Opinion ID: 2613967
Heading Depth: 1
Heading Rank: 2

Heading: the lawfulness of the 12.2% rate of return on equity

Text: The ratepayers assert that the Commission's authorization of a 12.2% rate of return on equity is not supported by the evidence and that the Commission's own findings compel the conclusion that the 11.8% rate of return previously in effect continued to reflect the actual cost of equity capital. In support of their argument, the ratepayers rely on the Commission's findings that (1) the previously authorized rate of return of 11.8% was sufficient to permit ... the Company to raise capital at reasonable rates; (2) since the last USWC rate case and the last filing in the instant case, USWC's capital costs had declined; and (3) USWC had financed almost 100% of its capital needs from cash flow created by extremely liberal rates of depreciation and deferred taxes. The ratepayers assert that the Commission, without any basis in law or fact, increased USWC's authorized rate of return to induce USWC to make discretionary investments in Utah. USWC contends that there is substantial evidence to support the 12.2% rate of return and that the ratepayers have not marshaled the evidence and shown that the evidence in support of that rate of return is legally inadequate. Two polar constitutional principles fix the parameters of rate regulation for natural monopolies: the protection of utility investors from confiscatory rates and, of equal importance, the protection of ratepayers from exploitive rates. Those principles were set out in the watershed case of Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591, 64 S.Ct. 281, 88 L.Ed. 333 (1944), and have been reiterated in subsequent cases, both federal and state. E.g., Federal Power Comm'n v. Memphis Light, Gas & Water Div., 411 U.S. 458, 474, 93 S.Ct. 1723, 1732, 36 L.Ed.2d 426 (1973) ([U]nder Hope Natural Gas rates are `just and reasonable' only if consumer interests are protected and if the financial health of the pipeline in our economic system remains strong....); Washington Gas Light Co. v. Baker, 188 F.2d 11, 19-20 (D.C.Cir.1950) (inclusion in rate base must be just and reasonable to consumers and investors), cert. denied, 340 U.S. 952, 71 S.Ct. 571, 572, 95 L.Ed. 686 (1951); Myers v. Blair Tel. Co., 194 Neb. 55, 230 N.W.2d 190, 196 (1975) (The commission can no more permit the utility to have confiscatory rates for the service it performs than it can compel a utility to provide service without just and equitable compensation.); Mountain States Tel. & Tel. v. Department of Pub. Serv. Comm'n, 191 Mont. 331, 624 P.2d 481, 483 (1981). To avoid confiscatory rates on the one hand and exploitive rates on the other, the Commission must determine what a just and reasonable rate is under Utah Code Ann. § 54-4-4 by applying a standard that is based on a utility's cost of service. A cost-of-service standard mandates that rates produce enough revenue to pay a utility's operating expenses plus a reasonable return on capital invested, often referred to as the cost of capital. The cost of capital includes the cost of debt service and a return on equity capital sufficient to attract investors, given the nature of the risk of the investment. Federal Power Comm'n v. Hope Natural Gas Co., 320 U.S. 591, 603, 64 S.Ct. 281, 288, 88 L.Ed. 333 (1944); Jersey Cent. Power & Light Co. v. FERC, 810 F.2d 1168, 1178 (D.C.Cir.1987); see also James C. Bonbright et al., Principles of Public Utility Rates 302-40 (2d ed. 1988). The cost of capital for utilities is generally less than the cost of capital for industrial corporations because investments in utilities are typically less risky than investments in industrial corporations. Throughout the proceedings before the Commission and in its brief before this Court, USWC has contended that the rate of return on equity capital to which it is entitled should be the same as the rate of return its unregulated parent corporation, U.S. West, Inc., earns on its equity capital. [5] The Commission initially rejected that conclusion and USWC's argument that economic and technological conditions in the regulated telecommunications industry had changed so much that USWC was simply the equivalent of an unregulated industrial corporation. The Commission ruled that despite technological changes in the industry, USWC was not like an unregulated company. The Commission stated that although the telecommunications industry is changing in significant ways[,] [s]uch changes have yet to disturb the essential characteristics of USWC as a regulated provider of essential services in this jurisdiction: the well known aspects of a monopoly position in the relevant market, the trust relationship between utility and consumers, and the imposed constraints upon both prices charged for services and rate of return. As conditions change, the Commission may, in future dockets, conclude otherwise. [6] Accordingly, the Commission discounted testimony from USWC's experts with respect to the cost of equity capital because their opinions were based on the incorrect premise that investment risks in USWC were comparable to investment risks in unregulated industrial corporations. [7] After reviewing the expert testimony presented by all parties which supported rates of return from 11.1% to 15% and considering a variety of other factors, the Commission stated, Were this a complete summary of our conclusions, a return award at, or, more probably, below the current allowed return [11.8%] would be inescapable. (Emphasis added.) In its penultimate conclusion in that part of its report fixing the rate of return on equity, the Commission stated: Without dispute, capital costs have declined since the previous rate of return decision of 11.8 percent, and even since the filing of direct testimony. Taken alone, this would argue for a reduction in allowed return.... The Commission is convinced a reduction in the current equity return, though advocated by witnesses for the Committee and the Division, would likewise be in error, given the risk implications of the changing industry and the status of the general economy in relation thereto. (Emphasis added.) Thus, the Commission refused to reduce USWC's rate of return below 11.8%, [8] even though the Commission had previously made allowances for the risk implications of the changing industry and the status of the general economy in relation thereto by allowing very liberal accelerated depreciation of USWC's assets. The Commission stated: In past decisions, the Commission has granted shorter asset lives and thereby increased depreciation expense. One result of this policy has been to protect the Company from the risks of technological obsolescence. Another has been to enhance the Company's positive cash flow thus enabling it to continue to expand and modernize the Utah infrastructure. The Commission finds that there is an implied relationship between its depreciation policy and its expectations for prudent and economic future investments. After declining to reduce the rate of return for the reasons stated, the Commission increased the rate of return from 11.8% to 12.2% to induce USWC to make discretionary investment decisions favorable to Utah. The Commission did that because USWC had explicitly linked discretionary investment aimed for the state with the allowed rate of return. [9] The ratepayers call the linkage a bribe by the Commission to induce USWC to invest in Utah. The Commission's own findings reveal the fallacious underpinnings of the Commission's conclusion: The Company repeatedly stressed that its discretionary investment decisions are driven by profitability considerations, meaning in part that economic analysis, or business case analysis, is employed to rank alternatives. Implied at times and explicit at times was the message that jurisdictional rate of return allowed by commissions could be the determining factor. The rate of return on equity in Utah is 11.8 per cent, the lowest in the 14-state USWC service territory. The Company's witnesses labeled that rate unreasonable and made the connection between it and discretionary investment aimed for this state. It is the fact that the earned rate of return on equity, as distinct from what is allowed, in Utah is among the highest in the 14 states, and has been so in recent years. The Company, however, argued that expected rate of return, based on allowed not past actual rate of return, is what is related to investment decisions. Nevertheless, the Commission notes that in the recent past when the allowed rate of return in Utah was among the highest, no discernably different pattern of discretionary investment decisions affecting Utah appeared. The Commission concludes that historical evidence does not reveal a clear relationship between either allowed or earned rate of return on equity on the one hand and the amount of discretionary investment in the state on the other. Nevertheless, the Commission acknowledges the logic of the relationship between rate of return and investment decision-making. Regulation presumes a reasonable management. This is a time when states are in a sense competing for hightech additions to and refinements of telecommunications plant and equipment. The Commission concludes that it is prudent to take these considerations into account when determining rate of return. Together, they argue for an addition to the cost of capital estimate produced by models. The Commission is concerned enough with the factors enumerated in the discussion to raise the allowed return on equity capital to 12.2 percent from the existing 11.8, and finds this return to be reasonable. (Emphasis added.) The legal issue before this Court, therefore, as framed by the Commission's ruling, is whether the Commission can increase the authorized rate of return on equity above a reasonable rate of return to induce a utility to make discretionary investments in its plant and equipment in Utah. Stated in the context of this case, the issue is whether the Commission can submit to USWC's implied threat to refrain from making appropriate investments in Utah if it is not allowed a greater return on capital than a prudent investor, given the nature of the risk of the investment, would require. It is necessary to state emphatically that the issue is not whether USWC needs a higher rate of return than a fair rate of return to be able to obtain necessary capital to invest in Utah. A fair rate of return, because it is based on the market cost of capital, necessarily ensures the availability of capital for investment. It is axiomatic that any time USWC wishes to resort to the capital markets of the nation, it can obtain capital at a fair rate of return to invest in Utah. In truth, the issue really is whether USWC should be given a higher rate of return than a fair return dictates to induce U.S. West, Inc., the parent corporation, to invest in USWC's operations in Utah. Before turning to the merits of that issue, we address the appropriate standard of review. Although USWC argues that the issue is factual and that we must accord the Commission broad discretion, [10] the issue really is what factors may the Commission take into account in setting a rate of return. The factors that the Commission may legitimately take into account in determining a rate of return are questions of law. As a general proposition, courts have ruled as a matter of law that certain factors are not includable in the rate base. E.g., Utah Power & Light Co. v. Public Serv. Comm'n, 107 Utah 155, 191-96, 152 P.2d 542, 559-61 (1944) (profits to affiliate not chargeable to ratepayers); Citizens Action Coalition of Ind., Inc. v. Northern Ind. Pub. Serv. Co., 485 N.E.2d 610 (Ind.1985) (cost of nuclear generating plant cancelled before completion not chargeable to ratepayers), cert. denied, 476 U.S. 1137, 106 S.Ct. 2239, 90 L.Ed.2d 687 (1986); Office of Consumers' Counsel v. Public Utils. Comm'n, 1 Ohio St.3d 22, 437 N.E.2d 586, 587-88 (1982) (investment in cancelled nuclear plants not chargeable to ratepayers). The same standard of review also applies when deciding whether the Commission has relied on improper factors in determining the rate of return that is to be applied to the rate base. See Utah Code Ann. § 63-46b-16(4)(d) (authorizing appellate court to grant relief from agency order if the agency has erroneously interpreted or applied the law); Utah Dep't of Admin. Servs. v. Public Serv. Comm'n, 658 P.2d 601, 608 (Utah 1983); see also Salt Lake Citizens Congress v. Mountain States Tel. & Tel. Co., 846 P.2d 1245 (Utah 1992) (deciding sub silentio that binding effect of Commission rule on nondeductibility of charitable contributions was issue of law). In both rate-of-return and rate-base cases, the issue is what economic factors the Commission may consider in determining what rates should be charged ratepayers for the benefit of shareholders, not how much weight should be accorded any given factor. Thus, the issue is whether a given factor is a legally permissible factor to take into account, and that issue is an issue of law. USWC's argument is that a utility can refuse to make necessary and appropriate investments for the public convenience and necessity unless the utility is paid more than a reasonable rate of return. That position is flatly irreconcilable with a utility's legal duties under the laws of the state of Utah and with the Commission's duties to require a utility to do all that is necessary to serve the public convenience and necessity in return for a fair and just rate of return. See Utah Code Ann. §§ 54-4-1, -4, -7, -8. To prevent a utility from using its monopoly power to charge exploitive rates, the Legislature has provided that a utility may charge only those rates found to be just and reasonable by the Public Service Commission. Utah Code Ann. § 54-4-4. Just and reasonable rates are necessarily based on cost of service and cost of capital, whatever the particular formula used. [11] The Legislature has provided that just and reasonable rates for telecommunications utilities are those based on cost of service. Utah Code Ann. §§ 54-8b-3.2, -3.3, -11. A rate based on cost of service means a rate sufficient to pay operating costs plus the cost of a fair return to investors for providing capital, both equity and debt. See Utah Dep't of Business Regulation v. Public Serv. Comm'n, 614 P.2d 1242 (Utah 1980); see also Utah Power & Light Co. v. Public Serv. Comm'n, 107 Utah 155, 212, 152 P.2d 542, 568 (1944) (citing Bluefield Water Works & Improvement Co. v. Public Serv. Comm'n, 262 U.S. 679, 692, 43 S.Ct. 675, 678-79, 67 L.Ed. 1176 (1923)). A fair return on capital means a rate of return, given the nature of the investment risk, sufficient to attract capital for investment. As stated in Utah Power & Light Co.: A public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public 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 corresponding risks and uncertainties; but it has no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures. The return should be reasonably sufficient to assure confidence in the financial soundness of the utility and should be adequate, under efficient and economical management, to maintain and support its credit and enable it to raise the money necessary for the proper discharge of its public duties. 152 P.2d at 568 (quoting Bluefield Water Works, 262 U.S. at 692, 43 S.Ct. at 679). USWC is a multi-state utility and a wholly owned subsidiary of a large industrial company. It has used those features to coerce a higher rate of return from the Commission by threatening to divert investment funds from Utah to other states and to the more profitable, but more risky, investments that the unregulated parent company can make. A utility's effort to obtain a higher rate of return by using the existence of more profitable alternative investment possibilities as a reason for not making appropriate investments in Utah is utterly inconsistent with a utility's legal obligations. USWC has a legal duty, as do all utilities, to make all investments necessary and appropriate to maintain and modernize its plant and equipment. The Commission may order, and in this case has ordered, improvements and modernization of USWC's plant and equipment, and that duty is implicit in the statutory scheme. That order is enforceable by the Commission under the statutes of this state. See Utah Code Ann. §§ 54-3-23, 54-7-24, 54-7-25, 54-7-26; see also Myers v. Blair Tel. Co., 194 Neb. 55, 230 N.W.2d 190 (1975) (affirming commission order directing utility to reduce rates retroactively because of inadequacy of its service). For the Commission to grant USWC an increased rate of return to induce it to invest in Utah rather than in some other state or in the more risky investments its parent might make is to subvert the statutory scheme designed to prevent utilities from using their monopoly power to extract exploitive rates from consumers. The Commission recognized as much when, in rejecting USWC's incentive regulation plan, it specifically rejected USWC's position that it had insufficient incentive to invest in Utah. In that connection, the Commission ruled, contrary to its ruling on rate of return, that allowing USWC the market cost of capital provided an appropriate long-term basis upon which investment decisions should be made by the Company: It appears that the essence of this [USWC's] argument is that the Company is discouraged from investing in activities and jurisdictions where the return is not as high as other jurisdictions or business opportunities. In fact, Company witnesses asserted on the record that all the Company is really after is a higher return on its investment. The Commission finds that a commitment by the Company to the provision of public service and an opportunity to earn the allowed rate of return equal to the market cost of capital, as determined by this Commission, provides an appropriate long-term basis upon which investment decisions should be made by the Company. (Emphasis added.) If the Commission's position with respect to the effect it can give to the profitability of alternative investments in determining rate of return were to stand, USWC could play off the Utah Public Service Commission against other state regulatory commissions. Each commission would have to bid against the other and offer ever higher rates of return to induce USWC to invest in that state. Alternatively, USWC could require the Commission to grant a rate of return equal to the riskiest of U.S. West, Inc.'s investments. For the Commission to yield to such threats is to detach the concept of the cost of capital in rate-making from any meaningful standard and to leave ratepayers subject to whatever exploitive rates a utility might be able to leverage from a compliant regulatory commission. Ironically, the Commission specifically rejected USWC's argument at a different point in its opinion when it denied USWC's motion to stay the Commission's order directing USWC to modernize its facilities. On its motion for a stay, USWC was unabashedly explicit that a regulated utility return was not acceptable to it because U.S. West, Inc., its parent (the source of USWC's equity capital), could obtain a greater return on its investments elsewhere. USWC stated: The Commission has stated that it will allow a reasonable return to be earned on these investments and that, therefore, they are without risk. Such an approach fails to recognize that USWC and its parent U.S. West, Inc., as managers of the capital on behalf of investors have a variety of options as to the use and deployment of capital. Among these options are the use of capital in projects with a greater return potential than a regulated utility return. Thus, the fact that USWC may be given the opportunity to earn a regulated utility return does not obviate the myriad other potential investment opportunities. (Emphasis added.) The Commission quite properly rejected the extraordinary impropriety of the argument in that context, even though it had yielded to that argument when it increased USWC's rate of return to 12.2%. In denying the stay, the Commission rejected USWC's argument and even suggested that USWC had not acted in good faith in failing to make investments contemplated by the Commission's accelerated depreciation policies. The Commission stated: While this statement is made in the context of a request for a stay of our order, nonetheless, it seems to reflect USWC's present attitude towards utility investments generally. In our judgment this attitude stands traditional regulation on its head. It is apparently the Company's view that utility investment is simply one among many investment opportunities. While it used to be that for a monopoly provider a public service obligation was paramount, now, in Mr. Fuehr's [USWC's witness] view, the provider is free to play one investment option against another, including utility investment. The Commission is therefore put in the position of having to bid, literally, against other non-utility investment options, real or imagined, in order to insure that utility investments required for service adequacy are made. . . . . Mr. Fuehr's statement is further flawed by the fact that it assumes that USWC has very limited access to financial resources and the required Utah utility investments would displace much more profitable investment opportunities elsewhere. There is absolutely no evidence on the record to show that USWC cannot go to the financial markets at any time and obtain the capital it desires on highly favorable terms. In addition, it is an established and well-known fact that utility investments are relatively safe, low-risk and dependable. Nonetheless, Mr. Fuehr's statement would require that we assume that these other supposedly more lucrative investments are equally low-risk, safe and dependable. In establishing the allowed return on investment, we fully consider risk, guided by the need for risk-return parity. Mr. Fuehr fails to note that the non-utility investments the Company may make will offer higher return only if greater risk is assumed. Nor does the USWC argument take into account the accelerated depreciation which the Company has enjoyed on its investments in utility service over the past five years. The accelerated depreciation was intended to make new utility investment more attractive to USWC but the investments haven't been made even though the Company has had the benefit of the increased revenues from the depreciation. (Emphasis added.) Clearly, the Commission's task of protecting the public interest is significantly more difficult when a utility is a wholly owned subsidiary of an unregulated industrial giant. Those facts, however, emphasize the need for closer scrutiny of the extent to which such a utility complies with its legal obligations to provide appropriate plant, equipment, and service at rates no higher than required by the cost of operations and the market cost of capital. It is a clear abuse of sound economic principles, to say nothing of fairness to ratepayers, to seek to charge the higher rates that would be necessary for more risky, unregulated enterprises or that would be required to meet rates in other jurisdictions where efficiency factors and other cost-of-service considerations are different. In short, the ratepayers in this case are correct in asserting that the governing standard in determining the rate of return on equity is the cost of inducing capital markets to invest in USWC, not the cost of inducing USWC to invest in Utah. Accordingly, we hold that the Commission's order fixing the rate of return on equity at 12.2% is unlawful, and we remand this case to the Commission to enter an order fixing a lawful rate of return consistent with this opinion. That does not, however, conclude this issue. The Commission's own admissions as to USWC's actual rates of return raise the most serious and fundamental questions concerning the Commission's nonperformance of its legal duties. In its order denying USWC's motion for a stay, the Commission made the stunning admission that USWC's rates would likely produce a rate of return approximating 17%, not the 12.2% fixed by the Commission. The Commission stated: Furthermore, we do not believe that the loss of allegedly more lucrative opportunities is a justification for a stay given the history of USWC's overearnings in Utah over the past five or six years. The Company has earned nearly 17% annually on its Utah investments over that period of time and we doubt very much that actual returns in the near future will be significantly lower. It is worth noting that in each of its rate cases for some years now the Company has projected a relatively dismal return on its investment and the actual return has been well above that authorized by this Commission. Therefore, the likelihood that the Company will lose substantial revenues by making a relatively modest investment in Utah as opposed to its pie-in-the-sky investments elsewhere is minimal. (Emphasis added.) The astonishing and perplexing indication that the Commission expected USWC to actually earn nearly 17%, approximately 40% more than the authorized rate of return, suggests a serious breakdown in the Commission's regulation of USWC's rates. Equally troubling is USWC's record of overearnings that goes far back in time. The history of USWC's unprecedented overearnings for a number of years indicates an extraordinary abdication by the Commission of its statutory duties. The Commission itself has admitted that USWC has earned nearly 17% annually on its Utah investments over the past five or six years. [12] That is approximately 45% more than USWC's authorized rate of return and amounts to many tens of millions of dollars collected from ratepayers in excess of a fair return. Notwithstanding that history, the Commission was apparently content to continue allowing exorbitant earnings even after the Order in this case, as indicated by its admission that we [the Commission] doubt very much that actual returns in the near future will be significantly lower than the historical actual returns of nearly 17%. We are at a loss to understand how the Commission could have fixed a 12.2% rate of return and then expect USWC's actual rate of return to approximate 17% in the near future. The record in this case and the history of prior proceedings give rise to grave concerns about the integrity of the Commission's regulation of USWC's rates and practices and why the regulatory process has been abused for some years now by a company that has repeatedly projected a relatively dismal return on its investment, as the Commission itself has acknowledged. Whether USWC has, in fact, collected profits since the Commission entered its Report and Order in this case that approximate a 17% rate of return, and if so, whether the excess earnings should be credited to the benefit of ratepayers, is not presently before us but might well be a matter that will come before the Commission on remand. See New England Tel. & Tel. Co. v. FCC, 826 F.2d 1101 (D.C.Cir.1987) (holding that where utility earns higher rate of return than rate prescribed by regulatory commission, rule against retroactive rate-making does not bar order requiring excess revenues to be credited to ratepayers in certain circumstances), cert. denied, 490 U.S. 1039, 109 S.Ct. 1942, 104 L.Ed.2d 413 (1989); see also MCI Telecoms. Corp. v. Public Serv. Comm'n, 840 P.2d 765, 775 (Utah 1992).