Opinion ID: 1918402
Heading Depth: 1
Heading Rank: 6

Heading: Determination of GSU's Capital Structure

Text: At issue in the sixth assignment of error is whether the gross proceeds or net proceeds of debt should be reflected in the Company's capital structure in order to determine a fair rate of return. A fair rate of return is computed using the cost of capital approach. South Central Bell Tele. Co., 594 So.2d at 362. Under this approach, the cost of capital equals the annual percentage rate which a utility must receive to maintain its credit, to pay a return to the owners of the enterprise, and to insure the attraction of capital in amounts adequate to meet future needs. Id. Mathematically, the cost of capital is the composite of the cost of the several classes of capital used by a utilitydebt, preferred (and preference) stock and common stock (par value plus earned and capital surplus)weighted on the basis of an appropriate capital structure. Id. Thus, in order to determine a utility's average weighted cost of capital, the capital structure of the utility must first be determined. The capital structure consists of capital ratios that express, as a percentage, the portions of the utility's total capitalization consisting of debt capital and equity capital. In addition to determining the capital structure, the cost of each type of capital must be ascertained and then applied to the capitalization of a utility to find the average weighted cost of capital. Typically, the cost of equity capital is higher than the cost of debt capital, which is significant because the proportions of equity and debt are used to determine the average weighted cost of capital invested in rate base. In other words, the average weighted cost of capital changes as the ratio of equity capital to debt capital changes. A higher percentage of equity capital, which is more expensive than debt capital, translates into a higher average weighted cost of capital. Conversely, a higher percentage of debt capital, which is less expensive than equity capital, translates into a lower average weighted cost of capital. [17] In applying the cost of capital standard, commissions face numerous and difficult problems `which almost defy solution.' Phillips, supra, at 388 (footnote omitted) (quoting Joseph R. Rose, Cost of Capital' in Public Utility Rate Regulation, 43 Va. L.Rev. (1957)). Financial experts, lawyers and economists frequently disagree about the resolution of these problems. Paul J. Garfield & Wallace F. Lovejoy, Public Utility Economics 128 (1964). The sole capital structure problem presented to this Court in this case is whether the Commission acted arbitrarily or capriciously by including the gross proceeds of debt, rather than the net proceeds of debt, in the Company's capital structure. The gross proceeds of debt is the amount of debt outstanding which the Company must repay. The net proceeds of debt is the amount of debt outstanding net of the unamortized balance of any discounts, premiums and issuance costs. These costs are recovered from the ratepayers in the computation of the effective cost rate associated with each of the outstanding issues of debt using the yield-tomaturity (YTM) method. The YTM method is the conceptual framework used to compute the effective cost rate, i.e., the effective interest rate, of the Company's debt. Under this method, the difference between the outstanding debt and net proceeds of debt is recovered in the form of a higher interest rate than the simple coupon interest rate associated with each issue. This occurs in the YTM calculation by implicitly assuming that the Company is indebted for the issuance costs (the difference between the net proceeds and the outstanding balance) and undertakes a loan to cover the issuance costs at the time of the issuance. The loan is paid back in a mortgage type, levelized payment, amortized over the life of the issue. In the instant case, the Company used the net proceeds of debt to determine the ratio of debt to equity capital in its capital structure. [18] The Commission, however, adjusted the Company's filing by reducing its average weighted cost of capital to reflect the gross proceeds of debt in the Company's capital structure. [19] Consequently, the Company's Louisiana jurisdictional revenue requirement reported in its May 31, 1995 filing decreased by $1.349 million. The Commission and the Company do not disagree regarding the cost rates to be applied to the debt and equity elements of the capital structure, just whether gross proceeds or net proceeds of debt should be used. In declining to adopt the Company's capital structure based upon the net proceeds of debt, the Commission reasons that gross proceeds of debt represents the Company's actual indebtedness, i.e., the amount of money recorded on the Company's books which it ultimately owes to its long-term bondholders. Moreover, the Commission argues that the use of net proceeds of debt is inappropriate because debt issuance costs have been accounted for in the effective cost rate associated with each of the outstanding issues of debt using the YTM method. The Commission further notes that Gulf States consistently employed and the Commission recognized gross proceeds of debt. [20] L.P.S.C. Order No. U-21485 at 16. Ultimately, the Commission asserts that use of net proceeds in the Company's capital structure substitutes the more expensive equity capital for debt capital, which results in an over-recovery of the allowed return on equity capital. The Company avers that net proceeds should be used to determine the Company's capital structure because that amount represents the actual capital the Company has available to invest in rate base. Thus, if the Company has a $1,000,000 debt issue with issuance costs of $50,000, the Company has only $950,000 to invest in rate base. At the time the debt is issued, the Company asserts, the implicit loan in the YTM method does not represent actual capital available for investment in rate base. Because issuance costs are amortized and collected over the life of the issue, the net proceeds available for investment in rate base will increase each year until the issue matures. Eventually, at the end of an issue's life, the gross proceeds of debt will be reflected in the capital structure because the Company will have paid, and recovered from ratepayers, the issuance costs. Ultimately, argues the Company, using gross proceeds in the capital structure, before the Company has recovered issuance costs, increases the percentage of the less expensive debt capital, which results in an under-recovery of the allowed return on equity capital. Each side presented expert testimony on the issue. On behalf of the Commission Staff, Mr. Stephen J. Baron filed prepared direct and surrebuttal testimony advocating the use of gross proceeds in the Company's capital structure. Assuming that the issuance expense has been borrowed at the cost of debt capital (implicit in the yield-to-maturity methodology) and is recovered in an amortized fashion similar to a mortgage, over the life of the bond, Mr. Baron concludes that the use of net proceeds of debt  produces an excess return on equity.  Surrebuttal Test. Mr. Baron at 7, L.P.S.C. (12/11/95). Conversely, the use of gross proceeds of debt in the capital structure, as the Company has done in prior rate cases, produces the correct result. Id. On behalf of the Company, Mr. J. David Wright filed rebuttal testimony responding to the Mr. Baron's recommendation. Mr. Wright testified, as did Mr. Baron, that the Company in fact used the net proceeds of debt to determine its capital structure in its filing for the 1993 test year during the first annual earnings review. Rebuttal Test Mr. Wright at 12, L.P.S.C. (11/13/95). Mr. Wright urges that the Commission again ascertain the Company's capital structure using the net proceeds of debt. Moreover, Mr. Wright testified that the use of gross proceeds of debt is entirely inappropriate for two reasons. First, it is the net proceeds which represent the amount of debt capital available for investment in rate base. The gross proceeds will eventually be reflected in the Company's capital structure but only at the end of an issue's life when the Company has recovered the issue costs. Second, the YTM method is based on net proceeds. The overall cost of capital is then applied to a rate base which has only net proceeds available to be invested. To then use gross proceeds in the capital structure to develop the overall rate of return would result in a mismatch, which would not allow the Company to recover its total debt cost and equity return. Id. at 13. After reviewing the arguments propounded by the Commission and Company, we conclude that there is no compelling support for the positions of either party, as far as we can discern. On the one hand, the Company reasonably contends that debt capital should only include the net proceeds of debt, as that amount represents the actual amount of debt capital available to invest in rate base. On the other hand, the Commission's choosing the gross proceeds of debt, which are reflected on the Company's books, is equally persuasive. The net proceeds method advocated by the Company inflates the percentage of equity capital in the Company's capital structure, effectively converting the issuance costs of debt capital into equity capital earning a higher rate of return. The gross proceeds method advocated by the Commission, however, inflates the percentage of debt capital actually available to the Company for investment in rate base by treating the issuance costs of debt as if they were fictitiously available to invest in rate base. In this very difficult situation, where each of the parties presents plausible arguments, it is important to bear in mind the constitutional scheme in which plenary ratemaking authority is delegated to the Commission, and the judiciary's limited role in reviewing the Commission's exercise of that authority. The Commission is authorized to fix just and reasonable rates for public utilities. In doing so, the jurisprudence in this state, and around the nation, has recognized the wide discretion accorded public service commissions as quasi-legislative bodies with constitutionally-derived powers. Courts should be hesitant to substitute their views for those of the expert body performing the legislative function of setting rates, and should not disturb the Commission's decision without a clear showing of abuse. The right of commissions to consider [capital structure] in setting rates cannot be questioned, since a commission has an obligation to protect the consumer from excessive wages, excessive pension provisions, excessive prices for purchased materials and supplies, and other such things, including excessive costs of capital. Garfield & Lovejoy, supra, 130. In the instant case, the Commission has done no more than adopt the Company's actual capital structure using the actual amount of debt outstanding on the Company's books. Importantly, the Commission is not denying the Company recovery of the issuance costs. Instead, the YTM method allows the Company to collect the interest on the debt plus the issuance costs. Moreover, the Company has cited, and our independent research has revealed, no jurisprudence or treatise favoring the Company's approach. The Company simply has not demonstrated that the Commission has set unjust or unreasonable rates. Accordingly, based on the testimony and facts presented to this Court, we find that the Commission's adjustment utilizing the gross proceeds of debt in the Company's capital structure is neither arbitrary or capricious, nor an abuse of authority. The record supports the Commission's adjustment.