Railroad Commission of Texas v. Entex, Inc.

DENTON, Justice.

This is a direct appeal by the Railroad Commission from a district court judgment invalidating the rate order entered by the Commission for Entex, a gas utility. We hold that the Railroad Commission’s order met all legal requirements and was supported by substantial evidence in the record. The district court judgment is reversed and the order of the Railroad Commission is reinstated.

In March 1976, Entex applied for a rate increase from the City of Beaumont, Texas (hereinafter referred to as City). The City failed to act, and Entex appealed to the Railroad Commission for a rate increase equal to an 8% return on the rate base. After an evidentiary hearing before an examiner, the Railroad Commission entered an order on September 12, 1977, which granted Entex a 4% rate of return on its adjusted value of invested capital rate base of $14,005,509. Entex filed a motion for rehearing. On October 24, 1977, the Railroad Commission entered an order which adopted the Examiner’s Report and Proposal for Decision and denied Entex’s objections to the order. Entex appealed to the District Court of Travis County which declared the order setting a 4% rate of return invalid, and permanently enjoined its enforcement, and remanded the order to the Railroad Commission (hereinafter referred to as the Commission).

The finding of the Commission that En-tex had operating expenses of $11,944,535 is unchallenged. The Commission followed Section 41 of the Public Utilities Regulatory Act, Tex.Rev.Civ.Stat.Ann. art. 1446c (hereinafter referred to as PURA) and determined Entex’s rate base from the value of property “used by and useful” to the utility in providing service. The adjusted value of the property was determined to be 14,005,509 by weighting 60% as original cost less depreciation and 40% as current cost less an adjustment for present age and condition. The controversy is whether the Commission made a proper determination of the rate of return under Sections 39 and 40 of the PURA, and whether a 4% rate of return on the adjusted value of invested capital is reasonable.

A proper rate determination requires a consideration of three important factors: (1) the utility’s reasonable operating expenses; (2) the rate base; and (3) a reasonable rate of return. Railroad Comm’n v. Houston Natural Gas Co., 155 Tex. 502, 289 S.W.2d 559, 573 (1956) (hereinafter referred to as the Alvin case). First, there must be a determination by the regulatory authority of the utility’s reasonable operating expenses. After deciding what utility property will be included in the rate base, the next step is the rate base calculation. The two major approaches currently used in rate base calculations are “original cost depreciated” and “fair value,” which represents the cost of reproducing the utility’s facilities. After the rate base is determined, the regulatory authority determines the rate of return, or the percent of the rate base which will be recoverable in revenues by the utility.

The rate base and rate of return are interdependent, and by manipulation of either, the regulatory authority may correct an inequitable rate which results from inflation or recession. In an inflationary period, a fair value approach would use a lower rate of return to counteract the inflated rate base. An original cost depreciated approach, on the other hand, would use a higher rate of return to insure a reasonable recovery for the utility. All of these factors must be taken into consideration for a reasonable rate to be determined. See, Butler, The Rate of Return in Texas — The Neglected Issue, 28 Baylor L.Rev. 937 (1976); Student Symposium, Public Utility Regulation in Texas, 7 St. Mary’s L.J. 515 (1975).

Texas is a fair value jurisdiction. A fair value rate base was first determined as a ratio between original and replacement costs in the Alvin case, but later this concept was utilized in the PURA. Section 41 of the PURA requires that the rate base be determined as a balance between original cost depreciated and current reproduction cost less an adjustment for age and condition. Under section 41, the “adjusted value” of property “used by and useful to the public utility” is based upon 60 to 75 percent of the original cost less depreciation and 25 to 40 percent current reproduction cost less an adjustment for age and condition. The exact balance is within the discretion of the Commission. This type of ratio has the advantage of stabilizing utility rates in periods of inflation or recession.

Within statutory guidelines the Commission has the discretion to determine the rate of return to be applied to the rate base. Section 39 of the PURA provides that the overall revenues which result from the application of the rate of return to the adjusted value rate base must be sufficient for the utility to recover its operating expense plus a “reasonable return on its invested capital.” In Southwestern Bell Tel. v. Public Utility Comm’n, 571 S.W.2d 503, 515 (Tex.1978) we held that “invested capital” in section 39 of the PURA meant original cost less depreciation.

In addition, in Section 40(a) of the PURA, the Commission is prohibited from setting a rate that would result in “more than a fair return upon the adjusted value of the invested capital used and useful in rendering service to the public.” Therefore, section 39 provides the “floor” on the rate of return, i. e. requiring minimum revenues to equal operating expenses plus a reasonable return on original cost less depreciation. Section 40(a) is the “ceiling” in that the rate of return cannot yield revenues greater than a fair return on adjusted value. The rate of return may be set by the Commission at any level within those two extremes. It should be pointed out that the “floor” and “ceiling” analogy is appropriate in an inflationary period, but that in a recession, section 39 might be the “ceiling” and section 40(a) the “floor.”

There may be other considerations in setting the rate of return. In times of shortage, the Commission may consider the need to provide an incentive for exploration or increased reserves. The reasonable rate must balance the consumer’s desire for low rates against the utility’s need to improve and expand.

Another factor in determining a reasonable rate of return is the utility’s financial structure. Debt financing or borrowed capital is generally cheaper than equity financing or capital obtained from the sale of stock, and utilities commonly use both sources of capital. The cost of debt and equity, and the ratio of the two types of financing yields the cost of capital. This cost of capital and the ratio of debt and equity must be established by expert testimony.

The Public Utility Commission has adopted substantive rules which weight the type of debt based on a utility’s actual capital structure. Each debt percentage is then multiplied times the debt cost in terms of percent return required on the debt. Added together these elements yield a composite rate of return which is then multiplied times the adjusted value rate base to equal the amount of return. For example:

Percent of Cost Weighted Type of Capital Total Capital Rate Cost

Debt 66% X 6% 4%

Common stock equity 34% X12% 4%

Composite rate of 8% return

Although the Commission has not adopted a similar substantive rule, based on the Commission’s findings, their preliminary approach to rate setting appears to be the same. However, after considering the 8% composite rate of return requested by En-tex, the Commission also considered the effect of that rate on the return to book common equity.¹

The importance of considering the return to book common equity in a fair value jurisdiction can be easily demonstrated. Debt and preferred stock costs are not affected by inflation because the utility’s obligation to the investor remains the same. Even with an increase in the adjusted value rate base, the holder of debt or preferred stock will not realize a greater return on the initial investment. Because the cost of this type of capital remains fixed, additional return to the utility due to an adjusted value rate base will go to the equity holder or common stock investor. An exorbitant return to the common stock equity could be considered by the Commission in determining a reasonable rate of return, however, the basic legal requirements for a rate of return must be satisfied.

The basic legal requirements of a rate of return were set out by the United States Supreme Court in Bluefield Water Works & Improvement Co. v. Public Serv. Comm’n of West Virginia, 262 U.S. 679, 43 S.Ct. 675, 67 L.Ed. 1176 (1923):

A public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties; but it has no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures. The return should be reasonably sufficient to assure confidence in the financial soundness of the utility, and should be adequate, under efficient and economical management, to maintain and support its credit and enable it to raise the money necessary for the proper discharge of its public duties. A rate of return may be reasonable at one time, and become too high or too low by changes affecting opportunities for investment, the money market, and business conditions generally.

Id. at 692-93, 43 S.Ct. at 679.

In FPC v. Hope Natural Gas Co, 320 U.S. 591, 64 S.Ct. 281, 88 L.Ed. 333 (1944), the United States Supreme Court further elaborated the requirements for a rate of return. By the time of the Hope opinion it was recognized that utility companies attract capital on a national market and greater emphasis was placed on the utility’s earnings in comparison to similarly situated utility companies. The Hope court stated:

[I]t is important that there be enough revenue not only for operating expenses but also for the capital costs of the business. These include service on the debt and dividends on the stock. ... By that standard the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital.

Id. at 603, 64 S.Ct. at 288.

In Railroad Comm’n v. Houston Natural Gas Corp., 155 Tex. 502, 289 S.W.2d 559 (1956) known as the Alvin case, Texas law was applied to utility rate making. In Alvin it was recognized that there are two means of raising capital, either by borrowing or by the sale of stock. It was also recognized that as a general rule, borrowing is the cheaper of the two methods, and that most utilities follow a well defined ratio between capital raised by investment in stock and that which is borrowed. Although the statute in effect in Alvin prohibited rates fixed upon stocks and bonds issued by the utility, it was stated that there was nothing to prohibit “general consideration of the two methods of raising capital and of arriving at a rate of return which is a composite of the two on the current market.” Id. at 573.

The major holding of the Alvin case was that Texas law mandated a fair value rate base rather than an original cost rate base. The rate of return issue was also considered, and it was held that the rate of return must be sufficient to avoid confiscation and must be “high enough to attract ample capital but need not go beyond that. .” Id. at 572. Indeed, the rate of return issue was framed as “what is the lowest composite percentage rate of return which will induce the investment of adequate capital?” Id. at 575.

Therefore, Alvin would allow a general consideration of the return necessary to common stock equity, in order to insure that the utility’s rate of return would be sufficient to attract capital. The PURA was enacted subsequent to the Alvin case. Still, under the PURA, a consideration of the return to common stock equity would also be in keeping with the requirement of section 39 that a reasonable return to invested capital be recovered.

In Southwestern Bell Tel. v. Public Utility Comm’n, 571 S.W.2d 503 (Tex.1978) (hereinafter referred to as Southwestern Bell), we considered the statutory requirements of the rate base and the rate of return under the PURA. In holding that in a rate base determination the regulatory authority must purport to follow section 41(a) of the PURA, and that a dual rate base calculation was an incorrect interpretation of that statute we stated:

It seems obvious that the Commission figured the total revenues or monetary return to which Bell was entitled by one method or the other, and merely used that same figure to determine a rate of return on the other rate base. As stated above, we do not accept a dual rate base theory, but the Commission purported to determine the monetary return based upon what we have held to be the correct rate base, the adjusted value of invested capital. By using this method of fixing revenues for Bell in the alternative, the Commission has acted correctly.

Id. at 515.

The rate of return was also at issue in Southwestern Bell. In discussing the breadth of the regulatory authority’s discretion in this area, this Court stated:

The rate of return is not specified in the PURA as any exact percentage. Rather, sections 39 and 40(a) provide that it shall be at least a reasonable return on invested capital, but not more than a fair return on the adjusted value of invested capital. We take these provisions to mean that the Commission has discretion in setting a reasonable or fair return on the value of Bell’s property used or useful in rendering service. In giving the Commission such discretion, we believe that the Legislature has acquiesced in the standard for rate of return set out in the Alvin case. . . . We are not to be understood as holding that the Legislature has codified the Alvin case, because the Commission rather than the trial court must set the rate of return. The PURA also establishes more specific standards in fixing a rate base than the general “fair value” language of Alvin. We do, however, regard the Commission as having the power to determine a percentage rate of return as a fact. The total revenues or monetary return to Bell lies within the limits prescribed by sections 39 and 40, and we regard the revenues as a fair return on the adjusted value of Bell’s invested capital. We therefore uphold the Commission’s determination as to the rate of return and revenues or monetary return to which Bell is entitled. Although we reject the notion of a dual rate base, we hold that the Commission’s alternative method of setting the rate of return and rate base was correct under the PURA.

Id. at 515-16.

Using this pragmatic approach, when the Commission follows section 41(a) in determining the rate base, and the rate of return is within the range prescribed by sections 39 and 40(a), then the statutory and basic legal requirements have been satisfied. Next we must consider how the Examiner reached the results in this case.

Entex does not question the Commission’s finding of a $14,005,509 adjusted value of invested capital rate base or the manner in which that determination was made. However, Entex does argue that it was error for the Commission to calculate the rate of return based on what would be a reasonable return to book common equity of Entex stock. Entex contends that such a determination is equivalent to making a rate base determination based solely on original cost depreciated rather than on fair value as required by Alvin and the PURA. They argue that by basing the rate of return on the return to book common equity, that the Commission has determined the reasonable revenues allowed on an original cost less depreciation base and “backed into” the fair return on adjusted value rate base required by PURA by means of a much lower rate of return. They argue that this “backing in” means of calculation is prohibited by Southwestern Bell. It is urged that the Court should follow the example of the courts in North Carolina, Ohio, Montana and Arizona and hold that the “standard for establishing a rate base must be the fair value of the property and not what the commission might believe was a fair rate of return on common equity.” Simms v. Round Valley Light & Power Co., 80 Ariz. 145, 294 P.2d 378 (1956); see, Arizona Corp. Comm’n v. Arizona Public Service Co., 113 Ariz. 368, 555 P.2d 326 (1976) (en banc); Cleveland Electric Illuminating Co. v. Public Utilities Comm’n of Ohio, 42 Ohio St.2d 403, 330 N.E.2d 1 (1975); Montana v. Public Service Comm’n, 131 Mont. 272, 309 P.2d 1035, 1039 (1957); State Utilities Comm’n v. Duke Power Co., 285 N.C. 377, 206 S.E.2d 269 (1974). Entex concedes that North Carolina, Ohio, and Montana have enacted new statutes departing from the statutory requirements of rate making that was used in the prior cases. It should be noted that none of these cases involved a statutory scheme such as Section 39 of PURA which required a consideration of fair return to invested capital.

In State Utilities Comm’n v. Duke Power Co., 285 N.C. 377, 206 S.E.2d 269 (1974) the North Carolina Supreme Court stated that “It is not for the Commission or for this Court, to evade the mandate of the statute by determining the number of dollars which would be a fair return on the original cost, depreciated, and then simply translating that amount into a percentage of ‘fair value’.” In that case the court concluded that the commission had determined the revenue recovery permitted the utility by: (1) calculating an original cost depreciated rate base; (2) multiplying the original cost rate base by the rate of return necessary to yield the permissible revenue; (3) increasing the rate base to the “fair value” required by statute but lowering the rate of return in the same proportion as the increase in the rate base. Id. at 279.

However, the Duke ease is easily distinguishable from the case before us. In Duke, the issue was whether the rate had actually been based on a fair value rate base, and there was no statutory requirement that invested capital be considered in determining a reasonable rate of return. Here, there is no contention that the Commission did not correctly determine the adjusted fair value rate base, and the PURA requires a consideration of the return to invested Capital in section 39. Therefore, we conclude that the Commission’s consideration of the return to book common equity in setting the rate of return, did not violate the statutory requirement that the rate be based on the adjusted fair value of the utility property used in providing the service.

Entex also argues that the district court was correct in its holding that a 4% rate of return was unreasonable. Texas law no longer provides for a trial de novo review of rate cases or for an “end-result” test as in the Alvin case. After the passage of the Texas Administrative Procedure Act, Tex.Rev.Civ.Stat.Ann. art. 6252-13a (hereinafter referred to as the APA), the standard for judicial review of the Commission’s orders is the substantial evidence rule. The court may reverse or remand the Commission’s decision if it is not reasonably supported by substantial evidence on the agency record, or if it is apparent that the agency action was arbitrary or an abuse of discretion. Southwestern Bell Tel. v. Public Utility Comm’n, 571 S.W.2d 503, 512 (Tex.1978).

Section 16(b) of the APA requires that agency decisions include separately stated findings of fact and conclusions of law. “The findings should be such that a court, on reading them, could fairly and reasonably say that they support the ultimate findings of fact required for its decision.” Railroad Comm’n v. Graford Oil Corp., 557 S.W.2d 946, 950 (Tex.1977). If the agency findings do not support its decision, then the order would be invalid for noncompliance with the APA. Therefore, this Court’s duty in reviewing the Commission’s order setting the rate of return is to insure that the decision was based on substantial evidence. In determining whether there is substantial evidence, we do not substitute our own judgment, but consider only the record upon which the decision was based. Imperial American Resources Fund Inc. v. Railroad Comm’n, 557 S.W.2d 280, 284-85 (Tex.1977). Entex has the burden of proof to show an absence of substantial evidence in the record which would support the Commission’s decision and they have the additional burden of showing that a 4% rate of return is unreasonable and unjust. Id. at 286; Section 40(b) PURA.

It is significant to note that the Examiner’s report adopted by the Commission states that the rate of return must be based on the utility rate base rather than the return to book common equity. However, noting the requirement of section 39 of the PURA, that there be a reasonable return to invested capital, the Commission considered the return to book common equity that would be realized by the requested rate of 8%. It was noted that in a fair value jurisdiction the rate of return multiplied by the rate base usually resulted in a higher return to the book common equity than in an original cost jurisdiction because of the inclusion of the reproduction cost new factor.

At page 14 of the report, the Commission concluded:

It is certainly true that book common equity figures are somewhat deceptive and unreliable but the fact cannot be denied that the return to book common equity is used as a performance indicator by the investor and cannot be ignored by blindly applying a rate of return to the fair value rate base without noting the consequences of such rate of return on the elements of the capital structure. The return to book equity even in a fair value jurisdiction should not be grossly out of line with such a return in an original cost jurisdiction.

(Emphasis added).

The expert witness for Entex testified that: (1) the utility needed a 16% return to the equity portion of the capital structure based on a return to the market value of the stock, rather than a consideration of the return to book common equity; (2) comparable gas distribution companies received a 14 to 16% return on book common equity; (3) he had not considered section 39 or the effect on the return to book common equity in reaching his conclusion; (4) in his opinion the company’s overall cost of capital exceeded 12%; and (5) Entex had asked for an 8% rate of return rather than 12% in order to follow the Commission’s past practice. The City’s experts testified that a return to book common equity of 13.5% to 14.5% would allow Entex to attract ample capital, but recommended that a return of 17.5% be allowed because of the unreliability of book figures. The City’s expert also testified that Entex had previously earned an average return of 21.31% on book common equity compared to other gas utilities in the same period which had earned a return to book common equity of only 12.81%.

The Commission considered the effect of an 8% rate of return on the adjusted value rate base of $14,004,187. When the income expense of $243,258 was deducted from the amount of required operating income, $1,120,335, there remained $877,077 to be applied to book common equity, for a return of 48.17% to book common equity. At page 15 of the adopted report it was concluded:

There is certainly no testimony in the record to support such a high return to book common equity. This is a prime example of the situation where the return on invested capital must be considered as a check on the return to the fair value rate base. The rate of return to the rate base is certainly the primary inquiry to determine the utility’s income requirements. In the same vein, the fairness of the rate base or the rate of return can be measured by the cash requirements of the utility. All are interdependent and ultimately need to be reconciled. . a return to book common equity which is out of proportion, as is true with Entex here, cannot be ignored since it is more than necessary to attract capital, and therefore, unfair to the ratepayer.

(Emphasis added).

The Commission then studied the effect of a 4% rate of return on the return to book common equity, and found that the return would be 17.6%. There is nothing in the report to indicate that the 4% rate of return was the result of a “backing in” type of calculation based on an original cost depreciated rate base. This return to book common equity was higher than the range that had been recommended by the City’s expert witness, but it was allowed by the Commission in order to compensate for various accounting factors.

On the record it would appear that there was substantial evidence to justify the setting of a 4% rate of return, and conversely that there was not substantial evidence to justify the 8% rate requested by Entex. It would also appear that the 4% rate of return was not arbitrary and not an abuse of the Commission’s discretion under the PURA. Therefore, since the statutory requirements and basic legal requirements have been satisfied, and there was substantial evidence in the record to support the Commission’s order, we hold that a 4% rate of return on the adjusted value rate base is not unjust and unreasonable, and we order that the judgment of the district court be reversed, and the Railroad Commission’s order be reinstated.

POPE, J., dissenting in which GREEN-HILL, C. J., and McGEE, J., join. GARWOOD, J., not sitting.

1 . The return to book common equity is a form of historical cost risk analysis and is one of the methods of evaluating proposed utility rates. It is a measure of the return to the common shareholders on their investment, and is often evaluated by regulatory authorities.