MO Pub Svc Cmsn v. FERC

United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued May 15, 2000 Decided June 27, 2000

No. 99-1169

Missouri Public Service Commission,
Petitioner

v.

Federal Energy Regulatory Commission,
Respondent

Kansas Corporation Commission, et al.,
Intervenors
Consolidated with
99-1171, 99-1241

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 jurisdic-
tion of the Federal Energy Regulatory Commission, filed for
a general rate increase under s 4 of the Natural Gas Act, 15
U.S.C. s 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 down-
ward 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

__________
1 In the course of the proceedings Williams Natural Gas Compa-
ny became Williams Gas Pipelines Central, Inc. We use "Williams"
as shorthand.

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 non-
exhaustive, 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 Indus-
tries 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.
s 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 ratemaking 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 subsid-
iary'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
__________
2 The proxy companies and their equity ratios were: Sonat, Inc.
(62%), TWC (47%), Enron Corporation (43%), Panhandle Eastern
Corporation (45%), Coastal Corporation (39%), and Transcontinen-
tal Energy Corporation (16%).

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 Precari-
ous 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 FERC-
regulated 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 con-
nected 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 debt

 and 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 Utili-
ties 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 Re-
hearing"). 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 Commis-
sion 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 of return inferred from the market experience of a
proxy group with much thinner equity ratios.

But how thick is "too thick," and how much difference in
thickness is too much? Here the issue is whether 64% equity
is "anomalous," bearing in mind that it is 22% above the
proxy average but only 2% above the highest in the proxy
group. See supra note 2. Judges are hardly in a position to
play this numbers game. Such numerical limits cannot readi-
ly be derived by judicial reasoning, Hoctor v. USDA, 82 F.3d
165, 170 (7th Cir. 1996), though to be sure courts are driven
to it occasionally, as in enforcement of the Administrative
Procedure Act's mandate to ensure that agency action is not
"unreasonably delayed." 5 U.S.C. s 706(1). The ultimate

choice may partake of arbitrariness--not in the sense of being
"arbitrary and capricious," but in the sense that, while nu-
merical lines sometimes must be drawn, it is impossible to
give a reasoned distinction between numbers just a hair on
the OK side of the line and ones just a hair on the not-OK
side.

Here, it seems clear at the outset that the Commission was
on firm ground in rejecting the idea that an equity ratio
outside the bounds of the proxy group must automatically
require an adjustment. See Second Rehearing, 84 FERC
p 61,080, at 61,355. Assume a proxy group with ratios vary-
ing from 40% to 44%. Insisting on an adjustment for a firm
with one of 45% would surely impute an improbable refine-
ment to the rough inferences derived from capital markets, as
well as raising the question just how great the adjustment
should be.

The Public Service Commission suggests in its brief that
Commission precedent can provide some guidance. In
Transcontinental Gas Pipeline Corp., 60 FERC p 61,246
(1992), reh'g denied 64 FERC p 61,039 (1993), FERC found
that Transco Energy Corporation's equity ratio (the pipeline
proposed using its parent's equity ratio) was 22% below the
proxy average and required a different imputed capital struc-
ture to boost pipeline returns. See North Carolina Utilities
Comm'n, 42 F.3d at 661, 663. FERC does not really respond
to this argument, although it did observe in the Second
Rehearing that the proxy group average here is brought
down by the 16% equity ratio for one of the proxy firms
(Transco, interestingly). 84 FERC p 61,080, at 61,358 n.31.
Indeed, Transco's presence lowered the proxy group average
over 5% (47.4% to 42.2%). But as petitioners point out, if one
outlier is to be removed, why not another (Sonat, at 62%)?
And the double removal would put the average at 43.8%,
which would leave Williams still well above the average and
even more above the new top (48%). Further, the Commis-
sion gives no explanation as to why any outlier should be
removed, see United States Telephone Assn. v. FCC, 188 F.3d
521, 525 (D.C. Cir. 1999) (agency eliminating outlying data
points must explain "why the outliers were unreliable or their

use inappropriate"), much less why a low outlier should be
removed and a high one retained. Had the Transco prece-
dent been properly raised, FERC's failure to offer a distinc-
tion might well have required a remand. See Greater Boston
Television Corp. v. FCC, 444 F.2d 841, 852 (D.C. Cir. 1970)
("[I]f an agency glosses over or swerves from prior prece-
dents without discussion it may cross the line from the
tolerably terse to the intolerably mute."). But petitioners'
exceptions before the Commission did not cite the North
Carolina Utilities Comm'n case or make such precedent-
based arguments.3

Nor is there much force to petitioners' argument that
creeping stare decisis will inch equity ratios ever-higher, as
each new peak in equity ratio will justify another, still higher
peak. The Commission swears off any such progression, see,
e.g., Second Rehearing, 86 FERC p 61,232, at 61,858, and
petitioners can identify nothing in the record to undercut its
commitment. A slippery slope argument is almost always
available. "Judges and lawyers live on the slippery slope of
analogies; they are not supposed to ski it to the bottom."
Robert H. Bork, The Tempting of America: The Political
Seduction of the Law 169 (1990). Especially with the Com-
mission's explicit pledge, the slope risk provides no basis for
us to upset the Commission's judgment.

Petitioners also claim that in looking in part to pipeline
companies outside the proxy group in determining the rea-
sonableness of Williams's equity ratio, the Commission failed
to provide adequate notice and thus failed to allow them an
opportunity to offer evidence distinguishing the companies
outside the proxy group. But after the Commission consid-
ered pipelines outside the proxy group in the Second Rehear-
ing, petitioners made no request to supplement the record.

__________
3 Petitioners have not been punctilious in their use of precedent,
mistaking in their brief the facts of North Carolina Utilities
Comm'n, 42 F.3d at 663, for those of Public Service Comm'n v.
FERC, 642 F.2d 1335 (D.C. Cir. 1980). See Petitioners' Opening
Br. at 32.

 All that said, this case is somewhat puzzling. No one
contests the Public Service Commission's point that a thick
equity ratio implies less risk and thus a lower rate of return,
everything else being equal. Yet the Commission selected a
proxy group with widely dispersed equity ratios, from 16% to
62%, as opposed to a proxy group nearer to Williams's capital
structure. Further, it is unclear why the Commission has
taken such an interest, both in its orders and in its brief here,
in explaining that Williams's 64% ratio is in the mainstream of
ratios in the pipeline industry generally. The rate of return
is inferred from the rate of return of the proxy group, so the
non-anomalous character of Williams's equity ratio by the
standards of the industry generally is not self-evidently perti-
nent.

But there are also gaps in the petitioners' attacks, which
undermine any inference that FERC's looking to the industry
generally had any material effect. Given the supposed rela-
tion between equity ratio, risk, and rate of return, we should
expect to see some effort to show it at work within the proxy
group, or broadly among publicly traded companies generally.
Yet petitioners offer no such analysis. We know the direction
of the effect of equity thickness on equity rate of return (as
no one contests it), but we have nothing on the degree.
Accordingly, we have no basis for thinking that relationship
to be so strong as to make a material difference, business risk
being held constant. On this record, then, we cannot find
anything arbitrary and capricious in the Commission's use of
Williams's capital structure and the proxy group's median
return on equity.

PCB removal cost estimates

Before the administrative law judge Williams presented
evidence of $4.2 million in past unamortized costs for cleaning
up PCB (polychlorinated biphenyl), plus projections of future
costs. The ALJ allowed the company to amortize the $4.2
million over three years, with a procedure for refunding any
amounts Williams recovered from third parties responsible
for the PCB. ALJ Opinion, 73 FERC p 63,015, at 65,074-75.
Because Williams made a new s 4 rate filing in 1995, the

issue of PCB cost recovery in the present case became
"locked in" for the period of November 1, 1993 through July
31, 1995.

For this locked-in period, the Commission rejected amorti-
zation in favor of the "test period" method. Williams Natu-
ral Gas Co., 77 FERC p 61,277, at 62,182 (1996) ("First
Order"); see generally Southwestern Public Service Co. v.
FERC, 952 F.2d 555 (D.C. Cir. 1992). This method takes
actual costs of the most recent 12-month period (the "base
period"), subject under some circumstances to adjustment on
the basis of data from a nine-month period following the base
period (the "adjustment period"), and absent some anomaly
projects them into the period covered by the rate filing. See
18 CFR s 154.303.

Without looking to whether Williams had offered such test
period figures, the Commission declared that "the $1.4 million
annual amount the participants and the ALJ arrived at using
an amortization method is a reasonable equivalent of WNG's
actual PCB-related test period costs." First Order, 77 FERC
p 61,277, at 62,182. It also asserted that Williams had pro-
jected 10-year costs of $20 million; "this averages to $2
million a year which is reasonably close to the $1.4 million
annual amount the ALJ permitted [Williams] to recover." Id.
at 62,183.

Williams did not object to use of the test period method.
But on rehearing it did strenuously argue that the Commis-
sion was wrong to convert the amortization figures into test
period figures. Williams pointed to Exhibit 216 in the record,
which stated "Test Period Actuals" and a total of
"$3,990,768." The Commission rejected the $3.9 million fig-
ure, however, claiming it inappropriately covered a 22-month
period; but in so doing the Commission cited Exhibit 24 not
Exhibit 216. First Rehearing, 80 FERC p 61,158, at 61,680 &
n.11. As for Exhibit 216, the Commission stated it provided
"no distinct record evidence" of the level of PCB costs
"incurred over any annual period during the test period." Id.
at 61,680 & n.13. The Commission offered no explanation as

to the precise flaw in Exhibit 216's statement of "Test Period
Actuals."

Sticking by $1.4 million as "representative of annual PCB
cost figures," the Commission chastised Williams for disput-
ing the figure, saying that this was the figure initially pro-
posed by Williams (albeit as a figure for amortization). Id. at
61,679-80.

At oral argument the Commission abandoned any claim of
equivalence between the $1.4 million accepted by Williams
under the amortization theory and imposed by the Commis-
sion as a "representative" test period amount. Clearly a
number that emerges from taking past aggregate costs and
amortizing them over an arbitrarily chosen future period is
not necessarily useful for applying past experience to project
future expenses--the basic principle of the test period meth-
od. It could hardly satisfy the Natural Gas Act's require-
ment of substantial evidence for facts found by the Commis-
sion, 15 U.S.C. s 717r(b). See also Public Service Comm'n,
813 F.2d at 451.

Instead, the Commission at oral argument seemed to de-
fend the use of $1.4 million as a response to what it claimed
was Williams's failure to place correct test period figures into
the record. The Commission's brief points out that $3.2
million of the total test period $3.9 million were incurred in
two months, proving (in its current view) that Williams's test
period figures were "unrepresentative." And for the very
first time in this seven-year saga, the Commission at oral
argument claimed that Williams's data failed to satisfy a
regulatory requirement of monthly cost figures during the
test period.

Williams maintains that Exhibit 216's "Test Period Actuals"
was sufficient evidence. Nothing said by the Commission up
until oral argument has supplied a reason to believe that that
was inadequate. That $3.2 million in costs were incurred
during two months of the test period may show that PCB
removal costs come in lumps. But it hardly shows that the
$3.9 million annual aggregate figure was unrepresentative, a

theory in any event never invoked in the Commission's or-
ders.

When the Commission at oral argument asserted a require-
ment of monthly data, Williams questioned the existence of
any such requirement and said that in fact it had supplied
such data. The new Commission theory is in any event the
purest form of "appellate counsel's post hoc rationalization,"
which in the usual case we do not accept. North Carolina
Utilities Comm'n, 42 F.3d at 663. Since the Commission no
longer defends the $1.4 million figure as representative, and
in its orders never sought to justify it as a solution to some
procedural default by Williams, we grant the petition and
remand the case for the Commission to address this issue.

* * *

The petitions of Public Service Commission are denied; the
petition of Williams is granted, that part of the order is
vacated, and the case is remanded to the Commission.

So ordered.