Illinois Cities of Bethany v. Federal Energy Regulatory Commission, Central Illinois Public Service Co., Intervenor , 670 F.2d 187 ( 1981 )

ORDER

Upon consideration of the petitions for rehearing filed by Respondent, Federal Energy Regulatory Commission, and Interve-nor, Central Illinois Public Service Co., and responses thereto, it is

ORDERED, by the Court, that petitions for rehearing are granted and Section III A of our opinion is amended to reflect the views set out in the supplemental opinion.

Opinion for the Court filed by Circuit Judge WALD.

WALD, Circuit Judge:

Our original opinion in this case was issued on August 17, 1981.¹ Pursuant to the Federal Rules of Appellate Procedure 35 and 40 and local rule 14, Respondent, the Federal Energy Regulatory Commission (“FERC” or “Commission”), and Intervenor, Central Illinois Public Service Company (“CIPSCO” or “Company”), with the support of the United States,² have petitioned for rehearing, requesting that Section III A of our opinion be vacated. We hereby grant the request for rehearing and vacate those parts of Section III A which are inconsistent with this supplemental opinion.³

Section III A examined Illinois Cities of Bethany’s (“Cities”) allegation that a wholesale electric power tariff, filed by CIPSCO under section 205 of the Federal Power Act, 16 U.S.C. § 824d, and approved by FERC, was too high in comparison with CIPSCO’s retail rates. Cities, a group of CIPSCO wholesale customers, claimed that they were being price squeezed.⁴ Relying upon a Staff study that indicated that CIPSCO’s profit margin was higher for its retail services than its wholesale services, see Joint Appendix (“J.A.”) at 16, 412, an Administrative Law Judge (“ALJ”) rejected Cities’ claim. Id. at 345, 406-17. FERC affirmed that decision. Id. at 425. Because we read the Supreme Court’s decision in F.P.C. v. Conway, 426 U.S. 271, 96 S.Ct. 1999, 48 L.Ed.2d 626 (1976) to permit the Commission, in the interests of competition, to adjust even cost-justified differentials, we remanded to allow the Commission, if it [found] that CIPSCO and petitioners [were] competitors, ... to reduce [CIPSCO’s wholesale] rate to the higher of the ‘lower end of the range of reasonableness’ or that needed to eliminate the price squeeze, or to justify a higher rate by reference to other factors.” Illinois Cities, supra, slip op. at 24. On rehearing, however, we have determined that no price squeeze exists so as to justify invocation of the Conway doctrine. We now vacate that decision and affirm the decision of the Commission.

ANALYSIS

Our decision to remand was based upon our finding that the ALJ had erred initially in rejecting a prima facie price squeeze case ⁵ presented by Cities and subsequently in failing to determine whether CIPSCO’s wholesale rate, although within the range of reasonableness, lay at the “lower end of the range of reasonableness,” i.e., at a point within the range of reasonableness that would permit elimination of the price squeeze. Id. at 19, 21. Upon further reflection, inspired in part by the additional information and reformulated arguments in the petitions for rehearing and the responses thereto, we now conclude that we were mistaken in ordering the remand.

The price squeeze case presented by Cities was based upon the Alcoa transfer price test. United States v. Aluminum Co. of America, 148 F.2d 416, 436-38 (2d Cir. 1945) (hereinafter Alcoa). That test maintains that “[i]f a vertically integrated entity cannot purchase at its own wholesale rates and still realize a profit at its own retail rates, then it can be concluded that the supplier has overcharged its wholesale customers.” Illinois Cities, supra, slip op. at 14.

The ALJ appears, however, to have misunderstood the appropriate transfer price test proffered. He concluded that “it would place in the hands of the party alleging discrimination the ability to create the discriminatory premises either willfully or simply through an inefficient municipal operation.” J.A. 416. Thus he viewed it as requiring an inquiry into whether a vertically integrated company could realize a profit by purchasing at its own wholesale rates and selling at the retail rates of the party alleging discrimination rather than at its own retail rates. Language in our original opinion ⁶ may inadvertently have contributed further to the confusion. Thus, both respondent⁷ and intervenor,⁸ in their petitions for rehearing, misconstrued our initial decision as “requiring the Commission to lower wholesale electric utility rates whenever a municipal customer, competing with the utility for retail business, cannot pay the rate, and (while incurring its own costs) resell at a profit.” ⁹ Properly understood, however, the transfer price test probes only whether the utility itself could buy or sell at its own prices.¹⁰ As such, it is similar to the method of analysis employed in the Staff study relied upon by the ALJ ¹¹ which compares the company’s rate of return on sales at both the wholesale and retail level to see whether the company is subsidizing lower retail prices through higher wholesale prices in order to compete against its wholesale customers.¹² Both tests depend upon a proper allocation of wholesale and retail costs, and both seek to test whether there is a price discrimination ¹³ — a non-cost justified differential— between wholesale and retail customers.¹⁴ Thus, Cities’ attempted use of the transfer price squeeze test to attack the findings of the Staff cost-of-service study is in fact not materially different from a direct attack upon the accuracy of the Staff study itself. Having acknowledged the discretion of the Commission to utilize its choice of an appropriate methodology ¹⁵ to prove or disprove a price discrimination, and having rejected Cities’ frontal assault upon that methodology,¹⁶ we should have found that Cities had failed to make out a price squeeze case. In sum, since the Staff study found that after fully allocating wholesale and retail costs the company’s rate of return on wholesale sales was reasonable and indeed less than its rate of return on retail sales, there was no reason to believe that Cities was being price squeezed at all. See n.14 supra. And where no price squeeze case exists, there is no need to decide whether Conway¹⁷ requires the ALJ to determine whether CIP-SCO’s wholesale rate, although within the range of reasonableness, lay at a point within that range where it could or should be lowered to eliminate the price squeeze. Because we erred in remanding for the Commission to consider applying Conway to this case, we vacate our earlier decision on this aspect of the case.

The Supreme Court in Conway held that although the Commission lacked jurisdiction to fix retail rates, its jurisdiction to set wholesale rates allowed it to take retail rates into consideration where wholesale customers were price squeezed by dint either of the utility company’s desire to drive out retail competitors or of the interplay between federally and locally regulated rates. .

The Commission must arrive at a rate level deemed by it to be just and reasonable, but in doing so it must consider the tendered allegations that the proposed rates are discriminatory and anticompeti-tive.¹⁸

The Supreme Court upheld a decision of this court, per Leventhal, J., and observed that this court was “quite correct” in concluding:

When costs are fully allocated, both the retail rate and the proposed wholesale rate may fall within a zone of reasonableness, yet create a price squeeze between themselves. There would, at the very least, be latitude in the FPC to put wholesale rates in the lower range of the zone of reasonableness, without concern that overall results would be impaired, in view of the utility’s own decision to depress certain retail revenues in order to curb the retail competition of its wholesale customers.¹⁹

We read that language as permitting the Commission to adjust wholesale rates within a range of reasonableness to respond either to utility efforts to depress retail rates to meet competition, or to situations where the imperfections of regulation result in an unintended price squeeze. Since ratemaking is an inexact science, even bona fide allocations of costs between wholesale and retail operations may be imperfect or rates of return set by different regulators at the wholesale and retail levels may make it impossible for purchasing wholesalers, no matter how efficient, to compete at the retail level. In such cases, Conway acknowledges the Commission’s discretion to press wholesale rates to the lower end of the zone of reasonableness. The Conway doctrine is not, however, we emphasize, designed to subsidize particular retail competitors. Rather, the doctrine allows the Commission some leeway where it finds that the process of price setting by regulation, and not the superior efficiency of the utility, might result in retail competitors being driven from the market.

Here, the requisite • proof that a price squeeze existed was not forthcoming and indeed was refuted by the Staff study. When costs were fully allocated between wholesale and retail operations, CIPSCO’s wholesale profit margin was both reasonable and sufficiently lower than its retail profit margin so that there was no occasion for the Commission to exercise its Conway discretion.

CONCLUSION

For the foregoing reasons, we vacate those parts of our initial decisions as are inconsistent with this supplemental opinion, and affirm the decision of the Commission.

1 . Illinois Cities of Bethany, et al. v. Federal Energy Regulatory Commission, No. 80-1633 (D.C.Cir. Aug. 17, 1981) (hereinafter Illinois Cities).

2 . The United States submitted an amicus brief in support of respondent and intervenor’s petitions for rehearing. A petition of Commonwealth Edison Co. to submit an amicus brief was denied.

3 . Specifically, the following sections of § HI A are vacated: slip op. at 2, lines 17 (beginning “in large”) to 19; slip op. at 9, line 4 (delete “must”); slip op. at 10, lines 17-19 and n.26; slip op. at 14, line 1 (delete “, quite correctly,”); slip op. text accompanying notes and notes 50-73; and slip op. at 27, following note 85 (delete “Remanded for further proceedings consistent with this opinion. ”)

4 . “[A] ‘price squeeze’ occurs when a wholesale supplier, who also sells at retail, charges such high rates to its wholesale customers that they cannot compete with the supplier’s retail rate.” Hjelmfelt, A Price Squeeze Theory For Implementation of Federal Power Commission v. Conway Corp., 50 U.Colo.L.Rev. 459 (1979). Because FERC is required to insure “just and reasonable” rates, 16 U.S.C. § 824d, we are concerned here only with price squeezes not due to the vertically integrated company’s superior efficiency.

5 . We apparently attached too much importance to the establishment of a prima facie case of price squeeze in our initial decision. The Commission informs us in its brief on Rehearing that it uses prima facie case “to mean that enough has been shown to warrant inquiry into the price squeeze allegations to ascertain whether price discrimination exists.... It is merely a threshold which must be crossed to put the question at issue. If there is sufficient evidence to suggest that price discrimination may exist, then the ‘prima facie case’ is established. The utility is then required to prove the absence of price discrimination. This is unlike the ordinary use of a ‘prima facie case’ where the party who establishes it is, as a matter of law, entitled to relief unless the defending party rebuts that case.” Respondent’s Petition For Rehearing and Suggestion For Rehearing En Banc (hereinafter Respondent’s Petition) at 8 n.l 1.

6 . Illinois Cities, supra, slip op. at 15. We were misled, as the ALJ may have been, by the assumption, suggested by questioning of an expert witness, that CIPSCO would have incurred the same costs that Cities has incurred. J.A. 139. Compare Petitioner’s Reply Brief, Illinois Cities, at 12-14 (Alcoa test properly set out).

7 . Respondent’s Petition at 3, 6, 9.

8 . Intervenor’s Petition For Rehearing and Suggestion For Rehearing En Banc at 2.

9 . Respondent’s Petition at 3.

10 . See Alcoa, 148 F.2d at 437:

The plaintiff’s theory is that “Alcoa” consistently sold ingot at so high a price that the “sheet rollers,” who were forced to buy from it, could not pay the expenses of “rolling” the “sheet” and make a living profit out of the price at which “Alcoa” itself sold “sheet.” To establish this the plaintiff asks us to take “Alcoa’s” costs of “rolling” as a fair measure of its competitors’ costs, and to assume that they had to meet “Alcoa’s” price for all grades of “sheet,” and could not buy ingot elsewhere.

We note that Alcoa’s own costs of rolling were used as a fair measure of its competitor’s costs. Here, competitor’s costs were offered as a fair measure of CIPSCO’s costs. Although it may be, as Cities asserts, that its retail costs were lower than CIPSCO’s, there was inadequate evidence in the record to prove that assumption. Petitioners draw our attention to J.A. 136-39. Although the evidence there correctly indicated that if CIPSCO owned each of the Cities’ distribution systems it would pay higher taxes, J.A. 136-38, the hypothetical itself merely assumed that CIPSCO would incur the same costs that Cities incurred.

11 . See Opinion No. 62, Southern California Edison Co. Opinion and Order on Rate Increases, FERC Docket No. ER 76-205, Aug. 22, 1979 at 31, J.A. 625.

12 . Cities argues that the Staff study cost of service test was inferior to the price squeeze test because it merely relied upon a sample of the relative rates of return in wholesale and retail markets. Response By Cities of Bethany, Et Al. To Petition Of CIPSCO For Rehearing and Suggestion For Rehearing En Banc at 3-4, 7. But see, slip op. at n.27 (sample used by petitioners themselves to establish prima facie price squeeze case). It is true that an exhaustive comparison of wholesale and retail rates of return would probably be more accurate than a sample. However, we do not find, as apparently the ALJ and FERC did not, that the sample indicated that there was need to conduct a full comparison of wholesale and retail rates of return. Had the Staff study indicated otherwise, we assume that either a more exhaustive cost of service study would have been run or possibly a transfer price test would have been conducted.

13 . See 16 U.S.C. § 824d(b); see also Federal Power Commission v. Conway, 510 F.2d 1264 (D.C.Cir.1975), aff'd, 426 U.S. 271, 96 S.Ct. 1999, 48 L.Ed.2d 626 (1976) (hereinafter Conway).

14 . Under the price transfer test the vertically integrated company’s costs of retail operations must be added to the product purchased at its wholesale rates to determine profitability, so the usefulness of that test depends upon an accurate identification of retail costs. If the company fails to realize a profit under this test, indications are that retail costs have been improperly transferred to the wholesale operations, (or, less likely, retail operations are inefficient). Under the methodology of the Staff study, wholesale and retail revenues over their respective incurred costs are compared. This method of analysis also depends upon a proper identification of wholesale and retail costs. If after wholesale and retail costs are fully allocated the company’s wholesale profit margin is significantly greater than its retail profit margin, indications are that a price discrimination is occurring. Both methods of analysis are acceptable methods of establishing a price squeeze case. See J.A. at 625. Although the results of a cost of service study are phrased in terms of a profit differential, see Memorandum By The Cities of Bethany, Et Al. In Response To The “Memorandum Amicus Curiae” Filed By The Antitrust Division of the Department of Justice at 4, like the price squeeze test, the cost of service study also seeks to determine whether the vertically integrated company maintains artificially high wholesale prices in order to squeeze out its retail competition. If, after costs are fully allocated, it appears that the wholesale rate of return of a vertically integrated company is reasonable and, in fact, lower than retail rate of return, it would appear that wholesale customers are not being price squeezed — indeed, the higher the retail rate of return vis-a-vis the wholesale rate of return, the greater the wholesale customer’s discount.

15 . Illinois Cities, supra, slip op. at 16 n.47; see also San Antonio, Texas Acting By and Through Its City Public Service Board v. United States and Interstate Commerce Commission, 631 F.2d 831, 837 (D.C.Cir.1980) (courts reluctant to interfere with agency’s choice of methodology); but see, id. at 841 (when errors in methodology apparent, courts available for relief).

16 . See Illinois Cities, supra, slip op. at 16 n.47.

17 . Conway, supra, 426 U.S. 271, 96 S.Ct. 1999, 48 L.Ed.2d 626.

18 . Id. at 279, 96 S.Ct. at 2004.

19 . Conway, supra, 510 F.2d at 1274 (footnotes omitted).