Public Utility Com'n of Texas v. Houston Lighting & Power Co.

• Decision Date: 15 December 1987
• Docket Number: No. C-5705,C-5705
• Citation: 748 S.W.2d 439
• Court: Texas Supreme Court
• Parties: PUBLIC UTILITY COMMISSION OF TEXAS v. HOUSTON LIGHTING & POWER COMPANY, et al.

Page 439

748 S.W.2d 439

PUBLIC UTILITY COMMISSION OF TEXAS v. HOUSTON LIGHTING & POWER COMPANY, et al.

No. C-5705.

Supreme Court of Texas.

Dec. 15, 1987.

Rehearing Denied May 4, 1988.

Jim Mattox, Atty. Gen., Carole J. Vogel, Fernando Rodriguez, Karen Pettigrew, Office of the Atty. Gen., Austin, for petitioner.

Hugh Rice Kelly, G. Schalles, III & H. Leven, Houston Lighting & Power Co., Houston, Robert J. Hearon, Jr., Graves, Dougherty, Hearon & Moody, Austin, Finis Cowan, Jr., Baker & Botts, Jefferson D. Giller, Lee C. Clyburn, Fulbright & Jaworski, Austin, for respondents.

OPINION

GONZALEZ, Justice.

This cause is an administrative appeal addressing the scope of authority of the Public Utility Commission (PUC) to allocate costs, profits and tax benefits between ratepayers and shareholders. Houston Lighting & Power Co. (HL & P) applied to the PUC for a rate increase. After a hearing, the final order of the PUC provided that a 16.85% return on equity was reasonable. However, the PUC penalized HL & P .5% for alleged imprudent management of two nuclear power projects--the Allen's Creek Nuclear Project (ACNP) and the South Texas Nuclear Project (STNP). The PUC also held that the ACNP should have been cancelled on January 1, 1980 and that all expenditures on the project after this date were disallowed and not recoverable from the ratepayers.

On appeal by HL & P, the trial court reversed the order of the PUC on the grounds that the PUC had no statutory authority to impose a penalty on a utility's rate of return. The trial court also reversed and remanded the PUC's order as it related to the recovery of ACNP cancellation costs, the treatment of tax benefits associated with $166 million in disallowed ACNP expenditures and the allocation of litigation expenses attributable to a suit between HL & P and Brown & Root involving the STNP. The trial court also remanded to the PUC for specific findings regarding Dow Chemical Company's assertions of rate discrimination by HL & P.

The court of appeals affirmed the judgment of the trial court in all respects, except that it deleted the trial court's conclusion that the PUC's finding of HL & P's mismanagement was "premature and presumptuous." 715 S.W.2d 98. We reverse and render in part the judgment of the court of appeals and affirm in part.

Facts

Plans for ACNP were initiated by HL & P in August of 1972, as a two-unit 2400 megawatt plant. However, in September of 1975, HL & P considered cancelling ACNP because its electric demand forecasts had been overly optimistic. While HL & P evaluated the future of ACNP, all activity on the project was suspended. HL & P eventually announced plans in late 1976 to cancel one of the 1200 megawatt units. Construction then resumed on the other unit.

From 1976 to 1979, three additional factors emerged which made continued expenditures by HL & P for the development of ACNP more venturesome: (1) The capital costs for nuclear plants escalated more rapidly than comparable costs for coal powered generation, (2) the safety regulations which governed the construction of ACNP increased substantially due to the Three Mile Island incident and (3) the licensing process for ACNP became stalled in 1979 because of construction difficulties.

Despite these obstacles, it was not until early 1981 that HL & P renewed consideration about cancelling ACNP. The project was ultimately cancelled by HL & P on August 26, 1982 at a total loss of $361 million. In 1982 HL & P filed with the PUC an application for a rate increase.

After considering all of the evidence in the record, the PUC set the rate of return at 16.35% (after the .5% penalty) and concluded that a prudent utility would have cancelled ACNP as of January 1, 1980. As a result, all ACNP related expenses incurred after January 1, 1980, in the amount of $166 million, were, by definition, imprudent. All ACNP related expenses incurred prior to January 1, 1980, in the amount of $195 million dollars, were prudent. The final order of the PUC provided that these prudently incurred expenses could be recovered by HL & P from its ratepayers through a ten year amortization plan. By the end of ten years, HL & P would recoup all of the $195 million as cost of service revenues. In addition, the amount paid by HL & P in income taxes on those revenues would be recovered in the rate structure.

The PUC recognized that HL & P intended to write-off for tax purposes, the $166 million of imprudent ACNP expenditures. The effect of such a write-off would provide tax savings to HL & P and cause it to bear less than its $166 million share of ACNP. In order to give effect to its ruling that HL & P bear the full burden of these imprudent expenses, the PUC determined that any tax savings derived from a write-off should inure to the benefit of the ratepayers.

HL & P argues that it should be allowed to retain all tax savings associated with the tax write-off of the $166 million. Under HL & P's proposal, its actual tax liability would be reduced by the savings attributed to the tax write-off of the disallowed expenses. However, for ratemaking purposes, HL & P's cost of service would not reflect these tax savings in the federal income tax allowance. Thus, HL & P's cost of service would be overstated by the amount that HL & P saves as a result of its tax write-off. In turn, the federal income tax expense passed on to the ratepayers would not be reduced to reflect HL & P's tax savings. The result is that the ratepayers of HL & P would be required to pay an amount for federal income tax expense in excess of that actually borne by the utility. This additional income tax expense is the benefit that HL & P seeks to retain.

Recovery of Operating Expenses

It is generally recognized that the establishment of just and reasonable rates requires consideration of three factors: (1) the utility's reasonable and prudent operating expenses; (2) the rate base; and (3) a reasonable rate of return. Railroad Commission of Texas v. Entex, Inc., 599 S.W.2d 292, 294 (Tex.1980); Railroad Commission of Texas v. Houston Natural Gas Co., 289 S.W.2d 559, 573 (Tex.1956); Tex.Rev.Civ.Stat.Ann. art. 1446c, § 39. Included in reasonable and prudent operating expenses are all taxes incurred by the utility, including federal income taxes. 16 Tex.Admin.Code § 23.21(b)(1)(D); Suburban Utility Corp. v. Public Utility Commission, 652 S.W.2d 358 (Tex.1983); see also Galveston Electric Co. v. City of Galveston, 258 U.S. 388, 42 S.Ct. 351, 66 L.Ed. 678 (1922).

In the ratemaking process, the amount of a utility's operating expenses has a direct effect upon the calculation of its rate. When a utility can demonstrate an increased level of reasonable and prudent operating expenses, its rate will be raised. To insure that its rate is just and reasonable, a utility must prove that all operating expenses have been actually incurred. Suburban Utility Corp., see also Federal Power Commission v. United States Pipeline Co., 386 U.S. 237, 87 S.Ct. 1003, 18 L.Ed.2d 18 (1967). ¹

Not all expenses that are incurred by a utility in providing service will necessarily be categorized as reasonable operating expenses for ratemaking purposes. Texas regulatory agencies possess the discretionary authority to disallow those operating expenses which are not prudently or actually incurred by a utility. Tex.Rev.Civ.Stat.Ann. art. 1446c, § 41(c)(3). Such expenses are considered to be improper and may not be used in the calculation of the utility's new rate. If improper expenses are disallowed from the rate structure, the shareholders of the utility absorb them rather than the ratepayers. See Suburban Utility Corp.; see generally E. Gelhorn & R. Pierce, Jr., Regulated Industries 97 (1982).

In this case the PUC asserts that the court of appeals erred as a matter of law by allocating the tax savings attributable to HL & P's write-off of the ACNP disallowed expenses to the utility and its shareholders rather than to the ratepayers. The issue before this court then is whether HL & P can recover from ratepayers a federal income tax expense which it did not incur. The resolution of this issue does not rest upon a determination of whether the disallowed expenses which generated the tax savings have been included in the calculation of the new rate. The question is whether HL & P actually incurred this tax expense.

Allocation of Tax Savings from Disallowed Expenses

In Suburban Utility Corp., a utility which operated as a Subchapter S corporation sought to have the federal income tax expense that it would have been required to pay as a conventional corporation included in its cost of service as a reasonable and prudent operating expense to be recovered from its ratepayers. Under the Internal Revenue Code, this Subchapter S corporation did not pay any federal income tax because all of its profits were paid directly to its two shareholders. The shareholders in turn paid taxes on the profits as ordinary income. The PUC refused to include the higher tax expense in the utility's cost of service on the basis that a tax expense which has not been actually incurred by a utility should not be recovered from its ratepayers.

On appeal this court followed the reasoning set forth by the United States Supreme Court in United States Pipeline Co., 386 U.S. at 237, 87 S.Ct. at 1003, and held that the utility was entitled to a just and reasonable rate which was...