IN RE ZIA NATURAL GAS CO.

• Citation: 998 P.2d 564,2000 NMSC 11,128 N.M. 728
• Decision Date: 01 March 2000
• Docket Number: No. 24, 699.,24, 699.
• Parties: In the Matter of the Petition by ZIA NATURAL GAS COMPANY, a division of Natural Gas Processing Co., to Establish New Service and Transportation Rates, Zia Natural Gas Company, a division of Natural Gas Processing Co., Appellant, v. NEW MEXICO PUBLIC UTILITY COMMISSION, Appellee, and Mescalero Apache Tribe, Intervenor-Appellee.
• Court: Supreme Court of New Mexico

998 P.2d 564

128 N.M. 728

2000 NMSC 11

In the Matter of the Petition by ZIA NATURAL GAS COMPANY, a division of Natural Gas Processing Co., to Establish New Service and Transportation Rates, Zia Natural Gas Company, a division of Natural Gas Processing Co., Appellant, v. NEW MEXICO PUBLIC UTILITY COMMISSION, Appellee, and Mescalero Apache Tribe, Intervenor-Appellee.

No. 24, 699.

Supreme Court of New Mexico.

March 1, 2000.

Rehearing Denied March 31, 2000.

Simons, Cuddy & Friedman, LLP, Daniel H. Friedman, Santa Fe, Mercedes Fernandez-Wells, Zia Natural Gas Company, Ruidoso Downs, for Appellant.

Stacey J. Goodwin, Commission Counsel, Santa Fe, for Appellee.

Cohen & Cohen, P.A., David S Cohen, Jill Z. Cooper, Santa Fe, for Intervenor-Appellee.

OPINION

MAES, Justice.

{1} This is an appeal by the Zia Natural Gas Company (hereinafter Zia) from an order of the New Mexico Public Utilities Commission (hereinafter Commission) in a natural-gas utility-rate proceeding. Pursuant to NMSA 1978, § 62-11-5 (1982), under which this Court may affirm or annul an action by the Commission, we are asked to annul and vacate the order of the Commission.

I. BACKGROUND

{2} Zia is an operating division of Natural Gas Processing, Inc.; both are located in Worland, Wyoming. Zia provides natural gas utility service in Ruidoso and surrounding areas in Lincoln County. Following acquisition of the assets of Jal Gas Co. in 1994 and Hobbs Gas Co. in 1996, Zia also serves Jal and Hobbs.

{3} Zia sought a rate increase of $2,704,158 and was granted an increase of $983,428. Zia raises five issues with regard to the rate proceeding: 1) whether a capital structure can be imputed to Zia; 2) whether the denial of Zia's actual tax expense is contrary to law; 3) whether the overall rate of return on the rate base which includes the rate of return on equity and the rate of return on debt established by the Commission is, on balance, supported by substantial evidence in the record as a whole; 4) whether the Commission's decision to deny Zia any cash working capital is supported by substantial evidence or is a denial of due process; and 5) whether the deletion of over $115,700 in aircraft operating expenses from Zia's rate base is supported by substantial evidence or was a denial of due process. We conclude the Commission's use of an imputed capital structure and the Commission's determination of the rate of return on the rate base are based on substantial evidence. Zia's evidence against use of an imputed capital structure to determine rates is inapplicable to current economic conditions. The Commission's denial of Zia's actual income tax expense was arbitrary and the denial of a cash working capital allowance as an element of the rate base and the reduction of aircraft expense in Zia's rate base from $140,000 to $24,252.92 were not based on substantial evidence. We reverse the decision of the Commission.

II. STANDARD OF REVIEW

{4} Our statutory authority in rate cases is set out in NMSA 1978, § 62-11-5 (1982). We have no authority to modify the order of the Commission. See Hobbs Gas Co. v. Public Serv. Comm'n, 115 N.M. 678, 680, 858 P.2d 54, 56 (1993)

. Although we do not substitute our judgment for that of the Commission or act legislatively in this matter, we may declare parts of a Commission order unlawful and vacate the order in toto, but at the same time in the interest of judicial economy declare other parts of the order to be lawful. Id. The statutory basis for our decision to affirm or annul is whether the decision of the Commission is unreasonable or unlawful. We expounded upon the meaning of unlawfulness in this context in Morningstar Water Users v. New Mexico Public Utility Commission, 120 N.M. 579, 582, 904 P.2d 28, 31 (1995). In Morningstar we explained the burden of showing unlawfulness or unreasonableness on the appealing party under NMSA 1978, § 62-11-4 (1965). Such unreasonableness or unlawfulness may be shown by demonstrating the decision: is arbitrary and capricious, is not supported by substantial evidence, or is an abuse of discretion "by being outside the scope of the agency's authority, clear error, or violative of due process." Morningstar, 120 N.M. at 581,

904 P.2d at 31. Although we review the whole record to determine whether there is substantial evidence to support the agency decision, we view the evidence in the light most favorable to the decision. Duke City Lumber Co. v. New Mexico Envtl. Improvement Bd., 101 N.M. 291, 294, 681 P.2d 717, 720 (1984).

III. IMPUTED CAPITAL STRUCTURE

{5} A utility's capital structure is used as a basis in determining the overall rate of return on a utility's investment. In this matter, the Commission, relying on the hearing examiner's recommendation, established a rate of return through the use of an imputed capital structure rather than Zia's actual capital structure. The process which Zia describes as the imputation of a capital structure is in fact a mathematical process through which the Commission determined the overall rate of return. Zia is owned by one investor. Zia currently operates with 100% equity and no debt. Zia argued that its rate base should be figured using a 13% rate of return on 100% equity. Instead, the Commission determined an overall rate of return for Zia using the debt and equity structure of a more typical natural gas company and typical rates of return for such companies on both debt and equity. The Commission used a hypothetical capital structure which included 51.5% common equity, 2 .63% preferred stock, and 45.88% debt (rounded to the nearest one hundredth). This typical capital structure is a less expensive capital structure than Zia's because the rate of return on equity is substantially higher than the rate of return on debt.

{6} Zia contends that the use of an imputed capital structure which included debt was not supported by substantial evidence and was a denial of procedural due process. Zia further alleges it should have been given advanced notice to adjust its capital structure to include a certain percentage of debt.

{7} It is well established that equity financing is more expensive than debt financing. See State Corp. Comm'n v. Mountain States Tel. & Tel. Co., 58 N.M. 260, 277, 270 P.2d 685, 696 (1954)

(hereinafter Mountain States 1954) (discussing capital structure as the ratio of debt to equity, this Court stated, "[d]ebt capital is substantially less expensive to the operating company than equity capital"). See also Railroad Comm'n of Tex. v. Entex, Inc., 599 S.W.2d 292, 295 (Tex.1980) ("Debt financing or borrowed capital is generally cheaper than equity financing or capital obtained from the sale of stock"); State v. Southern Bell Tel. & Tel. Co., 274 Ala. 288, 148 So.2d 229, 232-33 (1962) (deeming a low debt to equity ratio to be in "the nature of a company luxury not to be reflected in rates to be charged to the public"). A less-than-efficient capital structure which contains excessive equity is properly treated by the Commission as likely to result in higher rates. South Central Bell Tel. Co. v. Louisiana Pub. Serv. Comm'n, 594 So.2d 357, 362 (La.1992) (stating that the cost of capital consists of two factors, the cost of debt and the cost of equity; "[t]he first step in estimating the overall cost of capital is choosing the appropriate capital structure for regulatory purposes[;][t]his selection is crucial because, the cost of equity capital is usually higher than the cost of debt capital"). For rate-making purposes the hypothetical capital structure allows rates to be set as though overall cost of capital were based on an optimal ratio of debt to equity in the capital structure of the utility. To determine the proper ratio of debt to equity the Commission must determine each of the two elements of the cost of capital: the cost of debt and the cost of equity. See City of Pittsburgh v. Pennsylvania Pub. Util. Comm'n, 182 Pa.Super. 376, 126 A.2d 777, 781 (1956). Because equity is more costly than debt, capital structures should reflect as much debt as possible, though not to the point where the financial integrity of the firm is sacrificed. See Mountain States 1954,

58 N.M. at 277-78,

270 P.2d at 696. The overall lower cost of capital for the utility with an efficient capital structure, that is a capital structure with a reasonable amount of debt, translates into lower rates. While the actual debt ratio carried by the utility is a matter for the utility's management, id. at 278, 270 P.2d at 696-97, a capital structure which results in higher than necessary rates is properly treated by the Commission as economically inefficient. In rate making, the Commission may set rates based on an optimum, or at least an average, capital structure. Otherwise, the utility's choice of capital structure would always dictate rates, which would exaggerate the interests of investors over those of consumers. See NMSA 1978, § 62-3-1 (1967) (declaring public policy in the interest of consumers and investors to require regulation of utilities).

{8} Our cases have all but explicitly accepted the imputation of a capital structure to a utility company in rate making. See Gas Co. v. New Mexico Pub. Serv. Comm'n, 100 N.M. 740, 742, 676 P.2d 817, 819 (1984)

(imputing income to utility for undersales of condensed liquid gas to affiliate to protect against cross-subsidization approved); General Tel. Co. v. Corporation Comm'n (In re General Tel. Co.), 98 N.M. 749, 754, 652 P.2d 1200, 1205 (1982) [hereinafter General Tel. 1982 ] (holding it proper for Commission to allocate weighted cost to the elements of capital structure, including debt, to limit return on debt of subsidiary); Mountain States 1954,

58 N.M. at 277,

270 P.2d at 696 (using the term debt ratio to mean the proportion of debt to equity in the capital structure, the Court acknowledged a dispute "as to whether rates should be based upon actual debt ratio or an estimated proper debt ratio"). A...