State v. Public Utility Com'n of Texas , 883 S.W.2d 190 ( 1994 )

SPECTOR, Justice,

joined by GONZALEZ, DOGGETT and GAMMAGE, Justices,

dissenting.

Today the majority approves a creative accounting procedure that allows risk-free nuclear investment at the ratepayer’s expense. By statute, a utility is entitled to earn a reasonable return on its invested capital, over and above its reasonable and necessary operating expenses. During the periods at issue in this case, however, a utility is not entitled — statutorily or otherwise — to recover its operating expenses; and under no circumstances is the utility entitled to reap a profit on those expenses. By erasing the line between capital and expenses, the majority converts the utilities’ losses during the period before revised rates take effect into gains worth hundreds of millions of dollars. I dissent.

I.

The Public Utility Commission is required to set a utility’s revenues at a level that will allow the utility an opportunity to earn “a reasonable return on its invested capital used and useful in rendering service to the public over and above its reasonable and necessary operating expenses.” Public Utility Regulatory Act (“PURA”), Tex.Rev.Civ.Stat.Ann. art. 1446c, § 39(a) (Vernon Supp.1994). The valuation of its invested capital, or rate base, is thus critical in determining the amount that utilities are allowed to charge ratepayers.

PURA provides a simple mechanism for valuing a utility’s rate base: valuation is based on “the original cost of property used by and useful to the public utility in providing service.” § 41(a). “Original cost” is defined as the property’s actual money cost “at the time it shall have been dedicated to public use, whether by the utility which is the present owner or by a predecessor, less depreciation.” Id. This method could not be more straightforward; value is determined by looking to the property’s cost as of the time the plant is put into commercial operation.

This state’s adoption of original-cost valuation represented a rejection of the previous valuation system, which looked to the “fair value” of a company’s facilities. See Ron Moss, Ratemaking in the Public Utility Commission of Texas, 44 Baylor L.Rev. 825, 854-57 (1992). The fair value system was widely criticized because it involved the “laborious and baffling” task of finding an exchange value for property that is “not commonly bought and sold in the market.” Missouri ex rel. Southwestern Bell Tel. Co. v. Public Serv. Comm’n, 262 U.S. 276, 292, 43 S.Ct. 544, 548, 67 L.Ed. 981 (1923) (Brandeis, J., concurring, joined by Holmes, J.). Justice Brandeis urged an alternate approach to valuing rate base:

The thing devoted by the investor to the public use is not specific property, tangible and intangible, but capital embarked in the enterprise. Upon the capital so invested the Federal Constitution guarantees to the utility the opportunity to earn a fair return.

Id. at 290, 43 S.Ct. at 547. This shift in focus was eventually adopted, in large part, throughout the country. See Charles F. Phillips, Jr., The Regulation of Public Utilities 311 (2d ed. 1988).

In Texas, the shift toward “capital invested” came in stages. Before PURA, this Court — quoting at length from Justice Brandéis — concluded that the governing statutes required a “physical property valuation rate base.” Railroad Comm’n v. Houston Natural Gas Corp., 155 Tex. 502, 289 S.W.2d 559, 564, 567-68 (1956) (the Alvin case). With the enactment of PURA in 1975, the Texas Legislature likewise adopted the view that the valuation process should focus on the property actually embarked in the enterprise. See H. Louis Nichols and Randall Hagan Fields, Rate Base Under PURA: How Firm is the Foundation?, 28 Baylor L.Rev. 861, 869-70 (1976) (stating that PURA codified the Alvin case).¹ In 1983, the Legislature finally moved to a pure original-cost system, with cost fixed as of the date the property is dedicated to public use. PURA § 41(a); see Moss, 44 Baylor L.Rev. at 856.

Apart from the simplicity of its administration, the original-cost system has the advantage that it is not subject to political manipulation. Under the fair-value system, the ratesetting authority could avoid a politically-sensitive rate increase by simply making an inflation adjustment to the rate base; the utility’s nominal rate of return would remain the same, but consumers’ electric bills would go up. See Moss, 44 Baylor L.Rev. at 857. Original-cost valuation brings accountability to the ratesetting process: with value fixed at original cost, the Public Utility Commission must make adjustments to the rate of return. The original-cost method thus “sheds light on the ratesetting process and allows the public to discern the true rate of return.” Id.

A pure original-cost method — with cost fixed as of the date of commercial operation — is also consistent with accounting rules regarding the treatment of carrying costs before and after the commercial operation date. Up until the plant begins operating, the utility may accrue carrying costs in its allowance for funds used during construction (AFUDC), which can later be included in rate base. After the commercial operation date, however, such costs must be expensed. As the court of appeals concluded in another of the three causes decided today, “simple logic” requires that valuation must occur at the time that AFUDC capitalization ceases— that is, at the date of commercial operation. City of El Paso v. Public Util. Comm’n, 839 S.W.2d 895, 914 (Tex.App.—Austin 1992), rev’d, 883 S.W.2d 179 (Tex.1994).

The majority today abandons this approach, without even acknowledging the court of appeals’ reasoning. According to the majority, property is “dedicated to public use” within section 41(a) not at the date of commercial operation, but “when the expenditure is originally incurred,” supra at 200, whether that occurs before or after the commercial operation date.

The most obvious problem with the majority’s view is reconciling it with the language of the statute. If the Legislature had intended “original cost” to mean cost at the time of the expenditure, it could easily have said so, instead of referring to “the time [the property] shall have been dedicated to public use.” Other language in section 41(a) indicates that the Legislature did not intend a “time of expenditure” construction: property can hardly be “used by and useful to the public utility in providing service” before the utility has even begun providing service.

The majority dismisses the “dedicated to public use” language on the ground that it was intended to prevent the property’s value from being inflated by artificial transactions. Supra at 200 (citing American Tel. & Tel. Co. v. United States, 299 U.S. 232, 57 S.Ct. 170, 81 L.Ed. 142 (1936)).² The language was certainly intended to make actual capital investment simpler to ascertain; and the method chosen to accomplish that goal was to fix original cost at the commercial operation date. The majority provides no rationale for limiting the language’s effect to the particular type of manipulation considered in American Telephone & Telegraph.

By ignoring clear statutory limitations on the definition of invested capital, the majority opens the door to other types of manipulation, including rate base manipulation by the Public Utility Commission to avoid rate increases. Rate base will now include, for example, all types of post-in-service carrying costs, which are largely dependent on interest rates. The rate base will thus be at least as manipulable as it was under the old fair-value system: an inflation adjustment will have the same type of distorting effect now that it had before 1983.

The majority has achieved, in short, exactly what original-cost valuation was designed to prevent: the inclusion in rate base of items that should in fact be classified as expenses. With deferred accounting, a utility’s value is greater than its original cost— guaranteeing the utility a return greater than that authorized by the Legislature. See Re Puget Sound Power and Light Co., 62 P.U.R.4th 436, 440 (Wash. Util. & Trans. Comm’n 1984).³

The majority understandably downplays the distinction between capital and expenses, asserting that “there is no inherent or fundamental characteristic that determines whether a particular expenditure is an expense or a capital investment.” Supra at 194 n. 6. The authority the majority cites, however, states exactly the opposite. Professor Phillips describes the fundamental characteristics separating capital from expenses,⁴ and warns against blurring the line between the two: “If these distinctions are not made, earnings can be inflated by charging operating expenses to capital, or concealed by charging capital to operating expenses. Again, uniformity is essential....” Phillips, supra, at 206. The majority, disregarding this warning, allows the inclusion in rate base of such post-in-service items as operating and maintenance costs, which are by their very nature operating expenses — not invested capital.

The result of this judicial alchemy is that consumers will now be paying higher electric rates to compensate the utilities for expenses incurred in a period prior to the ratemaking proceeding. This result violates the most basic principle of ratemaking: rates are prospective only, so past losses are not recoverable under future rates. See Railroad Commission v. Lone Star Gas Co., 656 S.W.2d at 425 (calling this a “fundamental principle”); see also Bonbright, Principles of Public Utility Rates 198 (2d ed. 1988) (“Nor as a general rule of ratemaking will a utility be allowed to set rates to recover past losses.”).⁵

The majority acknowledges that this rule “prohibits a public utility commission from setting future rates to allow a utility to recoup past losses,” supra at 199; but it insists that the orders in this ease do not allow recoupment of past losses. This reasoning is sharply at odds with the generally-accepted accounting procedures on which the majority relies. See supra at 194 n. 5 and 194 (citing Statement of Financial Accounting Standards No. 71 (Fin. Accounting Standards Bd.1982)). Those accounting rules provide that deferred accounting is permissible only if “future revenue will be provided to permit recovery of the previously incurred cost rather than to provide for expected levels of similar future costs.” FAS 71 ¶ 9.b. Thus, under the majority’s own standards, deferred accounting must entail future recoupment of past losses.

Though today’s ruling is cast in arcane terms, its bottom line is simple: the Public Utility Commission may now levy a surcharge on consumers to reward massive utility companies for expenditures the companies made during the regulatory lag period. If the utilities reap unexpected profits in the future, consumers — many of them facing financial hardship — may rightly ask why they are not likewise entitled to an after-the-fact adjustment in rates.

II.

Regulatory lag, in the context of public utilities, is not an evil to be eliminated. Because utility rates are based on historical data from a test year, “some lag is inherent in the process.” Lone Star Gas Co., 656 S.W.2d at 425. Moreover, to the extent that a utility must absorb its own- costs during this period, regulatory lag provides a strong incentive for efficiency. See Phillips, supra, at 388 (calling regulatory lag “[pjerhaps the most significant incentive to efficiency”). Regulatory lag is thus central to the basic purpose of utility regulation: to provide a monopoly market with an effective substitute for competition.

In rare instances, the regulatory lag period may be so protracted as to pose a threat to the utility’s viability. The Texas Legislature has addressed that danger in section 43 of PURA, which “provides a detailed program in an attempt to compensate a utility for undue regulatory lag.” Lone Star Gas Co., 656 S.W.2d at 425. Section 43 places strict time limits on actions by the Public Utility Commission; authorizes the Commission to approve temporary rates; and permits the utility to institute new rates without the Commission’s approval by filing a bond adequate to protect the customers if the Commission ultimately approves a lower rate. § 46(c) — (e). The Legislature adopted the present provisions in 1983, after giving special consideration to imminent rate cases on nuclear plants, and “recogniz[ing] that in extended rate cases you do need to make special accommodations.” Debate on Tex.S.B. 232 on the Floor of the Senate, 68th Leg., R.S. 9 (April 6, 1983) (statement of Sen. Caperton).

The accounting maneuver approved today is not among the remedies chosen by the Legislature. In fact, had this maneuver been permissible in 1983, there would have been no need for any of the remedies in section 37. Deferred accounting treatment enables the Public Utility Commission to shift the entire burden of regulatory lag from shareholders to- ratepayers. All lag-period costs — 'from the time a new plant goes into service until the time new rates go into effect — may now be included in the utility’s rate base. Under such circumstances, the lag period will serve no efficiency role at all: a utility may not only recover all lag-period expenditures, but may actually earn a guaranteed return on those expenditures.

III.

Among the fundamental problems with deferred accounting is a lack of meaningful standards for implementing it. The majority holds that deferred accounting is permissible “to protect the financial integrity” of a utility. Supra at 196. Unfortunately, the proceedings in the present cases confirm what past experience has shown: that the “financial integrity” standard is, in effect, no standard at all.

Docket 9010 demonstrates the approach typically taken by the Public Utility Commission in applying the financial integrity standard. The Administrative Law Judge in that ease, after hearing all the evidence, submitted an Examiner’s Report concluding that deferred accounting should be denied:

Clearly, HL & P would be better off financially if the extension of deferred accounting were granted. That is not the issue, however. To balance the interests of utilities and their ratepayers, the Commission has decided to approve deferred accounting only if necessary to protect the utility’s financial integrity. In this case, an extension of deferred accounting is not necessary to ensure HL & P’s continued access to the capital markets on reasonable terms while its rate case is pending.

Texas Public Utils. Comm’n, Petition of Houston Lighting and Power Company to Continue Deferred Accounting Treatment for STP Unit One Beyond November 23, 1989, Docket No. 9010, 15 Tex.P.U.C.Bull. 1905, 1920 (Feb. 28, 1990). The Commission, however, overruled the Administrative Law Judge, and approved deferred accounting for the duration of the lag period — that is, until such time as the cost of South Texas Nuclear Project Unit 1 was included in rates. Id. at 1960. Commissioner Campbell dissented, stating that HL & P’s own evidence shows that without an extension of deferred accounting it will be able to retain access to the capital markets on reasonable terms.” Id. at 1966.

The indeterminate standard approved today is similar to one previously adopted by the Legislature in a related context. As enacted in 1975, PURA allowed the Commission to include in rate base expenditures on construction work in progress (CWIP) “where necessary to the financial integrity of the utility.” Act of June 2, 1975, 64th Leg., R.S., ch. 721, § 41(a), 1975 Tex.Gen.Laws 2327, 2341. From the outset, this provision met with criticism, as in the following passage:

The first question a consumer might pose is when will such an inclusion be “necessary to the financial integrity of the utility?” It is likely that the consumer will not be benefitted on this point, since it will be very easy for the Commission to always find it necessary to include utility construction work in the rate base, in order to strengthen the utility’s “financial integrity,” that is, to increase its profits.

H. Louis Nichols and Randall Hagan Fields, Rate Base Under PURA: How Firm is the Foundation?, 28 Baylor L.Rev. 861, 878-79 (1976). The Legislature reconsidered the CWIP provision in 1983, recognizing the “widespread dissatisfaction” with the 1975 standard. Ron Moss, Ratemaking in the Public Utility Commission of Texas, 44 Baylor L.Rev. 825, 848 (1992). It then adopted language that (1) provided that “construction work in progress is an exceptional form of rate relief’; and (2) shifted to the utility the burden of showing that inclusion of CWIP in the rate base was necessary to maintain the utility’s financial integrity. Act of May 26, 1983, 68th Leg., R.S., ch. 274, § 1, 1983 Tex.Gen.Laws 1258, 1297 (amending PURA § 41(a)); see also Moss, 44 Baylor L.Rev. at 849. The Public Utility Commission has recognized that the 1983 amendment requires a more stringent treatment of CWIP. Tex. Public Util. Comm’n, Application of Gulf States Utilities Company for a Rate Increase, Docket No. 5560, 10 Tex.P.U.C.Bull. 405, 435 (July 13, 1984); Moss, 44 Baylor L.Rev. at 850 & n. 114.

Fortunately, today’s decision, like the 1975 CWIP provision, may eventually be subject to legislative correction. Unfortunately, however, any such action will come too late to ease the burden today’s decision places on millions of consumers.

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I would affirm the judgments of the court of appeals with regard to the disallowance of deferrals of post-in-service carrying costs. In all other respects, I would reverse the judgments of the court of appeals and hold that expenses incurred after the beginning of commercial operation cannot be capitalized and included in rate base.

1 . PURA defines "facilities” to include "all tangible and intangible real and personal property without limitation.” § 3(n). This broad definition, however, was not incorporated into PURA’s definition of rate base. See Nichols and Fields, 28 Baylor L.Rev. at 874 ("Fortunately, this broad definition [of facilities] is not used in defining rate base under PURA. Valuations of 'intangible real and personal property without limitation' would be impossible without resort to capitalization of future earnings. This would lead to [the result Brandéis condemned].”)

2 . The majority also cites Office of Consumers' Counsel v. Public Util. Comm'n of Ohio, 18 Ohio St.3d 264, 480 N.E.2d 1105, 1107 (1985), stating that it was "interpreting similar language." Supra at 200. In fact, the language construed in that case was decisively different: the Ohio statute refers to "cost ... to the person that first dedicated the property to the public use,” and the court thus concluded that it "does not affect the timing of property valuation.” The Texas statute, in contrast, provides that a property's original cost is determined "at the time it shall have been dedicated to public use”; so it can hardly be said that the statute does not affect the timing of property valuation.

3 . "[A]ccrual of AFUDC after the in-service date of a utility plant would result in a utility plant with a value exceeding its ‘original’ cost. The original cost concept requires that the value of utility plant be determined at the time it is first placed in service to the public. To grant this petition would establish a dangerous and unwarranted precedent leading to further requests to disregard the original cost concept.”

4 . "Expenditures that represent investment in capital assets (plant and equipment) should be charged to fixed asset accounts rather than to operating expense accounts. Similarly, expenditures that represent costs of doing business should be charged to operating expense accounts rather than to capital.” Phillips, supra, at 206.

5 .In Lone Star Gas Co., we recognized that a regulatory authority may set new rates to be effective as early as the time the authority assumed jurisdiction over the ratemaking proceeding. 656 S.W.2d at 426. In the present case, however, the majority approves a procedure whereby rates will reflect costs incurred long before the agency's jurisdiction attached.