Railroad Commission of Texas v. Entex, Inc.
| Decision Date | 02 April 1980 |
| Docket Number | No. B-8584,B-8584 |
| Citation | 599 S.W.2d 292 |
| Parties | RAILROAD COMMISSION OF TEXAS et al., Appellants, v. ENTEX, INC., Appellee. |
| Court | Texas Supreme Court |
Mark White, Atty. Gen., J. Scott Wilson, Asst. Atty. Gen., Austin, Don R. Butler, Austin, for appellants.
Fulbright & Jaworski, Jefferson D. Giller, Louis S. Zimmerman, Houston, for appellee.
This is a direct appeal by the Railroad Commission from a district court judgment invalidating the rate order entered by the Commission for Entex, a gas utility. We hold that the Railroad Commission's order met all legal requirements and was supported by substantial evidence in the record. The district court judgment is reversed and the order of the Railroad Commission is reinstated.
In March 1976, Entex applied for a rate increase from the City of Beaumont, Texas (hereinafter referred to as City). The City failed to act, and Entex appealed to the Railroad Commission for a rate increase equal to an 8% return on the rate base. After an evidentiary hearing before an examiner, the Railroad Commission entered an order on September 12, 1977, which granted Entex a 4% rate of return on its adjusted value of invested capital rate base of $14,005,509. Entex filed a motion for rehearing. On October 24, 1977, the Railroad Commission entered an order which adopted the Examiner's Report and Proposal for Decision and denied Entex's objections to the order. Entex appealed to the District Court of Travis County which declared the order setting a 4% rate of return invalid, and permanently enjoined its enforcement, and remanded the order to the Railroad Commission (hereinafter referred to as the Commission).
The finding of the Commission that Entex had operating expenses of $11,944,535 is unchallenged. The Commission followed Section 41 of the Public Utilities Regulatory Act, Tex.Rev.Civ.Stat.Ann. art. 1446c (hereinafter referred to as PURA) and determined Entex's rate base from the value of property "used by and useful" to the utility in providing service. The adjusted value of the property was determined to be 14,005,509 by weighting 60% as original cost less depreciation and 40% as current cost less an adjustment for present age and condition. The controversy is whether the Commission made a proper determination of the rate of return under Sections 39 and 40 of the PURA, and whether a 4% rate of return on the adjusted value of invested capital is reasonable.
A proper rate determination requires a consideration of three important factors: (1) the utility's reasonable operating expenses; (2) the rate base; and (3) a reasonable rate of return. Railroad Comm'n v. Houston Natural Gas Co., 155 Tex. 502, 289 S.W.2d 559, 573 (1956) (). First, there must be a determination by the regulatory authority of the utility's reasonable operating expenses. After deciding what utility property will be included in the rate base, the next step is the rate base calculation. The two major approaches currently used in rate base calculations are "original cost depreciated" and "fair value," which represents the cost of reproducing the utility's facilities. After the rate base is determined, the regulatory authority determines the rate of return, or the percent of the rate base which will be recoverable in revenues by the utility.
The rate base and rate of return are interdependent, and by manipulation of either, the regulatory authority may correct an inequitable rate which results from inflation or recession. In an inflationary period, a fair value approach would use a lower rate of return to counteract the inflated rate base. An original cost depreciated approach, on the other hand, would use a higher rate of return to insure a reasonable recovery for the utility. All of these factors must be taken into consideration for a reasonable rate to be determined. See, Butler, The Rate of Return in Texas The Neglected Issue, 28 Baylor L.Rev. 937 (1976); Student Symposium, Public Utility Regulation in Texas, 7 St. Mary's L.J. 515 (1975).
Texas is a fair value jurisdiction. A fair value rate base was first determined as a ratio between original and replacement costs in the Alvin case, but later this concept was utilized in the PURA. Section 41 of the PURA requires that the rate base be determined as a balance between original cost depreciated and current reproduction cost less an adjustment for age and condition. Under section 41, the "adjusted value" of property "used by and useful to the public utility" is based upon 60 to 75 percent of the original cost less depreciation and 25 to 40 percent current reproduction cost less an adjustment for age and condition. The exact balance is within the discretion of the Commission. This type of ratio has the advantage of stabilizing utility rates in periods of inflation or recession.
Within statutory guidelines the Commission has the discretion to determine the rate of return to be applied to the rate base. Section 39 of the PURA provides that the overall revenues which result from the application of the rate of return to the adjusted value rate base must be sufficient for the utility to recover its operating expense plus a "reasonable return on its invested capital." In Southwestern Bell Tel. v. Public Utility Comm'n, 571 S.W.2d 503, 515 (Tex.1978) we held that "invested capital" in section 39 of the PURA meant original cost less depreciation.
In addition, in Section 40(a) of the PURA, the Commission is prohibited from setting a rate that would result in "more than a fair return upon the adjusted value of the invested capital used and useful in rendering service to the public." Therefore, section 39 provides the "floor" on the rate of return, i. e. requiring minimum revenues to equal operating expenses plus a reasonable return on original cost less depreciation. Section 40(a) is the "ceiling" in that the rate of return cannot yield revenues greater than a fair return on adjusted value. The rate of return may be set by the Commission at any level within those two extremes. It should be pointed out that the "floor" and "ceiling" analogy is appropriate in an inflationary period, but that in a recession, section 39 might be the "ceiling" and section 40(a) the "floor."
There may be other considerations in setting the rate of return. In times of shortage, the Commission may consider the need to provide an incentive for exploration or increased reserves. The reasonable rate must balance the consumer's desire for low rates against the utility's need to improve and expand.
Another factor in determining a reasonable rate of return is the utility's financial structure. Debt financing or borrowed capital is generally cheaper than equity financing or capital obtained from the sale of stock, and utilities commonly use both sources of capital. The cost of debt and equity, and the ratio of the two types of financing yields the cost of capital. This cost of capital and the ratio of debt and equity must be established by expert testimony.
The Public Utility Commission has adopted substantive rules which weight the type of debt based on a utility's actual capital structure. Each debt percentage is then multiplied times the debt cost in terms of percent return required on the debt. Added together these elements yield a composite rate of return which is then multiplied times the adjusted value rate base to equal the amount of return. For example:
Percent of Cost Weighted
Type of Capital Total Capital Rate Cost
------------------------ ------------- ----- --------
Debt 66% X 6% 4%
Common stock equity 34% X 12% 4%
--------
Composite rate of return 8%
Although the Commission has not adopted a similar substantive rule, based on the Commission's findings, their preliminary approach to rate setting appears to be the same. However, after considering the 8% composite rate of return requested by Entex, the Commission also considered the effect of that rate on the return to book common equity. 1
The importance of considering the return to book common equity in a fair value jurisdiction can be easily demonstrated. Debt and preferred stock costs are not affected by inflation because the utility's obligation to the investor remains the same. Even with an increase in the adjusted value rate base, the holder of debt or preferred stock will not realize a greater return on the initial investment. Because the cost of this type of capital remains fixed, additional return to the utility due to an adjusted value rate base will go to the equity holder or common stock investor. An exorbitant return to the common stock equity could be considered by the Commission in determining a reasonable rate of return, however, the basic legal requirements for a rate of return must be satisfied.
The basic legal requirements of a rate of return were set out by the United States Supreme Court in Bluefield Water Works & Improvement Co. v. Public Serv. Comm'n of West Virginia, 262 U.S. 679, 43 S.Ct. 675, 67 L.Ed. 1176 (1923):
A public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties; but it has no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures. The return should be reasonably sufficient to assure confidence in the financial soundness of the utility, and should be adequate, under efficient and economical management, to maintain and support its credit and...
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