Opinion ID: 1526377
Heading Depth: 1
Heading Rank: 6

Heading: capital structure issue

Text: One of the primary functions of regulatory agencies in the ratemaking process is the determination of the appropriate rate of return to be allowed utilities under its jurisdiction. Rate of return, i. e., the annual return to be allowed on the value of the utility's property devoted to public use, is determined by combining the capital structure of the utility with the proper cost of capital. Mechanic Falls, supra, at 1095. In a lengthy discussion of the rate of return issue in New England Telephone, supra, we observed that [i]t can be seen that the cost of capital depends not only upon the individual cost of the different items [i. e., debt & equity] making up a utility's capitalization, but also upon the proportion of those individual items to the total capital structure. 390 A.2d at 39. We also observed there that  a higher `debt ratio' means lower rate of return and lower rates to the utility's customers. Id. In the present case the Commission found that a capital structure containing 35 percent common equity, 13 percent preferred and 52 percent debt was appropriate for Central Maine and should be used to determine its rate of return. The Decree stated: . . . Central Maine's pro forma equity ratio of 36.6% is unreasonable and inefficient because it provides an excessive and unnecessary margin of safety which is being financed by ratepayers. For these reasons, we find that a capital structure containing 35% equity, 13% preferred, and 52% debt is appropriate and should be used to determine the fair rate of return. [42] Central Maine submits on appeal that this finding of unreasonableness was erroneous and without record support. Specifically, they contest what they contend is the Commission's inappropriate use of a hypothetical capital structure in lieu of their pro forma structure, which they insist was reasonable. The Commission, in reply, argues alternatively that it found Central Maine's near term pro forma capital structure rather than a hypothetical one, but that in any event use of a hypothetical structure would be justified and supported by its findings. We deny Central Maine's appeal on this issue, finding the Commission's use of a hypothetical capital structure to be reasonable and supported by substantial evidence. In Mars Hill & Blaine Water Co. v. Public Utilities Commission, supra , we upheld the Commission's substitution of a 60/40 capital structure for the utilities' [43] actual 57/43 capital structure  as constituting a reasonable exercise of the Commission's expert judgment . 397 A.2d at 583. We did so after finding that [t]he record supports the conclusion that General Waterworks was attempting to shift to a 60/40 capital structure and that the ratepayers have been incurring higher debt costs associated with the attempt. Id. Ratemaking being prospective in nature, we said,  facts which with certainty will gain life in the future, but do not affect the operations for the test year, must be weighed by the factfinder . . . . Id. at 584, quoting Central Maine Power Co. v. Public Utilities Comm., 153 Me. 228, 242, 136 A.2d 726, 735 (1957). The Commission contends that it found and employed Central Maine's Power's near term pro forma actual capital structure rather than a hypothetical one, citing principles announced in Mars Hill, supra . A review of the record, briefs, and decision in that case, however, discloses no hint that the Commission arguedor this Court heldthat the capital structure there imputed to the utilities was anything but hypothetical. Indeed, the Commission's brief to this Court in that case pointed out: Because the Companies do not issue their own debt, their actual capital structure is 100% equity. All parties agree that a 100% equity capital structure would be unreasonable for ratemaking purposes. The issue, therefore, is what hypothetical capital structure should be imputed to these General Waterworks subsidiaries. Accordingly, since neither the Commission, nor the Company, is advocating the actual capital structure of these Companies for rate-making purposes, appellants' extended discussions of cases dealing with actual versus hypothetical capital structures are irrelevant. [original emphasis]. Although we did not specifically refer to the capital structure used by the Commission as hypothetical, we referred to it as the appropriate one, as distinguished from the actual one. A  hypothetical  capital structure is not one created of thin air: for that reason the term is misleading. It is  hypothetical only to the extent that it assumes, as it must, certain trends in the financing of the utility during the future period for which rates are being set. It must, however, be based in present fact and future probability, which in the ordinary case means that the present actual capital structure of the Company must be the starting point for analysis. Thus, in Mars Hill, the Commission considered the 57/43 (debt/equity) capital structure of General Waterworks, but determined that because General Waterworks was clearly attempting to shift to a 60/40 capital structure (and that ratepayers had been incurring higher debt costs as a result) that structure was the  appropriate  one to use for cost of capital determination. The line between the use of a hypothetical  capital structure and an actual one constructed taking into account anticipated changes is a blurred one. Depending upon the degree of certainty which prospective changes present, [44] either a near term actual pro forma or a hypothetical  capital structure may be found, and either may, in proper circumstances, be within the Commission's discretion. As we suggested in Mars Hill, our approval in New England Telephone of two well-recognized situations in which a capital structure other than the actual test-year one may be used was neither comprehensive nor exclusive. There may be  case [s which] do not fit precisely into either category , 397 A.2d 583, yet in which the use of other than the actual capital structure may represent a reasonable exercise of the Commission's expert judgment supported by the record. In the present case, use of a 35% equity ratio, though premised on probably future trends in Central Maine Power's financing, must be considered hypothetical. Staff witness David Kosh presented testimony concerning both the Company's pro forma capital structure and a desirable one containing a lower equity figure. After presenting his pro forma study, he noted that . . . it is clear that the fair rate of return should be based on the appropriate capital structure as opposed to the actual one.  (emphasis added). The Decree reviewed both structures, and concluded that the  desirable one containing 35% equity was  appropriate and should be used . . . . The question remaining, therefore, is whether the Commission's determination is reasonable in result and methodology and supported by substantial evidence. New England Telephone, supra, at 34. The Commission's use of a 35 percent common equity ratio was based on its conclusion that while CMP's actual year-end equity ratio has gradually increased, from 30.64 percent in 1974 to 33.95 percent in 1977, that trend will cease in the short-term future. The testimony of Mr. Kosh, president of a utility consulting firm, is the primary basis of the Commission's finding in this regard. Kosh presented a study of the capital structures of 64 original cost electric utilities, concluding that their average year-end equity ratio in 1976 was 34.1 percent; at year-end in 1977, 35.5 percent. He concluded, in part on the basis of this study, that CMP's pro forma 36.6 percent equity ratio was above the zone of reasonableness, and advocated the 35.0 percent figure subsequently accepted. Aside from considerations of economy to ratepayers, however, the Commission is bound to give weight to the issue of safety to investors. With this in mind, Mr. Kosh studied the safety of a capital structure with a 35 percent equity ratio, and concluded that it could withstand a decline in earnings so severe as to have only a 1-in-100 chance of occurrence, and still produce an after-tax interest coverage of over two times. This study, based on historical data concerning CMP's rate earned on total capital during the period 1969-1977, led Mr. Kosh to conclude: Thus, in my opinion, a 35% equity ratio for Central Maine Power would lie at the upper end of the range of reasonableness. If anything, then, Central Maine Power's equity ratio which is in excess of 35% is somewhat above the upper end of the range of reasonableness. On cross-examination, counsel for Central Maine Power suggested that the periods 1970-77 and 1972-77 be used in the safety study, as they had produced the greatest fluctuations in return for Central Maine Power from 1960-1977. Recomputing the study, applying the same 1-in-100 disaster test, the after tax coverages were 1.98 times for 1970-77 and 1.97 times for 1972-77. The Commission accepted this study as evidence of the safety of a 35% equity ratio. Central Maine Power does not contest the Commission's finding that a 35 percent equity ratio is safe, as Mr. Kosh's studies indicate. Likewise it does not (and logically cannot) contest that fact that a 36.6 percent (or 36.15 percent) equity ratio is more expensive to ratepayers. It relies instead upon the claim that the capital structure of a utility is a function of management, citing In Re Stratton Water Co. Proposed Increase for Rates, Me., 383 A.2d 1373, 1377 (1978), and that the Commission lacked sufficient evidence to support its finding that the Company's pro forma 36.6 percent equity ratio was unreasonable. To this end, it also attacks the probity of the evidence relied upon by the Commission. Mr. Kosh, the Company contends, compared Central Maine Power's capital structure pro forma to year-end 1978 with the capital structures of 64 electric companies in 1976. At year end 1976, the Company claims, its common equity ratio was 32.5 percent, placing it in the mainstream of Kosh's figures for that date. [45] However, the Company continues, testimony of its witnesses established an industry-wide increase in common equity ratio after 1976, so that at year-end 1977 the breakdown of Kosh's 64 companies produced an average common equity ratio of 35.5 percent, above his range of reasonableness. [46] Kosh's figures, Central Maine argues, do not reflect market realities. Citing the American Bar Association's Annual Report of the Section of Public Utility Law (1978) at 236, they point to a year-end 1977 average of 36.3 percent common equity, the highest since 1968. The Commission responds to the citation of the American Bar Association Section Report by noting that short-term debt is excluded from the figures presented there, a condition which tends to inflate the equity ratio. If the companies in that report had short-term debt relatively comparable to Central Maine Power, the Commission notes, average equity ratio at year-end 1977 would have been 35.2 percentfar closer to the 35.0 percent advocated by Kosh and accepted by the Commission than the 36.6 percent (adjusted to 36.15 percent) suggested by the Company. This plethora of conflicting evidence illustrates the wisdom of our long-standing policy of according the Commission considerable deference in the realm of economic fact-finding. [47] This Court possess neither the resources, the expertise, nor the inclination to act as a super-commission. We cannot substitute our judgment of the economic facts presented for that of the Commission. We cannot say, on the basis of the evidence presented, that the Commission could not reasonably conclude that a 35 percent equity ratio was proper. The challenges to Kosh's testimony reviewed here were made known to the Commission; it would not be unreasonable for them to reject them as unpersuasive. Assuming arguendo that the upper end of Kosh's range of reasonableness should have been, e. g., 37 percent rather than roughly 35 percent, that would not prevent the Commission from concluding that a 35 percent equity ratio was proper. Many other variables bearing on Central Maine Power's peculiar case had to be considered than could neatly be settled by evidence of industry averages alone. It would not be unreasonable for the Commission to conclude, for example, that equity ratios had peaked and would decline in the near future, or that Central Maine's financing plans mandated a lower ratio than might prevail on the average. Such are the judgments entrusted to the Commission. The requirement that they be supported by substantial evidence does not demand that they be absolutely uncontested. The reasonableness of using a given ratio of capital structure cannot be judged in the abstract, but must be compared and contrasted with alternatives. Indeed, the very process of determining what is reasonable is one of selecting from among competing alternatives the choice which presents the optimal combination of necessary qualities. Thus, while an equity ratio of X may present greater economy to ratepayers, it is an unreasonable choice if it does so at the expense of safety to investors. Conversely, a higher equity ratio of Y could be exceedingly attractive to investors, but at inordinate cost to the ratepayers, and would thus be unreasonable. Ratemaking is an inexact science, fraught with the dangers which accompany all processes of prediction, economic or otherwise. Accordingly, there must be said to be theoretically a range of reasonableness in such matters, rather than an exclusive choice. Central Maine Power v. Public Utilities Commission, Me., 382 A.2d 302 (1978). That range may be said to parallel the Commission's discretion, and it is accordingly their right to choose from among alternatives, all arguably within the range of reasonableness, that one which is most reasonable, i. e., that one which presents the optimal combination of economy and safety. That is what we anticipated in New England Telephone, supra, when we approved use of a hypothetical capital structure by which rates . . . [could be] determined on the basis of a more reasonable and less expensive capital structure. 390 A.2d at 39 (Emphasis added). In the present case the Commission chose a 35 percent equity rationear the upper end of the zone of reasonableness constructed by staff witness Kosh. It did so on the basis of substantial evidence. Among the factors considered were prevailing ratios in comparable utilities; historical trends in Central Maine Power's financing; its announced intentions with respect to capital additions; and the impact of a severe earnings decline on a structure with a 35 percent equity ratio. The Commission was not required to show that Central Maine Power's pro forma capital structure was unreasonable in any absolute sense, but only in comparison to available alternatives. Where substantial evidence supports the Commission's findings that a lower equity ratio offers greater economy to ratepayers and sufficient safety to investors, it is clearly more reasonable. In selecting from among the choices presented by the range of reasonable alternatives, it acted reasonably. The Company relies heavily on its claim that the function of the Commission with respect to capital structure `is one of control and not management', citing In Re Stratton Water Company Proposed Increase In Rates, supra . The quoted portion is excepted from a broad statement of principles concerning managerial discretion in general; the Company here seeks to extend it beyond its limitations. Stratton presented a rather peculiar fact situation. We there said only that management was entitled to have a note it held endorsed and exchanged for stock (thus transferring debt capital to equity capital) rather than discharged, since cancellation would have altered Stratton's capital structure in such a way as to lessen [its] fair rate of return. Id. Management, we concluded, could properly choose to protect its right to a return, rather than provide a windfall to ratepayers. Finding such judgments to be a prerogative of management is a far cry from saying that as respects the prediction of future capital structure, requiring assessment of enormously complex contingenciesmany beyond the control of managementmanagerial judgments must be deferred to. To do so, as the Commission warns, could be to force the Commission to abdicate its supervisory responsibility in this area: Central Maine's equity ratio has slowly increased each year since 1974 in relatively small amounts and the Commission noted its concern about this trend. [. . .] Central Maine suggests that the mere fact that the 36.6% or the 36.2% ratio is close to 35% precludes the Commission from disturbing this function of management. If, indeed, the Commission cannot use a 35% hypothetical equity ratio because it is too close to the actual 36.2% equity ratio, that would, perforce, imply that a 36.2% equity ratio produces just and reasonable rates. The implication is clear. Under such reasoning the Commission would not have regulatory control over companies as long as the equity ratio rises by small increments. It is not a proper function of management to choose excessive safety at the cost of higher rates. [48] Central Maine has not, in its briefs to this Court, contested the validity of Mr. Kosh's study demonstrating the coverages produced with a 35 percent equity ratio in the face of even a severe earnings decline. If a 35 percent ratio is safe, is obviously more economical to ratepayers, and is otherwise found reasonable by the Commission, we cannot say that it was erroneous. 4. Land Held For Future Use Issue The remaining issue with respect to Central Maine Power's revenue requirements is the Commission's treatment of the utility's Land Held for Future Use (LHFU) and Investments in Joint Corporate Projects (IJCP) accounts. The Commission's action as to this issue is contested by the Consumer Action Coalition, while Central Maine Power joins with the Commission as an appellee. In its original filings in this case Central Maine Power proposed to include in its rate base all of the property held in its LHFU and its IJCP accounts. The Commission excluded two parcels of land, allocable to these accounts, located in Stockton Springs and in Richmond, Maine. The Commission determined that Central Maine Power had not demonstrated any definite plan to use these two properties at any point in the foreseeable future. [49] The Commission included 81 percent of Central Maine Power's property on Sears Island, finding the Company had demonstrated a sufficiently definite plan for its use as a site for a coal-fired generating plant. [50] Central Maine Power has not appealed from these exclusions or adjustments. The Commission made no explicit findings as to any of the other properties included in the two accounts. Instead, finding no record evidence of either the existence or non-existence of definite plans for the properties, the Commission concluded that they should be included in rate base. [51] The Consumer Action Coalition now contends that the Commission erred by including these properties in the absence of an affirmative showing by Central Maine Power of a definite plan for their proposed use. We deny the Coalition's appeal. A review of the record discloses that the only issues raised in proceedings below regarding property held for future use which was ultimately included in rate base concerned the Sears Island property. [52] The Coalition now concedes the propriety of Commission action with respect to Sears Island, and challenges only its determination to include, without evidence of specific development plans, some forty-three relatively small items representing an average year-end investment of $657,000 out of a total rate base of $514,032,000. The failure of the Coalition to raise before the Commission [53] the issue now presented to this Courtthe proper allocation of the burden of proof with regard to inclusion of such propertiesprecludes it from advancing it here. As we have repeatedly held with respect to trial court procedure: It is an acknowledged principle, and one generally followed by this Court as necessary to a sound appellate practice, than an issue raised for the first time at the appellate stage will be denied cognizance in the appellate review of the case. Walsh v. City of Brewer, Me., 315 A.2d 200, 209 (1974) (citations omitted). As we more recently noted, the principle applies with equal force to proceedings before the Public Utilities Commission: A reviewing court usurps the agency's function when it sets aside the administrative determination upon a ground not theretofore presented and deprives the Commission of an opportunity to consider the matter, make its ruling, and state the reasons for its action. Casco Bay Lines v. Public Utilities Commission, Me., 390 A.2d 483, 487 (1978) (per curiam), quoting Unemployment Compensation Commission of Alaska v. Aragon, 329 U.S. 143, 155, 67 S.Ct. 245, 251, 91 L.Ed. 136 (1946). Neither can the Coalition contend that the mere existence of the properties, and the necessity of some action either including or excluding them from rate base, itself raises the burden of proof issue. Decisions of this Court as well as of the Commission and other regulatory bodies makes clear that merely filing for a rate increase does not automatically place a burden on the utility with respect to every item of every account. While the utility has the burden of establishing the overall justness and reasonableness of its proposed rates, absent some prior notice it cannot be called upon to account for every allocation made, property purchased, or other action taken. Central Maine Power Co. v. Public Utilities Commission, 156 Me. 295, 325, 163 A.2d 762, 778 (1960); See also Re Consumers Power Co., 14 P.U.R.4th 1 (Mich.P.S.C.1976); Re Chesapeake & Potomac Telephone Co., 57 P.U.R.3d 1 (D.C.P.S.C.1964). The issue not having been passed upon by the Commission, it must be denied appellate cognizance.