Opinion ID: 436086
Heading Depth: 3
Heading Rank: 1

Heading: Original Cost Rate Base

Text: 90 Many parties to the Williams proceeding--including the FERC staff, the Department of Energy, the Justice Department, Farmers Union Central Exchange--advocated the calculation of oil pipeline rate bases by reference to original cost. 55 These witnesses called for the rejection of the old ICC methodology, because its use of a weighted average of original cost and replacement cost, see supra at 1495, lacks any economic rationale. 56 91 Despite explicit concessions as to the shortcomings of the ICC rate base formula and the recognized advantages of a rate base formula derived from original cost, 57 FERC rejected the original cost alternative. FERC offered four reasons for this decision. First, FERC wished to avoid the headache of analyzing the significance of guarantees--given by many parent oil companies to their subsidiary oil pipeline companies--in the estimation of the true capital structure of oil pipelines. 58 See 21 FERC at 61,620-22. Second, FERC believed that the major regulatory benefit that might be derived from a switch to original cost accounting--the facilitation of comparable earnings analysis in relation to other businesses with a comparable risk to the pipelines--would not be useful in oil pipeline rate regulation, because the oil managers, as professional risk takers, have ingrained attitudes toward risk and return unlike any other public utility investors. Third, an original cost rate base, without modification for inflation, would result in high initial rates that would decline as the rate base depreciates. FERC believed that competition in the oil pipeline business might prevent the pipelines from collecting the high initial rates, thereby preventing them from reaping their appropriate return on investment. See id. at 61,628-29. Finally, FERC found that any benefits resulting from changes in the rate base formula would not warrant the social costs entailed, id. at 61,631, specifically, the construction of transitional rate bases ... for each of the many common carrier oil pipelines, id. at 61,704 n. 376. We find that none of FERC's explanations for its rejection of an original cost rate base satisfies accepted standards of reasoned decisionmaking. 59 a. Parent Guarantees and Capital Structure 92 Because of parent companies' debt guarantees and throughput and deficiencies agreements, many shipper-owned pipelines are able to obtain debt financing more cheaply and in greater amounts than would be possible in the absence of such agreements. See supra note 58. Further, since cost of equity virtually always exceeds cost of debt, the greater the pipelines' debt ratio, the lower its overall cost of capital. See United States v. FCC, 707 F.2d 610, 613 (D.C.Cir.1983). Accordingly, as FERC recognized in its establishment of a suretyship premium, see supra at 1496, the real cost of capital to a pipeline that benefits from such parent guarantees is greater than its apparent cost of capital. 93 Regulatory agencies have often assessed a regulated company's true cost of capital by constructing hypothetical capital structures, and then applying the normal costs of equity and debt to the hypothetical mix of securities. See Communications Satellite Corp. v. FCC, 611 F.2d 883, 902-09 (D.C.Cir.1977) (citing numerous cases involving water, gas, electric and telephone utilities). By this method, regulatory agencies ensure that the derived rate is just and reasonable: 94 Although the determination of whether bonds or stocks should be issued is for management, the matter of debt ratio is not exclusively within its province. Debt ratio substantially affects the manner and cost of obtaining new capital. It is therefore an important factor in the rate of return and must necessarily come within the authority of the body charged by law with the duty of fixing a just and reasonable rate of return. 95 Id. at 903 (quoting New England Telephone & Telegraph Co. v. State, 98 N.H. 211, 220, 97 A.2d 213, 220 (1953)). In the case of oil pipelines, the hypothetical capital structure would be approximated by estimating the capacity of the pipeline to support debt in the absence of its parents' guarantees. See 21 FERC at 61,621. 96 FERC refused to adopt an original cost rate base in part because it believed that the attendant necessity for constructing hypothetical capital structures would be a laborious exercise in guesswork, a venture 'into the unknown and unknowable.'  Id. at 61,622 (quoting Christiana Securities Co., 45 SEC 649, 668 (1974)). In FERC's view, such an inquiry would be: 97 a perfect field day for regulatory economists. Professor A would testify that he thinks 70% debt and 30% equity right. Professor B would say 53% debt and 47% equity. Professor C would come on strong for 50-50. Miss D from an eminent Wall Street investment banking firm would testify that her computer tells her that 65% equity and 35% debt are the right mix. Mr. E from an even more eminent investment banking firm would have numbers of his own. 98 Id. at 61,622. In part to avoid such an inquiry, FERC chose to avoid an original cost rate base. 99 This explanation runs counter not only to the proven practice of FERC and many regulatory agencies 60 but also to FERC's own commentary later in the Williams opinion. As we have explained above, the technique of hypothesizing capital structures for oil pipelines would account for the increased capital costs associated with financing a pipeline in the absence of guarantees from the parents. Later in the Williams opinion, FERC devises its suretyship premium to compensate for the parents' guarantees of pipeline debt. FERC, however, appeared confident that any difficulties with estimating the value of this premium could be surmounted: 100 Credible expert testimony by persons associated with the rating services, the investment banking fraternity, and the credit insurance industry as well as by academics who have made a specialty of the bond market [can] establish[ ] that absent the parents' guarantee [what] the pipeline would have had to pay .... 101 Id. at 61,644. 102 We cannot square FERC's apparent confidence in its ability to estimate a pipeline's suretyship premium with its extreme skepticism about its ability to construct hypothetical capital structures. After all, the suretyship premium represents merely the differential between a pipeline's actual cost of capital and what its cost of capital would have been absent the parent guarantees. Thus the suretyship premium measures the same incremental cost of capital to the pipeline as the hypothetical capital structures that FERC felt incapable of estimating. The basis for FERC's preference for its suretyship premium approach, and for its aversion to hypothetical capital structures is therefore unclear. The decision to reject original cost accounting on the basis of this preference and aversion appears arbitrary, and, in any event, lacks sufficient explanation. 103 Moreover, even assuming that FERC's preference for its suretyship premium approach could be explained, its rejection of original cost ratemaking because of that preference relies on the assumption that original cost ratemaking is necessarily tied to hypothetical capital structures and necessarily incompatible with its newly devised suretyship premium. However, FERC never gave any reason at all why this assumption is valid. Indeed, we see no reason why FERC could not account for the parent guarantees by using a suretyship premium added to an original cost ratemaking formula. 104 If FERC, in the exercise of informed discretion, decides that the suretyship premium approach is more reliable or easier to administer than hypothetical capital structures, then it should state why. 61 As of now, neither FERC nor any of the parties has provided such an explanation. Even if they did so, however, we still would not understand why the hypothetical capital structure method must be used with original cost ratemaking, or why the suretyship premium approach cannot be used with original cost ratemaking.b. Comparable Risk Analyses 105 FERC discerned still more fundamental problems associated with the use of original cost ratemaking, beyond the estimation of appropriate capital structures. As typically applied under the just and reasonable standard, original cost ratemaking attempts to set the rate of return for a regulated enterprise at the same level as the rate of return of an unregulated enterprise with similar associated risks. See, e.g., FPC v. Hope Natural Gas Co., 320 U.S. 591, 603, 64 S.Ct. 281, 288, 88 L.Ed. 333 (1944) (By that standard [of 'just and reasonable' rates] the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks.); Bluefield Water Works & Improvement Co. v. Public Service Commission, 262 U.S. 679, 692, 43 S.Ct. 675, 679, 67 L.Ed. 1176 (1923) (A public utility is entitled to such rates as will permit it to earn a return ... equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by the same risks and uncertainties.); A. Priest, Principles of Public Utility Regulation 191-94 (1969). FERC, however, believed that such a risk inquiry was not useful or relevant to oil pipeline ratemaking. In FERC's view, oil company managers--who own many oil pipelines--are a special breed of risk takers, who demand a fair chance of earning as much on a pipeline as they would be likely to earn on something else in the unregulated sector regardless of risk. 21 FERC at 61,623. 62 Accordingly, FERC rejected original cost ratemaking in part because the conventional ratemaking inquiry that its use facilitates--the inquiry into risk--was, according to FERC, not helpful in oil pipeline ratemaking. 106 We think that this argument not only lacks any evidentiary support, it also lacks economic common sense. In neither the Williams opinion nor in its briefs to this court does FERC cite any evidentiary basis for its conclusion that oil managers will invest in only high return enterprises. In fact, the record is chock full of testimony regarding the risks of the oil pipeline business and the corresponding appropriate rate of return. 63 Furthermore, major studies of the oil pipeline industry have concluded that the oil company managers decide whether to invest in a particular pipeline only after an examination of whether the expected returns match the associated risks: 107 When appraising the economic viability of a proposed pipeline venture, the approach taken is similar to that used by investors in general; it is what may be termed as required rate of return analysis. An oil company has widespread operations with numerous investment opportunities bearing different degrees of risk. Because of this, each investment, including pipelines, must be examined individually, and its expected rate of return compared with the opportunity rate of return of other prospective investments with comparable risk characteristics. 108 G. Wolbert, Jr., U.S. Oil Pipelines, 156 (1979) (footnotes omitted); see Exxon Pipeline Co./Exxon Co., U.S.A., Rates of Return on Petroleum Pipeline Investments, reprinted in Oil Pipelines and Public Policy 261, 268-69 (E. Mitchell ed. 1979) ( 'The required rate of return on an investment opportunity depends on the riskiness of the investment. The greater the riskiness of the investment, the more the return demanded by investors.' ) (quoting E. Solomon & J. Pringle, Introduction to Financial Management 332 (1977)). 109 ICC oil pipeline ratemaking precedents also belie FERC's novel notions about the relationship between risk and required return in the industry. FERC's notion that the oil companies demand high returns, no matter how low the risk, represents a radical departure from the ICC practice of evaluating risk and estimating the required return accordingly. See, e.g., Reduced Pipe Line Rates and Gathering Charges, 272 I.C.C. 375, 381 (1948); Minnelusa Oil Corp. v. Continental Pipe Line Co., 258 I.C.C. 41, 51 (1944); Reduced Pipe Line Rates and Gathering Charges, 243 I.C.C. 115, 131 (1940). Similarly, in 1978 this court called on FERC to reexamine the complex of relevant factors in determining the proper rates of return for oil pipelines, including the hazards prevailing in the pipeline business. See Farmers Union I, 584 F.2d at 419. 110 We thus find no basis to support, and overwhelming evidence to contradict, FERC's finding that comparable risk analysis has no important role in oil pipeline rate regulation. We therefore believe that FERC's rejection of original cost ratemaking on the basis of that finding is arbitrary and capricious. 111 c. The Front-End Load Problem 112 FERC next offered another, independent reason for rejecting original cost ratemaking: the front-end load problem. 64 See supra at 1512. However, FERC itself acknowledged that this problem could be solved by using a trended, inflation-sensitive original cost rate base: 113 [W]e find the case for an inflation-sensitive oil pipeline rate base strong. 114 Such a rate base mitigates original cost regulation's income-bunching effect. It does not necessarily follow that the [old ICC rate base formula] is the ideal solution to the front-end load, income-bunching problem. Were we writing on an absolutely clean slate, were we beginning afresh in a brave new world, were pipelines a novelty that had just made their appearance, we would fashion an inflation-sensitive, anti-bunching rate base policy simpler and more logical than the ICC's. 115 21 FERC at 61,630. According to FERC, this simpler and more logical method would [k]eep[ ] the rate base in tune with the general price level by linking it to the consumer price index or to the gross national product. Id. The trended original cost method of calculating rate bases, as discussed by witnesses in the Williams proceeding and other experts, fits this description. See, e.g., J.A. at 1508-12 (testimony of Stewart C. Myers on behalf of Marathon Pipe Line Co.); J.A. at 1957 (testimony of David A. Roach on behalf of MAPCO); Streiter, Trending the Rate Base, Pub. Util. Fort., May 12, 1982, at 32; cf. J.A. at 1677-1702 (testimony of Michael C. Jensen on behalf of ARCO Pipe Line Co.) (describing inflation-adjusted original cost method, the results of which are equivalent to adjusting the rate base and depreciation by the unprojected inflation). Indeed, at one point, FERC declared that if it were beginning afresh on a clean slate [it] might be inclined to use something ... along the lines suggested by Marathon's witness Meyers [sic]. 21 FERC at 61,616. Marathon's witness Myers recommended the use of a trended original cost rate base if the old ICC method were to be abandoned. See J.A. at 1427, 1499. Thus FERC acknowledged that the front-end load problem could be solved, by adjusting an original cost rate base for inflation. Accordingly, FERC could not have reasonably relied upon the front-end load problem as a basis for rejecting the admittedly simpler and more logical trended original cost alternative. 116 d. The Social Costs and Benefits of Transition to a New Rate Base Formula 117 Although a trended original cost approach would evidently be simpler and more logical than the ICC's, 21 FERC at 61,630, FERC in the end rejected this alternative because of the social costs entailed in a transition from one rate base formula to another. See supra at 1512. FERC specified these social costs in an accompanying footnote: 118 Transitional rate bases would have to be constructed for each of the many common carrier oil pipelines. That would be a formidable, a difficult, and a costly endeavor. The task could be by-passed by using the most recent valuation (or in the alternative the cost of reproduction new less depreciation element of that valuation) as the transitional rate base. But then how much substantive change would there really be for existing pipelines? We conclude the change would be far more costly than it is worth. 119 Id. at 61,704 n. 376. We are reluctant to sanction the rejection of an admittedly more logical and accurate rate base formula on the basis of the conclusionary statement that the construction of transitional rate bases would be too costly. First, FERC failed to give a reasoned basis for its assumption that [t]ransitional rate bases would have to be constructed at all. Regulated industries have no vested interest in any particular method of rate base calculation. See FPC v. Natural Gas Pipeline Co., 315 U.S. 575, 586, 62 S.Ct. 736, 743, 86 L.Ed. 1037 (1942). Accordingly, as FERC acknowledged, a switch to a new rate base formula would not disrupt protected pipeline property. So long as the resulting rates are reasonable, the oil pipeline companies should have no difficulty maintaining their financial integrity. We are therefore at a loss to understand FERC's trepidation about a change in its regulatory method. Similarly, when this court granted FERC's request to remand this case so that it may begin its regulatory duties in this area with a clean slate, Farmers Union I, 584 F.2d at 421, we specifically advised that the pipelines' reliance on an outdated rate base formula should not justify a continuation of the error. Rather, the solution is not to perpet[u]ate that reliance but to end it prospectively, without allowing reparations based on its occurrence in the past. Id. at 419. We still adhere to that principle today. 65 120 Second, FERC never explained why the construction of transitional rate bases would be so formidable a task. It is not self-evident why the calculation of such rate bases would entail more regulatory costs than the calculation of rate bases under the arcane ICC formula. 66 Furthermore, the formulation of a method for calculating transitional rate bases involves questions no more complex than those confronting FERC regularly. 121 Finally, regardless of the regulatory or social costs entailed, FERC appeared to reject alternatives to the ICC formula because it found no clear showing that changing the methodology would produce substantial social benefits. Id. at 61,626; see also id. at 61,703 n. 373. This finding, however, apparently relies upon FERC's antecedent findings that oil pipeline ratemaking should merely set price ceilings that would seldom be reached in actual practice, and that comparable risk analysis would not be helpful to the ratemaking inquiry for oil pipelines. However, we have found those antecedent findings to be defective. See supra at 1502-03, 1515-16. As a result, we likewise disapprove of FERC's finding that a new rate base formula could not produce any substantial social benefit. 122 After carefully reviewing the bases put forward by FERC for rejecting the original cost alternative, we hold that FERC failed to examine the relevant data and articulate a satisfactory explanation for its action. Motor Vehicle Manufacturers Association, 103 S.Ct. at 2866. In our view it did not offer a reasoned explanation for adhering to an admittedly antiquated and inaccurate formula, but rather a host of unconvincing excuses that fail to add up to a rational choice. 123