Public Service Com'n of Kentucky v. F.E.R.C., 03-1092.

• Decision Date: 18 February 2005
• Docket Number: No. 03-1097.,No. 03-1092.,03-1092.,03-1097.
• Citation: 397 F.3d 1004
• Parties: PUBLIC SERVICE COMMISSION OF THE COMMONWEALTH OF KENTUCKY, Petitioner v. FEDERAL ENERGY REGULATORY COMMISSION, Respondent Midwest ISO Transmission Owners, et al., Intervenors
• Court: U.S. Court of Appeals — District of Columbia Circuit

397 F.3d 1004

PUBLIC SERVICE COMMISSION OF THE COMMONWEALTH OF KENTUCKY, Petitioner v. FEDERAL ENERGY REGULATORY COMMISSION, Respondent Midwest ISO Transmission Owners, et al., Intervenors

No. 03-1092.

No. 03-1097.

United States Court of Appeals, District of Columbia Circuit.

Argued January 7, 2005.

Decided February 18, 2005.

On Petitions for Review of Orders of the Federal Energy Regulatory Commission.

David E. Pomper argued the cause for petitioners. With him on the briefs were Thomas C. Trauger, David D'Alessandro, John E. McCaffrey, Richard G. Raff, Robert A. Weishaar, Jr., and Jeffrey L. Landsman.

Beth G. Pacella, Attorney, Federal Energy Regulatory Commission, argued the cause for respondent. With her on the brief was Cynthia A. Marlette, General Counsel.

Michael E. Small, Paul M. Flynn, and Wendy N. Reed were on the brief for intervenors in support of respondent.

Before: RANDOLPH, TATEL, and ROBERTS, Circuit Judges.

Opinion for the Court filed by Circuit Judge ROBERTS.

ROBERTS, Circuit Judge.

This petition arises out of a proceeding before the Federal Energy Regulatory Commission to set rates for the transmission of electricity over lines operated by a regional transmission organization. Over a century ago, the first Justice Harlan noted that regulated rates must ensure just compensation, but confessed that "[h]ow such compensation may be ascertained, and what are the necessary elements in such an inquiry, will always be an embarrassing question." Smyth v. Ames, 169 U.S. 466, 546, 18 S.Ct. 418, 42 L.Ed. 819 (1898) (quoted in Duquesne Light Co. v. Barasch, 488 U.S. 299, 308, 109 S.Ct. 609, 102 L.Ed.2d 646 (1989)). For our part, we have recognized that "agency ratemaking is far from an exact science," Time Warner Entm't Co. v. FCC, 56 F.3d 151, 163 (D.C.Cir.1995), and that it involves "complex industry analyses," Ass'n of Oil Pipe Lines v. FERC, 83 F.3d 1424, 1431 (D.C.Cir.1996), and "[i]ssues of rate design [that] are fairly technical," Town of Norwood v. FERC, 962 F.2d 20, 22 (D.C.Cir.1992). For these reasons, and because ratemaking "involves policy determinations in which the agency is acknowledged to have expertise, our review thereof is particularly deferential." Time Warner, 56 F.3d at 163 (internal quotation marks omitted).

Given the deferential standard, we uphold FERC's decisions to calculate the pertinent rate of return on equity in this case by reference to a particular "proxy group" of publicly-traded companies, and to base the rate of return on the midpoint, rather than the median or mean, of the rates in that group. But FERC is entitled to deference only if it plays fair, and we conclude that the Commission failed to give adequate notice that it would add 50 basis points to the rate of return generated by its calculations, to encourage participation in regional transmission organizations. We accordingly grant the petition in part.

I.

Midwest Independent Transmission System Operator, Inc. (MISO) is a regional transmission organization (RTO) — a company that combines multiple power grids into a single transmission system. In recent years, FERC has promoted the formation of RTOs as a means of increasing competition and driving down the price of electricity. According to the Commission, RTOs provide a large and stable transmission system that reduces regional pricing disparities and creates an efficient market for new power generators. See generally Regional Transmission Organizations, Order No.2000, 65 Fed.Reg. 809 (Dec. 20, 1999); Order No.2000-A, 65 Fed.Reg. 12,088 (Feb. 25, 2000). MISO, the first such organization in the nation, came into being when a series of midwestern utilities placed their grids under its centralized control. See Midwest ISO Transmission Owners, Inc. v. FERC, 373 F.3d 1361, 1365 (D.C.Cir.2004).

The rates charged by electric utilities such as MISO are regulated by FERC to ensure that they are just and reasonable, and not unduly discriminatory. See 16 U.S.C. §§ 824d, 824e. Utilities themselves initiate the ratemaking process by submitting proposals to the Commission, but FERC retains authority to modify such proposals to ensure compliance with the statutory standards. Id. §§ 824d(c)-(d), 824e(a).

A major component of the rates charged by MISO is the return on equity (ROE) paid to its member utilities. This rate compensates the utilities for the capital cost of the grids they placed under MISO's control. FERC derives the rate by estimating the annual return an equity investor in the utility would expect on such capital, had the utility continued to operate the grid outside the RTO. See generally Canadian Ass'n of Petroleum Producers v. FERC, 254 F.3d 289, 293-94 (D.C.Cir.2001). Calculating this rate would be relatively easy if a utility's interest in its grid — its business as a transmission owner (TO) — were publicly traded, but "there are no publicly traded independent pure electric transmission companies." MISO Initial Decision, 99 FERC ¶ 63,011, 65,040, 2002 WL 32056864 (2002). The Commission must therefore resort to more roundabout estimations.

In December 2001, MISO and certain of its member TOs petitioned the Commission to increase the ROE component of MISO's charges from a previously approved level of 10.5 percent to 13 percent. The Commission set the matter for hearing, at which all interested parties were allowed to present evidence. Among those availing themselves of this opportunity were the petitioners in this case — the Public Service Commission of the Commonwealth of Kentucky (PSCKY) and a group of private consumers and municipal entities (the Intervenor Group) — who appeared on behalf of ratepayers and argued against any rate increase or, in any event, for a more modest one.¹ At the hearing, an administrative law judge selected a proxy group of public companies to use in estimating the appropriate return on equity for the MISO TOs. The judge chose a group consisting of the parent companies of certain MISO TOs themselves — which, unlike the transmission-owning subsidiaries, are publicly traded. The judge rejected several other proposals, including one submitted by the Intervenor Group. Id. at 65,038-42.

Once she had made her choice, the judge sought to extract a single ROE value, representative of the proxy group as a whole, to be applied to all the MISO TOs. She chose the midpoint of the range — the average of the highest and lowest data points — which yielded a return of 12.38 percent. She rejected the recommendation of FERC staff to use the mean — the average of all values in the proxy group (11.74 percent) — as well as the Intervenor Group's proposal to use the median — the middle data point in the group (11.85 percent). Id. at 65,047-52. The judge also rejected competing pleas from MISO and the Intervenor Group to derive ROE using only part of the proxy range, such as the top or bottom half. Id.

FERC affirmed the ALJ's choice of the proxy group and her use of the midpoint. Speaking to the latter, the Commission noted that its electrical industry precedents — unlike its oil and gas cases — had relied on the midpoint as a measure of central tendency. The Commission, however, also decided sua sponte to increase the final return by 50 basis points, to 12.88 percent, as an incentive for companies to join a regional transmission organization. MISO Order Affirming Initial Decision, 100 FERC ¶ 61,292, 62,313-15, 2002 WL 31986513 (2002). FERC explained that it "will be clarifying [this] incentive rate policy in the near future." Id. at 62,315. Several months later, the Commission indeed issued a proposal to give "any entity that transfers operational control of transmission facilities to a Commission-approved RTO ... an incentive adder of 50 basis points on its ROE for all such facilities transferred." Proposed Pricing Policy for Efficient Operation and Expansion of Transmission Grid, 102 FERC ¶ 61,032, 61,065, 2003 WL 245747 (2003).

In the meantime, petitioners sought rehearing of FERC's order, which the Commission denied. Besides affirming its earlier findings, FERC rejected petitioners' contention that they had not been given sufficient notice of the possibility of an incentive-based adder. FERC explained that petitioners should have been aware of the possibility of such an adder, given the Commission's statutory power to amend proposals to ensure just and reasonable rates. FERC also noted that the final value of 12.88 percent was less than the 13 percent initially requested by MISO, and thus presumably within the range of petitioners' expectations at the outset of the proceedings. See MISO Order Denying Rehearing, 102 FERC ¶ 61,143, 61,395, 2003 WL 257395 (2003).

Petitioners then sought review in this court, but the Commission moved for a voluntary remand to allow further consideration of the rate of return. On remand, the Commission maintained its position, but offered a different rationale for the use of the midpoint in this case. FERC explained that the question here "is not what constitutes the best overall method for determining ROE generically (i.e. the midpoint versus the median or mean)." MISO Order on Remand, 106 FERC ¶ 61,302, 62,192, 2004 WL 598168 (2004). Rather, the Commission observed that under the "unique ... circumstances" of this case, in which the chosen value will apply "to a diverse group of companies," the midpoint provides the best measure because it emphasizes the endpoints of the proxy group range, ensuring that outlier as well as average TOs receive just and fair compensation. Id. at 62,192-93. The Commission also found that the proxy group was not too skewed to permit a midpoint analysis. Id. at 62,193.

PSCKY and the Intervenor Group now seek review of the FERC orders, challenging the selection of the proxy group, the use of the midpoint, and the incentive-based adder.

II.

The "arbitrary and capricious" standard of the Administrative Procedure Act governs our review. See 5 U.S.C. § 706(2)(A). Under this...