Citizens Util. Bd. v. Ill. Commerce Comm'n
| Citation | 116 N.E.3d 226,426 Ill.Dec. 377,2018 IL App (1st) 170527 |
| Decision Date | 11 September 2018 |
| Docket Number | Nos. 1-17-0527 & 1-17-0561 cons.,s. 1-17-0527 & 1-17-0561 cons. |
| Parties | CITIZENS UTILITY BOARD; Prairie Farms Dairy, Inc.; United States Steel-Granite City Works; and the University of Illinois, Appellants, v. The ILLINOIS COMMERCE COMMISSION and Illinois-American Water Company, Appellees. |
| Court | United States Appellate Court of Illinois |
Julie L. Soderna and Kelly A. Turner, of Chicago, for appellant Citizens Utility Board.
Eric Robertson and Ryan Robertson, of Leuders, Robertson & Konzen LLC, of Granite City, for appellant Prairie Farms Dairy, Inc.
Thomas R. Stanton, Special Assistant Attorney General, of Chicago, for appellee Illinois Commerce Commission.
Albert D. Sturtevant, Anne M. Zehr, and Nikhil Vijaykar, of Whitt Sturtevant LLP, of Chicago, and Kenneth C. Jones, of Belleville, for appellee Illinois-American Water Company.
¶ 1 This appeal arises from an order of the Illinois Commerce Commission (Commission) approving a general increase in the water and sewer service rates of Illinois-American Water Company (IAWC). More specifically, the Commission approved an increase in IAWC's authorized return on equity (ROE). Several intervenors in the proceedings below, Prairie Farms Dairy, Inc., United States Steel Corporation-Granite City Works, and the University of Illinois, as well as Citizens Utility Board (collectively, the intervenors), now appeal. On appeal, the intervenors assert that (1) the ROE approved by the Commission was not supported by substantial evidence, (2) the Commission failed to articulate a reasoned basis for its incorporation of size and leverage adjustments, and (3) the authorized ROE exceeded what was necessary to ensure IAWC's financial integrity and attract capital. For the following reasons, we affirm the Commission's order.
¶ 3 On January 21, 2016, IAWC filed with the Commission revised tariff sheets seeking a general increase in water and sewer rates. The Commission suspended the tariff sheets from taking effect and commenced this proceeding to investigate the proposed rate increase. As stated, several parties intervened.1
¶ 4 The purpose of the Public Utilities Act (Act) is to provide "adequate, efficient, reliable, environmentally safe and least-cost public utility services at prices which accurately reflect the long-term cost of such services and which are equitable to all citizens." 220 ILCS 5/1-102 (West 2016). The Commission uses the Act's rate of return principles to design and set just and reasonable rates for Illinois's least-cost public utility services. People ex rel. Madigan v. Illinois Commerce Comm'n , 2015 IL 116005, ¶ 29, 388 Ill.Dec. 895, 25 N.E.3d 587. Those principles used to determine the revenue requirement take into account a recovery of prudent, reasonable costs as well as a return on equity.2 Id. ¶ 30. In addition, the return should assure confidence in the utility's financial integrity in order to maintain its credit, attract capital ( Federal Power Comm'n v. Hope Natural Gas Co. , 320 U.S. 591, 603, 64 S.Ct. 281, 88 L.Ed. 333 (1944) ), and compensate the utility's investors (see Ameren Illinois Co. v. Illinois Commerce Comm'n , 2015 IL App (4th) 140173, ¶ 8, 393 Ill.Dec. 243, 33 N.E.3d 987 ).
¶ 5 During this proceeding, the parties resolved several issues but were unable to agree on an appropriate authorized ROE for IAWC. While IAWC sought a 10.75% ROE, the intervenors asserted that 9% was appropriate. The staff of the Commission (Staff) recommended a ROE of 8.12%. The intervenors now challenge the Commission's ultimate determination that an initial ROE of 9.87% is appropriate.
¶ 7 Michael Gorman, a public utility regulation consultant, testified on behalf of the intervenors. Gorman testified that he used the discounted cash flow (DCF) and capital asset pricing model (CAPM) to measure the current market cost of equity.3 The DCF model is based on the assumption that a stock's price equals the expected value of future dividends, discounted to present value, multiplied by the investors' required rate of return. See Id . ¶ 26. Under the CAPM formula, a utility's required rate of return equals the sum of the risk-free rate and a risk premium. Id. ¶ 10.4
¶ 8 For DCF, Gorman used models for constant growth, sustainable growth, and multi-stage growth. Because IAWC is not a publicly traded company, he used water and gas proxy groups of publicly traded companies to approximate IAWC's investment risk. See id. ¶ 12 (). As to the water proxy group, DCF analysis produced the following average ROEs: (1) constant growth of 9.12%, (2) sustainable growth of 8.05%, and (3) multi-stage growth of 7.09%. DCF analysis for the gas proxy group produced these average ROEs: (1) constant growth of 9.12%, (2) sustainable growth of 9.48%, and (3) multi-stage growth of 7.64%. Based on the foregoing, Gorman's recommended DCF range was from 8.3% to 9.3%. Thus, he found his analysis supported a ROE of 8.8%, the midpoint of the range.
¶ 9 Gorman's CAPM analysis resulted in 8.49% for his water proxy group and 9.77% for his gas proxy group. After modifying those results, the CAPM study suggested a reasonable ROE between 8.5% and 9.8%, with a midpoint of 9.15%. Gorman rounded the midpoint to 9.2%. Accordingly, Gorman found these studies indicated that a reasonable ROE would be between 8.8% (DCF) and 9.2% (CAPM), for an estimated ROE of 9%. Gorman further opined that a 9% ROE would support an overall rate of return that would permit IAWC to have an investment grade bond rating.
¶ 10 That being said, Paul Moul, IAWC's expert and a financial and regulatory consultant, found Gorman's DCF results were too low, too unrealistic and certain results were "simply not credible." Moul also found Gorman's sustainable growth DCF and multi-stage growth DCF results were flawed and his CAPM results were incomplete. Furthermore, Moul found Gorman failed to establish a reasonable basis for comparing IAWC with Gorman's gas proxy group.
¶ 11 Moul testified on behalf of IAWC that he applied DCF, CAPM, risk premium analysis and a comparable earnings study to a proxy group of publicly traded water companies. His constant growth DCF model led to a ROE of 9.72%. He had reduced his DCF results to account for IAWC having a higher level of debt than the proxy group (leverage adjustment). Additionally, after adjusting his CAPM outputs to reflect IAWC's smaller size (size adjustment), his CAPM results suggested a ROE of 11.03%. Thus, Moul's combined DCF and CAPM analyses indicated a range of 9.72% to 11.03% with a midpoint of 10.38%. Furthermore, Moul's risk premium analysis suggested a ROE of 11.25% and his comparable earnings analysis suggested a ROE of 13.05%.
¶ 12 Moul acknowledged, however, that all methods contain assumptions and constraints that are incomplete or overly restrictive. For example, he expressed concern for the circular nature of DCF analysis when used in rate cases. Moul further acknowledged his result did not take into consideration the possibility that unforeseen events would prevent IAWC from achieving its authorized rate of return, something that IAWC had not achieved for several years.
¶ 13 Moul determined that based on the foregoing analyses, a ROE of 10.75% represented a fair, reasonable cost of equity that would permit IAWC to attract capital to replace aging infrastructure. Moreover, Moul testified that his opinion assumed that the Commission would also approve a volume-balancing adjustment rider (Rider VBA): Without it, IAWC would have a higher risk profile than the utility companies in the proxy group.5
¶ 14 Gorman and Sheena Kight-Garlisch, a senior financial analyst in the Commission's Financial Analysis Division, found that Moul's size and leverage adjustments were inappropriate and, as a result, Moul's ROE of 10.75% was too high. They rejected Moul's suggestion that a leverage adjustment is required when a firm's capitalization, as measured by market value, varies from the book value capitalization. Additionally, had Moul excluded those adjustments, his DCF analysis would have resulted in a ROE of 9% and his CAPM analysis would have resulted in a ROE of 8.9%. Moul, however, added a leverage adjustment of 0.89 to both studies and a size adjustment to the CAPM result. Gorman and Kight-Garlisch disagreed with Moul's opinion that as a firm's size decreases, its risk and required return increase or that a size adjustment was required. Gorman and Kight-Garlisch further testified that the inputs for Moul's risk premium analysis inflated the risk premium.
¶ 15 Kight-Garlisch testified on behalf of the Staff that she performed DCF and CAPM analysis on water and utility proxy groups. With respect to DCF, she used a nonconstant, multistage growth model with three stages of dividend growth, which led to ROE estimates of 7.24% for her water proxy group and 7.51% for her utility proxy group. Kight-Garlisch declined to use the constant growth DCF model, finding that the near-term average dividend growth rate for the companies in her proxy groups were not sustainable long term. With respect to CAPM, she came to a ROE of 8.8% for the water proxy group and 8.9% for the utility proxy group, after making certain adjustments. She did not make adjustments based on size and leverage.
¶ 16 Kight-Garlisch testified that the average of her DCF and CAPM results for the water proxy group was 7.98%, while the average of her DCF and CAPM results for the gas proxy group was 8.16%. The average of both percentages was 8.07%, although she recommended a slightly higher ROE of 8.12%. Should the Commission approve IAWC's proposed Rider VBA, Kight-Garlisch suggested an additional reduction, to 8.04%. Moul extensively criticized KightGarlisch's...
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