Opinion ID: 2006220
Heading Depth: 1
Heading Rank: 2

Heading: method of determining cost of equity.

Text: Mass. Electric first argues that the Department's rejection of the use of NEES as a proxy for Mass. Electric in determining the cost of equity resulted in the setting of a confiscatory rate of return on equity. [2] The heart of its contention is that using NEES as a proxy is the only way in which Mass. Electric's cost of equity can be determined. Confiscation results when a ratemaking decision deprives a utility of the opportunity to earn a fair and reasonable return on its investment. Boston Edison Co. v. Department of Pub. Utils., 375 Mass. 1, 10 (1978). Boston Gas Co. v. Department of Pub. Utils., 368 Mass. 780, 789-790 (1975). A return is fair and reasonable if it covers utility operating expenses, debt service, and dividends, if it compensates investors for the risks of investment, and if it is sufficient to attract capital and assure confidence in the enterprise's financial integrity. Fitchburg Gas & Elec. Light Co. v. Department of Pub. Utils., 371 Mass. 881, 884 (1977). See Boston Edison Co. v. Department of Pub. Utils., supra at 10, and cases cited. A utility which alleges that the Department has set confiscatory or otherwise unlawful rates has the burden of proving these allegations. Fryer v. Department of Pub. Utils., 374 Mass. 685, 690 (1978). Fitchburg Gas & Elec. Light Co. v. Department of Pub. Utils., supra at 885. This court will not lightly interfere with the exercise of the Department's rate-making power; confiscation must be clearly established on the record before us. Boston Edison Co. v. Department of Pub. Utils., supra at 10-11. In this case, as in other rate proceedings, the Department used the cost of capital method to determine the fair rate of return. One step in applying this method, and the only one at issue in the present case, involves determining the cost of equity. In general, the return on equity must equal at least the amount which the company would have to pay in order to `hire' its equity capital under current conditions. New England Tel. & Tel. Co. v. Department of Pub. Utils., 327 Mass. 81, 88 (1951). See Boston Edison Co. v. Department of Pub. Utils., supra at 11. The return on equity should be commensurate with returns on investments in other enterprises having corresponding risks. FPC v. Hope Natural Gas Co., 320 U.S. 591, 603 (1944). See Boston Edison Co. v. Department of Pub. Utils., supra at 12. In addition, the rate of return on equity should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital. FPC v. Hope Natural Gas Co., supra . See Boston Edison Co. v. Department of Pub. Utils., supra at 13-14. Mass. Electric contends that without using NEES as a proxy in determining the cost of equity it would be impossible to apply the comparable earnings test. Mass. Electric is one of four wholly owned electric operating subsidiaries of NEES, [3] a registered holding company under the Public Utility Holding Company Act of 1935, 15 U.S.C. § 79 et seq. (1970). Mass. Electric, which sells electric energy directly to retail customers in 145 cities and towns across Massachusetts, owns no generation or bulk transmission facilities, and purchases its entire power requirements for resale from New England Power Company (NEPCO), another wholly owned subsidiary of NEES. Mass. Electric argues that since it is the only wholly owned electric subsidiary of its size which restricts its activities to distribution, no comparable companies exist by which its cost of equity may be determined. Comparability, however, is a question of degree. The cost of equity of similar, although not identical, companies could be evaluated, and adjustments could be made for significant differences in characteristics. See Boston Gas Co. v. Department of Pub. Utils., 359 Mass. 292, 302-306 (1971); Wannacomet Water Co. v. Department of Pub. Utils., 346 Mass. 453, 467-470 (1963). Mass. Electric next argues that, because as a wholly owned subsidiary, its ability to attract capital is dependent on NEES's ability to attract capital, the cost of equity to Mass. Electric, equals the cost of equity to NEES. Thus, Mass. Electric maintains that it is impossible to determine its return on equity under the capital attraction standard without using the proxy approach. However, when there is more than one subsidiary, the cost of equity of a subsidiary is not necessarily the same as the cost of equity of the parent corporation. The cost of equity of the parent corporation reflects the aggregate of the costs of equity of each of its various subsidiaries. If the subsidiaries are characterized by different degrees of risk, the cost of equity of the parent corporation will not equal the cost of equity of each of the subsidiaries. In fact, if the return on equity of the parent corporation is used as the cost of equity for the subsidiaries, the less risky subsidiaries will be allowed too great a cost of equity and the ratepayers of that utility will be subsidizing the utilities subject to greater risks. While conceivably some adjustments might be made to eliminate the subsidization problem if all the subsidiaries were regulated by the same regulatory body, where, as here, the subsidiaries are regulated by different agencies, [4] such a solution is impossible. See Fitzpatrick, Subsidiaries' Capital Costs  A Compromise Approach, 99 Pub. Utils. Fort. 23, 24 (No. 13, June 23, 1977). Moreover, it is not generally agreed that the use of a proxy approach is the appropriate method by which a wholly owned subsidiary's cost of equity should be determined. Rather, several different approaches are advocated and used. See Norton Water Co. v. Public Utils. Comm'n, 24 Conn. Supp. 441 (Super. Ct. 1962); Penn Sheraton Hotel v. Pennsylvania Pub. Util. Comm'n, 198 Pa. Super. Ct. 618, 632-633 (1962); Michigan Bell Tel. Co., 85 P.U.R.3d 467, 489 (Mich. Pub. Serv. Comm'n 1970); General Tel. Co. of the Southeast, 18 P.U.R.4th 440, 470 (N.C. Utils. Comm'n 1976); Pennsylvania Pub. Util. Comm'n v. Allegheny County Steam Heating Co., 19 P.U.R.4th 422, 438 (Pa. Pub. Util. Comm'n 1977); Wisconsin Natural Gas Co., 92 P.U.R.3d 164, 169 (Wis. Pub. Serv. Comm'n 1971); Fitzpatrick, Subsidiaries' Capital Costs  A Compromise Approach, 99 Pub. Utils. Fort. 23 (No. 13, June 23, 1977). When alternative methods are available, the Department is free to select or reject a particular method as long as its choice does not have a confiscatory effect or is not otherwise illegal. New England Tel. & Tel. Co. v. Department of Pub. Utils., 372 Mass. 678, 683-684 (1977). Fitchburg Gas & Elec. Light Co. v. Department of Pub. Utils., 371 Mass. 881, 886 (1977). New England Tel. & Tel. Co. v. Department of Pub. Utils., 367 Mass. 67, 71 (1976). Boston Gas Co. v. Department of Pub. Utils., 367 Mass. 92, 98 (1975). We find that the 12% return on equity has not been shown to be confiscatory.
Under G.L.c. 30A, § 11(8), inserted by St. 1954, c. 681, § 1, the Department must provide a statement of reasons for the decision, including determination of each issue of fact or law necessary to the decision. These reasons must warrant the Department's conclusion. See Westborough v. Department of Pub. Utils., 358 Mass. 716, 717-718 (1971). General Laws c. 30A, § 14 (7), provides for judicial review of the Department's decision to determine, inter alia, whether it is based on an error of law, whether it is supported by substantial evidence, and whether it constitutes an abuse of discretion. The Department stated that because of the probability that the different subsidiaries would be characterized by different degrees of risk, the proxy approach should not be applied. As one indication that this difference in risks existed, the Department noted that there were differences between the coverage of fixed charges of NEES and that of fixed charges and preferred dividends of Mass. Electric. For these reasons, the Department rejected the use of NEES as a proxy in determining Mass. Electric's cost of equity. The Department went on to state that even if the subsidiaries earned the same percentage on NEES's respective investments in them, the cost of equity of NEES still could not be used as a proxy. Since NEES's investment in Mass. Electric is represented by debt as well as equity, the return on NEES's equity would be higher than the return on Mass. Electric's equity if the cost of debt to NEES is less than the cost of equity to Mass. Electric. Finally, the Department noted that to use NEES as a proxy would be contrary to the doctrine of Mystic Valley Gas Co. v. Department of Pub. Utils., 359 Mass. 420 (1971). Mass. Electric contends that none of these reasons is sufficient under the standards of the APA.
Mass. Electric argues that the Mystic Valley decision neither warrants nor supports the decision to reject the proxy approach and thus, that the Department erroneously applied that decision in reaching its conclusion. In Mystic Valley Gas Co. v. Department of Pub. Utils., supra , we concluded that unless the capital structure of a regulated company varied so unreasonably and substantially from the usual practice as to impose an unfair burden on the consumer, the utility was entitled to have its actual capital structure used in determining a fair rate of return. The debt equity ratio of a company affects its cost of equity. If NEES were used as a proxy for Mass. Electric, NEES's capital structure would thus affect Mass. Electric's cost of equity. Therefore, although the rejection of the proxy approach would not seem to be compelled by Mystic Valley, that decision's requirement of using a company's actual capital structure does provide support for the Department's decision.
a. Differing rates of return. Mass. Electric next advances several arguments primarily directed to demonstrating that the Department's finding that it is probable that the subsidiaries are characterized by different degrees of risk does not warrant the rejection of the proxy approach. As previously discussed, such a finding supports a conclusion that Mass. Electric's cost of equity does not equal NEES's cost of equity. Thus, this finding, which demonstrates the inaccuracies and shortcomings of the proxy method, warrants the Department's decision to reject the proxy approach. Mass. Electric further argues that this finding is not supported by substantial evidence. If there is a paucity of evidence on this point, it must be attributed to Mass. Electric. The burden of proof that a rate increase was necessary was on Mass. Electric. In D.P.U. 18204, the Department, in rejecting the proxy approach, relied heavily on comparative earnings figures for the various subsidiaries. In spite of the fact that it is clear that the Department found such evidence extremely relevant, Mass. Electric chose not to present data concerning comparative earnings in this case. Mass. Electric, therefore, must be charged with the lack of detailed evidence on this issue. See William Rodman & Sons v. State Tax Comm'n, 373 Mass. 606 (1977). We conclude that there was sufficient evidence to support the Department's finding. The Department's decision in D.P.U. 18204, which was part of the record in this case, indicated that the NEES subsidiaries were characterized by different degrees of risk. Moreover, considering the experience, technical competence, and specialized knowledge of the Department, G.L.c. 30A, § 14 (7), as appearing in St. 1973, c. 1114, § 3, it was more than reasonable for the Department to conclude that there was a high probability that different subsidiaries would in fact possess different earning capabilities. b. Coverages. Mass. Electric argues that, although the record indicates that there were differences in coverages, there was no evidence to indicate that coverage ratios are relevant in determining cost of equity. [5] Coverage ratios are, however, one indication of the risk associated with a company. See New England Power Co., F.P.C., - (1977). [a] Although, as Mass. Electric points out, no witness testified that they are relevant in determining return on equity, there was also no evidence presented that coverage ratios were not significant in making such a decision. In such a situation, the Department may give weight to that evidence which, in the exercise of its expertise, it finds persuasive. See Boston Edison Co. v. Department of Pub. Utils., 375 Mass. 1, 12 (1978); Wannacomet Water Co. v. Department of Pub. Utils., 346 Mass. 453, 465-471 (1963); G.L.c. 30A, § 14(7). c. NEES's debt. The Department concluded that, since NEES's investment in Mass. Electric is represented by both debt and equity, Mass. Electric's cost of equity is less than NEES's cost of equity. Mass. Electric challenges this finding on the ground that it is not supported by substantial evidence. Mass. Electric contends that since NEES's debt consisted of debentures payable eight months from the end of the test period, they should not have been classified as part of NEES's permanent capital structure, but rather should have been considered a current liability. Mass. Electric, however, does not claim that this debt would not be refinanced; in fact, as Mass. Electric implicitly admits, the debentures probably were refinanced. [6] Thus, they were correctly considered to constitute debt in evaluating NEES's capital structure. Mass. Electric states that the proceeds of the original debenture issue were not directly invested in the equity of Mass. Electric, but rather were used to facilitate the 1946 reorganization of NEES. Therefore, it claims that the Department's decision to consider NEES's debt in determining Mass. Electric's cost of equity is inconsistent with Brockton Edison Co., 14 P.U.R.4th 186, 193 (Mass. Dep't Pub. Utils. 1976) which found that it was inappropriate to adjust a subsidiary's rate of return for the parent corporation's debt when the proceeds of the debt were not invested for the subsidiary's benefit. It is not clear that expenses spent in a general reorganization would not be viewed as benefiting Mass. Electric. Moreover, Mass. Electric does not claim that it has not benefited from any subsequent debt that might have been incurred by NEES. Thus, we cannot conclude that the Department's decision is inconsistent with its approach in Brockton Edison Co., supra. Mass. Electric also states that NEES and Mass. Electric would not have different common equity costs even if the debentures were considered since NEES's fiscal and corporate expenses offset any leverage which the debentures might provide. The contentions that the expenses are equivalent to the leverage and that they should be used to offset leverage are simply not supported by the record. Mass. Electric contends that, even if the Department's finding on this issue were supported by substantial evidence, it does not warrant rejection of the proxy approach. Although there is some controversy concerning the validity of the theory that debt in the parent corporation's capital structure reduces the cost of equity of the subsidiary, see Brockton Edison Co., 14 P.U.R.4th 186, 193 (Mass. Dep't of Pub. Utils. 1976), it is an approach that is accepted by some experts. Since this theory demonstrates that simply using the cost of equity of the parent corporation as the cost of equity for the subsidiary would yield too high a cost of equity for the subsidiary, it warrants the Department's rejection of the proxy approach. At this point Mass. Electric argues for the first time that it would be possible to derive Mass. Electric's cost of equity by determining NEES's cost of equity and adjusting the figure thus obtained for NEES's debt. [7] The Department, of course, may choose to utilize this or some similar approach. However, the availability of these alternatives does not require the use of NEES as a straight proxy for Mass. Electric in determining cost of equity, the position urged by Mass. Electric throughout these proceedings.
Mass. Electric argues that the Department's decision to reject the proxy approach was arbitrary and capricious and constituted an abuse of discretion. It maintains that it would be impossible to determine Mass. Electric's cost of equity under either the capital attraction test or the comparable earnings test without using NEES as a proxy. We have already considered and rejected this contention. Mass. Electric also claims that three findings which it contended were not supported by substantial evidence do not provide a sufficient rationale to withstand scrutiny under the arbitrary and capricious standard. We have analyzed these findings in detail and have concluded that they logically support the Department's decision to reject the proxy approach. There was no abuse of discretion. In summary, we conclude that the Department's decision was not based on legal error, that the findings made by the Department were supported by substantial evidence, that the reasons provided by the Department, particularly the discussion concerning the different degrees of risks among subsidiaries, warranted its rejection of the proxy approach, and that its decision did not constitute an abuse of discretion. [8]