Opinion ID: 436086
Heading Depth: 3
Heading Rank: 2

Heading: The Inflation Adjustment and the Double Counting Problem

Text: 162 The problem of double counting for the effects of inflation, once in the rate base and again in the rate of return, has plagued oil pipeline ratemaking for some time. See, e.g., Farmers Union I, 584 F.2d at 419, 420-21; Williams Brothers Pipe Line Co., 355 I.C.C. at 487. The ICC rate base formula purports to account for inflation in valuing a pipeline's assets. See 21 FERC at 61,646; see also Farmers Union I, 584 F.2d at 421. If the chosen rate of return also reflected the effects of inflation, then the resulting return might compensate for inflation twice, and so would be excessive. 163 FERC attempted to eliminate the double counting problem by subtracting an inflation allowance from the nominal rate of return before applying it to the inflation-sensitive ICC valuation rate base. See 21 FERC at 61,646-47. Because the nominal rates of return are derived from original cost accounting, see supra at 74, they include a premium to compensate investors for the expected future rate of inflation. However, because the ICC valuation rate base is, according to FERC, already inflation-sensitive, FERC's method should deduct from the nominal rate of return the percentage by which the valuation rate base has been written up during the relevant period. Id. at 61,647. FERC defined the relevant period to be the time period that was looked to in order to derive the appropriate nominal rate of return. Id. at 61,712 n. 511. For example, if the nominal rate of return were set by reference to returns on shareholder book equity over the most recent year, that nominal rate would be reduced by the percentage amount that the valuation rate base had increased over the most recent year. In this way FERC believed it could avoid overcompensation for inflation. Id. at 61,646. 164 Farmers Union, among others, objects to this inflation adjustment on the ground that it does not compensate for actual inflation. It put forward strong evidence, including calculations made by Commissioner Hughes in his separate statement, to show that the valuation rate base does not track inflation in any predictable manner. 71 See 21 FERC at 61,725 (Hughes, Comm'r, dissenting in part and concurring in part) (A ... serious defect [in FERC's decision], and I believe, an uncorrectable one, is the unstated assumption that the trending of the rate base in the valuation formula approximates or should approximate the course of inflation.); 72 see also Farmers Union I, 584 F.2d at 519 & n. 29; J.A. at 2455 (testimony of Thomas C. Spavins) (highlighting the lack of a clear correspondence between [the ICC] valuation returns and any clear system of indexing returns for inflation). 165 FERC in a footnote anticipated such a criticism, and responded: Suppose that [the ICC formula] does lead to an overly generous allowance for inflation in the rate base. What of it? The rate of return on equity is reduced by the precise amount of the overstatement. 21 FERC at 61,712 n. 513. This defense is sound, as far as it goes. Speaking precisely, FERC's inflation adjustment does not operate as an adjustment to compensate for the effects of inflation; rather, it operates as an adjustment to compensate for the effects of rate base appreciation, which, if left in the calculus, would lead to double counting. The important feature of such a scheme is not that the rate of inflation and the rate of rate base write up are the same; instead, it is important only to assure that the increase in the rate base--which is affected and indeed justified by the fact that present values reflect inflationary effects--is not counted in calculating rates because expected inflation is already reflected in the level of rates of return. In simple terms, then, the inflation adjustment operates to write off the write-up in the valuation rate base through a deduction from the nominal rate of return. See 21 FERC at 61,646-47. 166 Unfortunately, however, and without explanation, FERC decided that the needed adjustment should be determined by reference to rate base appreciation during the time period that was looked to in order to derive the appropriate nominal rate of return. See supra at 1524. This time period could range from the most recent year only, to the long run--25 years, 50 years, or more. 21 FERC at 61,645; see supra at 1522. The allowable returns to the pipeline, by contrast, reflect the entire appreciation in the rate base over the life of the pipeline's assets. The inflation adjustment, therefore, will not necessarily reflect the full rate of write up reflected in the rate base. Furthermore, it is likely that the inflation adjustment will leave in the final rates significant double counting, because under FERC's method the oil pipelines are empowered to select for themselves the applicable rate of return index, and, as a corollary, they also select the time period relevant to calculating the inflation adjustment. Accordingly, the FERC methodology allows the oil pipeline companies to select a time period during which the rate base appreciated at a slower rate than average. In this way, the FERC method permits the regulated companies to select the rate of return index that will result in an adjustment that understates the actual overall rate base appreciation. In Commissioner Hughes' words, the FERC method invites an enormous amount of gamesmanship. Eight rate of return options are suggested, some with multiple choices of time periods. The inflation/valuation variance gives an exciting new twist to a pipeline's choice among the candidates. Thus a firm might choose to base its return one year on stock market performance after a bull market, and in its next filing switch to a high oil company comparison which might be offset by a small increase in its own valuation. 21 FERC at 61,726 (Hughes, Comm'r, dissenting in part and concurring in part). 167 3. FERC's Equity Component Has No Meaningful Relation to the Rates of Return on Book Equity 168 Even more capricious was FERC's application of the rates of return, representing revenues on the book equity of unregulated companies, to what FERC called the equity component of the valuation rate base. As noted above, FERC's notion of the equity component includes the original paid-in equity of the pipeline plus the entire write up in the rate base. See supra at 1522. For example, consider an oil pipeline, originally financed with $900,000 debt and $100,000 equity. The original cost of the pipeline is one million dollars. Over time, the pipeline's valuation rate base increases to, say, $1,500,000. Under FERC's method, the equity component of the rate base amounts to $600,000, six times its book equity, even though the valuation rate base as a whole has appreciated only by half. Thus, FERC's method magnifies the equity component of the rate base to spectacular proportions, especially in an industry as highly debt-leveraged as the oil pipelines. 73 See supra note 58. At the same time, however, FERC's selected rates of return reflect the revenues of the unregulated companies as a percentage of their book equity. To set allowable revenues for the oil companies, FERC took these rates of return and applied them to a completely different measure of net worth, the equity component of the rate base. Book equity, unlike FERC's newly devised equity component, represents the underlying net assets in original cost terms. Because book value of an equity share has no significance as to the present value of the company's assets, the returns on book equity likewise have no significance in relation to the equity component of the valuation rate base. See, e.g., J. Gentry, Jr. & G. Johnson, Finney & Miller's Principles of Accounting 367-68 (8th ed. 1980). 169 Assuming arguendo that the inflation adjustment accurately compensates for the rate of rate base appreciation, which it does not, see supra at 1524-25, such an adjustment would compensate only for the appreciation attributable to the portion of the rate base financed by the paid-in capital of equityholders. It would never compensate for the fact that FERC includes the entire appreciation on the rate base--attributable to both the equity and debt components of the pipeline--in its equity component. Accordingly, FERC's method ensures that the allowable revenues for oil pipelines will exceed the revenues earned by its selected unregulated companies by the extent to which the pipelines' equity component exceeds the portion of the rate base financed through equity investments. Cf. 21 FERC at 61,712 n. 519 (under the more austere standard of fairness, FERC would trend only the equity portion of the rate base for inflation). In most cases, this difference will be very large. 74 170 Indeed, FERC provides no analysis of why its application of its selected rates of return to an unrelated measure of rate base equity should keep a cap on gross abuse in the resulting rates, not to mention the lack of any assurance that the resulting rates will be just and reasonable. Commissioner Hughes appears to have rightly characterized FERC's game as Dialing for Dollars instead of The Price is Right. See 21 FERC at 61,730 n. 4 (Hughes, Comm'r, dissenting in part and concurring in part). We cannot condone such a ratemaking methodology, which assures nothing except that permissible rate levels will be very high. 171 In an attempt to defend the mismatch between its selected rates of return (on book equity) and its equity component of the valuation rate base, FERC claimed that its method of calculating the equity component gives the equityholders the full benefit of debt leveraging. Just as a seller of a house benefits from the entire appreciation of the value of the house regardless of the amount of debt that financed the original purchase, FERC believed that so, too, should the equityholders in oil pipelines receive an equity kicker in their rate base. See 21 FERC at 61,648-50. This analysis overlooks the fact that oil pipeline companies are in fact free to sell their assets, and thereby enjoy the full benefit of debt leveraging in the difference between the sale price and the original cost of the assets. Such an equity kicker, however, has no significant relationship with the determination of the cost of capital. A rate of return should set the proper rewards for investors in the form of current income, not asset appreciation and sale. FERC's attempted defense of its use of its equity component thus fails to meet minimal standards of reason. 75 172 While the determination of a fair rate of return cannot and should not be constrained to the mechanical application of a single formula or combination of formulas, the ratemaking agency has a duty to ensure that the method of selecting appropriate rates of return are reasonably related to the method of calculating the rate base. See, e.g., FPC v. Hope Natural Gas Co., 320 U.S. 591, 605, 64 S.Ct. 281, 289, 88 L.Ed. 333 (1944); Dayton Power & Light Co. v. Public Utilities Commission, 292 U.S. 290, 311, 54 S.Ct. 647, 657, 78 L.Ed. 1267 (1934); NEPCO Municipal Rate Committee v. FERC, 668 F.2d 1327, 1342 (D.C.Cir.1981), cert. denied, 457 U.S. 1117, 102 S.Ct. 2928, 73 L.Ed.2d 1329 (1982). Our disapproval of FERC's decision to retain the ICC rate base formula, see supra at 1520-21, did not turn on the substantive validity of the rate base calculations. FERC may adopt any method of valuation for rate base purposes so long as the end result of the ratemaking process is reasonable. See, e.g., FPC v. Natural Gas Pipeline Co., 315 U.S. 575, 586, 62 S.Ct. 736, 743, 86 L.Ed. 1037 (1942); NEPCO Municipal Rate Committee v. FERC, 668 F.2d at 1333; Washington Gas Light Co. v. Baker, 188 F.2d 11, 18 (D.C.Cir.1950), cert. denied, 340 U.S. 952, 71 S.Ct. 571, 95 L.Ed. 686 (1951). Rather, our disapproval arose out of the FERC's failure to give a reasoned explanation for its rejection of responsible rate base alternatives. We now find, however, as a result of the foregoing considerations, that the combination of FERC's rate base and rate of return methodologies does not produce an acceptable end result. Accordingly, we disapprove FERC's ratemaking methodology on this additional basis.