Montana-Dakota Utilities Co. v. Montana Department of Public Service Regulation

No. 87-60
IN THE SUPREME COURT OF THE STATE OF MONTANA

1988

MONTANA-DAKOTA UTILITIES CO.,
a Delaware Corporation,
9

Plaintiff, E~t,t;cme r
and Appellant,
-vs-
MONTANA DEPARTMENT OF PUBLIC SERVICE
REGULATION, MONTANA PUBLIC SERVICE
COMMISSION, and MONTANA CONSUMER COUNSEL,
Defendants, . R e q ~ x m f k n k ~
and Respondents.

APPEAL FROM: District Court of the First Judicial District,
In and for the County of Lewis & Clark,
The Honorable Gordon Bennett, Judge presiding.
COUNSEL OF RECORD:
For Appellant:
Hughes, Kellner, Sullivan & Alke; John Alke & George
Dalthorp argued, Helena, Montana
Steven G. Gerhart, Mont-Dakota Utilities, Bismarck,
North Dakota
For Respondent:
Geralyn Driscoll argued, Public Service Commission,
Helena, Montana
Mary Wright argued, Montana Consumer Counsel, Helena,
Montana

Submitted: December 4, 1987
Decided: March 11, 1988
Filed: B R 1 1 vJ@l
A
? * -
Mr. Chief Justice J. A. Turnage delivered the Opinion of the
Court.
Plaintiff Montana-Dakota Utilities Company (MDU) ap-
peals a December 7, 1986, judgment of the First Judicial
District Court, Lewis and Clark County. The District Court
upheld the decision of the Montana Public Service Commission
(PSC), which reduced the coal expenses used by MDU in setting
rates for Montana electric service. We affirm.
MDU raises three issues for our review:
1. Did the PSC err in adopting the "rate of return"
method to determine the amount of MDU's coal expense which
could be passed through to Montana ratepayers?
2. Did the PSC err in applying the "rate of return"
method to MDU's coal expense?
3. Does the record support the PSC decision?
In September of 1983, MDU filed a request with the PSC
for a $8,731,439 rate increase, using 1982 as the "test
year. " As part of its supporting evidence, MDU reported a
$15,622,000 expense for lignite coal used by MDU to generate
electricity for Montana consumers. The coal expense was paid
by MDU to Knife River Coal Mining Company (KRC). KRC is a
wholly-owned subsidiary of MDU Resources Group, Inc., of
which MDU is a division. The coal expense represented 100
percent of MDU's coal purchases for 1982. MDU1s purchases
represented 25 percent of KRC1s total coal sales for 1982.
Montana Consumer Counsel (MCC), the agency established
to represent ratepayers' interests, contended that MDU's coal
expense should be reduced by $585,000. MCC's expert witness,
Dr. John Wilson, compared KRC to six natural resource compa-
nies which sold both coal and oil. Dr. Wilson testified that
the six companies' 1982 average rate of return on equity was
15 percent, while KRC1s rate of return on equity was 22
percent.
 After hearing the arguments, the PSC disallowed
$ 3 4 7 , 0 0 0 of MDU's claimed coal expense. The PSC determined
that KRC's return rate of 22 percent was too high and "evaded
the spirit of regulation." However, the PSC found weaknesses
in both MCC and MDU1s methods for calculating MDU's coal
expense. PSC determined MDU's annual coal expense for
ratemaking purposes by applying a hybrid rate of return of
1 4 . 5 6 5 percent to KRC on owner's equity. To arrive at this
percentage, the PSC calculated the rate of return for the six
companies suggested by Dr. Wilson and one comparable company,
Baukol-Noonan, Inc., suggested by MDU. The PSC then adjusted
the rate of return to "normalize" KRC's 1982 test year and
also factored in KRC1s tax rate. The PSC calculated the rate
of return on KRC1s total year-end equity, but limited its
final adjustment to the 25 percent of KRC1s total sales to
MDU. Thus, the PSC avoided regulating the price of coal
charged by the subsidiary KRC, and yet fixed a fair price for
coal expense to be incurred by MDU when considered for
ratemaking purposes.
The PSC justified its calculation procedure in Finding
165:
The classification of coal reserve
operations as a nonutility or utility
function becomes important to electric
ratepayers due to the different
ratemaking treatments afforded to the
coal fuel expense. It is not clear to
the Commission why coal reserves of
Knife River Coal Company should be
considered a nonutility function with
its ratemaking treatment based on compa-
rable profits and prices. Public utili-
ties are required to provide service at
the lowest reasonable rate, and' the
Commission is required to allow rates
that reflect the lowest reasonable
costs.
 Upon judicial review, the District Court found that the
record supported the positions of both parties. However, the
court concluded that the PSC "rate of return" analysis method
was not an abuse of discretion and affirmed the PSC. The
District Court noted that recent Montana Supreme Court deci-
sions emphasize "the reasonableness of the price for coal
paid by the parent to the subsidiary and not on the propriety
of ratebasing the subsidiary." (Emphasis added.) MDU appeals.

Issue 1. Adoption of "rate of return" method.
MDU contends that PSC1s rate of return method is flawed
because four of the six companies were not truly comparable
to KRC. MDU argues that these companies deep-mined bitumi-
nous coal in the East, where the high overhead costs squeezed
profit margins. MDU asserts that Baukol-Noonan, which earned
a higher return than KRC, was the only company truly compara-
ble to KRC.
On review of this issue, we note that the PSC is vested
by statute with the duty to supervise and regulate the opera-
tions of public utilities and to see that their rates are
"just and reasonable." Section 69-3-330, MCA.
In determining what is just and reasonable, the PSC is
not restricted to any single formula, if the method followed
and the order entered "when applied to the facts and viewed
as a whole do not produce an unjust or arbitrary result."
Montana-Dakota Utilities Co. v. Bollinger (Mont. 1981), 632
P.2d 1086, 1091, 38 St.Rep. 1221, 1227 (where the PSC reduced
MDU's coal expenses from KRC using Dr. Wilson's rate of
return method, but this Court remanded the case to the PSC to
determine if a factual basis existed for the rate of return
method).
The PSC has the power to adopt any non-arbitrary method
it chooses. Bollinger, 632 P. 2d at 1091. In the instant
case, the PSC adopted Dr. Wilson's method to compare KRC's
rate of return to the coal industry generally. Perfect
comparisons are impossible because coal is not a fungible
commodity. Coal has many variables such as density, latent
BTU's, sulphur content, debris, extraction costs, and trans-
portation costs. At the delivery site, the coal consumer's
boilers must be custom-matched to the coal producer's partic-
ular fuel. The comparable which could precisely correlate
with the MDU-KRC rate of return does not exist. The PSC used
similar comparables, then extrapolated the variables. In
doing so, the PSC was simply trying to determine whether the
coal expense paid by MDU was reasonable.
The PSC decision conforms to our past holdings on this
issue. The PSC adopted a method which was far from perfect,
but it was also far from arbitrary. In the balance, we find
it was reasonable. We hold that the method was valid on its
face and now move to the validity of its application.

Issue 2. Application of the method.
MDU contends that the PSC exceeded its jurisdiction
when it applied the rate of return method to KRC's sales,
thereby improperly treating KRC as part of MDU. MDU asserts
that the PSC must limit its scrutiny to KRC's sales to MDU
and may not examine the other 75 percent of KRC sales. MDU
further asserts that KRC's most profitable sales were not to
MDU, and therefore these other sales distorted the profit
margins on sales to MDU.
In reviewing this issue, we note that the "interest of
the PSC is to see that MDU does not reap an unfair profit on
its investment in its subsidiary by allowing the subsidiary
to overcharge the parent for coal when the coal expense will
be passed on to the ratepayers." Bollinger, 632 P.2d at
1089.
 Contrary to MDU's assertions, MDU's coal purchases are
at issue, not KRC's coal sales. The key factor in the PSC's
examination was the extent to brhich KRC functioned as an
organ of MDU. As the PSC noted: "The vertical integration
by MDU into the coal mining business may provide the Company
with an opportunity to circumvent effective return regulation
by capturing monopoly profits in its affiliated upstream coal
operations." Throughout the proceedings, PSC maintained its
regulatory focus on MDU, not KRC.
In determining a reasonable rate of return, the PSC
made several economic corrections in MDU's favor. The final
PSC decision came close to splitting the difference between
the $585,000 adjustment advocated by MCC and the zero dollar
adjustment advocated by MDU. The final $347,000 adjustment
amounted to approximately a 2 percent reduction in MDU's
allowable coal expense. The final adjustment had no effect
on KRC, but only on MDU.
As applied, the PSC method scrutinized the captive coal
transaction to ensure a reasonable rate. "When one of the
expenses submitted by MDU is caused by transactions with a
subsidiary company, the scrutiny applied by the PSC must be
all the more intense." Bollinger, 632 P.2d at 1089. We hold
that the PSC's "rate of return on equity" method was properly
composed and applied.

Issue 3. Support in the record.
MDU contends that the PSC's decision is not supported
in view of the whole record. MDU argues that its evidence
was more probative. MDU asserts that the price KRC charged
MDU for its coal was competitive and that MDU could not
acquire cheaper coal from any other source. Furthermore, MDU
asserts that the contracts to sell coal to MDU were negotiat-
ed in an arm's length transaction by a third-party
 independent utility. MDU concludes that the PSC actions
reflected a predetermined decision that PSC was going to
reduce MDU1s coal expense regardless of the evidence in the
record.
In reviewing this issue, we note:
... The Commission is the judge of the
facts and the court only decides ques-
tions of law. [Citation omitted.] In
deciding questions of law, this Court
may determine whether the PSC acted
arbitrarily and unreasonably without
sufficient evidence to support its
findings, or exercised its authority
unreasonably, or set the utility rates
so low that they are confiscatory and
deprive the utility of its property
without due process of law. [Citation
omitted.] This Court on appeal cannot
substitute its judgment for that of the
PSC. [Citation omitted. 1
Mountain States Telephone & Telegraph Company v. Department
of Public Service Regulation, Montana Public Service Commis-
----rz
sion, et al. (Mont. 1981), 624 P.2d 481, 485, 38 St.Rep. 165,

"Our inquiry is limited to determining whether substan-
tial evidence was presented to support the PSC1s decision or
if the decision was unjust or arbitrary." The Montana Power
Company v. Dept. of Public Service Regulation, Mont. Public
Service Commission, et al. (1983), 204 Mont. 224, 229, 665
P.2d 1121, 1123 (where the PSC reduced MPC1s coal expenses
from its wholly-owned subsidiary using Dr. Wilson's rate of
return method, and this Court affirmed on the basis that
substantial evidence supported the PSC's decision).
Essentially, MDU argues that the decision of the PSC is
not sustainable because some of the evidence in the record
supports MDU1s position. MDU has misstated the burden of
.
pro0 f "If a party contends that the order of the PSC is
unreasonable, it is creating a fact issue, and under
§ 69-3-402(4), MCA, that party has the burden of proof before
the reviewing court on the issue. If it is contending that
the order or decision of the PSC is unlawful, the appealing
party has the burden to show PSC abused its discretion."
Montana Dakota Utilities Co. v. Montana Department of public
Service Regulation, et al. (1986), 725 P.2d 548, 553, 43
St.Rep. 1648, 1653-1654.
MDU has failed to show how the PSC decision was unrea-
sonable or arbitrary. MDU presented no evidence which
tracked its own coal expenses by market price. We note that
MDU's coal purchases from KRC were an affiliated transaction,
where coal is bought and sold in a vertically-integrated
market. MDU had no market incentive to pay KRC the lowest
possible price. When MDU paid KRC, MDU was paying itself.
Similarly, MDU did not present any evidence of fair
market prices from comparable coal companies. The market
price method may actually be less quantifiable than the rate
of return method because coal is a commodity with fluctuating
prices. In either case, the selection of methods lies
squarely within the discretion of the PSC:
We did not hold [in Bollingerl that the
PSC must use a "market price" method if
a competitive marketplace can be estab-
lished; the choice of methods is left to
the PSC. In the instant case, thle PSC
chose to apply a "rate of return" method
in an effort to determine the reason-
ableness of the price paid by MPC for
Western Energy coal.

- 665 P.2d at 1123.
MPC,
Alternatively, MDU argues that the rate of return on
equity must be based in part on the fair mark'et value of MDU
coal assets and not the depreciated original cost of the
coal. This argument is flawed due to the great difference
between the current price of coal and the original price of
the coal reserves. In exercising its authority to determine
a rate of return for MDU, the PSC essentially concluded that
MDU's proposed return on assets method, valuing coal reserves
at current market prices, would result in a rate of return in
excess of what the PSC determined to be reasonable.
In conclusion, we hold that the PSC's method of reduc-
ing MDU's coal expense is supported by substantial, credible
evidence. The PSC used both Dr. Wilson's and MDU's
comparables. The PSC's final calculation represented a
compromise. In both Bollinger and - the issue turned on
MPC,
the sufficiency of evidence, and not on the superiority of
method. PSC's summary of evidence tracks in its conclusion.
"So long as the record supports the [PSC's] decision, that
judgment must stand." - 665 P.2d at 1124.
MPC,
Affirmed.

7 5 %5.knLnAa7
Hon. C. B. McNeil, ~istrict
Judge, sitting in place of Mr.
Justice L. C. Gulbrandson
Mr. Justice Fred J. Weber dissents as follows:

While I substantially agree with the principles of law
contained in the majority opinion, I dissent from the appli-
cation of the principles to the facts of the present case.
Rate cases are extremely difficult for our appellate review
because of the complexity of the information presented, the
extensive testimony, and also because the Public Service
Commission (PSC) sets forth hundreds of findings of fact and
many conclusions, making it difficult to analyze or distin-
guish. In the present case (MDU 11), I contend that there is
a superficial adherence to the opinions of this Court, but in
actuality a fundamental disregard of the past holdings. Let
us consider the two most recent cases involving similar
issues.
Montana-Dakota Utilities Co. v. Bollinger (Mont. 1981) ,
632 P.2d 1086, 38 St.Rep. 1221, (MDU I) was decided in 1981.
In MDU I we vacated the judgment of the district court and
remanded the case to the PSC for additional hearings. MDU I
involved the same utility company, the same Knife River Coal
Company, and the same question of rate fixing with regard to
coal sold by Knife River, MDU's wholly owned subsidiary. We
there chose not to accept the rate of return theory as pre-
sented by the Consumer Counsel through the expert Dr. Wilson.
We stated as follows:

In view of the necessity for a rehearing, the PSC
should again consider if there is an independent,
competitive market which establishes a going market
price for coal, from which the PSC can determine if
the price MDU pays Knife River for coal is reason-
able. While it is true that the PSC found that
absolute comparability between coal prices impossi-
ble to determine, it appears to this Court that the
prices paid by a number of other companies to Knife
River for two-thirds of its coal production is
 evidence of a competitive market for comparison to
the Knife River price paid by MDU. In addition,
there was evidence of prices charged by other
companies in the competitive area. If the PSC
finds that the present evidence is insufficient, it
appears appropriate that the PSC require the par-
ties to submit additional evidence ...
As a matter of justice, it appears to this
Court that it might be better for the PSC to use a
marketplace cost of coal approach, if it can obtain
sufficient facts for its determination, rather than
using the rate of return method with all of its
difficult theories and com~utations. While - -
the PSC
- - the right find a factualmethod followed,
does have -
this Court - - - -
did not
to choose the
reason - -
for the
summary rejection - - marketplace - -of coal
of the cost -
approach. (Emphasis supplied.)
MDU I, 632 P.2d at 1091-92. We therefore reversed the PSC
determination because there was no factual reason given for
the summary rejection of the marketplace cost evidence sub-
mitted by MDU.
With MDU I in mind, let us consider the next case,
Montana Power Co. v. Department of Pub. Serv. (1983), 204
Mont. 224, 665 P.2d 1121, herein referred to as MPC. The
argument between the parties in - was similar to that in
MPC
MDU I. The MPC presented extensive evidence by ~ r t h u rD.
Little, Inc., a firm of national prominence in the field of
coal supply contracts. That firm sought and received bids
from nine companies and determined that the price of coal
charged by the MPC subsidiary was the lowest price available
to MPC's Billings plant. In referring to MDU I, this Court
concluded that we did not hold that the PSC must use a market
price method if a competitive marketplace can be established,
but that the choice of methods was left to the PSC. As a
result the Court did not consider whether there was substan-
tial evidence to support the market price method. Instead,
it analyzed whether there was substantial evidence to support
the rate of return method. The standard which it applied was
whether the PSC acted arbitrarily and unreasonably without
sufficient evidence to support its findings. The Court then
pointed out that the MPC did not challenge or oppose the
values submitted by the Consumer Counsel through Dr. Wilson,
its expert. As a result it then concluded that the record
was sufficient to support the decision made by the PSC and no
challenge would be allowed on appeal. A vigorous dissent was
prepared by Justice Harrison pointing out that there was an
arbitrary and capricious decision made by the PSC. I wish to
emphasize that in - the rule applied was that no argument
MPC,
could be made by MPC, because it had failed to present evi-
dence at the administrative level opposing the expert evi-
dence submitted by the Consumer Counsel.
The present case is a continuation of the conflict
between of marketplace cost of coal approach as compared to
rate of return approach. Here it is important to consider
the nature of the evidence submitted by both MDU and the
Montana Consumer Counsel. The uncontradicted evidence sub-
mitted by MDU established that there were not less than six
major generating stations in the general area and that there
were five different coal mines supplying coal to the sta-
tions. As a result those purchasing coal from Knife River
had a number of other alternatives. Other witnesses testi-
fied that there is a very competitive market for the supply-
ing of Northern Plains lignite coal in this area. In
addition to Knife River there are four companies, each of
which operate mines that have the capacity to produce in
excess of one million tons per year of Northern Plains
lignite, the same type of coal produced by Knife River.
These were Consolidation Coal Company, now wholly owned by
Dupont, North American Coal Company and its subsidiary,
Falkirk Mining Company, and Baukol-Noonan, Inc. In addition
North American was in the process of developing a new mine
through another subsidiary. There were also several other
operators producing smaller quantities basically for domestic
markets. The total output of lignite coal from this area in
one year was close to eighteen million tons. Detailed evi-
dence was presented of the coal prices charged by these
various operators. In addition, evidence was presented on
the approximately seventy-five percent of Knife River's coal-
which was sold on the marketplace to parties other than MDU.
In substance, MDU presented more than sufficient evidence to
prove the competitive market price for coal in the Knife
River vicinity. In my view, the evidence was clearly suffi-
cient to meet the standard outlined in MDU I.
In addition, I would emphasize that no contrary evidence
was submitted by any party. At that point, if the rationale
of - were applied, it would seem that the PSC could have
MPC
been required to consider in detail and explain in detail its
reasons for refusing to accept the uncontradicted evidence,
and to determine the coal price on a market price theory.
That seems particularly true in view of our holding in MDU I
where we suggested as a matter of justice that it appeared
that it might be better to use the marketplace cost of coal
approach. MDU I, 632 P.2d at 1092. However, I recognize
that that statement was weakened by - when we stated that
MPC
the choice of methods was left to the PSC.
However, I suggest that while the choice of methods may
be left to the PSC, it should not be allowed to make an
arbitrary decision denying the use of the marketplace cost of
coal. Instead of pointing out any shortcomings in the evi-
dence submitted by MDU, the PSC quoted from a Department of
Justice report, "Competition in the Coal Industry," which
stated that in practice, identification of the appropriate
competitive prices is virtually impossible. That quote
emphasizes that coal prices are not some broad national
aggregate but are tied to very specific locations and quality
factors. It further emphasizes that it may prove difficult
to estimate an appropriate set of market prices to use. That
is not a justification for refusing to consider the evidence
submitted by MDU. That is a general statement which pertains
to the comparison of coal prices on a broad or national
scale. It does not appear determinative when we have specif-
ic price figures offered for the sale of coal of the same
type and quality in the specific area, with the only differ-
ing factor being transportation costs. I conclude that as
was true in MDU I, the Court cannot find a factual reason for
the summary rejection of the marketplace cost approach and
the judgment should therefore be vacated.
As a result of my foregoing analysis, I disagree strong-
ly with the conclusions in the majority opinion that MDU
presented no evidence which tracked its own coal expense by
market price and that MDU did not present evidence of fair
market prices from comparable coal companies. In the present
case, the evidence presented by MDU of the seventy-five
percent of the coal sold by Knife River to other parties is
substantial evidence of such coal expense as only twenty-five
percent was sold to MDU itself. As pointed out in MDU I, it
should appear to this Court that the prices paid by a number
of other companies to Knife River for two-thirds (which has
now become seventy-five percent) of its coal production is
evidence of a competitive market for comparison of the Knife
River price to MDU. I also disagree with the conclusion that
MDU failed to present evidence of fair market prices from
comparable coal companies as there is substantial evidence of
that type which is unrebutted in the record.
I further disagree with the conclusion that there is
substantial evidence to support the rate of return method as
determined by the P S C . In contrast to - where the utility
MPC
failed to present any rebutting testimony to that testimony
of Dr. Wilson, in the present case, MDU presented substantial
evidence to show that there were a number of problems with
the testimony of Dr. Wilson. The PSC pointed out in its own
findings that the inclusion of eastern mining operations
which mine bituminous coal and have characteristics signifi-
cantly different from Knife River operations posed signifi-
cant problems in determining if they are comparable coal
companies. As a result the PSC concluded that it was reason-
able to check such admittedly imperfect data by looking at
other areas of the economy for profitability figures. The
response of the PSC to the proof of the inadequacy of the Dr.
Wilson evidence was to use as comparable companies, other
companies which no one contended were comparable. These
included Ashland Oil, Atlantic Richfield, Houston Natural
Gas, Mobil, Kerr-McGee, and Occidental Petroleum, most of
which were oil companies. The use of such companies which no
one contended were comparable in itself appears to be arbi-
trary. Further, the excess profit calculation performed by
Dr. Wilson considers the profitability of the entire Knife
River Coal Company. The most profitable sales by that compa-
ny were not the sales to MDU. As a result, there was an
improper scaling back of the earnings of Knife River. As
contended by MDU, the effect of this methodology is to cap-
ture a portion of the Knife River profits from sales to
parties other than MDU and use them to subsidize the MDU
electric customers.
The effect of the calculation of the rate of return
method by the PSC is the indirect regulation of Knife River.
Apparently that is the theory which the PSC set forth in
Finding 165 which is quoted in the majority opinion.
In MDU I, the majority opinion discussed the California
approach of rate determination (which Justice Sheehy
earnestly advocated in his dissent) and in refusing to apply
that approach stated as follows:

Perhaps the PSC, in setting the rate of return
level, was relying upon the theory prevalent in the
"California approach" to the issue at hand. Under
this approach, the subsidiary is treated not as an
independent entity but as part of the utility for
ratemaking purposes. The theory underlying this
position was discussed in Washington Water Power v.
Idaho Public Util. (1980) . ..
F e note, however, that the majority of those
7
cases using this approach involve the Bell Tele-
phone System and its manufacturing subsidiaries.
These subsidiaries sell virtually all their manu-
factured products to the parent, Bell Telephone - a
fact which is materially different from the present
situation where the bulk of Knife River coal (a
depletable natural resource) is sold to customers
other than its parent. . . . - -an approach
Such
should - - deemed applicable - -
not be in this instance.
(Emphasis supplied.)
MDU I, 632 P.2d at 1090-91. I frankly am not clear of the
effect of the majority opinion on the "California approach."
From the statements made by the PSC, it seems clear that it
intends to pursue such an approach in its rate determination.
If the intention of the majority opinion is to overrule this
determination in MDU I, because of its extreme significance
on all similar cases, it should be discussed in detail and
the rationale explained. I personally do not find any argu-
ment presented which persuades me that the "California ap-
proach" is a necessary part of the rate determination process
for Montana. There of course has been no such determination
by the legislature.
Under the factual analysis as above set forth, I con-
clude that it is not appropriate to affirm the PSC and the
order of the District Court which in turn affirmed the PSC.
I would remand this case for further proceedings.