Opinion ID: 1356002
Heading Depth: 2
Heading Rank: 3

Heading: imputed capital structure

Text: {5} A utility's capital structure is used as a basis in determining the overall rate of return on a utility's investment. In this matter, the Commission, relying on the hearing examiner's recommendation, established a rate of return through the use of an imputed capital structure rather than Zia's actual capital structure. The process which Zia describes as the imputation of a capital structure is in fact a mathematical process through which the Commission determined the overall rate of return. Zia is owned by one investor. Zia currently operates with 100% equity and no debt. Zia argued that its rate base should be figured using a 13% rate of return on 100% equity. Instead, the Commission determined an overall rate of return for Zia using the debt and equity structure of a more typical natural gas company and typical rates of return for such companies on both debt and equity. The Commission used a hypothetical capital structure which included 51.5% common equity, 2 .63% preferred stock, and 45.88% debt (rounded to the nearest one hundredth). This typical capital structure is a less expensive capital structure than Zia's because the rate of return on equity is substantially higher than the rate of return on debt. {6} Zia contends that the use of an imputed capital structure which included debt was not supported by substantial evidence and was a denial of procedural due process. Zia further alleges it should have been given advanced notice to adjust its capital structure to include a certain percentage of debt. {7} It is well established that equity financing is more expensive than debt financing. See State Corp. Comm'n v. Mountain States Tel. & Tel. Co., 58 N.M. 260, 277, 270 P.2d 685, 696 (1954) (hereinafter Mountain States 1954 ) (discussing capital structure as the ratio of debt to equity, this Court stated, [d]ebt capital is substantially less expensive to the operating company than equity capital). See also Railroad Comm'n of Tex. v. Entex, Inc., 599 S.W.2d 292, 295 (Tex.1980) (Debt financing or borrowed capital is generally cheaper than equity financing or capital obtained from the sale of stock); State v. Southern Bell Tel. & Tel. Co., 274 Ala. 288, 148 So.2d 229, 232-33 (1962) (deeming a low debt to equity ratio to be in the nature of a company luxury not to be reflected in rates to be charged to the public). A less-than-efficient capital structure which contains excessive equity is properly treated by the Commission as likely to result in higher rates. South Central Bell Tel. Co. v. Louisiana Pub. Serv. Comm'n, 594 So.2d 357, 362 (La.1992) (stating that the cost of capital consists of two factors, the cost of debt and the cost of equity; [t]he first step in estimating the overall cost of capital is choosing the appropriate capital structure for regulatory purposes[;][t]his selection is crucial because, the cost of equity capital is usually higher than the cost of debt capital). For rate-making purposes the hypothetical capital structure allows rates to be set as though overall cost of capital were based on an optimal ratio of debt to equity in the capital structure of the utility. To determine the proper ratio of debt to equity the Commission must determine each of the two elements of the cost of capital: the cost of debt and the cost of equity. See City of Pittsburgh v. Pennsylvania Pub. Util. Comm'n, 182 Pa.Super. 376, 126 A.2d 777, 781 (1956). Because equity is more costly than debt, capital structures should reflect as much debt as possible, though not to the point where the financial integrity of the firm is sacrificed. See Mountain States 1954, 58 N.M. at 277-78, 270 P.2d at 696. The overall lower cost of capital for the utility with an efficient capital structure, that is a capital structure with a reasonable amount of debt, translates into lower rates. While the actual debt ratio carried by the utility is a matter for the utility's management, id. at 278, 270 P.2d at 696-97, a capital structure which results in higher than necessary rates is properly treated by the Commission as economically inefficient. In rate making, the Commission may set rates based on an optimum, or at least an average, capital structure. Otherwise, the utility's choice of capital structure would always dictate rates, which would exaggerate the interests of investors over those of consumers. See NMSA 1978, § 62-3-1 (1967) (declaring public policy in the interest of consumers and investors to require regulation of utilities). {8} Our cases have all but explicitly accepted the imputation of a capital structure to a utility company in rate making. See Gas Co. v. New Mexico Pub. Serv. Comm'n, 100 N.M. 740, 742, 676 P.2d 817, 819 (1984) (imputing income to utility for undersales of condensed liquid gas to affiliate to protect against cross-subsidization approved); General Tel. Co. v. Corporation Comm'n (In re General Tel. Co.), 98 N.M. 749, 754, 652 P.2d 1200, 1205 (1982) [hereinafter General Tel. 1982 ] (holding it proper for Commission to allocate weighted cost to the elements of capital structure, including debt, to limit return on debt of subsidiary); Mountain States 1954, 58 N.M. at 277, 270 P.2d at 696 (using the term debt ratio to mean the proportion of debt to equity in the capital structure, the Court acknowledged a dispute as to whether rates should be based upon actual debt ratio or an estimated proper debt ratio). A significant number of jurisdictions have accepted the concept of an imputed capital structure in rate making. See Communications Satellite Corp. v. FCC, 611 F.2d 883, 904-05 (D.C.Cir.1977) (collecting cases); General Tel. Co. v. Idaho Pub. Utils. Comm'n, 109 Idaho 942, 712 P.2d 643, 646 (1986) (same). {9} The staff witnesses engaged in the imputation process in order to compare Zia with more typical natural gas companies and to determine what the company's situation would be if it operated with a capital structure that was less costly to the ratepayer. Because Zia is not a publicly-traded company, the staff witness calculated the cost of equity for a group of eight comparable gas distribution companies, all of which receive 100% of their revenues from gas distribution activities and are evaluated by Value Line Investor Service, an organization historically relied on by the Commission for accuracy in long-term forecasting. The market price of Zia's stock was estimated in order to evaluate the return on that stock. In addition to computing an average capital structure using the eight companies and imputing that structure to Zia, the staff witnesses also compared Zia to the eight companies. We conclude the Commission relied on substantial evidence in establishing an imputed capital structure for Zia in order to set rates. {10} The Commission has not suggested that Zia adjust its actual capital structure to conform to the imputed structure. Such changes are a matter of internal management prerogative as recognized in Mountain States 1954, 58 N.M. at 278, 270 P.2d at 696-97. The actual capital structure, referred to by this Court in Mountain States 1954 as the debt ratio, is a matter for management, but the evaluation of the capital structure in setting rates is a matter for the regulator. It is appropriate for the Commission to consider the effect of the actual capital structure on ratepayers and to hypothetically adjust that structure in rate determination to strike a balance between the interests of ratepayers and the interests of investors in achieving a just and reasonable rate of return. State v. Southern Bell, 148 So.2d at 232. This seems to be a well-recognized proposition. See Federal Power Comm'n v. Hope Natural Gas Co., 320 U.S. 591, 603, 64 S.Ct. 281, 88 L.Ed. 333 (1944). Because the Commission is not insisting on any change in Zia's management, Zia's argument confuses actual structure with use of a hypothetical structure in establishing a reasonable rate of return. In any case, as Mountain States 1954, 58 N.M. at 277-78, 270 P.2d at 696-97 indicates, Zia should have been on notice that a 100% equity capital structure could be detrimental to ratepayers and would not be the basis for setting rates.