Opinion ID: 484619
Heading Depth: 1
Heading Rank: 5

Heading: rate of return on equity

Text: 55 The final issue in this case involves FERC's calculation of the rate of return allowed on the equity capital Tennessee invested in the pipeline to provide service between June 1982 and January 1983. The ALJ rejected Tennessee's suggested rate of return and instead arrived at a rate of 15.1%. In so doing, she purported to calculate this rate by applying the method previously used by the Commission in Opinion 190 to calculate Tennessee's equity rate of return for the November 1980 through May 1982 period. The ALJ regarded Opinion 190 as carrying great weight, since it had been issued only two months earlier. 56 In Opinion 190, the Commission defined a zone of reasonableness for Tennessee's return on equity by considering rates of return of relatively riskless investments such as United States Treasury Bonds, the cost of equity to Tenneco (Tennessee's diversified corporate parent), the recommendations of the parties (the Commission staff and Tennessee), and returns recently allowed for other pipelines. The high end of the zone was capped by Tenneco's current cost of common equity, which the Commission calculated by a method called Discounted Cash Flow analysis (DCF). 22 DCF analysis, as the Commission uses the term, adds the dividend growth rate to the dividend yield of the pipeline's stock, resulting in a total rate of return to the hypothetical buyer of the company's stock. 23 The growth rate is simply the expected increase in the dividend, expressed in percentage form. To compute the dividend yield, the Commission examines the dividend paid (expressed as a percentage of the share price) for each month ... for the entire rate period, Opinion 190 at 61,094; Consolidated Gas Supply Corp., Opinion No. 180, 24 FERC p 61,046 (1983), and then determines the average dividend yield for the entire rate period, Opinion 190 at 61,094. In Opinion 190, the Commission examined the dividend yield for each month of the rate period and concluded the overall dividend yield during the January 1980 through May 1982 period was between 7.18% and 7.87%. It then averaged these two figures (yielding 7.53%) and added this to the growth rate for the same period (determined to be the average of 9.2% to 9.6%, or 9.4%), resulting in a high end rate of return on equity of 16.93%. 57 The Commission thereafter determined the floor of the zone of reasonableness by calculating a low end rate of return on equity. In Opinion 190, the Commission began with the average rate of return of United States Treasury Bonds (a near-riskless investment) and added a risk factor of 1.2%. Because the average rate of return for Treasury Bonds between January 1980 and May 1982 was 13.8%, the Commission settled on a low end rate of return of 15.0%. Concluding that Tennessee had average risk for companies of its type, the Commission in Opinion 190 averaged these two values (16.93% and 15.0%), arriving at a final equity rate of return of 15.95%. 58 Purporting to apply this calculation to the June 1982 through January 1983 filing at issue here, the ALJ first adjusted the low end rate of return downward to reflect the decline in interest rates paid on Treasury bonds during the later rate period. The new low end rate became 13.2%. But turning to the high end rate of return based on the sum of Tennessee's growth rate and dividend yield, the ALJ failed to similarly adjust the data used in the DCF formula to reflect the fact that Tenneco's dividend yield during the 1982-83 period had increased to between 9.0% and 9.8% from its 1980-82 level of 7.18% to 7.87%. 24 She instead simply applied the final result of Opinion 190 's DCF analysis, a final high end rate of 16.93%. The ALJ's only gesture toward updating the figures used in the DCF formula was to examine the spot dividend for a single day, November 30, 1983 (a date not even within the rate period at issue before her). On that day, the spot dividend was 7.23%. She concluded that because the spot dividend was within the 7.18% to 7.87% range of dividend yields used in the Opinion 190 DCF calculation, the numbers used in that calculation were applicable to this period as well. Although the record is unclear concerning whether the ALJ had evidence of Tenneco's actual 1982-83 dividend yields before her, 25 she certainly failed to make any effort to insert average dividend and price data for each month ... for the entire rate period as required by Opinion 190 and Consolidated Gas Supply Corp. The result, of course, was that her definition of the zone of reasonableness for the rate period at issue here became 13.2% (low end) to 16.93% (high end). Taking the middle point of the zone, the ALJ determined that an equity rate of return of 15.1% was proper. 59 Petitioner Tennessee, joined by FERC's own staff, objected to the ALJ's finding. Both pointed out that if she had updated the high end calculation in the same way she brought the low end calculation up to date, the DCF analysis would have produced a high end rate of return not of 16.93%, but of 18.56% (the higher dividend yield raises the overall rate). 26 The middle point of the resulting zone of reasonableness would have been 15.9%. 60 Faced with the perfectly sensible contention that if the ALJ was to use the Opinion 190 rate calculating method, she had an obligation to insert data for the relevant period, the Commission nevertheless upheld the ALJ. The Commission explained that the ALJ's 16.93% ceiling was reasonable because interest rates had fallen from the 1980-82 period to the 1982-83 period, therefore, Tennessee's overall rate of return should be lower. But, as we understand the Commission's analytical framework established in Opinion 190, the decline in basic interest rates is fully reflected in the low end calculation of the zone of reasonableness. Indeed, the ALJ reduced this low end from 15.0% to 13.2% to reflect this overall interest rate decline. The high end calculation requires an entirely different set of figures--Tenneco's dividend growth and yield. Neither the ALJ nor the Commission explained why reduced market interest rates justified reducing the final high end rate of return by using outdated, and seemingly inapplicable, dividend yields in the DCF calculation. 61 The Commission also asserted that since Opinion 190 was handed down only two months before the ALJ reached her decision, the ALJ's approach in this case was reasonable. This would be an understandable response if Tennessee had contended that a different calculation method should have been used, but that was not the issue here. The temporal proximity of the two decisions has nothing to do with the undisputed proposition that each decision considered an entirely different rate period. During each rate period, different market interest rates were in effect and (apparently) Tenneco was generating different dividend yields. The proximity of the two decisions provides no justification for the Commission's failure to include relevant data in the DCF calculation. 62 After the Commission's decision, Tennessee requested a rehearing, thoroughly describing the errors discussed above and setting forth what it viewed as the correct figures and calculations. Yet the Commission's response in Opinion 240-B was terse: [Tennessee] does not point to any record evidence or explanation that would substantiate why investors would require dividend yields for the locked-in period that are almost 2 percentage points ... higher than those found by the Commission to be appropriate for the locked-in period covered in Opinion 190. Opinion 240-B at 61,009. 63 Although it is not our role to tell the Commission what the correct rate of return calculation is, Permian Basin Rate Cases, 390 U.S. at 767, 88 S.Ct. at 1360; Public Service Commission of New York v. FERC, 642 F.2d at 1342, we do have an obligation to remand when the Commission's conclusions are contrary to substantial evidence or not the product of reasoned decisionmaking, ANR Pipeline Co. v. FERC, 771 F.2d at 516. The Commission appears to have made a policy assumption that, notwithstanding Opinion 190, since general interest rates fell from the 1980-82 period to the 1982-83 period, Tennessee's rate of return must also fall. Although a straightforward application of the DCF formula would in fact have produced a slight decline in Tennessee's rate of return (from 15.95% to 15.9%), the Commission apparently believed a greater reduction was warranted. Instead of implementing this policy view in an explicit manner (by adopting a new rate of return formula, for example), the Commission simply performed the DCF calculation using obsolete data. Such result-oriented manipulation of an objective ratemaking calculation is patently arbitrary and capricious decisionmaking. 27 64 We therefore vacate FERC's rate of return decision and remand the matter to the Commission for proceedings consistent with this opinion. The other aspects of the Commission's decision are affirmed. 65 So Ordered.