Southern California Gas Co. v. Public Utilities Commission , 23 Cal. 3d 470 ( 1979 )

CLARK, J., Concurring and Dissenting.

I concur in the majority’s holding that the Public Utilities Commission could reasonably conclude that SoCal’s election of ratable flow-through—rather than immediate flow-through—of the tax benefits had collateral benefits warranting an appropriate rate of return adjustment. However, the adjustment made was inappropriate.

The commission’s finding of collateral benefits, according to Decision No. 86117 denying rehearing, was predicated upon testimony that “ ‘SoCal’s cash flow would be maximized, its interest coverage increased,[¹⁰] and the financial requirements in constructing facilities and acquiring gas supplies relieved. [Citation.] Each of these benefits reduces SoCal’s risk.’ ” (Ante, p. 481.)

It is obvious that before any collateral benefit may be obtained, the utility must actually receive some additional funds. Otherwise, cash flow cannot be increased, interest coverage cannot be increased, and the financial requirements cannot be relieved.

As the majority point out, choice of immediate flow-through rather than ratable flow-through would result in a reduction of SoCal’s revenue requirement of $4.4 million for 1975. (Ante, p. 478.) On the basis of the collateral benefits assertedly flowing to SoCal from ratable flow-through, the commission reduced SoCal’s rate of return on its $824.5 million rate base by .25 percent: 8.5 percent to 8.25 percent. This results in a reduction in the revenue requirement after application of the net to gross multiplier of $4.4 million.

Thus, the use of ratable flow-through would result in an increase of $4.4 million in the revenue requirement over the use of immediate flow-through. But the use of ratable flow-through also requires, according to the commission, a reduction in the rate of return, and that reduction —translated to dollars—equals $4.4 million. Second grade arithmetic teaches that the two adjustments cancel each other. Rates are fixed on the basis of revenue requirement and will be the same whether using immediate or ratable flow-through.

Similarly when we compare the utility’s position without the investment tax credit and rate of return reduction with the utility’s position in light of the commission’s order, there is no substantial change and thus no benefit to the utility. The investment tax credit results in a tax savings to the utility (ante, p. 478) and the rate of return reduction results in a further tax savings (ante, p. 476, fn. 4). Those tax savings reduce the utility’s expenses. The total of the tax savings or reduction in utility expense is approximately $4.4 million. The revenue requirement or anticipated income is also reduced approximately $4.4 million. Because expenses and income are reduced in the same amount, there is no net benefit to the utility.

When the revenue requirement is reduced by an amount equal to anticipated extra cash, extra cash does not exist, and it is patent cash flow is not increased, and financial requirements will not be relieved. Because the utility will receive exactly the amount of cash it would have received had it elected immediate flow-through, there are no benefits—collateral or otherwise—flowing to it from its election of ratable flow-through. The two adjustments cancelling each other, SoCal has ended up with the cash flow, interest coverage, and financial requirements which according to commission determinations warrant an 8.5 percent rate of return. But the commission is only allowing an 8.25 percent rate of return. Absent some extra cash received or kept by the utility, there is no benefit to justify reduction in the rate of return.¹

The reduction in rate of return is predicated upon the conclusion that there would be in fact some benefit to the utility. Because the reduction in the permitted rate of return is so large as to itself preclude any benefit, it cannot be upheld.

Moreover, from an investment standpoint, whether debt or equity, there is actually a detriment rather than benefit flowing from the determination to choose ratable flow-through. While the cash flow remains constant in the current year, the investor is aware that the utility in future years will have to bear the burden of ratable flow-through, a future reduction in rates as the investment tax credit is flowed through in later years. There can be no justification for concluding that the utility’s choice has reduced risk warranting .25 percent reduction in the rate of return. Instead the commission has stopped any benefit from flowing to the utility and has increased its risk.

For the foregoing reasons, the commission’s decisions should be annulled.

While the foregoing should dispose of the case before us, I must take issue with the majority’s statement that the policy of the State of California—unless contrary to federal law—requires immediate flow-through to the ratepayers of the tax benefits resulting from accelerated depreciation and the investment tax credit. (Ante, p. 476.) In an inflationary period such policy is shortsighted, resulting in ratepayers paying less than their fair share of utility costs and ultimately endangering the utility system and economy of our state.

Few would dispute that the ratepayers should be required to pay rates sufficiently high to permit the utility to earn a fair return on its investment and to cover its expenses. (City and County of San Francisco v. Public Utilities Com. (1971) 6 Cal.3d 119, 129 [98 Cal.Rptr. 286, 490 P.2d 798].) Plant and equipment must constantly be replaced if current levels of production are to be sustained. Included within the expenses used to set rates is an allowance for depreciation—an allowance designed to compensate the utility for plant and equipment wear and to provide funding for replacement.

In the current period of severe inflation, depreciation allowance will obviously not provide sufficient funds to replace womout plants and equipment. The allowance is based on historical cost—partially on costs incurred 30 and 40 years earlier. Replacement of plant and equipment to truly maintain current levels of production may cost twice or three times actual allowance.

Because the cost of replacement exceeds allowance, the utility is forced to seek other sources of capital to maintain current production, and unless the supplemental source is generated internally, the utility is required to continually go deeper and deeper into debt.² And if the utility is required to continually enter capital markets to finance what should be considered current expense—replacement of worn-out plant and equipment—the result can only be that the market for California utilities’ debt securities will become increasingly expensive or will close entirely. The problem quickly becomes acute when the utility must borrow not only to maintain current production but also to increase plant and equipment to meet the expanding needs of the California economy.³

Although the intent of Congress in originally providing for accelerated depreciation and the investment tax credit may have been to encourage investment generally thereby creating jobs, it is apparent that in our inflationary economy one function of those tax reduction provisions should be to help business replace worn-out plant and equipment—to make up part of the difference between the allowance for depreciation and the replacement cost of plant and equipment necessary to maintain current production. The accelerated depreciation and the investment tax credit are intended to reduce taxable income, taxable income is roughly equivalent to profit, and enterprises which cannot generate enough income to replace worn-out plant and equipment should not be considered profitable enterprises. The benefits of accelerated depreciation and the investment tax credit are tied to recent and current costs. Although the benefits also flow from investments made to increase productive capacity, it is apparent that replacement investment is necessary before there may be investment to increase productivity. Thus it is clear that one of the main functions of the tax savings should be to provide an internal source of replacement capital.

Once we recognize that in these inflationary times one of the main functions of accelerated depreciation and the investment tax credit is to permit the business enterprise to replace worn-out plant and equipment at current costs, it is apparent that the congressional tax policy and our commission regulatory policy are not in conflict. Establishment of rates sufficient to maintain adequate service is, of course, a crucial part of the commission’s duties. (See, e.g., Pub. Util. Code, §§ 726-730.) Continuation of utility financial integrity must be viewed as a goal of both Congress and the commission.

Accelerated depreciation with normalization, and ratable flow-through of the investment tax credit, do not mean that ratepayers are deprived of the benefits of tax savings. Although normalization permits the utility to build up a capital account, the utility will not receive any return from such capital. Rather, ratepayers will ultimately benefit because the reduction in need for capital will permit later rate reductions. Ratable rather than immediate flow-through of the investment tax credit merely delays the ratepayers’ benefits. Moreover, even if benefits were not ultimately “flowed through” to the ratepayers, there is nothing unjust in requiring ratepayers to pay the replacement cost of worn-out plant and equipment, and accelerated depreciation and the investment tax credit would do no more than provide funds to make up part of the difference between the depreciation allowance based on historical cost and the current replacement cost.

I believe that neither we nor the commission should establish an inflexible state policy requiring immediate flow-through of tax savings by the ratepayers. Instead, policy should be flexible giving due regard to current ratepayers, future ratepayers, and the financial integrity of utilities. Fair consideration of those interests during periods of great inflation will often, if not customarily, counsel against immediate flow-through of tax benefits.

Richardson, J., concurred.

Petitioner’s application for a rehearing was denied May 24, 1978, and the opinion was modified to read as printed above. Clark, J., and Richardson, J., were of the opinion that the application should be granted.

10 “‘Interest coverage’ expresses a relationship between the amount of return devoted to debt capital costs, as opposed to the amount available to equity investors, and the rate of return as a whole. It is usually used to express the ratio between rate of return and allowance for debt cost (interest). Interest coverage is a major indicator considered by securities analysts and bond rating services.”

1 Although the instant decision involves a refund rather than initial fixing of rates, the basis of the refund order is that the rates as set allowed too great a rate of return.

2 AIthough theoretically the utility might raise funds by issuing stock, few investors can be expected to be interested in an enterprise which is unable to obtain a reasonable return on investment and other income sufficient to maintain its plant and equipment at current levels of production.

3 The problem of increasing expense of selling bonds for California utilities has already commenced. Pacific Telephone, for example, has had its bonds downgraded repeatedly in the last two years, receiving the lowest rating of any Bell system company. Last winter the downgrading of a $300 million bond issue meant that Pacific will have to pay $80 million additional interest over the 40-year life of the bonds. (Southern Cal. Edison Co. v. Public Utilities Com. (1978) 20 Cal.3d 813, 842 [744 Cal.Rptr. 905, 576 P.2d 945] (dis. opn.).)