Opinion ID: 2279962
Heading Depth: 1
Heading Rank: 8

Heading: The Rate at Which AFUDC Should Be Capitalized

Text: In 1978, this Court decided that the election to capitalize AFUDC at either a gross or a net rate is within the sound discretion of the PUC. Central Maine Power Company v. Public Utilities Commission, Me., 382 A.2d 302, 321 (1978). We thereby affirmed, over the Company's challenge, the PUC's longstanding practice of choosing the gross rate. See e. g., Re: Central Maine Power Company, 15 PUR 4th 455, 471-72 (Me.P.U.C.1976). In this appeal, the Company once again attacks that practice, claiming that the PUC abused its discretion by electing, contrary to the testimony of its own as well as a Company witness, not to employ a net rate. AFUDC, or Allowance for Funds Used During Construction, is the cost of capital expended on construction work in progress (CWIP). For purposes of analysis, the cost of capital, which resembles other construction related costs such as wages and purchases, may be said to have two components. The first, an interest component, would be explicit interest on borrowed funds. The second, an equity component, would be the return that is foregone when capital passes into ongoing construction work rather than into alternative investments. According to Staff witness Bruce Louiselle, when a utility plant is not yet in service, wages, purchases, and all other costs of CWIPwith the notable exception of AFUDCare not included by the Company as current expenses in its test-year income statement. Rather, they are capitalized, prorated over the useful life of the plant under construction, and ultimately recovered from future ratepayers by means of depreciation expenses. [5] AFUDC, by contrast, does appear in the test-year income statement. Although booked by accounting convention as other income, AFUDC generates savings on income tax as a current expense. For rate-making purposes, the Commission has consistently treated the AFUDC accrued over the given test-year as income, not as expense. AFUDC thus offsets CWIP, which the PUC adds to rate base. (Rate base, again, consists of capital owners' investment in property used or required to be used in utility service; when rate base is multiplied by the fair rate of return, it gives the required return in dollars). So long as AFUDC is itself capitalized at the fair rate of return, the gross rate, the return required by virtue of CWIP's inclusion in rate base, is effectively offset by the return earned by virtue of AFUDC's inclusion in income. Construction work in progress, consequently, does not generate a rate increase. If, however, the above-mentioned tax savings attributable to the interest component of AFUDC are netted out of the fair rate of return and AFUDC is capitalized at this lesser net rate, the return required becomes greater than the return earned, and construction work in progress can generate need of a rate increase. In practical effect, therefore, the PUC's decision to capitalize AFUDC at a gross rate flows through to current ratepayers the benefits of the Company's current tax savings. In Central Maine Power v. Public Utilities Commission, Me., 382 A.2d 302, 319-20 (1978), the Company argued against the reasonableness of this flow-through. The Company does not renew those arguments in this appeal. Instead, its contentions rest entirely on the alleged impact of the gross rate on its financial integrity, that is, on the Company's future bond ratings and ability to attract capital. When the effects of attrition, or the tendency of inflation to diminish the actual rate of return, are added to the effects of use of the gross rate, the PUC's handling of the AFUDC issue concededly reduces the Company's revenue requirements by some $5,500,000. Staff witness Bruce Louiselle conducted an exhaustive study of the impact of the gross versus the net rate on the Company's financial integrity. In so doing, Louiselle made use of a Company-supplied 1980-1990 construction schedule. The schedule included projected expenditures for the planned coal-fueled generating facility on Sears Island. Basing one set of calculations on the assumption that Sears Island would be built as scheduled and another set of calculations on the opposite assumption, Louiselle concluded: In my view ... [the results of my study] indicate that CMP can finance its construction program, including Sears Island, on reasonable terms were it required to capitalize AFUDC at a net rate. Were Sears Island not to be constructed and not replaced by another project, CMP could finance its program on reasonable terms were it required to capitalize AFUDC at a gross rate. (emphasis added). In opting against the net rate, the PUC is its decree described Louiselle's study, quoted his conclusions, and then noted: [The Staff] takes the position that the `gross' AFUDC rate should be used because at this time it is unclear whether Sears Island (or some other project) will be undertaken. The Staff thus urges that `the Commission should not at present make a blind guess as to the future of the Sears Island Coal Plant and should therefore continue its present practice [of using the gross AFUDC rate] until that future is ascertained.' The Commission agrees with the staff on this point . . . . Relying on the above-quoted portion of Louiselle's testimony, the Company argues in this appeal that the PUC's continuing use of the gross rate unreasonably assumes that no new generating capacity will be needed. [6] The Commission counters that its order assumes no such thing. The order merely finds that existing uncertainties surrounding Sears Island and the need for new capacity warrant no change as yet in past practice. By the time of the next rate proceedingwhen, presumably, the Company's now pending petition to construct the Sears Island plant will have been decided and its load forecast and proposed construction schedule will therein have been revieweda change to a net capitalization rate may be in order. But such a change, for the present, would be irresponsible. After carefully reviewing the record, we conclude that the Commission's decision to continue its past practice of capitalizing AFUDC at the gross rate was well within its discretion. At bottom, that decision rests on the Commission's factual finding that a shift [from gross to net capitalization rate] is not now essential to the Company's financial integrity.  (emphasis added). Support for this finding lies in the testimony of Dr. Ileo, consultant to intervenor Bath Iron Works, who stated: In my opinion, the only time a utility should be permitted to earn a return on CWIP projects is when it is determined that the utility will repeatedly suffer cash flow problems. My analysis of CMP'S cash flow position indicates that it has no such problem. Support also lies in the testimony of Louiselle himself. Louiselle's study determined that if the PUC continues to capitalize AFUDC at the gross rate, Company debt coverage would fall below minimum indenture requirements by 1985. But Louiselle readily admitted that another rate proceeding was likely before 1985. He assumed for purposes of his recommendations that construction would proceed according to the Company-supplied 1980-90 program. But he admitted that utilities in the past had often overestimated their load forecasts, and he noted the reasonableness of the Company's construction program, the likelihood that it would proceed on schedule, and that the accuracy of the expenditures it proposed had not been examined by him. Finally, Louiselle stated that as a matter of principle AFUDC should be based on the fair rate of return, except in extraordinary circumstances. [7] The PUC staff, obviously, was unwilling to assume the existence of extraordinary circumstances until it had had full opportunity to review the need for new capacity in the context of the pending Sears Island certification petition. On this record, the Staff position was clearly justified, and it was not error for the Commission to adopt it. See Central Maine Power Company v. P.U.C., supra, 405 A.2d at 185-86. See also Central Maine Power Company v. P.U.C., Me., 414 A.2d 1217, 1232 (1980).