Missouri Public Serv. Comm'n v. Fed. Energy Comm'n

• Decision Date: 27 June 2000
• Docket Number: Nos. 99-1169,99-1171,99-1241,s. 99-1169
• Citation: 215 F.3d 1
• Parties: (D.C. 2000) Missouri Public Service Commission, Petitioner v. Federal Energy Regulatory Commission, Respondent Kansas Corporation Commission, et al., Intervenors
• Court: U.S. Court of Appeals — District of Columbia Circuit

Page 1

215 F.3d 1 (D.C. 2000)

Missouri Public Service Commission, Petitioner v. Federal Energy Regulatory Commission, Respondent

Kansas Corporation Commission, et al., Intervenors

Nos. 99-1169, 99-1171, 99-1241

United States Court of Appeals FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued May 15, 2000

Decided June 27, 2000

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

Charles F. Wheatley, Jr. and David D'Alessandro argued the cause and filed the briefs for petitioners Kansas Cities and the Missouri Public Service Commission. Kelly A. Daly entered an appearance.

Gary W. Boyle argued the cause and filed the briefs for petitioner/intervenor Williams Gas Pipelines Central, Inc. Beverly H. Griffith, Gregory Grady and Joseph S. Koury entered appearances.

Andrew K. Soto, Attorney, Federal Energy Regulatory Commission, argued the cause for respondent. With him on the brief were John H. Conway, Deputy Solicitor and Susan J. Court, Acting Deputy Solicitor. Jay L. Witkin, Solicitor, entered an appearance.

Before: Williams, Henderson and Rogers, Circuit Judges.

Opinion for the Court filed by Circuit Judge Williams.

Williams, Circuit Judge:

In 1993 Williams Natural Gas Company,¹ a natural gas pipeline company within the jurisdiction of the Federal Energy Regulatory Commission, filed for a general rate increase under 4 of the Natural Gas Act, 15 U.S.C. 717c. The proceeding closed in 1999 with the Commission's third rehearing order. Williams Natural Gas Co., 86 FERC p 61,323 (1999) ("Third Rehearing"). That and the underlying orders are attacked from two sides. A host of Kansas cities, the Missouri Public Service Commission and others, which we will collectively call the "Public Service Commission," attack the allowed rate of return. They argue that the Commission wrongly refused (a) to impute to Williams the capital structure of its corporate parent, or alternatively, (b) to adjust Williams's return on equity downward to reflect its subsidiary status and the "thickness" of its equity ratio in comparison to that of firms in the proxy group used by the Commission to calculate the return on equity. The pipeline itself attacks on an unrelated issue, objecting to the Commission's method of projecting the costs for cleaning up PCB (polychlorinated biphenyl).

We cannot say that the Commission's use of Williams's capital structure and the median return on equity for the proxy group was arbitrary and capricious. As to clean-up costs, the Commission no longer defends the $1.4 million annual cost recovery as a figure representative of actual cost, and its decision does not purport to rely on any procedural default by Williams; we therefore grant Williams's petition and remand for further proceedings.

Capital structure and rate of return on equity

The Public Service Commission's brief offers a nonexhaustive, but here uncontested, explanation of the role of capital structure and equity rate of return. It points out that a firm's return on equity must be higher than the return on debt because (1) any dividends are paid out of after-tax earnings, whereas the firm can deduct interest on debt, and (2) equity is riskier. Because the overall cost of equity is the product of the equity share of capital and the equity rate of return, these factors imply that an increase in the equity-debt ratio tends to increase a firm's allowable overall rate of return. But there is an offset: Because debt service has priority, the higher the proportion of equity capital, the lower the financial risk for the firm's stock, and thus, in this respect, the lower the necessary rate of return. See also Richard J. Pierce, Jr. & Ernest Gellhorn, Regulated Industries 136-37 (3d ed. 1994).

Williams is a wholly owned subsidiary of The Williams Companies ("TWC"). Williams's own capital structure is 35.71% debt and 64.29% equity, while TWC's is 50% debt, 3% preferred equity, and 47% common equity. Assuming use of the same equity rate of return, FERC's use of TWC's ratio would be an advantage for Williams's customers.

In calculating the equity rate of return of a wholly owned subsidiary, the Commission has a special problem. Since its shares are not traded in the market, they have no market price from which to infer their rate of return. So the Commission looks instead to a proxy group of supposedly similar firms whose stock is traded, calculates their return on equity with the "DCF" or "discounted cash flow" method, and then tacks the resulting number onto the equity of the subsidiary. See generally Williston Basin Inter. Pipeline Co. v. FERC, 165 F.3d 54, 56-57 (D.C. Cir. 1999); North Carolina Utilities Comm'n v. FERC, 42 F.3d 659, 661 (D.C. Cir. 1994).

Here the Commission used Williams's capital structure. It found the company's business risk average, and, though not explicitly so labelling its financial risk, held that its overall risk (the amalgam of the two) was not outside the "broad middle range of average risk." Third Rehearing, 86 FERC p 61,323, at 61,860-61. It thus allowed Williams the median rate of return of the proxy group. In doing so, it made no adjustment to reflect the fact that Williams's equity ratio was a good deal thicker than the average of the proxy group (and therefore presumably less risky). Indeed, Williams's ratio was higher than the highest equity ratio of the proxy group-64%, compared with 42% and 62% for the average and highest ratio of the proxy group, respectively.²

We review the challenge under the arbitrary and capricious standard of the Administrative Procedure Act. 5 U.S.C. 706(2)(A). The Commission must consider the relevant factors and draw "a rational connection between the facts found and the choice made." Williston Basin, 165 F.3d at 60 (citation and quotation marks omitted). On the technical aspects of rate making FERC's decisions necessarily enjoy considerable deference. Public Service Comm'n v. FERC, 813 F.2d 448, 451 (D.C. Cir. 1987).

The attack on the Commission's refusal to use TWC's capital structure opens with the "double leveraging" theory. The theory's basic concept is that the true cost of a subsidiary's equity capital is the overall cost of the parent's capital. Accordingly, the cost of the subsidiary's equity should be computed as the weighted average of the parent's debt and equity costs. Otherwise, says the theory, shareholders of the parent receive not only the higher equity returns associated with the parent's equity, but an artificial (doubly leveraged) return on the subsidiary's equity.

Although the Commission in the first rehearing order opted in favor of using TWC's capital structure, Williams Natural Gas Co., 80 FERC p 61,158 (1997) ("First Rehearing"), even then it rejected double leveraging as a rationale: "The rate of return to a pipeline should not depend on who owns the pipeline, nor on how that owner, whether a holding company or individual stockholders, financed its investment." Id. at 61,682; see also Third Rehearing, 86 FERC p 61,323, at 61,858-59. The double leveraging theory would in principle be applicable to a pipeline owned by a single individual, or by a group of investors, requiring the Commission to pursue its inquiry into these owners' finances. Further, an expert quoted by the Commission makes the point that the pipeline investment's true opportunity cost does not depend on the capital structure of the investor, but rather on the foregone risk-adjusted returns of alternative investments. See James E. Brown, "Double Leverage: Indisputable Fact or Precarious Theory," Public Utilities Fortnightly 26, 29 (May 9, 1974), cited at First Rehearing, 80 FERC p 61,158, at 61,682 n.21.

It is not for us to say whether these arguments have put the kibosh on the double leverage theory. We can, however, say that the Public Service Commission's quick response-individual investors would never directly own a FER Cregulated pipeline, and if they did, they would not stand for such high equity ratios--is not a serious intellectual answer to them. On this record we have no basis to disturb FERC's refusal to apply the double leveraging theory.

The Commission nevertheless briefly flirted with the idea of using TWC's capital structure. First Rehearing, 80 FERC p 61,158, at 61,683. But on the next lap it dropped that approach, with the reasoning stated in a chronologically connected case:

Traditionally, the Commission has preferred to utilize the applicant's own capital structure and will continue to do so if the applicant issues its own non-guaranteed debtand has its own bond rating. But the Commission will utilize an imputed capital structure (most often that of the corporate parent) if the record in a particular case reveals that the pipeline's own equity ratio is so far outside the range of other equity ratios approved by the Commission and the range of proxy company equity ratios that it is unreasonable.

Transcontinental Gas Pipe Line Corp., 84 FERC p 61,084, at 61,413 (1998) ("Order 414-A"), affirmed North Carolina Utilities Comm'n v. FERC, No. 99-1037 (D.C. Cir. Feb. 7, 2000) (unpublished opinion). The Commission applied this policy to Williams on the second rehearing. Williams Natural Gas Company, 84 FERC p 61,080, at 61,356 (1998) ("Second Rehearing"). As Williams issued its own non-guaranteed debt and had its own bond rating, the normal pre-conditions for using Williams's own capital structure were satisfied.

We now turn to the Public Service Commission's argument that Williams's equity ratio is so out of line that the Commission should either have applied the caveat in the excerpt quoted above (calling for use of an imputed capital structure in cases of anomalous equity ratios), or should have adjusted Williams's equity rate of return down from that of the proxy group. The common sense of this attack is clear. Given that a high equity ratio reduces financial risk (everything else being equal), it would make no sense for the Commission to use a rate...