeline ratemaking is not close work. Id. at 61,616. This is not a sufficient justification. 53 89 It is well established that an agency has a duty to consider responsible alternatives to its chosen policy 54 and to give a reasoned explanation for its rejection of such alternatives. See, e.g., Motor Vehicle Manufacturers Association, 103 S.Ct. at 2869-71; International Ladies' Garment Workers' Union, 722 F.2d at 815. This responsibility becomes especially important when the agency admits its own choice is substantially flawed. We find that FERC failed to satisfy this duty with respect to certain proposed modifications in the rate base formula.
90 Many parties to the Williams proceeding--including the FERC staff, the Department of Energy, the Justice Department, Farmers Union Central Exchange--advocated the calculation of oil pipeline rate bases by reference to original cost. 55 These witnesses called for the rejection of the old ICC methodology, because its use of a weighted average of original cost and replacement cost, see supra at 1495, lacks any economic rationale. 56 91 Despite explicit concessions as to the shortcomings of the ICC rate base formula and the recognized advantages of a rate base formula derived from original cost, 57 FERC rejected the original cost alternative. FERC offered four reasons for this decision. First, FERC wished to avoid the headache of analyzing the significance of guarantees--given by many parent oil companies to their subsidiary oil pipeline companies--in the estimation of the true capital structure of oil pipelines. 58 See 21 FERC at 61,620-22. Second, FERC believed that the major regulatory benefit that might be derived from a switch to original cost accounting--the facilitation of comparable earnings analysis in relation to other businesses with a comparable risk to the pipelines--would not be useful in oil pipeline rate regulation, because the oil managers, as professional risk takers, have ingrained attitudes toward risk and return unlike any other public utility investors. Third, an original cost rate base, without modification for inflation, would result in high initial rates that would decline as the rate base depreciates. FERC believed that competition in the oil pipeline business might prevent the pipelines from collecting the high initial rates, thereby preventing them from reaping their appropriate return on investment. See id. at 61,628-29. Finally, FERC found that any benefits resulting from changes in the rate base formula would not warrant the social costs entailed, id. at 61,631, specifically, the construction of transitional rate bases ... for each of the many common carrier oil pipelines, id. at 61,704 n. 376. We find that none of FERC's explanations for its rejection of an original cost rate base satisfies accepted standards of reasoned decisionmaking. 59 a. Parent Guarantees and Capital Structure 92 Because of parent companies' debt guarantees and throughput and deficiencies agreements, many shipper-owned pipelines are able to obtain debt financing more cheaply and in greater amounts than would be possible in the absence of such agreements. See supra note 58. Further, since cost of equity virtually always exceeds cost of debt, the greater the pipelines' debt ratio, the lower its overall cost of capital. See United States v. FCC, 707 F.2d 610, 613 (D.C.Cir.1983). Accordingly, as FERC recognized in its establishment of a suretyship premium, see supra at 1496, the real cost of capital to a pipeline that benefits from such parent guarantees is greater than its apparent cost of capital. 93 Regulatory agencies have often assessed a regulated company's true cost of capital by constructing hypothetical capital structures, and then applying the normal costs of equity and debt to the hypothetical mix of securities. See Communications Satellite Corp. v. FCC, 611 F.2d 883, 902-09 (D.C.Cir.1977) (citing numerous cases involving water, gas, electric and telephone utilities). By this method, regulatory agencies ensure that the derived rate is just and reasonable: 94 Although the determination of whether bonds or stocks should be issued is for management, the matter of debt ratio is not exclusively within its province. Debt ratio substantially affects the manner and cost of obtaining new capital. It is therefore an important factor in the rate of return and must necessarily come within the authority of the body charged by law with the duty of fixing a just and reasonable rate of return. 95 Id. at 903 (quoting New England Telephone & Telegraph Co. v. State, 98 N.H. 211, 220, 97 A.2d 213, 220 (1953)). In the case of oil pipelines, the hypothetical capital structure would be approximated by estimating the capacity of the pipeline to support debt in the absence of its parents' guarantees. See 21 FERC at 61,621. 96 FERC refused to adopt an original cost rate base in part because it believed that the attendant necessity for constructing hypothetical capital structures would be a laborious exercise in guesswork, a venture 'into the unknown and unknowable.'  Id. at 61,622 (quoting Christiana Securities Co., 45 SEC 649, 668 (1974)). In FERC's view, such an inquiry would be: 97 a perfect field day for regulatory economists. Professor A would testify that he thinks 70% debt and 30% equity right. Professor B would say 53% debt and 47% equity. Professor C would come on strong for 50-50. Miss D from an eminent Wall Street investment banking firm would testify that her computer tells her that 65% equity and 35% debt are the right mix. Mr. E from an even more eminent investment banking firm would have numbers of his own. 98 Id. at 61,622. In part to avoid such an inquiry, FERC chose to avoid an original cost rate base. 99 This explanation runs counter not only to the proven practice of FERC and many regulatory agencies 60 but also to FERC's own commentary later in the Williams opinion. As we have explained above, the technique of hypothesizing capital structures for oil pipelines would account for the increased capital costs associated with financing a pipeline in the absence of guarantees from the parents. Later in the Williams opinion, FERC devises its suretyship premium to compensate for the parents' guarantees of pipeline debt. FERC, however, appeared confident that any difficulties with estimating the value of this premium could be surmounted: 100 Credible expert testimony by persons associated with the rating services, the investment banking fraternity, and the credit insurance industry as well as by academics who have made a specialty of the bond market [can] establish[ ] that absent the parents' guarantee [what] the pipeline would have had to pay .... 101 Id. at 61,644. 102 We cannot square FERC's apparent confidence in its ability to estimate a pipeline's suretyship premium with its extreme skepticism about its ability to construct hypothetical capital structures. After all, the suretyship premium represents merely the differential between a pipeline's actual cost of capital and what its cost of capital would have been absent the parent guarantees. Thus the suretyship premium measures the same incremental cost of capital to the pipeline as the hypothetical capital structures that FERC felt incapable of estimating. The basis for FERC's preference for its suretyship premium approach, and for its aversion to hypothetical capital structures is therefore unclear. The decision to reject original cost accounting on the basis of this preference and aversion appears arbitrary, and, in any event, lacks sufficient explanation. 103 Moreover, even assuming that FERC's preference for its suretyship premium approach could be explained, its rejection of original cost ratemaking because of that preference relies on the assumption that original cost ratemaking is necessarily tied to hypothetical capital structures and necessarily incompatible with its newly devised suretyship premium. However, FERC never gave any reason at all why this assumption is valid. Indeed, we see no reason why FERC could not account for the parent guarantees by using a suretyship premium added to an original cost ratemaking formula. 104 If FERC, in the exercise of informed discretion, decides that the suretyship premium approach is more reliable or easier to administer than hypothetical capital structures, then it should state why. 61 As of now, neither FERC nor any of the parties has provided such an explanation. Even if they did so, however, we still would not understand why the hypothetical capital structure method must be used with original cost ratemaking, or why the suretyship premium approach cannot be used with original cost ratemaking.b. Comparable Risk Analyses 105 FERC discerned still more fundamental problems associated with the use of original cost ratemaking, beyond the estimation of appropriate capital structures. As typically applied under the just and reasonable standard, original cost ratemaking attempts to set the rate of return for a regulated enterprise at the same level as the rate of return of an unregulated enterprise with similar associated risks. See, e.g., FPC v. Hope Natural Gas Co., 320 U.S. 591, 603, 64 S.Ct. 281, 288, 88 L.Ed. 333 (1944) (By that standard [of 'just and reasonable' rates] the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks.); Bluefield Water Works & Improvement Co. v. Public Service Commission, 262 U.S. 679, 692, 43 S.Ct. 675, 679, 67 L.Ed. 1176 (1923) (A public utility is entitled to such rates as will permit it to earn a return ... equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by the same risks and uncertainties.); A. Priest, Principles of Public Utility Regulation 191-94 (1969). FERC, however, believed that such a risk inquiry was not useful or relevant to oil pipeline ratemaking. In FERC's view, oil company managers--who own many oil pipelines--are a special breed of risk takers, who demand a fair chance of earning as much on a pipeline as they would be likely to earn on something else in the unregulated sector regardless of risk. 21 FERC at 61,623. 62 Accordingly, FERC rejected original cost ratemaking in part because the conventional ratemaking inquiry that its use facilitates--the inquiry into risk--was, according to FERC, not helpful in oil pipeline ratemaking. 106 We think that this argument not only lacks any evidentiary support, it also lacks economic common sense. In neither the Williams opinion nor in its briefs to this court does FERC cite any evidentiary basis for its conclusion that oil managers will invest in only high return enterprises. In fact, the record is chock full of testimony regarding the risks of the oil pipeline business and the corresponding appropriate rate of return. 63 Furthermore, major studies of the oil pipeline industry have concluded that the oil company managers decide whether to invest in a particular pipeline only after an examination of whether the expected returns match the associated risks: 107 When appraising the economic viability of a proposed pipeline venture, the approach taken is similar to that used by investors in general; it is what may be termed as required rate of return analysis. An oil company has widespread operations with numerous investment opportunities bearing different degrees of risk. Because of this, each investment, including pipelines, must be examined individually, and its expected rate of return compared with the opportunity rate of return of other prospective investments with comparable risk characteristics. 108 G. Wolbert, Jr., U.S. Oil Pipelines, 156 (1979) (footnotes omitted); see Exxon Pipeline Co./Exxon Co., U.S.A., Rates of Return on Petroleum Pipeline Investments, reprinted in Oil Pipelines and Public Policy 261, 268-69 (E. Mitchell ed. 1979) ( 'The required rate of return on an investment opportunity depends on the riskiness of the investment. The greater the riskiness of the investment, the more the return demanded by investors.' ) (quoting E. Solomon & J. Pringle, Introduction to Financial Management 332 (1977)). 109 ICC oil pipeline ratemaking precedents also belie FERC's novel notions about the relationship between risk and required return in the industry. FERC's notion that the oil companies demand high returns, no matter how low the risk, represents a radical departure from the ICC practice of evaluating risk and estimating the required return accordingly. See, e.g., Reduced Pipe Line Rates and Gathering Charges, 272 I.C.C. 375, 381 (1948); Minnelusa Oil Corp. v. Continental Pipe Line Co., 258 I.C.C. 41, 51 (1944); Reduced Pipe Line Rates and Gathering Charges, 243 I.C.C. 115, 131 (1940). Similarly, in 1978 this court called on FERC to reexamine the complex of relevant factors in determining the proper rates of return for oil pipelines, including the hazards prevailing in the pipeline business. See Farmers Union I, 584 F.2d at 419. 110 We thus find no basis to support, and overwhelming evidence to contradict, FERC's finding that comparable risk analysis has no important role in oil pipeline rate regulation. We therefore believe that FERC's rejection of original cost ratemaking on the basis of that finding is arbitrary and capricious. 111 c. The Front-End Load Problem 112 FERC next offered another, independent reason for rejecting original cost ratemaking: the front-end load problem. 64 See supra at 1512. However, FERC itself acknowledged that this problem could be solved by using a trended, inflation-sensitive original cost rate base: 113 [W]e find the case for an inflation-sensitive oil pipeline rate base strong. 114 Such a rate base mitigates original cost regulation's income-bunching effect. It does not necessarily follow that the [old ICC rate base formula] is the ideal solution to the front-end load, income-bunching problem. Were we writing on an absolutely clean slate, were we beginning afresh in a brave new world, were pipelines a novelty that had just made their appearance, we would fashion an inflation-sensitive, anti-bunching rate base policy simpler and more logical than the ICC's. 115 21 FERC at 61,630. According to FERC, this simpler and more logical method would [k]eep[ ] the rate base in tune with the general price level by linking it to the consumer price index or to the gross national product. Id. The trended original cost method of calculating rate bases, as discussed by witnesses in the Williams proceeding and other experts, fits this description. See, e.g., J.A. at 1508-12 (testimony of Stewart C. Myers on behalf of Marathon Pipe Line Co.); J.A. at 1957 (testimony of David A. Roach on behalf of MAPCO); Streiter, Trending the Rate Base, Pub. Util. Fort., May 12, 1982, at 32; cf. J.A. at 1677-1702 (testimony of Michael C. Jensen on behalf of ARCO Pipe Line Co.) (describing inflation-adjusted original cost method, the results of which are equivalent to adjusting the rate base and depreciation by the unprojected inflation). Indeed, at one point, FERC declared that if it were beginning afresh on a clean slate [it] might be inclined to use something ... along the lines suggested by Marathon's witness Meyers [sic]. 21 FERC at 61,616. Marathon's witness Myers recommended the use of a trended original cost rate base if the old ICC method were to be abandoned. See J.A. at 1427, 1499. Thus FERC acknowledged that the front-end load problem could be solved, by adjusting an original cost rate base for inflation. Accordingly, FERC could not have reasonably relied upon the front-end load problem as a basis for rejecting the admittedly simpler and more logical trended original cost alternative. 116 d. The Social Costs and Benefits of Transition to a New Rate Base Formula 117 Although a trended original cost approach would evidently be simpler and more logical than the ICC's, 21 FERC at 61,630, FERC in the end rejected this alternative because of the social costs entailed in a transition from one rate base formula to another. See supra at 1512. FERC specified these social costs in an accompanying footnote: 118 Transitional rate bases would have to be constructed for each of the many common carrier oil pipelines. That would be a formidable, a difficult, and a costly endeavor. The task could be by-passed by using the most recent valuation (or in the alternative the cost of reproduction new less depreciation element of that valuation) as the transitional rate base. But then how much substantive change would there really be for existing pipelines? We conclude the change would be far more costly than it is worth. 119 Id. at 61,704 n. 376. We are reluctant to sanction the rejection of an admittedly more logical and accurate rate base formula on the basis of the conclusionary statement that the construction of transitional rate bases would be too costly. First, FERC failed to give a reasoned basis for its assumption that [t]ransitional rate bases would have to be constructed at all. Regulated industries have no vested interest in any particular method of rate base calculation. See FPC v. Natural Gas Pipeline Co., 315 U.S. 575, 586, 62 S.Ct. 736, 743, 86 L.Ed. 1037 (1942). Accordingly, as FERC acknowledged, a switch to a new rate base formula would not disrupt protected pipeline property. So long as the resulting rates are reasonable, the oil pipeline companies should have no difficulty maintaining their financial integrity. We are therefore at a loss to understand FERC's trepidation about a change in its regulatory method. Similarly, when this court granted FERC's request to remand this case so that it may begin its regulatory duties in this area with a clean slate, Farmers Union I, 584 F.2d at 421, we specifically advised that the pipelines' reliance on an outdated rate base formula should not justify a continuation of the error. Rather, the solution is not to perpet[u]ate that reliance but to end it prospectively, without allowing reparations based on its occurrence in the past. Id. at 419. We still adhere to that principle today. 65 120 Second, FERC never explained why the construction of transitional rate bases would be so formidable a task. It is not self-evident why the calculation of such rate bases would entail more regulatory costs than the calculation of rate bases under the arcane ICC formula. 66 Furthermore, the formulation of a method for calculating transitional rate bases involves questions no more complex than those confronting FERC regularly. 121 Finally, regardless of the regulatory or social costs entailed, FERC appeared to reject alternatives to the ICC formula because it found no clear showing that changing the methodology would produce substantial social benefits. Id. at 61,626; see also id. at 61,703 n. 373. This finding, however, apparently relies upon FERC's antecedent findings that oil pipeline ratemaking should merely set price ceilings that would seldom be reached in actual practice, and that comparable risk analysis would not be helpful to the ratemaking inquiry for oil pipelines. However, we have found those antecedent findings to be defective. See supra at 1502-03, 1515-16. As a result, we likewise disapprove of FERC's finding that a new rate base formula could not produce any substantial social benefit. 122 After carefully reviewing the bases put forward by FERC for rejecting the original cost alternative, we hold that FERC failed to examine the relevant data and articulate a satisfactory explanation for its action. Motor Vehicle Manufacturers Association, 103 S.Ct. at 2866. In our view it did not offer a reasoned explanation for adhering to an admittedly antiquated and inaccurate formula, but rather a host of unconvincing excuses that fail to add up to a rational choice. 123
124 The Association of Oil Pipelines (AOPL) endorsed the ICC valuation approach to rate base calculations. See J.A. at 3870 (AOPL Opening Brief to FERC). AOPL, however, did not endorse the ICC approach in all its details. Instead, it asked FERC to make the following alterations to the ICC formula:(1) calculate reproduction costs for current expenses by reference to the current year's price index, or to an average of the indices for the most recent past year, the current year, and the next future year. Under the ICC method, costs are estimated by reference to a five-year period index consisting of the current year, one future year and three past years. APOL contended that this method understates actual current costs in times of inflation. 125 (2) increase the allowance for interest during construction employed in calculating the reproduction cost of pipeline assets. AOPL believed the six percent allowance was far too low to cover the prevailing rates to be paid during construction. 126 (3) calculate the present value of land and rights-of-way to account for their real appreciation in value over time. The ICC method calculates the present value of land at fifty percent of original cost and rights-of-way at original cost less depreciation. The AOPL claimed that such methods seriously undervalue the real present value of land and rights-of-way. 127 (4) adjust the construction damage allowance to reflect inflation up to the current year. AOPL argued that the ICC method, which adjusted the figures for inflation only from 1947 to 1953, understates actual costs. 128 (5) adjust the amounts assigned for pipe coating to reflect present prices. AOPL criticized the ICC method, which adjusted such costs for inflation only from 1947 to 1963. 129 (6) once the foregoing alterations are made, eliminate the six percent going concern value escalator to total valuation. 130 See J.A. at 3915-17 (AOPL Opening Brief). AOPL argued that these modifications would improve the accuracy of the valuation rate base. Id. at 3917. 131 FERC rejected AOPL's proposals, finding that (1) only relatively insubstantial amounts were at stake, (2) the six percent going concern value roughly compensates for methodological errors elsewhere, and (3) the old ICC method should not be altered without first engaging in a notice and comment rulemaking on the proper method of calculating depreciation. See supra at 1496. AOPL argues to this court that FERC's rejection of its proposals was arbitrary and capricious agency action because it was not supported by reasoned findings based on the evidence of record. AOPL Brief at 35-39. We agree. 132 We note at the outset that FERC failed, both in the Williams opinion and in its briefs to this court, to provide any factual basis in the record for its conclusion that the sums involved are relatively insubstantial. 21 FERC at 61,631. On the other hand, AOPL cites unrebutted testimony in the record that the use of the ICC's period indices results in consistently and substantially understated current valuations. J.A. at 1180 (testimony of John A. Jeter of Arthur Anderson & Co.). This same witness provided further unrebutted testimony that the ICC's allowance for interest during construction should be much higher in order to reflect current interest levels. See id. at 1183-85. Furthermore, in its brief, FERC states that the ICC rate base formula significantly undercounts for interest during construction, several other construction-related elements, and the value of land. 67 Indeed, in the Williams opinion FERC conceded that the AOPL proposals may well be warranted prospectively. 21 FERC at 61,631. 133 FERC, however, felt that the need for change was far from pressing because it believed that the six percent going concern value in a rough way compensated for the other flaws in the ICC methodology. Thus FERC rejected all of AOPL's objections on the grounds that the over -counting due to the going concern value--which would by itself be pure water, id.--was in effect cancelled out by the under counting created by the methodological features that gave rise to the rest of AOPL's objections. 134 In basic terms, FERC reasoned that a series of inaccuracies is permissible because another inaccuracy systematically compensates for the prior errors. Such an approach, of course, assumes that the two errors are in fact predictably related to one another so that the anticipated self-correction will actually take place. In this case, however, FERC failed to make any finding to assure that the errors will offset each other. Especially when, as here, the proposed methodological adjustments appear easy to make, and the methodological defects are discrete, clear and acknowledged, FERC indulged an unreasonable presumption that its two wrongs would in practice render a right result. In the absence of any explanation of what warrants such an assumption, we find FERC's rejection of the AOPL proposals to be arbitrary and capricious. 135 Neither did FERC explain why its decision on the AOPL proposals should be delayed until it could conduct a notice and comment rulemaking on depreciation methods. FERC merely declared that it would be wrong to alter the status quo without looking at the whole picture. Id. at 61,632. It is not at all apparent, however, why a decision on the AOPL proposals should be considered so intimately related to depreciation policy. FERC offered no rationale for its assumption that the changes proposed by AOPL should not be made separately from the decisions on depreciation policy. In fact, all of AOPL's proposals would apparently improve the accuracy of the rate base formula, regardless of the particular depreciation method employed. Thus, the adoption of the AOPL proposals would not seem to have any significant bearing on the future consideration of depreciation policy alternatives. FERC also made other similar adjustments to the rate base formula without examining the whole picture. See FERC Brief at 71 n. 81. Moreover, FERC expressly declined to commit itself to ever conducting a rulemaking on depreciation issues: 136 To be fruitful, such a rulemaking should be preceded by intensive staff studies. The whole endeavor would be costly and time-consuming. Would it be worth the cost? 137 This question calls for further reflection. This is neither the time nor the place for that. We can ponder the point on another day. 138 21 FERC at 61,632. While we recognize that an administrative agency may exercise its informed discretion in deciding whether to proceed on a given issue by way of rulemaking or adjudication, see, e.g., NLRB v. Bell Aerospace Co., 416 U.S. 267, 294, 94 S.Ct. 1757, 1771, 40 L.Ed.2d 134 (1974); SEC v. Chenery Corp., 332 U.S. 194, 203, 67 S.Ct. 1575, 1580, 91 L.Ed. 1995 (1947), we believe that in this case FERC failed entirely to make any such choice. Instead, FERC decided to delay implementation of the AOPL proposals, which it said were well taken and were deserving of a hard look, id. at 61,631, until it could conduct a seemingly unrelated depreciation rulemaking, which it then said might never take place. Such self-contradictory, wandering logic does not constitute an adequate explanation for its rejection of admittedly valuable proposals. 139 In sum, we hold that FERC failed to explain adequately its rejection of both the original cost alternative and AOPL's proposed alterations. We emphasize that this holding does not go to the wisdom or efficacy of the ICC rate base formula, although the Williams opinion does not provide a cogent defense of it. 68 Rather, our decision here turns on the inadequacies manifest in the decisionmaking process followed by FERC. 140 Even in the absence of such infirmities in FERC's method of choice among rate base methods, our review would still include scrutiny of the rate of return methodology, to see whether the selected rate of return, applied in combination with the selected rate base, leads to a reasonable result. As FERC observed, the agency must assure that the combination of rate base and rate of return provides a[n] ... acceptable end result. 21 FERC at 61,616. We now proceed to examine whether FERC engaged in reasoned decisionmaking when it chose its rates of return for use in oil pipelines ratemaking.
141 FERC divided its rate of return into three components: (1) debt service, (2) the suretyship premium, and (3) the  'real ' entrepreneurial rate of return on the equity component of the valuation rate base. 21 FERC at 61,644. The debt service element, which represents the cost of interest and repayment of indebtedness, gives rise to no objections from the parties, and need not detain us. 142 The suretyship premium similarly demands little comment apart from our previous observations that it requires much of the same kind of theorizing involved with the use of hypothetical capital structures. See supra at 1513-14. Farmers Union believes that FERC erred when it assumed that such a premium is an 'add on' to the cost of capital without comparing pipeline and parent company risk. Farmers Union Brief at 59 n. 1. Our reading of the Williams opinion, and FERC's representations to this court, however, convince us that FERC made no such assumption, and, accordingly, pipelines must show that the guarantees reduce perceived investor risk in order to establish their entitlement to and extent of a suretyship premium. See 21 FERC at 61,621, 61,644, 61,711 nn. 492, 493; FERC Brief at 72-73. 143 Only the real entrepreneurial rate of return on the equity component of the valuation rate base remains. FERC began its discussion of this component from the premise that [i]t seems obvious to us that allowed real rates of return on oil pipeline equity investments should be appreciably higher than those the Commission awards to natural gas pipelines and to wholesalers of electric energy. 21 FERC at 61,645. Considering that oil companies [and the owners of the independent pipelines] have lots of places to put their money, ... and that the social need in this field is for returns high enough to induce the construction of new pipelines and to avert the premature abandonment of old ones, FERC enumerated the following eight measures of the rate of return on equity: 144 (i) Realized nominal rates of return on the book value of shareholders' equity in the oil industry generally over the past 5 years; 145 (ii) Realized nominal rates of return on the book value of shareholders' equity in the oil industry generally over the past year; 146 (iii) Realized nominal rates of return on shareholders' book equity in American industry generally over the past 5 years; 147 (iv) Realized nominal rates of return on shareholders' book equity in American industry generally during the most recent year; 148 (v) The particular parent or parents' realized nominal rate of return on total non-pipeline book equity over the past 5 years; 149 (vi) The particular parent or parents' realized nominal rate of return on total non-pipeline book equity in most recent fiscal year; 150 (vii) Total returns (dividends plus capital gains) on a diversified common stock portfolio over the past 5 years ...; and 151 (viii) Total returns (dividends plus capital gains) on a diversified common stock portfolio over the long run--25 years, 50 years, or more.... 152 See 21 FERC at 61,645. FERC further held that it would normally be proper to choose the measure most favorable to the particular carrier or carriers involved. Id. 153 Although most of these rates of return are expressed in terms of return on the book equity of unregulated companies, i.e., on the basis of original cost, 69 FERC's methodology would nevertheless apply them, after an adjustment for inflation, to the equity component of the ICC valuation rate base. Moreover, under FERC's methodology, the equity component is equal to the total valuation rate base, less the face value of the outstanding debt. See supra at ----. By this approach, the entire amount of appreciation in the rate base is allocated to the equity component, while none of it is allocated to the debt component. 154 We frankly cannot locate the rhyme nor reason of this rate of return methodology; nor is it based upon a consideration of all relevant factors in oil pipeline ratemaking. To begin with, FERC offered no rational explanation that linked its regulatory purposes with its chosen rate of return indices. FERC made no attempt to estimate the risks involved with oil pipeline operations, and therefore could not reasonably estimate the rate of return required to maintain a viable oil pipeline industry. Moreover, in summary form, with a more elaborate discussion below, the inflation adjustment to the selected rates of return does not reliably compensate for the appreciation to the valuation rate base, and, therefore, overcompensation for inflation is not reliably prevented. FERC's willingness to permit the oil pipeline companies to choose among a wide variety of rate of return indices only makes these defects worse. FERC's method of calculating the equity component of the rate base further enlarges the allowable returns without good reason. As a result, the total returns allowable under FERC's methodology have no discernible regulatory significance beyond the fact that they are bound to be very large. FERC does not even offer an explanation of why its ratemaking formula sets a cap of gross abuse, let alone a just and reasonable rate.
155 As previously discussed, FERC made no effort to study and estimate the risks associated with oil pipeline operations. Accordingly, FERC offered no reason to believe that the risks associated with the unregulated enterprises from which it derived its rates of return were equivalent to the risks of running an oil pipeline. 70 Because the level of risk associated with an enterprise determines the returns it requires to attract capital, see supra at 1515-16, FERC never established a reasonable connection between its stated purpose to preserve the financial integrity and economic viability of oil pipelines and its selected rate of return indices. 156 FERC attempted to establish such a connection by arguing: 157 If the returns do not exceed those being realized somewhere or other in a roughly comparable segment of the economy's unregulated sector, it is hard to see how they can be branded extortionate or abusive. 158 Our relative permissiveness makes the risk problem more manageable. Can even the riskiest of pipelines argue that it is so hazardous that it is entitled to more than anyone makes any place else? 159 21 FERC at 61,645-46 (emphasis in original). The first sentence of this passage lacks any semblance of valid reasoning from the record. FERC never even attempted to establish that the relevant segments of the economy's unregulated sector were in fact roughly comparable to the oil pipelines. If the enterprises were roughly comparable, the reference to them might be justified. FERC, however, assumed, without explanation, the existence of that factual predicate in order to justify its selected rate of return indices. Unfortunately, this assumption is not supported by any sound explanation based on the record, and therefore this attempted justification rests on nothing more than a blind, conclusionary assertion of rough comparability. 160 The second paragraph in this passage makes use of a non sequitur. In preceding paragraphs, FERC had permitted the oil pipelines to choose a rate of return for themselves from a buffet bedecked with those found in a wide variety of lucrative unregulated enterprises. It is therefore pure illogic to assume that the risk problem is the spectre that the oil pipelines might claim entitlement to even greater rewards. As we have discussed above, the real risk problem with FERC's methodology--the problem FERC entirely failed to address--lies in whether FERC's selected indices grossly overestimate the risks and needed returns prevailing in the oil pipeline business. 161
162 The problem of double counting for the effects of inflation, once in the rate base and again in the rate of return, has plagued oil pipeline ratemaking for some time. See, e.g., Farmers Union I, 584 F.2d at 419, 420-21; Williams Brothers Pipe Line Co., 355 I.C.C. at 487. The ICC rate base formula purports to account for inflation in valuing a pipeline's assets. See 21 FERC at 61,646; see also Farmers Union I, 584 F.2d at 421. If the chosen rate of return also reflected the effects of inflation, then the resulting return might compensate for inflation twice, and so would be excessive. 163 FERC attempted to eliminate the double counting problem by subtracting an inflation allowance from the nominal rate of return before applying it to the inflation-sensitive ICC valuation rate base. See 21 FERC at 61,646-47. Because the nominal rates of return are derived from original cost accounting, see supra at 74, they include a premium to compensate investors for the expected future rate of inflation. However, because the ICC valuation rate base is, according to FERC, already inflation-sensitive, FERC's method should deduct from the nominal rate of return the percentage by which the valuation rate base has been written up during the relevant period. Id. at 61,647. FERC defined the relevant period to be the time period that was looked to in order to derive the appropriate nominal rate of return. Id. at 61,712 n. 511. For example, if the nominal rate of return were set by reference to returns on shareholder book equity over the most recent year, that nominal rate would be reduced by the percentage amount that the valuation rate base had increased over the most recent year. In this way FERC believed it could avoid overcompensation for inflation. Id. at 61,646. 164 Farmers Union, among others, objects to this inflation adjustment on the ground that it does not compensate for actual inflation. It put forward strong evidence, including calculations made by Commissioner Hughes in his separate statement, to show that the valuation rate base does not track inflation in any predictable manner. 71 See 21 FERC at 61,725 (Hughes, Comm'r, dissenting in part and concurring in part) (A ... serious defect [in FERC's decision], and I believe, an uncorrectable one, is the unstated assumption that the trending of the rate base in the valuation formula approximates or should approximate the course of inflation.); 72 see also Farmers Union I, 584 F.2d at 519 & n. 29; J.A. at 2455 (testimony of Thomas C. Spavins) (highlighting the lack of a clear correspondence between [the ICC] valuation returns and any clear system of indexing returns for inflation). 165 FERC in a footnote anticipated such a criticism, and responded: Suppose that [the ICC formula] does lead to an overly generous allowance for inflation in the rate base. What of it? The rate of return on equity is reduced by the precise amount of the overstatement. 21 FERC at 61,712 n. 513. This defense is sound, as far as it goes. Speaking precisely, FERC's inflation adjustment does not operate as an adjustment to compensate for the effects of inflation; rather, it operates as an adjustment to compensate for the effects of rate base appreciation, which, if left in the calculus, would lead to double counting. The important feature of such a scheme is not that the rate of inflation and the rate of rate base write up are the same; instead, it is important only to assure that the increase in the rate base--which is affected and indeed justified by the fact that present values reflect inflationary effects--is not counted in calculating rates because expected inflation is already reflected in the level of rates of return. In simple terms, then, the inflation adjustment operates to write off the write-up in the valuation rate base through a deduction from the nominal rate of return. See 21 FERC at 61,646-47. 166 Unfortunately, however, and without explanation, FERC decided that the needed adjustment should be determined by reference to rate base appreciation during the time period that was looked to in order to derive the appropriate nominal rate of return. See supra at 1524. This time period could range from the most recent year only, to the long run--25 years, 50 years, or more. 21 FERC at 61,645; see supra at 1522. The allowable returns to the pipeline, by contrast, reflect the entire appreciation in the rate base over the life of the pipeline's assets. The inflation adjustment, therefore, will not necessarily reflect the full rate of write up reflected in the rate base. Furthermore, it is likely that the inflation adjustment will leave in the final rates significant double counting, because under FERC's method the oil pipelines are empowered to select for themselves the applicable rate of return index, and, as a corollary, they also select the time period relevant to calculating the inflation adjustment. Accordingly, the FERC methodology allows the oil pipeline companies to select a time period during which the rate base appreciated at a slower rate than average. In this way, the FERC method permits the regulated companies to select the rate of return index that will result in an adjustment that understates the actual overall rate base appreciation. In Commissioner Hughes' words, the FERC method invites an enormous amount of gamesmanship. Eight rate of return options are suggested, some with multiple choices of time periods. The inflation/valuation variance gives an exciting new twist to a pipeline's choice among the candidates. Thus a firm might choose to base its return one year on stock market performance after a bull market, and in its next filing switch to a high oil company comparison which might be offset by a small increase in its own valuation. 21 FERC at 61,726 (Hughes, Comm'r, dissenting in part and concurring in part). 167 3. FERC's Equity Component Has No Meaningful Relation to the Rates of Return on Book Equity 168 Even more capricious was FERC's application of the rates of return, representing revenues on the book equity of unregulated companies, to what FERC called the equity component of the valuation rate base. As noted above, FERC's notion of the equity component includes the original paid-in equity of the pipeline plus the entire write up in the rate base. See supra at 1522. For example, consider an oil pipeline, originally financed with $900,000 debt and $100,000 equity. The original cost of the pipeline is one million dollars. Over time, the pipeline's valuation rate base increases to, say, $1,500,000. Under FERC's method, the equity component of the rate base amounts to $600,000, six times its book equity, even though the valuation rate base as a whole has appreciated only by half. Thus, FERC's method magnifies the equity component of the rate base to spectacular proportions, especially in an industry as highly debt-leveraged as the oil pipelines. 73 See supra note 58. At the same time, however, FERC's selected rates of return reflect the revenues of the unregulated companies as a percentage of their book equity. To set allowable revenues for the oil companies, FERC took these rates of return and applied them to a completely different measure of net worth, the equity component of the rate base. Book equity, unlike FERC's newly devised equity component, represents the underlying net assets in original cost terms. Because book value of an equity share has no significance as to the present value of the company's assets, the returns on book equity likewise have no significance in relation to the equity component of the valuation rate base. See, e.g., J. Gentry, Jr. & G. Johnson, Finney & Miller's Principles of Accounting 367-68 (8th ed. 1980). 169 Assuming arguendo that the inflation adjustment accurately compensates for the rate of rate base appreciation, which it does not, see supra at 1524-25, such an adjustment would compensate only for the appreciation attributable to the portion of the rate base financed by the paid-in capital of equityholders. It would never compensate for the fact that FERC includes the entire appreciation on the rate base--attributable to both the equity and debt components of the pipeline--in its equity component. Accordingly, FERC's method ensures that the allowable revenues for oil pipelines will exceed the revenues earned by its selected unregulated companies by the extent to which the pipelines' equity component exceeds the portion of the rate base financed through equity investments. Cf. 21 FERC at 61,712 n. 519 (under the more austere standard of fairness, FERC would trend only the equity portion of the rate base for inflation). In most cases, this difference will be very large. 74 170 Indeed, FERC provides no analysis of why its application of its selected rates of return to an unrelated measure of rate base equity should keep a cap on gross abuse in the resulting rates, not to mention the lack of any assurance that the resulting rates will be just and reasonable. Commissioner Hughes appears to have rightly characterized FERC's game as Dialing for Dollars instead of The Price is Right. See 21 FERC at 61,730 n. 4 (Hughes, Comm'r, dissenting in part and concurring in part). We cannot condone such a ratemaking methodology, which assures nothing except that permissible rate levels will be very high. 171 In an attempt to defend the mismatch between its selected rates of return (on book equity) and its equity component of the valuation rate base, FERC claimed that its method of calculating the equity component gives the equityholders the full benefit of debt leveraging. Just as a seller of a house benefits from the entire appreciation of the value of the house regardless of the amount of debt that financed the original purchase, FERC believed that so, too, should the equityholders in oil pipelines receive an equity kicker in their rate base. See 21 FERC at 61,648-50. This analysis overlooks the fact that oil pipeline companies are in fact free to sell their assets, and thereby enjoy the full benefit of debt leveraging in the difference between the sale price and the original cost of the assets. Such an equity kicker, however, has no significant relationship with the determination of the cost of capital. A rate of return should set the proper rewards for investors in the form of current income, not asset appreciation and sale. FERC's attempted defense of its use of its equity component thus fails to meet minimal standards of reason. 75 172 While the determination of a fair rate of return cannot and should not be constrained to the mechanical application of a single formula or combination of formulas, the ratemaking agency has a duty to ensure that the method of selecting appropriate rates of return are reasonably related to the method of calculating the rate base. See, e.g., FPC v. Hope Natural Gas Co., 320 U.S. 591, 605, 64 S.Ct. 281, 289, 88 L.Ed. 333 (1944); Dayton Power & Light Co. v. Public Utilities Commission, 292 U.S. 290, 311, 54 S.Ct. 647, 657, 78 L.Ed. 1267 (1934); NEPCO Municipal Rate Committee v. FERC, 668 F.2d 1327, 1342 (D.C.Cir.1981), cert. denied, 457 U.S. 1117, 102 S.Ct. 2928, 73 L.Ed.2d 1329 (1982). Our disapproval of FERC's decision to retain the ICC rate base formula, see supra at 1520-21, did not turn on the substantive validity of the rate base calculations. FERC may adopt any method of valuation for rate base purposes so long as the end result of the ratemaking process is reasonable. See, e.g., FPC v. Natural Gas Pipeline Co., 315 U.S. 575, 586, 62 S.Ct. 736, 743, 86 L.Ed. 1037 (1942); NEPCO Municipal Rate Committee v. FERC, 668 F.2d at 1333; Washington Gas Light Co. v. Baker, 188 F.2d 11, 18 (D.C.Cir.1950), cert. denied, 340 U.S. 952, 71 S.Ct. 571, 95 L.Ed. 686 (1951). Rather, our disapproval arose out of the FERC's failure to give a reasoned explanation for its rejection of responsible rate base alternatives. We now find, however, as a result of the foregoing considerations, that the combination of FERC's rate base and rate of return methodologies does not produce an acceptable end result. Accordingly, we disapprove FERC's ratemaking methodology on this additional basis.