Opinion ID: 1872130
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Heading: Choice Of Capital Structure

Text: The generally accepted method of computing the fair rate of return is the cost of capital approach. The fair rate of return is essentially the same as the overall cost of capital. See South Central Bell v. Louisiana Pub. Serv. Comm'n, 352 So.2d 964, 970 (La.1977). The cost of capital may be defined briefly as the annual percentage which a utility must receive to maintain its credit, to pay a return to the owners of the enterprise, and to insure the attraction of capital in amounts adequate to meet future needs. Mathematically, the cost of capital is the composite of the cost of the several classes of capital used by a utilitydebt, preferred (and preference) stock, and common stock (par value plus earned and capital surplus)weighted on the basis of an appropriate capital structure. Phillips, The Regulation of Public Utilities at 369. The first step in estimating the overall cost of capital is choosing the appropriate capital structure for regulatory purposes. This selection is crucial because the cost of equity capital is usually higher than the cost of debt capital, both generally and for South Central Bell. The Commission disregarded South Central Bell's actual capital structure of 40.55% debt and 59.45% equity and based its determination of the cost of capital on an optimal hypothetical structure of 50% debt and 50% equity constructed from the testimony of its own expert witness. The Commission did not find that the utility's existing capital structure was unreasonable or the result of imprudent investment practices. The effect of the Commission's decision was to reduce the cost of capital, the rate of return, and consequently the revenue requirement to be raised by the rates by some $9 million annually. The end result, of course, was that the Commission fixed significantly lower rates than it would have if it had used the utility's existing capital structure. Justice Brandeis described the cost of capital and its relationship to the rate of return as follows: In essence, there is no difference between the capital charge and operating expenses, depreciation, and taxes. Each is a part of the current cost of supplying the service; and each should be met from current income. When the capital charges are for interest on the floating debt paid at the current rate, this is readily seen. But it is no less true of a legal obligation to pay interest on long-term bonds, entered into years before the rate hearing and to continue for years thereafter; and it is true also of the economic obligation to pay dividends on stock, preferred or common. The necessary cost and hence the capital charge, of money embarked recently in utilities, and of that which may be invested in the near future, may be more, as it may be less, than the prevailing rate of return required to induce capital to enter upon like enterprises at the time of a rate hearing ten years hence. To fix the return by the rate which happens to prevail at such future day opens the door to great hardships. Where the financing has been proper, the cost to the utility of the capital required to construct, equip, and operate its plant should measure the rate of return which the Constitution guarantees opportunity to earn.    The adoption of the amount prudently invested as the rate base and the amount of the capital charge as the measure of the rate of return would give definiteness to these two factors involved in rate controversies    . Missouri ex rel Southwestern Bell Tel. Co., 262 U.S. 276, 306, 43 S.Ct. 544, 552-553, 67 L.Ed. 981 (1923) (Brandeis, J., with whom Holmes, J. joined, concurring). South Central Bell contends that its existing capital structure represents an aggregate of investments that must be presumed to have been prudently made until shown otherwise and that consequently the utility is entitled to a reasonable return on its capital as actually invested. Therefore, it is argued, the Commission acted arbitrarily, capriciously and unreasonably by, in effect, disallowing part of the capital embarked by its investors for this purpose without finding that its capital structure was in any way imprudent or unreasonable. The Commission relies primarily on our opinion in South Central Bell v. Louisiana Pub. Serv. Comm'n, 373 So.2d 478 (1979) in which we held, first, that the authority of the Commission to establish a rate of return for a regulated utility on the basis of a hypothetical structure had been settled in Louisiana and, second, that it would be anomalous to require the agency to find the utility's actual capital structure imprudent or unreasonable before it is allowed to disregard it and hypothesize an artificial structure in place of the real one. Ironically, however, it is the second part of that holding that now appears to have been anomalous, particularly in light of the growing utilization of the prudent investment test and recognition of its arguable constitutional dimension. Accordingly, after reconsidering the decision carefully, in light of these factors, we conclude that it was partially in error and that the Commission must find a utility's capital structure imprudent or unreasonable before disregarding it in ratemaking. In Duquesne Light Co. v. Barasch, 488 U.S. 299, 109 S.Ct. 609, 616-7, 102 L.Ed.2d 646 (1989), Chief Justice Rehnquist succinctly set forth the history of the prudent investment or historical cost rule in the Supreme Court: At one time, it was thought that the Constitution required rates to be set according to the actual present value of the assets employed in the public service. This method, known as the `fair value' rule, is exemplified by the decision in Smyth v. Ames, [169 U.S. 466, 18 S.Ct. 418, 42 L.Ed. 819 (1898)], supra. Under the fair value approach, a `company is entitled to ask ... a fair return upon the value of that which it employs for the public convenience,' while on the other hand, `the public is entitled to demand ... that no more be exacted from it for the use of [utility property] than the services rendered by it are reasonably worth.' Id., 169 U.S. at 547, 18 S.Ct. at 434. In theory the Smyth v. Ames fair value standard mimics the operation of the competitive market. To the extent utilities' investments in plants are good ones (because their benefits exceed their costs) they are rewarded with an opportunity to earn an `above-cost' return, that is, a fair return on the current `market value' of this plant. To the extent utilities' investments turn out to be bad ones (such as plants that are canceled and so never used and useful to the public), the utilities suffer because the investments have no fair value and so justify no return. Although the fair value rule gives utilities strong incentive to manage their affairs well and to provide efficient service to the public, it suffered from practical difficulties which ultimately led to its abandonment as a constitutional requirement. In response to these problems, Justice Brandeis had advocated an alternative approach as the constitutional minimum, what has become known as the `prudent investment' or `historical cost' rule. He accepted the Smyth v. Ames eminent domain analogy, but concluded that what was `taken' by public utility regulation is not specific physical assets that are to be individually valued, but the capital prudently devoted to the public utility enterprise by the utilities' owner. Missouri ex rel. Southwestern Bell Telephone Co. v. Public Service Comm'n, 262 U.S. 276, 291, 43 S.Ct. 544, 547-548, 67 L.Ed. 981 (1923). Under the prudent investment rule, the utility is compensated for all prudent investments at their actual cost when made (their `historical' cost), irrespective of whether individual investments are deemed necessary or beneficial in hindsight. The utilities incur fewer risks, but are limited to a standard rate of return on the actual amount of money reasonably invested. Forty-five years ago in the landmark case of Federal Power Comm'n v. Hope Natural Gas Company, 320 U.S. 591, 64 S.Ct. 281, 88 L.Ed. 333 (1944), this Court abandoned the rule of Smyth v. Ames , and held that the `fair value' rule is not the only constitutionally acceptable method of fixing utility rates. In Hope we ruled that historical cost was a valid basis on which to calculate utility compensation. 320 U.S., at 605, 64 S.Ct. at 289. (`Rates which enable [a] company to operate successfully, to maintain its financial integrity, to attract capital, and to compensate its investors for the risk assumed certainly cannot be condemned as invalid, even though they might produce only a meager return on the so called `fair value' rate base'). In Duquesne the court held that a state scheme of utility regulation does not take the utility's property in violation of the Fifth and Fourteenth Amendments simply because it requires the state regulatory commission to disallow in rate making prudent capital investments that are not used and useful in service to the public. The complaining utilities did not attempt to show that the overall rate produced an end result that was confiscatory. The opinion's extensive elaboration on the prudent investment or historical cost rule, of which the state's scheme was a slightly modified form, strongly reaffirmed the rule as a valid basis on which to fix utility rates. But the court again declined to adopt a single rule as the exclusive theory of valuation as a constitutional requirement, remaining consistent with the view the court had taken since FPC v. Hope Natural Gas Co., 320 U.S. 591, 64 S.Ct. 281, 88 L.Ed. 333 (1944) ([I]t is not theory but the impact of the rate order which counts. Id. at 602, 64 S.Ct. at 288.). This leaves open the question of whether prudent investment, which need not be taken into account as such in ratemaking formulas, may nevertheless need to be taken into account in assessing the constitutionality of the particular consequences produced by those formulas. We cannot determine whether the payments a utility has been allowed to collect constitute a fair return on investment, and thus whether the government's action is confiscatory, unless we agree upon what the relevant investment is. For that purpose, all prudently incurred investment may well have to be counted. As the Court's opinion describes, that question is not presented in the present suit, which challenges techniques rather than consequences. Duquesne Light Co., 109 S.Ct. at 620 (Scalia, J., joined by Justices White and O'Connor, concurring.) Moreover, the Supreme Court indicated that the misuse or inconsistent use of a crucial rate making method, such as the prudent investment rule, even without a showing of confiscatoriness by the utility, may amount to a denial of due process. Admittedly, the impact of certain rates can only be evaluated in the context of the system under which they are imposed.    Consequently, a State's decision to arbitrarily switch back and forth between methodologies in a way which required investors to bear the risk of bad investments at some times while denying them the benefits of good investments at others would raise serious constitutional questions. Duquesne Light Co., 109 S.Ct. at 619. We need not consider the question of confiscation or any other federal or state constitutional issue that may be raised by the Commission's use of the prudent investment or original cost methodology. In the present civil case, this court's jurisdiction extends to both law and facts. La. Const. Art. V, § 5(C). United Gas Pipeline Co. v. Louisiana Pub. Serv. Comm'n, 241 La. 687, 130 So.2d 652 (1961); Southern Bell Tel. Co. v. Louisiana Pub. Serv. Comm'n, 239 La. 175, 118 So.2d 372 (La.1960); Vicksburg, S & P Ry. Co. v. Railroad Comm'n of Louisiana, 132 La. 193, 61 So. 199 (1913). It is sufficient to consider the case only under the self-imposed limited judicial review standard that this court has adopted in Public Service Commission cases. Accordingly we will determine whether the Commission's action was arbitrary, unreasonable, capricious or not based correctly on the law and supported by the evidence. Gulf States Utilities v. Louisiana Pub. Serv. Comm'n, 578 So.2d 71 (La.1991); South Central Bell v. Louisiana Pub. Serv. Comm'n, 352 So.2d 964, 968 (La.1977). The Public Service Commission reports that the prudent investment or original cost rule is its method of valuation of a utility's rate base. J. Bonbright, Principles of Public Utility Rates, 230 (1961), citing National Association of Regulatory Utility Commissioners, 1984 Annual Report on Utility and Carrier Regulation (Washington, D.C., 1985), pp. 446 and 829. Since 1932, La.R.S. 45:1176 has authorized the Commission in fixing rates to disallow any unreasonable charge or expense based on a proper finding after a hearing. In CLECO v. Louisiana Pub. Serv. Comm'n, 373 So.2d 123 (La.1979), this court held that the Commission has the power to disallow for ratemaking purposes any unreasonable or unjust operating expense paid by a utility, but [b]efore the regulatory body can make this type of adjustment, however, there must be warrant in the record of the rate case for a factual finding, or at least a reasonable inference, that the charges or expenses, are in fact unreasonable. Id. at 127. Recently, the Commission vigorously embraced and applied the prudent investment rule by finding that an electric utility's decision to continue a nuclear power plant construction project had been imprudent and by disallowing $1.4 billion of the utility's investment as part of its rate base. This court observed that the finding and disallowance were based on 40 days of hearings and voluminous evidence and upheld the Commission's action as not having been arbitrary, capricious or unreasonable. Gulf States Utilities v. Louisiana Pub. Serv. Comm'n, 578 So.2d 71 (La.1991). Explaining the prudent investment rule as approved for use by the Commission, this court said: The prudent investment standard was articulated in Justice Brandeis' seminal dissent in Southwestern Bell Telephone Co. v. Public Service Comm'n, 262 U.S. 276, 43 S.Ct. 544, 67 L.Ed. 981 (1923). Although the standard has been used by regulators to a much greater extent in the years following 1974, particularly in evaluating nuclear power plants, the concept has been long established in Louisiana jurisprudence, see Morehouse National Gas Co. v. Louisiana Public Service Comm'n, 245 La. 983, 162 So.2d 334 (1964), as well as in other jurisdictions. See, e.g., In re Consolidated Edison Co., 73 P.U.R.3d 417 (N.Y.Pub.Serv.Comm'n 1968); Waukesha Gas & Elec. Co. v. Railroad Comm'n, 181 Wis. 281, 194 N.W. 846 (1923).    Further, under the prudent investment rule, a utility is compensated for all prudent investments at their cost when made, irrespective of whether they are deemed necessary or beneficial in hindsight. Duquesne Light Co. v. Barasch, 488 U.S. 299, 109 S.Ct. 609, 102 L.Ed.2d 646 (1989). That is, the focus in a prudence inquiry is not whether a decision produced a favorable or unfavorable result, but rather, whether the process leading to the decision was a logical one, and whether the utility company reasonably relied on information and planning techniques known or knowable at the time. Metzenbaum v. Columbia Gas Transmission Corp., Opinion No. 25, 4 FERC 161,277. Although a prudence review is necessarily retrospective in that it involves an examination of past circumstances, past information available, and past decisions, these factors may not be evaluated in light of subsequent knowledge. Gulf States Utilities v. Louisiana Pub. Serv. Comm'n, 578 So.2d 71, 84-85 (1991). Applying the foregoing precepts, in light of the Commission's theory and practice in this case and others, we conclude that the Commission acted arbitrarily, capriciously and unreasonably in its refusal to accord the utility its due under the prudent investment rule. Under that principle, South Central Bell is entitled to be compensated for all prudent investments at their actual cost when made (their historical cost) irrespective of whether individual investments are deemed necessary or beneficial in hindsight. Duquesne Light Co., 109 S.Ct. at 616; and the utility is entitled to the presumption that the investments were prudent, unless the contrary is shown. Missouri ex rel, 262 U.S. at 289, n. 1, 43 S.Ct. at 547, n. 1. Evidently, the Commission correctly applies the prudent investment or original cost rule in valuating or disallowing the utility's investments to establish the rate base, thus limiting the utility to a standard rate of return on the actual amount of money prudently invested, rather than allowing it a fair return on the present value of that which it employs for the public convenience. On the other hand, the Commission did not adhere to the prudent investment rule when it would have worked to the utility's benefit in estimating the cost of capital. Without finding that the utility's capital investments were imprudent or that the capital structure resulting therefrom was unreasonable, the Commission disqualified the capital as actually invested and structured. Applying hindsight the Commission hypothesized the composition of a theoretical capital investment and structure for the utility. Because the hypothetical capital as theoretically structured would cost less, the Commission used this cost of capital in ratemaking, thereby reducing the revenue to be returned on the company's capital investment by some $9 million per year. Thus, by applying the prudent investment rule to valuate property and assets for the rate base but not to appraise the cost of capital, the Commission switched back and forth between methodologies in a way that deprived investors of any benefit of appreciation in their property value while penalizing them for having a prudent, rather than a theoretically optimal, capital structure. Insofar as we are aware, the Commission now follows the consistent practice of making a finding of imprudence based on adequate evidence after a hearing before disallowing the inclusion of an asset or investment in a utility's rate base. Because, as Justice Brandeis observed, there is no essential difference between a capital charge and an operating expense, as a cost of supplying the service that must be met from the revenue requirement, the Commission's failure to apply the rule equally to both types of costs or investments was arbitrary and unjustified. Besides, the prudent investment rule is now emerging as one of the constitutional touchstones for determining whether the payments a utility is allowed to collect constitute a fair return on investment. Consequently, a regulatory commission that does not take into account all prudently incurred investment has acted arbitrarily. The value of adhering to the precedent of South Central Bell v. Louisiana Pub. Serv. Comm'n, 373 So.2d 478 (La.1979), viz., that it is not incumbent on the commission to find the company's actual capital structure unreasonable before it could set a rate of return on the basis of a hypothetical structure, Id. at 483, is overshadowed by the injustice and arbitrariness that it engenders. Moreover, the persuasiveness of that part of the holding of the case is diminished by intrinsic problems. In the 1979 South Central Bell case, this court correctly observed that it had previously approved the Commission's use of hypothetical capital structures in ratemaking. But the court overlooked the fact that it had never before actually decided the question of whether the Commission could disregard a utility's capital structure in estimating its cost of capital without first finding that the capitalization had been based on imprudent investments or lack of due care for ratepayers' interest. In each of the two cases relied on by the 1979 SCB rate case in its holding the debt ratio was obviously unreasonably low and arguably reflected imprudence on its face. South Central Bell v. Louisiana Pub. Serv. Comm'n, 239 La. 175, 118 So.2d 372 (La. 1960) (24.7% debt/74.6% common stock) and South Central Bell v. Louisiana Pub. Serv. Comm'n, 232 La. 446, 94 So.2d 431 (La.1957) (22.3% debt/74.6% common stock). Moreover, the opinions in those cases did not discuss or rule out the possibility that the Commission actually had found that the utility had been imprudent in its investments based on evidence in the record. More important, in South Central Bell v. Louisiana Pub. Serv. Comm'n, 373 So.2d 478 (La.1979) this court evidently was not aware that the prudent investment standard had become an integral part of the Commission's methodology to the extent that the Commission's refusal to apply the rule to a utility's actual capital investment, while applying it to other types of investments, constituted an arbitrary switching between methodologies to the unfair disadvantage of the utility. Also, this court failed to take into account and discuss the cogent reasoning of courts in several other jurisdictions that expressly required that a regulatory commission make a finding of some type of imprudence or unreasonableness prior to choosing a hypothetical structure rather than a utility's actual capitalization. In Mystic Valley Gas Co. v. Department of Pub. Utilities, 359 Mass. 420, 269 N.E.2d 233 (1971), the Supreme Judicial Court of Massachusetts held that although the department would not have been bound to follow the management decision if that decision had been shown to be plainly unreasonable, the record did not show any departure from a reasonable capital structure. Therefore, the court did not perceive any justification for substituting a hypothetical capital structure for Mystic's actual capital structure. The Idaho Supreme Court decided in Boise Water Corp. v. Idaho Pub. Util. Comm'n, 97 Idaho 832, 555 P.2d 163 (1976) that the commission must accept for ratemaking purposes the actual capital structure of the utility unless it finds, on the basis of substantial evidence, that the structure is unreasonably constructed, citing e.g., New England Tel. and Tel. Co. v. Department of Pub. Utilities, 360 Mass. 443, 275 N.E.2d 493. In Southern Bell Tel. & Tel. v. Mississippi Pub. Serv. Comm'n., 237 Miss. 157, 113 So.2d 622 (1959), the Mississippi Supreme Court allowed the commission, after finding that the capital structure of the company was imprudent and uneconomical, to adopt a hypothetical capital structure for ratemaking. The Supreme Court of Colorado in Peoples Natural Gas Co. v. Public Util. Comm'n, 193 Colo. 421, 567 P.2d 377 (1977) agreed with these authorities that a utility regulatory authority cannot base rates on a hypothetical rather than the actual capital structure of a utility unless `existing capital structures of regulated companies ... so unreasonably and substantially vary from usual practice as to impose an unfair burden on the consumer.'  Id. 567 P.2d at 380. See also Alabama Pub. Serv. Comm'n v. Southern Bell Tel. Co., 253 Ala. 1, 42 So.2d 655 (1949); City of Lynchburg, et al v. Chesapeake and Potomac Tel. Co. of Virginia, 200 Va. 706, 107 S.E.2d 462 (Va.1959) (It is only when it is made clear by the evidence that the officers and directors are following a policy in this regard which unreasonably favors the stockholders at the expense of the consumers that the rate-making tribunal should substitute a capital structure radically different from one fashioned by the officers and directors of the corporation.) Nor did this court take into account in the 1979 SCB rate case that the use of a hypothetical capital structure had been adversely criticized by respected ratemaking commentators, such as Bonbright, Principles of Utility Rates 234-244. He referred to the use of a hypothetical structure as substituting an estimate of what the capital cost would be under nonexisting conditions for what it actually is or will soon be under prevailing conditions. He recognized, however, that if the existing security structure is clearly unsound or    extravagantly conservative, the rate must be modified in the public interest, in which event [a]ctual cost of capital may    disqualified in favor of legitimate cost. See also Phillips, Economics of Regulation, 282-283; Garfield & Lovejoy, Public Utility Economics, 128-131. The better reasoned decisions in other jurisdictions subsequent to 1979, the year of South Central Bell v. Louisiana Pub. Serv. Comm'n, 373 So.2d 478 (La.1979), have adopted a rule similar to that advocated by the Massachusetts, Mississippi, Idaho, Colorado, Virginia and Alabama courts and the commentators. For example, in Turpen v. Oklahoma Corp. Comm'n, 769 P.2d 1309 (Okla.1988) the Supreme Court held that [s]ince good faith is presumed on the part of public utility managers, their judgment about prudent outlays, including outlays for capital, should not be overruled unless inefficiency or improvidence on their part is shown, Id. at 1330, and approved the commission's decision not to overrule the judgment of the utility managers and impute a hypothetical debt-equity ratio. See also Continental Tel. Co. v. Alabama Pub. Serv. Comm'n, 427 So.2d 981 (Ala. 1982), citing Continental Tel. Co. v. Alabama Pub. Serv. Comm'n, 376 So.2d 1358, 1365 (Ala.1979) (It is also incorrect to arbitrarily disregard capital ratios absent some showing in the record that the ratios are temporarily distorted, deliberately misstated, or otherwise unreliable.) For the foregoing reasons, under the circumstances of this case, there having been no finding by the Commission that the actual capital structure of the utility resulted from unreasonable or imprudent investments, South Central Bell is entitled to have its rates fixed on the basis of its actual cost of capital under its existing capital structure. The Commission, upon remand of the case to it, is to reconsider, in the light of this opinion, the portions of its decisions relating to South Central Bell's appropriate capital structure and cost of capital for rate-making purposes, and to make any amendment to its rate order called for.