United States Court of Appeals
FOR T HE D ISTRICT OF CO LUM BIA CIR CUIT
Argued January 7, 2005 Decided February 18, 2005
No. 03-1092
PUBLIC SERVICE COMMISSION OF THE COMMONWEALTH OF
KENTUCKY ,
PETITIONER
v.
FEDERAL ENERGY REGULATORY COMMISSION ,
RESPONDENT
MIDWEST ISO TRANSMISSION OWNERS , ET AL.,
INTERVENO RS
Consolidated with
03-1097
On Petitions for Review of Orders of the
Federal Energy Regulatory Commission
David E. Pomper argued the cause for petitioners. With
him on the briefs were Thomas C. Trauger, David
D’Alessandro, John E. McCaffrey, Richard G. Raff, Robert A.
Weishaar, Jr., and Jeffrey L. Landsman.
Beth G. Pacella, Attorney, Federal Energy Regulatory
Commission, argued the cause for respondent. With her on the
brief was Cynthia A. Marlette, General Counsel.
Michael E. Small, Paul M. Flynn, and Wendy N. Reed were
on the brief for intervenors in support of respondent.
Before: RANDOLPH , TATEL, and ROBERTS, Circuit Judges.
Opinion for the Court filed by Circuit Judge ROBERTS.
ROBERTS, Circuit Judge: This petition arises out of a
proceeding before the Federal Energy Regulatory Commission
to set rates for the transmission of electricity over lines operated
by a regional transmission organization. Over a century ago, the
first Justice Harlan noted that regulated rates must ensure just
compensation, but confessed that “[h]ow such compensation
may be ascertained, and what are the necessary elements in such
an inquiry, will always be an embarrassing question.” Smyth v.
Ames, 169 U.S. 466, 546 (1898) (quoted in Duquesne Light Co.
v. Barasch, 488 U.S. 299, 308 (1989)). For our part, we have
recognized that “agency ratemaking is far from an exact sci-
ence,” Time Warner Entm’t Co. v. FCC, 56 F.3d 151, 163 (D.C.
Cir. 1995), and that it involves “complex industry analyses,”
Ass’n of Oil Pipe Lines v. FERC, 83 F.3d 1424, 1431 (D.C. Cir.
1996), and “[i]ssues of rate design [that] are fairly technical,”
Town of Norwood v. FERC, 962 F.2d 20, 22 (D.C. Cir. 1992).
For these reasons, and because ratemaking “involves policy
determinations in which the agency is acknowledged to have
expertise, our review thereof is particularly deferential.” Time
Warner, 56 F.3d at 163 (internal quotation marks omitted).
Given the deferential standard, we uphold FERC’s decisions
to calculate the pertinent rate of return on equity in this case by
reference to a particular “proxy group” of publicly-traded
companies, and to base the rate of return on the midpoint, rather
than the median or mean, of the rates in that group. But FERC
2
is entitled to deference only if it plays fair, and we conclude that
the Commission failed to give adequate notice that it would add
50 basis points to the rate of return generated by its calculations,
to encourage participation in regional transmission organiza-
tions. We accordingly grant the petition in part.
I.
Midwest Independent Transmission System Operator, Inc.
(MISO) is a regional transmission organization (RTO) — a
company that combines multiple power grids into a single
transmission system. In recent years, FERC has promoted the
formation of RTOs as a means of increasing competition and
driving down the price of electricity. According to the Commis-
sion, RTOs provide a large and stable transmission system that
reduces regional pricing disparities and creates an efficient
market for new power generators. See generally Regional
Transmission Organizations, Order No. 2000, 65 Fed. Reg. 809
(Dec. 20, 1999); Order No. 2000–A, 65 Fed. Reg. 12,088 (Feb.
25, 2000). MISO, the first such organization in the nation, came
into being when a series of midwestern utilities placed their
grids under its centralized control. See Midwest ISO Transmis-
sion Owners, Inc. v. FERC, 373 F.3d 1361, 1365 (D.C. Cir.
2004).
The rates charged by electric utilities such as MISO are
regulated by FERC to ensure that they are just and reasonable,
and not unduly discriminatory. See 16 U.S.C. §§ 824d, 824e.
Utilities themselves initiate the ratemaking process by submit-
ting proposals to the Commission, but FERC retains authority to
modify such proposals to ensure compliance with the statutory
standards. Id. §§ 824d(c)-(d), 824e(a).
A major component of the rates charged by MISO is the
return on equity (ROE) paid to its member utilities. This rate
compensates the utilities for the capital cost of the grids they
3
placed under MISO’s control. FERC derives the rate by
estimating the annual return an equity investor in the utility
would expect on such capital, had the utility continued to operate
the grid outside the RTO. See generally Canadian Ass’n of
Petroleum Producers v. FERC, 254 F.3d 289, 293–94 (D.C. Cir.
2001). Calculating this rate would be relatively easy if a utility’s
interest in its grid — its business as a transmission owner (TO)
— were publicly traded, but “there are no publicly traded
independent pure electric transmission companies.” MISO
Initial Decision, 99 FERC ¶ 63,011, 65,040 (2002). The
Commission must therefore resort to more roundabout estima-
tions.
In December 2001, MISO and certain of its member TOs
petitioned the Commission to increase the ROE component of
MISO’s charges from a previously approved level of 10.5
percent to 13 percent. The Commission set the matter for
hearing, at which all interested parties were allowed to present
evidence. Among those availing themselves of this opportunity
were the petitioners in this case — the Public Service Commis-
sion of the Commonwealth of Kentucky (PSCKY) and a group
of private consumers and municipal entities (the Intervenor
Group) — who appeared on behalf of ratepayers and argued
against any rate increase or, in any event, for a more modest
one.1 At the hearing, an administrative law judge selected a
proxy group of public companies to use in estimating the
appropriate return on equity for the MISO TOs. The judge chose
a group consisting of the parent companies of certain MISO TOs
themselves — which, unlike the transmission-owning subsidiar-
1
The Intervenor Group should not be confused with the
intervenors in this appeal — the MISO TOs — who appear in support
of the Commission. We use the label “Intervenor Group” because that
is what was used in the orders under review, and because the parties
themselves continue to use that shorthand before us.
4
ies, are publicly traded. The judge rejected several other
proposals, including one submitted by the Intervenor Group. Id.
at 65,038–42.
Once she had made her choice, the judge sought to extract
a single ROE value, representative of the proxy group as a
whole, to be applied to all the MISO TOs. She chose the
midpoint of the range — the average of the highest and lowest
data points — which yielded a return of 12.38 percent. She
rejected the recommendation of FERC staff to use the mean —
the average of all values in the proxy group (11.74 percent) —
as well as the Intervenor Group’s proposal to use the median —
the middle data point in the group (11.85 percent). Id. at
65,047–52. The judge also rejected competing pleas from MISO
and the Intervenor Group to derive ROE using only part of the
proxy range, such as the top or bottom half. Id.
FERC affirmed the ALJ’s choice of the proxy group and her
use of the midpoint. Speaking to the latter, the Commission
noted that its electrical industry precedents — unlike its oil and
gas cases — had relied on the midpoint as a measure of central
tendency. The Commission, however, also decided sua sponte
to increase the final return by 50 basis points, to 12.88 percent,
as an incentive for companies to join a regional transmission
organization. MISO Order Affirming Initial Decision, 100
FERC ¶ 61,292, 62,313–15 (2002). FERC explained that it
“will be clarifying [this] incentive rate policy in the near future.”
Id. at 62,315. Several months later, the Commission indeed
issued a proposal to give “any entity that transfers operational
control of transmission facilities to a Commission-approved
RTO . . . an incentive adder of 50 basis points on its ROE for all
such facilities transferred.” Proposed Pricing Policy for
Efficient Operation and Expansion of Transmission Grid, 102
FERC ¶ 61,032, 61,065 (2003).
5
In the meantime, petitioners sought rehearing of FERC’s
order, which the Commission denied. Besides affirming its
earlier findings, FERC rejected petitioners’ contention that they
had not been given sufficient notice of the possibility of an
incentive-based adder. FERC explained that petitioners should
have been aware of the possibility of such an adder, given the
Commission’s statutory power to amend proposals to ensure just
and reasonable rates. FERC also noted that the final value of
12.88 percent was less than the 13 percent initially requested by
MISO, and thus presumably within the range of petitioners’
expectations at the outset of the proceedings. See MISO Order
Denying Rehearing, 102 FERC ¶ 61,143, 61,395 (2003).
Petitioners then sought review in this court, but the Com-
mission moved for a voluntary remand to allow further consider-
ation of the rate of return. On remand, the Commission main-
tained its position, but offered a different rationale for the use of
the midpoint in this case. FERC explained that the question here
“is not what constitutes the best overall method for determining
ROE generically (i.e. the midpoint versus the median or mean).”
MISO Order on Remand, 106 FERC ¶ 61,302, 62,192 (2004).
Rather, the Commission observed that under the “unique . . .
circumstances” of this case, in which the chosen value will apply
“to a diverse group of companies,” the midpoint provides the
best measure because it emphasizes the endpoints of the proxy
group range, ensuring that outlier as well as average TOs receive
just and fair compensation. Id. at 62,192–93. The Commission
also found that the proxy group was not too skewed to permit a
midpoint analysis. Id. at 62,193.
PSCKY and the Intervenor Group now seek review of the
FERC orders, challenging the selection of the proxy group, the
use of the midpoint, and the incentive-based adder.
6
II.
The “arbitrary and capricious” standard of the Administra-
tive Procedure Act governs our review. See 5 U.S.C.
§ 706(2)(A). Under this standard, FERC must consider relevant
data and “articulate a rational connection between the facts
found and the choices made.” Williston Basin Interstate
Pipeline Co. v. FERC, 165 F.3d 54, 60 (D.C. Cir. 1999) (cita-
tions omitted). The Commission must also respond meaning-
fully to the arguments raised before it. See Canadian Ass’n of
Petroleum Producers, 254 F.3d at 299. The Commission’s
factual findings are conclusive if supported by substantial
evidence. See 16 U.S.C. § 825l(b).
A. Petitioners first question the proxy group chosen to
represent the MISO TOs’ expected return on equity. They assert
that the ALJ improperly dismissed the Intervenor Group’s
proposal, which would have considered (and heavily weighted)
four generation-divested electric utilities in addition to the
companies ultimately chosen. They also maintain that the
Commission failed to engage their petition on this issue, and
erroneously saddled them with the burden of proof in the group
selection process. We find these arguments unavailing.
The judge chose a group submitted by MISO, consisting of
the publicly-owned parent companies of the TOs themselves.
She reasoned that “[t]his is the best proxy group since it involves
companies that are currently in the MISO; the group includes
comparable risk companies, similar in business profiles and
size.” Initial Decision, 99 FERC at 65,041. She also relied on
a prior FERC decision that approved a proxy group in part
because that group contained parent companies of the utility
whose rates were being set. Id. (citing Southern California
Edison, 92 FERC ¶ 61,070 (2000)). She dismissed the
Intervenor Group’s proposal because “it consisted of distribution
companies, not transmission companies.” Id. at 65,042. FERC
7
summarily affirmed these findings. Order Affirming Initial
Decision, 100 FERC at 62,312.
Petitioners provide us with insufficient reason for overturn-
ing the selection of the proxy group. At the hearing before the
ALJ, the Intervenor Group’s own expert conceded that MISO’s
proposal was one of “the two most appropriate groups to use in
establishing the range” and that “[t]he TOs or their parent
companies have rates at issue in this proceeding and are there-
fore an appropriate group to use as a reasonable starting point.”
Testimony of J. Bertram Solomon at 67. On appeal, petitioners
note that the parents’ businesses extend well beyond transmis-
sion, and maintain that the judge underestimated the transmis-
sion component of the additional companies in their own
proposal.
Given the deferential standard of review, this is just nibbling
at the margins. The Supreme Court explained long ago that
ratemaking is a pragmatic exercise, see FPC v. Hope Natural
Gas Co., 320 U.S. 591, 602 (1944), and more than second-
guessing close judgment calls is required to show that a rate
order is arbitrary and capricious. Id. FERC chose reasonably
from the options presented, based on the testimony offered and
the Commission’s own precedent.
Petitioners’ remaining challenges to the proxy group also
fall short of the mark. Their contention that FERC failed to
engage their petition finds no support in our case law. While we
have held that FERC may not ignore an argument presented to
it, our cases addressed situations where neither the Commission
nor an ALJ addressed the issue. See Canadian Ass’n of Petro-
leum Producers, 254 F.3d at 298–99; NorAm Gas Transmission
Co. v. FERC, 148 F.3d 1158, 1165 (D.C. Cir. 1999). Here, by
contrast, FERC reviewed the ALJ’s extensive discussion of
proxy groups and expressly adopted her rejection of petitioners’
proposal. See Order Affirming Initial Decision, 100 FERC at
8
62,312 (“For the reasons set forth in the Initial Decisions, we
find that the Intervenor Group has failed to set forth convincing
evidence [regarding its proposal].”).
As for the burden of proof, petitioners rely on a handful of
isolated statements in the rulings under review. At one point in
her decision, the judge noted that the Intervenor Group’s witness
did not “prove[]” that the companies in its proposal had risks
comparable to the TOs. Initial Decision, 99 FERC at 65,042.
In affirming the ALJ, the Commission observed that the
Intervenor Group “has not demonstrated that the [chosen proxy]
group is unrepresentative,” and “has failed to set forth convinc-
ing evidence” of the superiority of their own proposal. Order
Affirming Initial Decision, 100 FERC at 62,312. Based on these
statements, petitioners argue that FERC improperly saddled
them with the burden of proving the validity of the rate increase
at issue — a burden statutorily assigned to the proponent of the
increase, in this case MISO. See 16 U.S.C. 824d(e) (“the burden
of proof to show that the increased rate or charge is just and
reasonable shall be upon the public utility”).
In proceedings before the ALJ, however, MISO expressly
assumed the burden of justifying the proposed rate increase.
Prehearing Conference at 25 (“PRESIDING JUDGE: And you
have the burden of proof, don’t you? MR. SMALL [counsel for
MISO]: Yes, your Honor . . . .”). In selecting MISO’s proposal,
the judge explained that she found it “consistent with Commis-
sion precedent,” and described the Intervenor Group’s alterna-
tive as “more speculative and statistically less reliable.” Initial
Decision, 99 FERC at 65,042. MISO acknowledged and carried
its burden of proof before the ALJ. As for the statements in
FERC’s order, these are best read as merely affirming the
reasonableness of the judge’s decision. See Town of Norwood,
962 F.2d at 26 (interpreting similar phrasing as “a rather
perfunctory restatement of the Commission’s finding . . . and not
9
an indication that the FERC improperly shifted the burden of
proof to the petitioner”).
B. PSCKY and the Intervenor Group next challenge the
Commission’s use of the midpoint. They question the cogency
of FERC’s reasoning in general, and dispute its application on
the facts of this case. They also point to language in FERC’s
order on remand suggesting that the Commission chose the
midpoint simply because it yielded the highest rate of return.
In the order on remand the Commission stepped back from
its prior reliance on electrical industry precedents, and even
acknowledged that the median, and not the midpoint, may be
“the most refined measure of central tendency.” Order on
Remand, 106 FERC at 62,192. The Commission rested its use
of the midpoint on a wholly different ground: it distinguished
between “cases in which a ROE is set for one gas pipeline or
electric utility” and cases where “applicants proposed setting a
single ROE for across-the-board application.” Id. In the latter
situation, where “the ROE will apply to a diverse set of compa-
nies,” FERC reasoned that the range of results becomes as
important as the central value. Id. The midpoint — unlike the
other measures of central tendency — “fully considers that
range,” because it is derived directly from the endpoints of the
range. Id.
This justification provides a reasoned approach that lends
itself to consistent application over a series of cases. While
petitioners highlight the shortcomings of the Commission’s
method, they fail to debunk its fundamental premises. For
instance, petitioners are correct in noting that all measures of
central tendency “consider” the entire proxy group range, in the
sense that all are influenced — at least indirectly — by each data
point in the range. Pet. Br. at 23. But only the midpoint
emphasizes that range, as it is equally placed between the top
and bottom values. Likewise, petitioners rightly suggest that
10
using the midpoint undermines the statistical sampling of the
proxy group process, id. at 28–30, as only the mean places equal
weight on every point in a sample. But the Commission made
clear that it was less interested in particular data points than in
the full range covered by the group.
Petitioners’ more technical challenges fare no better. First,
they contend that the Commission erred in calculating the
midpoint of a range containing two values for each company —
a high and a low estimate — because FERC meant to “fully
consider” the range of companies in the proxy group, and high
or low estimates by themselves do not reflect a company’s ROE
without considering the corresponding low or high estimate.
Pet. Br. at 26–27. The Commission’s use of a high estimate to
mark the high end for its midpoint calculation was, however,
balanced to some extent by its use of a low estimate to mark the
low end. It is true that this balance is imperfect, particularly on
this record, where the company whose high estimate marks the
high end also had a low estimate among the lowest values in the
range. But it is certainly consistent with FERC’s rationale to
calculate the midpoint of the entire range, rather than — as
petitioners now seem to suggest — averaging each company’s
high and low estimates and then determining the midpoint of
that narrower range. See Pet. Br. at 27. At any rate, no such
alternative proposal was ever presented to the Commission.
Second, petitioners maintain that the data in this case were
too skewed for a midpoint analysis. Pet. Br. at 33–37. This too
is a matter squarely within the Commission’s expertise. The
proxy group clearly has some skew — otherwise all measures of
central tendency would have produced the same result — but
this is part of the reason FERC used the midpoint in the first
place. FERC acknowledged that some distributions are too
skewed for such an analysis, but the Commission evaluated the
distortion here and found it not to be excessive. Order on
11
Remand, 106 FERC at 62,193; compare Northwest Pipeline
Corp., 99 FERC ¶ 61,305 (2002) (employing a similar method
for evaluating skew). As the Commission explained, this is not
a case where one end-point is considerably out of line with the
rest of the range; ratemaking is not an “exact science,” Time
Warner, 56 F.3d at 163, and FERC was not required to adopt
petitioners’ mathematical model for determining when some
skew becomes too much skew.
All this notwithstanding, the order on remand does contain
language clouding the clarity of FERC’s midpoint rationale. In
a footnote, the Commission observes that:
The results of our proxy group yielded a midpoint of 12.38,
a median of 11.85, and a mean of 11.74. Relying on the
median or mean in this case would result in an unreasonably
low ROE in light of the high end values in the proxy group
and could substantially under-compensate those utilities at
the upper end of the range.
106 FERC at 62,192 n.14. Elsewhere, FERC notes that “the
midpoint does not have as deleterious an effect as the median on
those [MISO] TOs whose returns are higher than what we allow
for [MISO] TOs here,” and that this “offers additional incentive
for such companies to join RTOs.” Id. at 62,193–94. According
to petitioners, these passages indicate that FERC chose the
midpoint simply because it yielded the highest result.
If FERC’s orders premised a policy of using the midpoint on
an effort to obtain the highest rate of return, the orders could not
withstand APA review. This is because there would be no
logical connection between the rationale and the result: nothing
about the midpoint ensures it will be higher than the median or
the mean in any particular case. Of course, FERC could have
explained that it would always choose the measure that yields
the highest result, and tried to defend that rationale here. But the
12
Commission cannot justify a commitment to the midpoint on the
ground that it produced the highest return, because that is pure
happenstance.
We think the most reasonable reading of FERC’s order on
remand as a whole is that it selected the midpoint because the
rate of return would apply to a diverse group of companies, and
that the language petitioners point to simply reflects FERC’s
view that the resulting rate gave it confidence that it was not
undercompensating MISO TOs. The bulk of the order sets forth
the “diverse companies” rationale. The contrary language
appears in a footnote and a single paragraph near the end of the
opinion. The Commission emphasized the rate’s across-the-
board applicability to MISO TOs — rather than the greater value
of the midpoint — in both its brief and at oral argument. In light
of all this, we read the order as resting on its principal rationale.
Should the Commission elect to abandon that rationale to rely on
a higher median or mean in the next case involving applicability
of the chosen rate to several companies, it will have to justify its
departure from the precedent established by this case.
C. Finally, PSCKY and the Intervenor Group argue that
FERC arbitrarily adopted the 50-point premium, and that the
Commission violated due process by announcing its decision sua
sponte without prior notice to the parties. We focus on the latter
claim.
The Due Process Clause and the APA require that an agency
setting a matter for hearing provide parties “with adequate notice
of the issues that would be considered, and ultimately resolved,
at that hearing.” Williston, 165 F.3d at 63; see 5 U.S.C.
§ 554(b)(3). This requirement ensures the parties’ right to
present rebuttal evidence on all maters decided at the hearing.
See Bowman Transp., Inc. v. Arkansas-Best Freight Sys., Inc.,
419 U.S. 281, 288 n.4 (1974); Hatch v. FERC, 654 F.2d 825,
835 (D.C. Cir. 1981); Hill v. FPC, 335 F.2d 355, 363 (5th Cir.
13
1964). In addition, the Federal Power Act authorizes FERC to
approve rate increases only “after full hearings” — a require-
ment that itself “unquestionably imposes the duty to give
adequate notice of the subject to which the orders pertain.” 16
U.S.C. § 824d(e); City of Winnfield v. FERC, 744 F.2d 871, 876
(D.C. Cir. 1984).
Here, the Commission failed to place the parties on notice
that its post-hearing order would contemplate an incentive-based
premium for the MISO TOs. When MISO and its TOs first filed
for the subject rate increase, they sought an incentive adder of
100 basis points, but FERC declined to consider such “innova-
tive ratemaking proposals,” limiting the subject matter of the
hearing to “ROE rates that essentially provide for appropriate
cost-recovery.” Order Accepting in Part and Rejecting in Part
Proposed Tariff Changes and Establishing Hearing Procedures,
98 FERC ¶ 61,064, 61,165 (2002). The ALJ refused to consider
premium-related proposals, noting “that establishing an incen-
tive based ROE seems to be outside the scope of this proceed-
ing.” Initial Order, 99 FERC at 65,052. As a result, the record
compiled at the hearing contained no evidence on the need for
— or appropriate size of — such a premium.
On appeal, FERC maintains that it gave petitioners all the
process they were due by considering their requests for rehear-
ing, which contained extensive challenges to the premium.
FERC Br. at 47; see PSCKY Req. for Reh’g at 9–14; Intervenor
Group Req. for Reh’g at 41–49. Considering petitioners’
arguments, however, is not the same thing as allowing them to
present evidence on the issue — as at least one of the petitioners
pointed out to the Commission. See PSCKY Req. for Reh’g at
10 (“the parties were not given the opportunity to present
evidence, or refute the use of such innovative rate making
policy”); see also Williston, 165 F.3d at 63–64 (granting petition
14
to review based on insufficient notice and lack of substantial
evidence).
Nor did FERC obviate the need for such a presentation by
relying, in the order denying rehearing, on its proposed policy to
reward any entity that joins an RTO with a bonus of 50 basis
points. The Commission issued that proposal after its sua
sponte order and after the filing deadline for rehearing requests
in MISO’s case. Moreover, the proposed policy is just that —
it is not a rule binding on the public, or even on the agency itself.
See Proposed Pricing Policy, 102 FERC at 61,066–67 (inviting
public comment and holding off implementation until the
issuance of a final policy statement). As such, it plainly cannot
govern the outcome of this case.
Likewise, FERC’s assertion that petitioners should have
been aware that it always possesses the power to modify rate
proposals to ensure that they meet statutory standards plainly
proves too much; FERC’s power to take such action does not
carry with it the authority to exercise such power without
adequate notice of the basis for doing so.
In sum, FERC failed to place petitioners on notice that it
would consider an incentive-based premium, and ultimately
applied the adder in MISO’s case without considering any record
evidence. In so doing, FERC denied petitioners — and the other
parties to the proceeding, for that matter — a chance to present
their side of the case. We express no view on petitioners’
substantive challenges to the incentive-based adder, but grant the
petition because FERC failed to provide adequate notice that it
would consider such an element in assessing the pending rate
proposal. In all other respects, we affirm the Commission.
15