Opinion ID: 484619
Heading Depth: 1
Heading Rank: 4

Heading: capital structure

Text: 35 In setting the rate of return an interstate pipeline is allowed to recover on invested capital, the Commission considers the applicable capital structure (the percentages of debt, preferred stock, and common stock) and the rate of return each form of capital is permitted to earn. See Public Service Co. of New Mexico v. FERC, 653 F.2d 681, 683 (D.C.Cir.1981). The overall rate of return is determined by computing an average of the three separate rates of return, weighted by the relative amounts of each type of capital. Id. 36 Tennessee Gas Pipeline Company is an unincorporated division of Tenneco, Inc., a conglomerate that has several other operating divisions and a number of wholly-owned subsidiaries engaged in related and unrelated businesses, including three other natural gas pipelines. In the orders at issue here, the Commission approved Tennessee's proposal to use the capital structure of its parent, Tenneco, with a 51.1% equity ratio. Opinion 240 at 61,223; Opinion 240-B at 61,008. 37 Petitioner Public Service Commission of the State of New York (New York), supported by intervenors Cities of Clarksville and Springfield, Tennessee, challenges the Commission's determination of Tennessee's capital structure and rate of return for the period from June 1, 1982 through January 31, 1983. In a prior decision establishing the capital structure and rate of return to be applied for the period immediately preceding the one at issue here, 16 the Commission stated that, although the parties had agreed that the capital structure of Tenneco would be used in that case, 38 [w]e are concerned over the appropriateness of using the consolidated capital structure [of the parent corporation] to set the return on capital for a pipeline division where the business operations of the consolidated company are predominantly unregulated and its overall risk, which is reflected in its capital structure, is different from that of its regulated business alone.... [I]n future cases involving Tennessee and other pipelines that are divisions or subsidiaries of parent companies that are in non-pipeline businesses, we will consider whether a hypothetical capital structure should be imputed for the pipeline rather than simply relying on the parent's capitalization. 39 Tennessee Gas Pipeline Co., Opinion No. 190, 25 FERC p 61,020 (1983), at 61,093, reh'g denied, Opinion No. 190-A, 26 FERC p 61,109 (1984). The Commission cited Consolidated Gas Supply Corp., 24 FERC p 61,046 (1983), a case in which FERC had used a hypothetical capital structure to set the rate of return for a pipeline subsidiary because of the difference in the degree of business risk faced by the parent and the subsidiary, 17 and noted that in its brief on exceptions Staff states that in its next proceeding where Tennessee's rate of return is at issue, Docket No. RP82-12-000 [this case], it is proposing a hypothetical capital structure. Opinion 190 at 61,109 n. 11. 40 In this rate proceeding, Tennessee proposed that the capital structure of its parent, Tenneco, with a 51.11% equity ratio, be used to determine Tennessee's rate of return. The ALJ, relying on the Commission's earlier decision in Opinion 190, rejected Tennessee's proposal and imposed a hypothetical capital structure. Tennessee Gas Pipeline Co., 25 FERC p 63,052 (1983), at 65,164-66. The ALJ held that the Commission's earlier decisions established that Tenneco's capital structure could be imputed to Tennessee only if Tennessee showed that the two entities were subject to similar business risks. 25 FERC at 65,164. She noted that the Commission had determined in Opinion 190 that Tennessee is less risky than Tenneco because of the greater risk of the non-pipeline businesses that make up the bulk of Tenneco's operations, and concluded that Tenneco, Inc.'s capital structure is inapplicable to Tennessee. Id. To select the appropriate equity ratio to be applied, the ALJ first determined that the appropriate range for Tennessee's equity ratio was between 40 percent (the average equity ratio for 21 Aa/AA rated electric utilities in March 1982) and 50 percent (the 1980 average equity ratios for gas transmission companies). 25 FERC at 65,165-66. On the basis of the Commission's statement in Opinion 190 that Tennessee was of about average risk for a gas pipeline, the ALJ chose the midpoint of this range (45%) as the equity ratio to be applied. 18 25 FERC at 65,166. The Commission reversed the ALJ's decision and accepted Tennessee's proposal to use the imputed capital structure of Tenneco with a 51.11% equity ratio. In explaining its decision, the Commission stated: 41 The Commission recently issued Opinion No. 235 [Arkansas Louisiana Gas Co. (Arkla), 31 FERC p 61,318 (1985) ], which establishes a general policy of using actual capital structures rather than hypothetical capital structures for purposes of developing the rate of return for regulated pipelines. That policy is applicable to this proceeding. Therefore, we will incorporate herein the rationale of the Arkla decision and will reverse the initial decision on this issue. 42 Opinion 240 at 61,223. Arkla, the decision on which the Commission relied, also involved a pipeline which was a division of a diversified corporation. In that case, as in this one, the Commission applied the imputed capital structure of the parent corporation, reversing the ALJ's adoption of a hypothetical capital structure. The Commission reasoned that 43 we are not persuaded that hypothetical capital structures are appropriate for regulated pipelines because the competition and risks in the pipeline industry have changed significantly in recent years.... Given these recent changes in competition and risk, we believe that attempts to develop a reasonable hypothetical capital structure for a pipeline will be difficult and may result in unnecessary interference with management decisions regarding the financing of pipeline operations.... Furthermore, the Commission believes that there are other techniques which can be used to ensure that pipeline rates reflect reasonable capital structures. 44 Arkla at 61,728. It concluded that as a matter of general policy ... actual rather than hypothetical capital structures should be used for developing an overall rate of return for regulated pipelines. Id. at 61,726. 45 New York argues that the Commission should have imputed to Tennessee a hypothetical capital structure with a lower equity ratio than the 51.1% it adopted. The Commission's decision on this issue was based exclusively on its determination that the Arkla presumption in favor of using actual rather than hypothetical capital structures should be applied to this case. Thus, petitioner's argument requires us to resolve two questions: first, whether the policy set out in Arkla, a case decided only one month before the Commission's decision in this case, could permissibly be applied to this case at all; and second, whether the Commission properly applied the Arkla policy to the facts of this case. 46 In arguing that FERC impermissibly applied the policy announced in Arkla to this case, New York points out that this case was litigated and briefed months before the Commission issued its decision in Arkla. 19 New York asserts that it was denied an opportunity to challenge the policy set forth in Arkla; the Commission has, New York contends, unfairly placed upon it the burden of introducing evidence to demonstrate the invalidity of a general policy adopted by the Commission long after the record was closed and the Initial Decision issued. Reply Brief of Petitioner Public Service Commission of the State of New York at 4. 47 This court has held that FERC  'may attach precedential, and even controlling weight to principles developed in one proceeding and then apply them under appropriate circumstances'  in a subsequent proceeding. Public Service Co. of New Mexico v. FERC, 653 F.2d 681, 692 (D.C.Cir.1981) (quoting Michigan Wisconsin Pipe Line v. FPC, 520 F.2d 84, 89 (D.C.Cir.1975)). New York's argument that it was inappropriate for the Commission to apply its Arkla policy to this case rests on two unwarranted assumptions: first, that the application of the policy announced in Arkla represented a departure from the Commission's position in prior Tennessee rate cases on the issue of the capital structure to be used in determining Tennessee's overall rate of return; and, second, that the issue was litigated in this proceeding before the Commission on the understanding that a hypothetical capital structure would be imputed to Tennessee. See Brief of Petitioner Public Service Commission of the State of New York at 12 (the Commission may not ... apply automatically the new general policy to cases which were litigated under a different set of guidelines). In fact, the Commission had imputed the capital structure of Tenneco to Tennessee in prior rate-making proceedings, including Opinion 190, the rate case for the period immediately preceding the period at issue here. See Opinion 190 at 61,093; see also J.A. at 57 (testimony by Tennessee's Director of Rates that Tennessee has consistently relied on the capital structure of Tenneco as the basis for its claimed rate of return on equity). 20 Further, it is clear that, in litigating this case, New York and Cities could not reasonably have assumed and did not assume that the Commission would apply a hypothetical capital structure. The parties were clearly on notice that the Commission considered the decision whether to impute Tenneco's capital structure to Tennessee or to adopt a hypothetical capital structure to be an open question. While the Arkla policy had not yet been announced, the issues underlying that policy (the relative risks facing a pipeline division and its diversified parent corporation, and the significance of those risks in determining the appropriate capital structure to be applied to the pipeline) were vigorously litigated in this proceeding. See 25 FERC at 65,161-64 (ALJ's summary of positions of the parties on capital structure issue). New York's argument that the Commission's application of the Arkla policy to this case represented an abrupt departure from its earlier position without proper opportunity for the parties to challenge that policy must be rejected. 48 New York also argues that, even if the parties did receive an adequate opportunity to challenge the policy announced in Arkla, the record in this case does not support the application of that policy. The Commission's decision in Arkla was largely based on its finding that the competition and risks in the pipeline industry have changed significantly in recent years. Arkla at 61,728. New York argues that the changes in risks affecting the pipeline industry on which the Commission relied in Arkla occurred after the period at issue here and were therefore irrelevant to the determination of whether to adopt a hypothetical capital structure in setting Tennessee's rate of return for this period. This court has noted, however, that 49 a regulated company faces the same long-term problems regardless of the frequency of its rate filings. To look only at short-term risks and costs in considering a locked-in rate raises the possibility that the company will never be adequately compensated for long-term risks and costs present during the locked-in period. 50 Public Service Commission of New York v. FERC, 642 F.2d at 1349. There is evidence in the record that during the relevant time period, Tennessee was faced with the same kind of long-term risks with which the Commission was concerned in Arkla. For example, Tennessee's Vice President of Customer Relations and Marketing testified in July of 1982 that well over 80% of Tennessee's sales are subject to a significant level of uncertainty by reason of competition from alternate interstate suppliers of natural gas, and that Tennessee was also facing immediate competition in the industrial market from alternate energy sources. J.A. at 246-47. See also J.A. at 25 (same witness testified in August, 1982 that the market risk that we are now going through today [is] the downturn of the markets because of competition from other fuels.) (emphasis added). Tennessee's expert witnesses also testified in July of 1982 that Tennessee and the pipeline industry as a whole were facing increased risks and competition from other pipelines as well as from alternate fuels. See J.A. at 116-19, 223-24. The Commission's conclusion that the policy announced in Arkla was applicable to this case is clearly supported by the record. 51 New York also asserts that, even if FERC correctly decided to impute the capital structure of Tenneco to Tennessee in setting Tennessee's rate of return, the Commission's method of determining that capital structure was erroneous in two respects. First, New York argues that the Commission erred in adopting Tenneco's unconsolidated capital structure, which excludes certain debt securities and unappropriated retained earnings of subsidiary companies. Opinion 240-B at 61,008. New York contends that the Commission should have used the consolidated capital structure with a 47% equity ratio set out in Tenneco's 1981 Annual Report because that capital structure was more likely to reflect market reality than the unconsolidated capital structure, which is not the actual capital structure for financial reporting or accounting purposes. See Brief of Petitioner New York Public Service Commission of the State of New York at 19-21. The Commission rejected this argument in its opinion on rehearing, concluding that New York's position was predicated only on the result, i.e. lower overall rate of return and unsupported by any rationale. Opinion 240-B at 61,008. 52 The unconsolidated capital structure adopted here has consistently been used by Tennessee in previous rate proceedings. See Opinion 240-B at 61,008 (Commission applied unconsolidated capital structure in Opinion 190; same methodology was used in this case); J.A. at 55, 57 (Tennessee's Director of Rates testified that Tennessee had consistently used unconsolidated capital structure of Tenneco, although resulting equity ratio was sometimes unfavorable for Tennessee). Further, the items excluded from the unconsolidated capital structure were debt securities issued independently by Tenneco's subsidiaries, which were not traceable to the parent company and not part of the investment in the rate base, and unappropriated retained earnings of the subsidiaries, which were also unavailable to Tenneco for investment in the rate base. The Commission acted reasonably, therefore, in excluding these items from the capital structure imputed to Tennessee. 53 New York also argues that the Commission should have excluded from Tenneco's capital structure common and preferred stock issued to acquire the assets of Southwestern Life Corporation and Houston Oil and Minerals Corporation, and that exclusion of this stock would lower Tenneco's equity ratio from 51.11% to 48%. See Brief of Petitioner Public Service Commission of the State of New York at 22-23. New York contends that Tennessee's ratepayers receive no benefit from Tenneco's acquisition of these unrelated businesses (an insurance company and an oil company), and that therefore the ratepayers should not bear any part of the burden (cost) of these acquisitions. Id. at 24. The Commission rejected this argument as simply an attempt by New York to impose a hypothetical capital structure which would, if permitted, undermine the policy announced in Arkla. See Opinion 240-B at 61,008. 54 New York itself points out that Tenneco is predominantly not a pipeline company; in fact, the net income of all four of Tenneco's pipelines accounted for only 17% of Tenneco's total income in 1981. See Brief of Petitioner Public Service Commission of the State of New York at 23 (citing 25 FERC at 65,161). Because Tenneco is a conglomerate with numerous non-pipeline subsidiaries and divisions, any attempt to exclude stock attributable to businesses engaged in unrelated activities would necessarily result in the adoption of a hypothetical capital structure, the approach rejected in Arkla. New York has not offered any justification for singling out these two acquisitions from all of the other non-pipeline businesses operated by Tenneco. Further, there is some evidence in the record to undercut New York's assertion that Tennessee's ratepayers receive no benefit from Tenneco's acquisition of unrelated businesses. One of Tennessee's expert witnesses testified that the diversification resulting from Tenneco's acquisition of unrelated businesses would substantially reduce the risk inherent in each of the operations separately. J.A. at 132. Diversification thus could reasonably be presumed to benefit Tennessee's ratepayers by reducing Tennessee's operating and financial risks. The Commission clearly acted within its discretion in refusing to exclude the stock used to acquire these two businesses from Tenneco's capital structure. 21