Opinion ID: 2551972
Heading Depth: 2
Heading Rank: 3

Heading: Reacquired Debt

Text: {11} PNMGS sought to recover adjusted net losses on reacquired debt derived from a gross loss of $5,990,800 at the end of the base period. PNMGS's costs on reacquired debt stemmed from two instances of debt refinancing by PNM. PNM operates both PNMGS, which is a gas utility, and an electric utility through two separate divisions that are independently regulated by the Commission. In 1986, PNM separately refinanced approximately $54.6 million, $55.2 million, and $60.45 million of its high-cost debt, which was in the form of first mortgage bonds. In Case No. 2147, PNMGS's most recent litigated rate case before the Commission prior to the present proceeding, PNMGS sought to recover the portion of PNM's net losses from reacquired debt incurred in 1986 that were attributable to the gas utility division of the company. The Commission, in that rate case, permitted PNMGS to recover those costs, a total of approximately $8.5 million, through rate base treatment and amortization recovery. At the end of the test-year period utilized in the present proceeding, PNMGS maintained on its books losses of approximately $5.5 million associated with the cost of reacquiring debt in 1986. On a separate occasion, in 1994, PNM retired additional high-cost debt of approximately $45 million. PNMGS experienced losses of approximately $400,000 associated with the 1994 refinancing, for which PNMGS had not previously sought recovery. {12} In the present proceeding, PNMGS petitioned the Commission to recover the costs of reacquiring debt in 1986 and 1994. Specifically, PNMGS sought continued recovery of the $5.5 million in losses on reacquired debt remaining from 1986 and the $400,000 in losses on reacquired debt incurred in 1994. After offsetting for gains associated with the reacquired debt, PNMGS proposed to recover adjusted net losses on reacquired debt of $359,857 in annual amortization expenses and to include the remaining unamortized balance of $4,648,695 in the rate base. {13} The Attorney General's expert witness, James D. Cotton, explained the process involved in reacquiring high-cost debt. Bonds, or long-term debt, are generally a significant component of a utility's capital structure. Loss on reacquisition of debt usually happens when a utility acquires some of its older bonds which have higher interest rates than current rates in the debt market. In order for a utility to reacquire an old bond issuance that carries a higher than current market interest rate, it must pay a premium over the face value of its bond.... Since the utility and its investors paid more than face value for the bonds, the utility has taken a loss upon reacquiring the bonds, and the utility has effectively increased its investment in the utility. That is why the loss is added to rate base and this amount is amortized to expense for ratemaking purposes over the remaining life of the bonds. For the reasons expressed by Mr. Cotton, the Commission has previously allowed PNMGS and other utilities to recover losses on reacquired debt. Indeed, a nearly unanimous consensus of state regulatory bodies agree that gains as well as losses resulting from the repurchase of debentures should be passed on to ratepayers. Washington Gas Light Co. v. Public Serv. Comm'n, 450 A.2d 1187, 1216 (D.C.1982). The Commission established in Case No.1916 that it would permit recovery for losses on reacquired debt as long as the utility demonstrated that the benefit to current and future ratepayers exceeds the costs associated with the reacquisition. {14} The Commission Staff and the Attorney General advocated against recovery of losses on reacquired debt in the present rate case due to the methodology used in establishing the rate of return for PNMGS. In determining a reasonable rate of return for a utility, the Commission considers several factors, including the utility's capital structure, which refers to the ratio between the company's debt and equity, and the utility's cost of capital, which, according to Staff witness James Brack, represents the weighted average of individual rates on long term debt, preferred stock, and common equity. See Phillips, supra, at 369 (describing cost of capital as a composite of the cost of the several classes of capital used by a utility debt, preferred (and preference) stock, and common stock ...weighted on the basis of an appropriate capital structure). PNMGS, as a division of PNM, has neither debt and equity in its own name upon which to base the cost of capital nor an actual capital structure of its own. Furthermore, compared to less risky A-rated utility companies, PNM is a more risky BB junk-bond-rated company, and the business operating risks associated with PNM's electric utility division are significantly different from those applicable for PNMGS. PNMGS believed that it was important to relieve its ratepayers from the risks and problems associated with the electric utility division of PNM. As a result, PNMGS proposed the use of a hypothetical, or imputed, capital structure and a hypothetical cost of capital, including a hypothetical cost of debt. Specifically, even though PNMGS would likely not be treated as an A-rated company if it existed as a separate entity, PNMGS proposed to treat the gas utility division of PNM as if it were a separate A-rated company. PNMGS developed a hypothetical capital structure and cost of debt on the basis of eight A-rated natural gas distribution companies. PNMGS asserted that a hypothetical capital structure and cost of debt would benefit ratepayers by lowering PNMGS's overall cost of capital. Thus, although PNM has a cost of debt of 7.76%, PNMGS proposed the use of an imputed cost of debt of 7.56%. {15} Staff also utilized a hypothetical capital structure and cost of capital in calculating the appropriate rate of return for PNMGS. Staff, like PNMGS, used eight A-rated natural gas distribution companies in formulating a hypothetical capital structure but proposed a cost of debt of 7.30%, instead of PNMGS's proposed 7.56%, based on more current data available at the time Staff submitted the pre-filed testimony of its expert, Mr. Brack. In addition, the Attorney General's expert, Mr. Cotton, testified that the use of a hypothetical capital structure and cost of capital for PNMGS was appropriate in this proceeding. However, Staff and the Attorney General relied on the use of a hypothetical capital structure and cost of debt in opposing recovery of losses on reacquired debt. {16} According to the Attorney General's expert, Mr. Cotton, [c]apital structure and the cost of debt are directly related to the amount of debt reacquired. Mr. Cotton further explained that [t]he result of reacquiring long-term debt is a lower actual cost of debt. Thus, [i]f the Company had used its actual capital structure at test period end, then, of course, its adjustment for gains and losses on reacquired debt might have been appropriate. However, PNMGS had proposed a hypothetical capital structure and cost of debt, and, according to Mr. Cotton, [i]t is inconsistent for the Company to claim the loss on reacquiring debt but not to then use the lower cost of debt that resulted from the Company's actions. In the Company's proposal, the result is that ratepayers receive none of the benefit of the debt reacquisition. Similarly, Staff's expert, Dennis Gee, testified that it is not likely that the benefits to ratepayers of these transactions can be shown in this proceeding.... Staff believes that the necessary nexus cannot be drawn between any benefits from gain/loss on reacquired debt transactions because these [affect] the actual capital structure and cost of capital but ... [do] not [affect] an imputed capital structure and cost of capital. {17} Based on this testimony, the Commission determined that PNMGS has failed, therefore, to carry its burden of proving that the costs of losses on reacquired debt are outweighed by the cost of capital benefits to ratepayers. The Commission further determined that it was not bound by prior decisions allowing recovery of losses on reacquired debt, including Case No. 2147, because none of those cases involved a rate of return based on both an imputed capital structure and an imputed cost of debt. The Commission concluded that PNMGS's request to use an imputed cost of debt in its cost of capital ... has made direct measurement of the debt reacquisition's effect on rates impossible. Finally, the Commission determined that, due to the substantial benefits realized by shareholders from the reacquired debt, estimated by the Commission to be approximately $80 million on a company-wide basis, PNM would have undertaken the debt retirements had it anticipated that the losses on reacquired debt would be disallowed in rates, and denied all recovery of the losses. {18} After reviewing the record as a whole, we believe the Commission's decision to disallow recovery of losses on reacquired debt is not supported by substantial evidence. We first address the Commission's determination that PNMGS failed to carry its burden of proof. Although PNMGS's use of an imputed capital structure and an imputed cost of debt made it difficult to calculate directly the extent of benefit realized by ratepayers, PNMGS nonetheless contended that the reacquisition of debt allowed it to utilize an imputed cost of debt in calculating its revenue requirement and that the imputed cost of debt was itself a benefit that ratepayers received from the retirement of high-cost debt. According to PNMGS's expert, Thomas Sategna, PNMGS's actual cost of debt would have been 10.82% if PNM had not retired the high-cost debt at issue in the rate proceeding. Comparing this figure to the proposed 7.56% imputed cost of debt and using PNMGS's proposed imputed capital structure, Mr. Sategna calculated that PNMGS's annual revenue requirement would have been approximately $2.37 million higher in the absence of the reacquisition of debt in 1986 and 1994. Dr. Charles Moyer testified that [i]t is only because PNM has prudently seized opportunities to lower its embedded cost of debt ... that PNMGS has been able to adopt the comparable firm capital structure and debt costs. Without having taken these actions to lower its imbedded debt costs, PNMGS would have sought full recovery of its actual imbedded debt costs and it would have sought a return on equity consistent with its current financial condition (as reflected in its junk bond status). Another PNMGS expert, J. Patrick Keene, testified that [t]he nexus can be drawn between the costs of reacquiring debt in 1986 and 1994 and the benefits realized by ratepayers. Absent PNM's actions to reduce its cost of long term debt, PNMGS would have been unable to include a cost of debt comparable to financially healthier companies in this proceeding. Thus, PNMGS contended that the lower overall cost of capital from its proposed imputed cost of debt, made possible by the reacquisition of high-cost long-term debt, resulted in a substantial benefit to ratepayers. Additionally, PNMGS experts testified that ratepayers also received an indirect benefit of a more financially stable utility. Cf. Arkansas La. Gas Co., 150 Pub. Util. Rep. 4th (PUR) 333, 361, 1994 WL 121423 (Ark. Pub. Serv. Comm'n 1994) (adopting a utility's proposed actual cost of debt but reviewing expert testimony by a staff witness proposing a hypothetical cost of debt and including recovery for losses on reacquired debt because, although difficult to quantify, the reacquired debt provided some benefit to ratepayers). {19} While not disputing PNMGS's contention that the reacquisition of debt enabled the utilization of an imputed cost of debt that was lower than PNM's actual cost of debt, the Commission rejected PNMGS's calculation of the benefit received by ratepayers in using the imputed cost of debt. The Commission determined that the calculations were not persuasive due to Mr. Sategna's use of the proposed imputed capital structure to derive the amount of $2.37 million. According to the Commission, PNMGS failed to carry its burden of proof by not providing additional calculations based on its actual capital structure. Based on our review of the record as a whole, however, we believe this determination was arbitrary and capricious. As previously mentioned, Staff also utilized a hypothetical capital structure in its calculations, and the Attorney General's expert testified that the use of a hypothetical capital structure was appropriate. In fact, PNMGS has no actual capital structure of its own. Although, in denying recovery for losses on reacquired debt, the Commission referenced testimony by Mr. Cotton, the Attorney General's expert, that an imputed capital structure was not in the best interests of ratepayers, we believe the Commission disregarded the context of Mr. Cotton's remark. Mr. Cotton further testified that using the actual capital structure would have been inappropriate, and he utilized the proposed imputed capital structure in his calculations because it is more representative of the parent's (PNM) capital structure during the time that rates will actually be in effect than the base period (actual) capital structure. Indeed, the Commission's reference to Mr. Cotton's comment concerning ratepayer benefit can only be regarded as spurious due to the Commission's ultimate wholesale adoption of the hearing examiner's recommendations regarding the proposed imputed capital structure. The hearing examiner concluded that the capital structure for PNM's electric utility division was unrelated to PNMGS, that the two utility divisions had significantly different operating risks, and that, therefore, the use of PNMGS's proposed hypothetical capital structure was just and reasonable. {20} Further, the Commission had previously adopted the use of a hypothetical capital structure in determining an appropriate rate of return for PNMGS in Case No. 2147, yet the Commission expressed no concern in that rate case that an imputed capital structure would prevent a cost/benefit analysis with respect to losses on reacquired debt. In fact, the Commission allowed recovery of such losses in Case No. 2147 without requiring additional calculations utilizing an actual capital structure. Under these circumstances, we do not believe that the Commission provided adequate notice to PNMGS that additional proof would be necessary. With respect to the adequacy of PNMGS's offer of proof, we believe it is significant that nearly all of the losses at issue concerned the proposed continued recovery of losses which the Commission had previously held in Case No. 2147 to confer a benefit to ratepayers in excess of the costs associated with reacquisition. Therefore, we reject the Commission's determination that PNMGS failed to carry its burden of proof. {21} As a related matter, we reject the Commission's determination that changed circumstances justified a departure from its previous decisions. The Commission deemed this a unique case because of the use of both an imputed capital structure and an imputed cost of debt. The Commission determined that the use of an imputed cost of debt constituted a changed circumstance justifying departure from Case No. 2147 because PNMGS could not demonstrate a benefit to ratepayers. As discussed above, however, because the imputed cost of debt in this case was lower than PNM's actual cost of debt, we believe that PNMGS's rate of return methodology did not prevent it from carrying its burden by showing that the benefit to ratepayers in the use of an imputed cost of debt outweighed the costs associated with the retirement of high cost debt. [1] In addition, considering that the vast majority of losses on reacquired debt were approved by the Commission in Case No. 2147 and considering that PNMGS has no actual capital structure or cost of debt of its own, PNMGS reasonably relied on the Commission's prior determinations concerning losses on reacquired debt. A radical departure from past practice ... without sufficient prior notice of departure and without reasonable justification as reflected by the record... [is] improper. General Tel. Co., 98 N.M. at 756, 652 P.2d at 1207. Applying the five-factor test adopted in Hobbs Gas Co., 115 N.M. at 682, 858 P.2d at 58, we conclude that although the Commission's order in this case, to a limited extent, fills a void in the law with respect to the use of an imputed cost of debt, the slight interest in applying the Commission's new rule is outweighed by PNMGS's reasonable reliance on the Commission's prior practice and the significant burden imposed under the new rule. {22} We also reject the Commission's final basis for denying recovery of losses on reacquired debt: shareholder benefit. The appropriate test for the recovery of losses on reacquired debt is not whether the utility would have retired the debt irrespective of rate case recovery; instead, as the Commission established in Case No. 1916, the proper test is whether the benefits to ratepayers outweigh the costs associated with the reacquisition. Nevertheless, we agree with the Commission that the relationship between shareholder and ratepayer benefit related to the reacquisition of debt is an important concern; however, as indicated by Mr. Cotton's testimony concerning the basis for recovery of losses on reacquired debt quoted above in Paragraph 13, the Commission's established methodology of amortizing losses as an expense and including unamortized amounts in the rate base, coupled with a lower cost of debt in calculating the overall cost of capital, achieves a proper balance between shareholders and ratepayers. Cf. Southern Bell Tel. & Tel. Co., 159 Pub. Util. Rep. 4th (PUR) 425, 436, 1994 WL 791922 (S.C. Pub. Serv. Comm'n 1994) (stating that amortization and rate base treatment provides a sharing of refinancing costs between the ratepayer and the shareholder and does not allow [the utility] to overrecover its costs). In this case, Staff's proposed imputed cost of debt of 7.30%, which was adopted by the Commission, represented a lower cost of debt that inured to the benefit of ratepayers. {23} It appears that the Commission believed that the use of an imputed capital structure disrupted the balance between ratepayers and shareholders. According to the Commission, for ratepayers to obtain the full benefits of a loss on reacquired debt, one must apply the lower actual cost of debt to the actual capital structure, which presumably has a much greater percentage of debt than the imputed capital structure. (Emphasis added.) While it is true that an imputed capital structure can impact the balance between ratepayers and shareholders by potentially exaggerating or understating the extent to which reacquired debt decreases the overall cost of long-term debt, there is no evidence in the record indicating that PNMGS's proposed imputed capital structure tipped the balance in favor of shareholders. We therefore conclude that the Commission's reliance on shareholder benefit, a factor not previously considered by the Commission with respect to losses on reacquired debt, is not supported by substantial evidence. {24} Beyond the lack of substantial evidence in the record to support the Commission's decision to deny recovery of losses on reacquired debt, we are troubled by the punitive aspects of the Commission's reasoning. The Commission broadly determined that recovery for losses on reacquired debt is inconsistent with a rate of return methodology based on an imputed cost of debt. As the hearing examiner noted in reference to the positions of Staff and the Attorney General, however, PNMGS, under this view, could never recover loss on reacquired debt if the Commission were to determine that an imputed capital structure and cost of capital were proper for ratemaking purposes. The Commission, in response to this criticism, determined that a complete bar to recovery was appropriate because it was PNMGS's choice in this case ... to use an imputed cost of debt as well as an imputed capital structure and an imputed, comparable group cost of equity. As noted above, PNMGS does not have an actual capital structure or cost of debt of its own. Additionally, although PNMGS proposed the use of an imputed cost of debt, the ultimate decision to implement that proposal rested with the Commission. Further, as reflected by the expert testimony in this case, the Commission has the power to adopt an imputed cost of debt and an imputed capital structure for purposes of ratemaking even if it is not initially proposed by the utility. See Zia Natural Gas Co. v. New Mexico Pub. Util. Comm'n (In re Petition by Zia Natural Gas Co.), 2000-NMSC-011, ¶ 10, 128 N.M. 728, 998 P.2d 564; cf. United Water Del., Inc. v. Public Serv. Comm'n, 723 A.2d 1172, 1174 (Del.1999). Dr. Moyer, PNMGS's expert, testified that PNM would have been imprudent not to refinance its high-cost debt, and there is no evidence in the record that the losses incurred by PNM in reacquiring debt were imprudent. The Commission's determination of an inconsistency between losses on reacquired debt and an imputed cost of debt would appear to apply regardless of the amount of a utility's losses, whether the losses were prudently incurred, and the extent of benefit realized by ratepayers. {25} We believe it is improper for the Commission to penalize PNMGS for its proposed methodology, a methodology supported by the Attorney General and Staff, found just and reasonable by the hearing examiner, and ultimately adopted by the Commission, by prohibiting the utility from having an opportunity to recover costs that were, undisputedly, prudently incurred. We believe that such a blanket rule fails to achieve a fair balance between ratepayers and investors. See § 62-3-1(B). See generally Federal Power Comm'n v. Hope Natural Gas Co., 320 U.S. 591, 603, 64 S.Ct. 281, 88 L.Ed. 333 (1944) (From the investor or company point of view it is important that there be enough revenue not only for operating expenses but also for the capital costs of the business.... [T]he return to the equity owner ... should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital. (citation omitted)), quoted in State v. Mountain States Tel. & Tel. Co., 54 N.M. 315, 336, 224 P.2d 155, 169 (1950). While it is true that [n]either New Mexico case law nor the Public Utility Act imposes any one particular method of valuation upon the Commission in ascertaining the rate base of a utility, Hobbs Gas Co., 94 N.M. at 734, 616 P.2d at 1119, we believe that the Commission's decision to deny recovery for losses on reacquired debt in this case, without support in the record and contrary to the Commission's previously established policy, is unreasonable and unlawful.