TABLE OF CONTENTS
Page
I. BACKGROUND ................................. 1490
II. THE FERC OPINION ........................... 1492
A. The Congressional Purpose in Mandating
"Just and Reasonable" Oil Pipeline
Rates ................................... 1492
B. The Economic Context .................... 1493
C. Rate Base ............................... 1495
D. Rate of Return .......................... 1496
E. Other Matters ........................... 1497
III. The STANDARD OF REVIEW ..................... 1498
IV. FERC's ACTION CONTRAVENES THE STATUTORY
DIRECTIVE TO DETERMINE WHETHER RATES ARE
"JUST AND REASONABLE" ...................... 1500
V. FERC's DECISION LACKS A REASONED BASIS ..... 1510
A. Rate Base ............................... 1511
1. Original Cost Rate Base .............. 1511
a. Parent Guarantees and Capital
Structure ......................... 1513
b. Comparable Risk Analyses .......... 1515
c. The "Front-End Load" Problem ...... 1516
d. The Social Costs and Benefits of
Transition to a New Rate Base
Formula ........................... 1517
2. The Association of Oil Pipelines'
Recommendations ...................... 1518
B. Rate of Return .......................... 1521
1. Risk and Allowance Rate of Return .... 1523
2. The "Inflation Adjustment" and
the "Double Counting" Problem ........ 1523
3. FERC's "Equity Component" Has
No Meaningful Relation to the
Rates of Return on Book Equity ....... 1525
VI. MISCELLANEOUS ISSUES ....................... 1527
A. Purchase Price of Williams' Assets ...... 1527
B. Systemwide vs. Point-to-Point Rate
Regulation .............................. 1528
C. Tax Normalization ....................... 1529
VII. CONCLUSION ................................. 1530
WALD, Circuit Judge:
Petitioners, along with the Department of Justice and the Williams Pipe Line Company, challenge an order of the Federal Energy Regulatory Commission (FERC) on a wide variety of grounds. The FERC order in question specified the generic ratemaking methodology to be applied to all oil pipelines pursuant to the Interstate Commerce Act. In its order, the Commission articulated for the first time its belief that oil pipeline rate regulation should serve only as a cap on egregious price exploitation by the regulated pipelines, and that competitive market forces should be relied upon in the main to assure proper rate levels. Furthermore, in devising a specific ratemaking methodology in accordance with these beliefs, FERC retained the rate base formula used in the past in oil pipeline ratemaking, even though this formula had met with severe criticism from this court in Farmers Union Central Exchange v. FERC, 584 F.2d 408 (D.C.Cir.1978), cert. denied sub nom. Williams Pipe Line Co. v. FERC, 439 U.S. 995, 99 S.Ct. 596, 58 L.Ed.2d 669 (1978). At the same time, the Commission revised its rate of return methodology so that the resulting rate levels would represent ceilings seldom reached in actual practice.
For the reasons set forth below, we find that the Commission's order contravenes its statutory responsibility to ensure that oil pipeline rates are "just and reasonable." In addition, we hold that FERC failed both to give due consideration to responsible alternative ratemaking methodologies proposed during its administrative proceedings, and to offer a reasoned explanation in support of its own chosen ratemaking methodology, and that therefore the FERC order constitutes impermissible "arbitrary and capricious" agency action. Accordingly, we remand this case for further proceedings consistent with this opinion.
I. BACKGROUND
Williams Pipe Line Company (Williams),
Petitioners, various oil producers and refiners that ship their products through Williams' pipeline, challenged the lawfulness of these rates before the Interstate Commerce Commission (ICC) in 1972. After evidentiary hearings, the presiding administrative law judge concluded that the Williams rates were "just and reasonable" within the meaning of the Interstate Commerce Act, 49 U.S.C. § 1(5), and a three-commissioner division of the ICC subsequently adopted in full the administrative law judge's findings. See 355 I.C.C. 102 (1975).
Petitioners then sought judicial review in this court. In 1977, during the pendency of the appeal, Congress transferred regulatory authority over oil pipelines to the newly created Federal Energy Regulatory Commission (FERC).
In February 1979, after Williams had filed other new rate changes, FERC reopened the remanded case, and assigned an administrative law judge (ALJ) to hold hearings on the consolidated cases.
Eight months after reargument, FERC had still failed to issue a decision. Upon petition from Farmers Union, the district court, finding that FERC had abrogated its statutory responsibilities under both the Interstate Commerce Act
On November 30, FERC issued Opinion No. 154, the subject of this appeal. See 21 FERC (CCH) ¶ 61,260 (Nov. 30, 1982). The Department of Justice, representing the United States as statutory respondent under 28 U.S.C. §§ 2344, 2348, joined petitioners in seeking reversal of the FERC opinion.
II. THE FERC OPINION
FERC heralded its Opinion No. 154 (the Williams opinion) as "the longest and most elaborate" decision it had ever issued.
FERC's essential conclusion in Williams is that ratemaking for oil pipelines should serve only "to restrain gross overreaching and unconscionable gouging"
Trans Alaska Pipeline System, 21 FERC (CCH) ¶ 61,092, at 61,285 (Nov. 30, 1982). The following summary describes how FERC reached that conclusion, and how it translated that conclusion into a particular ratemaking methodology.
A. The Congressional Purpose in Mandating "Just and Reasonable" Oil Pipeline Rates
In 1906, Congress adopted the Lodge Amendment to the Hepburn Act, which extended
FERC also found that in the early twentieth century the Standard Oil Company maintained its dominance over the entire American oil business by setting its pipeline rates at such extraordinarily high levels that access to the pipelines (and hence to important downstream markets) was cut off. See 21 FERC at 61,597. From this observation, FERC concluded that the Congress, in mandating that oil pipeline rates be "just and reasonable," intended to outlaw only outrageously high rates: "Prohibitive rates were a means to that end [of dominating American oil markets]. Congress wanted to forbid both the use of the means and the attainment of the end. The policy at which it fired was a policy of `prohibitive' pricing." Id. In the belief that "[t]he phrase in question, `just and reasonable,' is a high-level abstraction[,] ... a mere vessel into which meaning must be poured," id. at 61,594, and considering numerous differences in the reasons for the establishment of a regulatory scheme over "public utilities," such as electric companies, as opposed to "transportation companies," such as oil pipelines, id. at 61,591-96, FERC determined that:
Id. at 61,597. Thus, on the basis of this historical survey, FERC interpreted the statutory mandate that oil pipeline rates be "just and reasonable" to require only the most lighthanded regulation, with no necessary connection between revenue recoveries and the cost of service.
B. The Economic Context
FERC next surveyed the changes since 1906 in the economics of the oil pipeline industry, and determined that the modern
Comparing the dollars spent in 1981 in America for petroleum products to the dollars spent in the same year for oil pipeline transportation,
FERC also found that, from Congress' perspective in 1906, oil pipeline rates did in fact make a difference to the oil consuming public. Reviewing cost and revenue trends, FERC showed that in the past pipeline charges comprised as much as sixty-eight percent of what the oil producer received for crude oil.
Finally, FERC found that the economic market for oil pipelines has become competitive since 1906. In contrast to the industry during the early part of this century, today "[p]rohibitive pricing has become uneconomic"
In light of all the foregoing considerations, FERC expressed its belief that the consumer's interest in low pipeline rates is "submicroscopic" while the real threat to the public is underinvestment in needed oil
FERC then turned to apply this general principle to formulate a ratemaking methodology for oil pipelines.
C. Rate Base
Under the old ICC method, an arcane formula, comprised chiefly of a weighted average of original cost and cost of reproduction new,
In doing so, FERC expressly rejected two proposed alternatives to the ICC ratemaking formula. First, the Commission eschewed original cost ratemaking in the belief that the chief advantage of such an approach — the facilitation of comparable earnings analysis — was of little use in the oil pipeline context, and that the switch to original cost alternative would create unnecessary regulatory burdens and social costs. See infra at 1511-18. Second, FERC rejected specific alterations to the ICC rate base formula proposed by the Association of Oil Pipe Lines because, in FERCs view, only "relatively insubstantial" amounts of money would be affected, and, in any event, the ICC's methodological
Thus FERC reaffirmed the ICC rate base method, admitting it to be "much too blunt or too clumsy for close work," but still finding it "pragmatic" and "usable." 21 FERC at 61,616.
D. Rate of Return
Quoting at length from this court's opinion in Farmers Union I, FERC launched its inquiry into rate of return methods from the premise that "[t]he need for reform is plain."
The first component, debt service, represents the amount needed to pay interest on the debt the pipeline has accumulated. The second component, the suretyship premium, represents the additional amount that would have been needed above actual debt service in the absence of a debt guarantee from the oil pipeline company's parent.
The third component, the "entrepreneurial" rate of return, according to FERC, "follows logically from [the] basic concept that what the historical background and contemporary public policy needs call for here is a cap on gross abuse." Id. at 61,645. Accordingly, FERC offered eight different measures for the "entrepreneurial" rate of return. The measures included the nominal rates of return on book equity realized over the most recent one- or five-year period for (1) the oil industry generally, (2) American industry generally, or (3) the parent company or companies, excluding pipeline operations. The remaining two measures of an entrepreneurial rate of return took the total returns (dividends plus capital gains) on a "diversified common stock portfolio" over (1) the past five years or (2) "the long run — 25 years, 50 years, or more." Id. Under FERC's method, the pipeline would normally be permitted to choose the applicable rate of return from among these indices.
Once this rate of return is selected, it is adjusted downward "[t]o avoid overcompensation for inflation." Id. at 61,646. FERC's methodology subtracts from the selected rate of return the percentage by which the valuation rate base has increased during "the time period that was looked to in order to derive the appropriate nominal rate of return."
This adjusted rate of return is applied not to book equity, nor to the percentage of the valuation rate base represented by the
This method, FERC concedes, would result in "handsome rate base writeups," followed by "creamy returns on book equity." Id. at 61,650. FERC, however, believed that such high returns comported with its general ratemaking principles for oil pipelines: "Here we are setting ceilings that will seldom be reached in actual practice."
E. Other Matters
FERC made three other rulings in Williams that are challenged in this appeal. FERC held that (1) the original cost of transferred pipeline plant — and not its purchase price — should be used in ratemaking, (2) oil pipeline rate regulation should generally take place on a systemwide, rather than point-to-point, basis and (3) the "tax normalization" method of accounting may be employed by the oil pipeline companies if they so wish.
First, FERC set down as a general rule that the "purchase price [for pipeline plant] is not entitled to any recognition at all for any ratemaking purpose."
Second, FERC decided to regulate oil pipeline rates on a systemwide basis. FERC maintained that the alternative — ruling on the reasonableness of particular rates on specific routes — would require cost allocation inquiries that would be "metaphysical inconclusive, and barren." Id.
Third, FERC permitted, but did not require, oil pipeline companies to "normalize" their accounts that reflect accelerated depreciation on equipment for tax purposes.
Finally, FERC prohibited pipelines that choose tax normalization from including the resulting tax reserve accounts in their rate bases. Otherwise, "the rate payer who has paid higher taxes reflecting normalization accounting would be paying the carriers for earnings on the tax differential even though it was the rate payer who contributed the differential in the first place." Id. at 61,657 (quoting San Antonio v. United States, 631 F.2d 831, 847 (D.C.Cir.1980)).
III. THE STANDARD OF REVIEW
The FERC order before us today is an exercise of its general ratemaking authority under 49 U.S.C. § 15(1).
Under the "arbitrary and capricious" standard, a reviewing court must conduct a "searching and careful"
Motor Vehicles Manufacturers Association v. State Farm Mutual Automobile Insurance Co., ___ U.S. ___, 103 S.Ct. 2856, 2867, 77 L.Ed.2d 443 (1983). Most fundamentally, our task is "to ensure that the [agency] engaged in reasoned decision-making." International Ladies' Garment Workers' Union v. Donovan, 722 F.2d 795, 815 (D.C.Cir.1983); see American Gas Association v. FPC, 567 F.2d 1016, 1029-30 (D.C.Cir.1977), cert. denied, 435 U.S. 907, 98 S.Ct. 1457, 55 L.Ed.2d 499 (1978).
Agency decisionmaking, of course, must be more than "reasoned" in light of the record. It must also be true to the congressional mandate from which it derives authority. Therefore, a reviewing court must be satisfied that the agency's reasons and actions "do not deviate from or ignore the ascertainable legislative intent." Ethyl Corp. v. EPA, 541 F.2d 1, 36 (D.C.Cir.) (en banc) (quoting Greater Boston Television Corp. v. FCC, 444 F.2d 841 (D.C.Cir.1970)), cert. denied sub nom. E.I. Du Pont de Nemours & Co. v. EPA, 426 U.S. 941, 96 S.Ct. 2662, 49 L.Ed.2d 394 (1976); see 5 U.S.C. § 706(2)(C) ("The reviewing court shall ... hold unlawful and set aside agency action ... in excess of statutory jurisdiction, authority, or limitations."). Beyond that, however, we are not at liberty to substitute our own judgment in the place of the agency's. In this sense, the "arbitrary and capricious" standard is narrow and restricted. See Small Refiner Lead Phase-Down Task Force, 705 F.2d at 520-21.
The "arbitrary and capricious" standard demands that an agency give a reasoned justification for its decision to alter an existing regulatory scheme. See Motor Vehicle Manufacturers Association, 103 S.Ct. at 2866. We are well aware that changed circumstances may justify the revision of regulatory standards over time. Indeed, our initial remand in Farmers Union I was impelled by our suspicion that prior ICC methods might no longer be useful. See 584 F.2d at 412-20. To acknowledge that circumstances have changed, however, is not to eliminate the burden upon the agency to set forth a reasoned analysis in support of the particular changes finally adopted. Furthermore, in light of the purpose of the remand in Farmers Union I — "to build a viable modern precedent for use in future cases that not only reaches the right result, but does so by way of ratemaking criteria free of the problems that appear to exist in the ICC's approach"
Thus we take up the task of reviewing the Williams opinion with two objectives in mind. First, we will examine whether FERC's actions and supporting rationale comport with its delegated authority to set oil pipeline rates at a "just and reasonable" level. Second, we then will scrutinize the Williams opinion to see whether FERC considered all relevant factors and demonstrated a reasonable basis for its decision. See Sierra Club v. Costle, 657 F.2d 298, 323 (D.C.Cir.1981).
IV. FERC'S ACTION CONTRAVENES THE STATUTORY DIRECTIVE TO DETERMINE WHETHER RATES ARE "JUST AND REASONABLE"
Under section 1(5) of the Interstate Commerce Act, all rates charged for oil pipeline transportation "shall be just and reasonable." Similarly, under section 15(1), Congress authorized FERC "to determine and prescribe what will be the just and reasonable" rate for such transportation services.
Congress delegated ratemaking authority to FERC in broad terms. Accordingly, "the breadth and complexity of the Commission's responsibilities demand that it be given every reasonable opportunity to formulate methods of regulation appropriate for the solution of its intensely practical difficulties." Permian Basin Area Rate Cases, 390 U.S. 747, 790, 88 S.Ct. 1344, 1372, 20 L.Ed.2d 312 (1968). In arriving at a just and reasonable rate, "no single method need be followed." Wisconsin v. FPC, 373 U.S. 294, 309, 83 S.Ct. 1266, 1274, 10 L.Ed.2d 357 (1963). Indeed, and more specifically, FERC is not required "to adhere `rigidly to a cost-based determination of rates, much less to one that base[s] each producer's rates on his own costs.'" FERC v. Pennzoil Producing Co., 439 U.S. 508, 517, 99 S.Ct. 765, 771, 58 L.Ed.2d 773 (1979) (quoting Mobil Oil Corp. v. FPC, 417 U.S. 283, 308, 94 S.Ct. 2328, 2346, 41 L.Ed.2d 72 (1974)).
On the other hand, the delegation of the power to prescribe rates is accompanied by standards to which FERC, as delegate, must conform. As Judge Leventhal observed, "Congress has been willing to delegate its legislative powers broadly — and courts have upheld such delegation — because there is court review to assure that the agency exercises the delegated power within statutory limits...." Ethyl Corp. v. EPA, 541 F.2d at 68 (Leventhal, J., concurring). Surely, FERC enjoys substantial discretion in its ratemaking determinations; but, by the same token, this discretion must be bridled in accordance with the statutory mandate that the resulting rates be "just and reasonable." See FPC v. Texaco, Inc., 417 U.S. 380, 394, 94 S.Ct. 2315, 2324, 41 L.Ed.2d 141 (1974); Atchison, Topeka & Sante Fe Railway Co. v. Wichita Board of Trade, 412 U.S. 800, 806, 93 S.Ct. 2367, 2374, 37 L.Ed.2d 350 (1973).
The "just and reasonable" statutory standard is, of course, not very precise, and does not unduly confine FERC's ratemaking authority. As this court once explained, "[t]he necessity for an anchor to `hold the terms "just and reasonable" to some recognizable meaning' is plain, for the words themselves have no intrinsic meaning applicable alike to all situations." City of Chicago v. FPC, 458 F.2d 731, 750 (D.C.Cir.1971) (quoting City of Detroit v. FPC, 230 F.2d 810, 815 (D.C.Cir.1955)), cert. denied, 405 U.S. 1074, 92 S.Ct. 1495, 31 L.Ed.2d 808 (1972). We therefore seek guidance from basic principles developed by the judiciary in furtherance of its task of assuring that ratemaking agencies conform to their duty to prescribe just and reasonable rates.
City of Chicago, 458 F.2d at 750-51 (emphasis in original). The "zone of reasonableness" is delineated by striking a fair balance between the financial interests of the regulated company and "the relevant public interests, both existing and foreseeable." Permian Basin Area Rate Cases, 390 U.S. at 792, 88 S.Ct. at 1373; see, e.g., FERC v. Pennzoil Products Co., 439 U.S. at 519, 99 S.Ct. at 772; Trans Alaska Pipeline Rate Cases, 436 U.S. 631, 653, 98 S.Ct. 2053, 2066, 56 L.Ed.2d 591 (1978).
The delineation of the "zone of reasonableness" in a particular case may, of course, involve a complex inquiry into a myriad of factors. Because the relevant costs, including the cost of capital, often offer the principal points of reference for whether the resulting rate is "less than compensatory" or "excessive," the most useful and reliable starting point for rate regulation is an inquiry into costs. See, e.g., Mobil Oil Corp. v. FPC, 417 U.S. at 305-06, 316, 94 S.Ct. at 2344-45, 2349; FPC v. Hope Natural Gas Co., 320 U.S. at 602-03, 64 S.Ct. at 287-88. At the same time, non-cost factors may legitimate a departure from a rigid cost-based approach. See, e.g., Pennzoil Products, 439 U.S. at 518, 99 S.Ct. at 771; Mobil Oil, 417 U.S. at 308, 94 S.Ct. at 2345. The mere invocation of a non-cost factor, however, does not alleviate a reviewing court of its duty to assure itself that the Commission has given reasoned consideration to each of the pertinent factors. On the contrary, "each deviation from cost-based pricing [must be] found not to be unreasonable and to be consistent with the Commission's [statutory] responsibility." Mobil Oil, 417 U.S. at 308, 94 S.Ct. at 2346; see Pennzoil Products, 439 U.S. at 518, 99 S.Ct. at 772. Thus, when FERC chooses to refer to non-cost factors in ratesetting, it must specify the nature of the relevant non-cost factor and offer a reasoned explanation of how the factor justifies the resulting rates.
In Williams, FERC departed from these established ratemaking principles. At the outset, we cannot square FERC's statutory responsibilities with its own, quite novel principle that oil pipeline ratemaking should protect against only "egregious exploitation and gross abuse," 21 FERC at 61,649 (emphasis added), "gross overreaching and unconscionable gouging," id. at 61,597 (emphasis added). Rates that permit exploitation, abuse, overreaching or gouging are by themselves not "just and reasonable." FERC itself overreaches the bounds of its statutory authority when it permits such oil pipeline rates, so long as they are not "egregious," "gross" or "unconscionable." Ratemaking principles that permit "profits too huge to be reconcilable with the legislative command" cannot produce just and reasonable
We recognize, of course, that "non-cost" factors may play a legitimate role in the setting of just and reasonable rates. In Williams, FERC invoked the need to stimulate additional oil pipeline capacity as one reason for setting maximum rates at such high levels. See supra at 1494-95. As this court has observed before, "[r]eliance on non-cost factors has been endorsed by the courts primarily in recognition of the need to stimulate new supplies." Consumers Union v. FPC, 510 F.2d 656, 660 (D.C. Cir.1974) (footnote omitted) (discussing Permian and Mobil Oil). However, in this case FERC failed to forecast or otherwise estimate the dimensions of the need for additional capacity, and did not even attempt to calibrate the relationship between increased rates and the attraction of new capital. See supra note 27.
In the absence of such a reasoned inquiry, we cannot countenance FERC's approval of oil pipeline rates which, by FERC's own admission, ensure "creamy returns" to the carriers, 21 FERC at 61,650, and are "far more generous than those [rates] that [FERC] or other regulators give elsewhere," id. at 61,646. In a similar context, this court explained:
City of Detroit v. FPC, 230 F.2d 810, 817 (D.C.Cir.1955), cert. denied sub nom. Panhandle Eastern Pipe Line Co. v. City of Detroit, 352 U.S. 829, 77 S.Ct. 34, 1 L.Ed.2d 48 (1956); see San Antonio v. United States, 631 F.2d 831, 851-52 (D.C. Cir.1980) (ICC action, adding seven percent above costs in setting rates, is arbitrary and capricious because it lacks "adequate justification for [the] choice of a particular increment above fully allocated costs"), rev'd on other grounds sub nom. Burlington Northern, Inc. v. United States, 459 U.S. 1229, 103 S.Ct. 1238, 75 L.Ed.2d 471 (1983); Public Service Commission v. FERC, 589 F.2d at 553-54 (citing cases). In the Williams proceeding, FERC "made no attempt at all to verify the accuracy of its prediction that granting pipeline [rate] incentives will spur increased investment." City of Charlottesville v. FERC, 661 F.2d 945, 955 (D.C.Cir.1981) (Wald, J., concurring). Indeed, FERC here failed to make its prediction with any specificity beyond the bald statement that "[e]verybody agrees that the nation needs and will need more pipeline plant." 21 FERC at 61,614.
FERC also found another basis for its new and liberal interpretation of "just and reasonable" rates in what it labeled the "climate of opinion," prevalent in the early twentieth century, in favor of dismantling the Standard Oil trust. FERC believed that Congress initiated rate regulation of the oil pipelines out of a desire to eliminate prohibitive pricing practices by the Standard Oil Company, and from this belief concluded that the "just and reasonable" standard requires far less stringent rate regulation than the same statutory standard requires for other regulated industries, including those industries once regulated under the very same section of the Interstate Commerce Act. See supra at 1492-93; 21 FERC at 61,578-99; FERC Brief at 29-44. Accordingly, FERC felt that the Interstate Commerce Act permitted ratesetting at levels so high that they would "seldom be reached in actual practice." 21 FERC at 61,649. We cannot endorse this interpretation of FERC's statutory duties.
In some circumstances, the contrasting or changing characteristics of regulated industries may justify the agency's decision to take a new approach to the determination of "just and reasonable" rates. See, e.g., Permian Basin Area Rate Cases, supra. We find, however, that in this case FERC has not merely developed a new method for determining whether a rate is "just and reasonable"; rather, it has abdicated its statutory responsibilities in favor
Furthermore, an examination of the relevant legislative history reveals that Congress intended to subject oil pipelines to the same general ratemaking principles that applied to other common carriers. The Hepburn Act of 1906 was enacted primarily to remedy defects in the original Interstate Commerce Act of 1887. Although the Act as passed in 1887 provided that "[a]ll charges made for any service rendered in the transportation of passengers or property ... shall be reasonable and just; and every unjust and unreasonable charge for such service is prohibited and declared to be unlawful," 24 Stat. 379, the Supreme Court ten years later held that the ICC lacked authority to prescribe rates, but instead could only declare whether charges set by the carriers were unreasonable or unjust in the context of granting reparations to injured shippers. ICC v. Cincinnati, New Orleans & Texas Pacific Railway Co., 167 U.S. 479, 17 S.Ct. 896, 42 L.Ed. 243 (1897) (the Maximum Rate Case); see Trans Alaska Pipeline Rate Cases, 436 U.S. at 639, 98 S.Ct. at 2059. The Hepburn Act remedied this shortcoming by granting to the ICC express authority to set maximum rates to be observed by carriers prospectively. See 49 U.S.C. § 15. In this context, the Congress, by amendment originating in the Senate, adopted the Lodge Amendment, which conferred common carrier status upon oil pipelines, thus subjecting oil pipelines to the ratemaking jurisdiction of the ICC.
It appears evident from the floor debates that oil pipelines were intended to be treated in the same fashion as other common carriers under the Interstate Commerce Act. "It appears to me," Senator Lodge said in support of his amendment, "that it is a plain injustice to the railroads of this country to put them all under the Interstate Commerce Commission, to make the most drastic regulations to control and supervise them, and leave out one of the greatest article of interstate commerce [i.e., oil transported through pipelines]." 40 Cong.Rec. 6365 (1906). "This amendment," he said a few days later, "makes the pipelines and the oil companies subject to all the provisions to the bill." Id. at 7009. Thus Congress chose consciously to regulate oil pipeline rates in accordance with the same principles devised contemporaneously in other provisions of the Hepburn Act, which, as we noted above, augmented the ICC's authority over all common carriers.
The legislative history furthermore evidences that the "just and reasonable" rates prescribed by the Congress in 1906 meant more than a ban on prohibitive pricing. Congress primarily wanted to authorize the ICC to set enforceable rates that would permit the carriers to earn a fair return, while protecting the shippers and the public from economic harm. As Senator Elkins put it:
Legislative History at 879. Discussions of what constituted a just and reasonable rate focused not upon prohibitive pricing practices, but instead on setting a fair price that would be neither excessive to the shipper nor threatening to the financial integrity of the carrier. See, e.g., id. at 854 (remarks of Senator Clay) (Under the "just and reasonable" standard, ICC must determine "whether or not the rate so fixed is confiscatory or not compensatory for the services performed."); id. at 859 (remarks of Senator Clay) ("Can the [ICC's] power be exercised either to oppress the roads or the shippers? Can this power be exercised either to wrong or injure the carrier or the shipper? .... Can the Commission fix a rate that would prevent the railroads from making operating expenses and denying to them just compensation for the services performed? I answer, `No.' ... The object and purpose of this legislation is to make [carriers] do right and to make shippers do right."); id. at 880 (remarks of Senator Culberson) ("[T]he Supreme Court has held that the words `just and reasonable' have relation both to the rights of the public and of the companies, and that the rate must be fixed with reference to the rights of each.").
Additional evidence of congressional intent can be found by examining the decision to delete from the original Hepburn bill the requirement that rates be "fairly remunerative" in addition to "just and reasonable." After quoting the definition of "remunerative" found in a contemporary Standard Dictionary — "Affording, or tending to afford, ample remuneration; giving good or sufficient return; paying; profitable" — Senator Culberson questioned whether the additional phrase served any useful purpose, and worried whether the phrase might "have exclusive reference to the interests of the companies," thus "liberalizing the rule [of `just and reasonable' rates] rather than narrowing it or keeping it where it is under the common law and under the decisions of the Supreme Court." See id. at 880-81. As Senator LaFollette later elaborated:
Id. at 906. Eventually, the phrase was deleted from the bill, in part because the "fairly remunerative" standard was thought to add nothing to the already established "just and reasonable" standard,
While we recognize that the legislative history of the Lodge Amendment contains a number of references to the Standard Oil Company,
Finally, FERC believed that the changes since 1906 in the economics of oil pipelines also justified its novel interpretation of its statutory responsibilities under the Interstate Commerce Act. FERC determined that the cost of pipeline transportation, relative to the price of oil, had become so insignificant that close regulation was not required. See supra at 1493-95. In addition, FERC found that competition in the oil pipeline business had served to keep prices down. See supra at 1494. FERC therefore concluded that oil pipeline ratemaking "can and should rely far more heavily on the market" and that rate regulation should be "peripheral to the pricing process." 21 FERC at 61,649. Accordingly, in FERC's opinion, oil pipeline ratemaking should merely set "ceilings that ... will seldom be reached in actual practice."
We believe that this apologia for virtual deregulation of oil pipeline rates oversteps the proper bounds of agency discretion under the "just and reasonable" standard. First, the fact that oil prices have skyrocketed does not repeal the statutory requirement that oil pipeline rates must be just and reasonable.
Second, we find FERC's largely undocumented reliance on market forces
Legislative History at 677. The courts have echoed this observation, noting that
We recognize that the market price of oil could, "in an individual case, coincide with just and reasonable rates" and may "be a relevant consideration in the setting of area rates; it may certainly be taken into account along with other factors." FPC v. Texaco, 417 U.S. at 399, 94 S.Ct. at 2327 (citations omitted). The Williams opinion, however, goes far beyond what we regard as rational or permissible assumptions about the relationship between "just and reasonable" rates and the market price.
FERC's methodology, by its own admission, merely sets "ceilings seldom reached in actual practice," and permits "creamy returns" to oil pipelines. As we have explained above, such ratemaking does not comport with FERC's statutory responsibilities. FERC's methodology, therefore, exposes a range of permissible prices that would exceed the "zone of reasonableness" by definition, unless competition in the oil pipeline market drives the actual prices back down into the zone. But nothing in the regulatory scheme itself acts as a monitor to see if this occurs or to check rates if it does not. That is the fundamental flaw in the Commission's scheme. See Texaco, Inc. v. FPC, 474 F.2d 416, 422 (D.C.Cir.1972), approved in relevant part and vacated on other grounds, 417 U.S. 380, 94 S.Ct. 2315, 41 L.Ed.2d 141 (1974).
Moving from heavy to lighthanded regulation within the boundaries set by an unchanged statute can, of course, be justified by a showing that under current circumstances the goals and purposes of the statute will be accomplished through substantially less regulatory oversight. See Black Citizens for a Fair Media v. FCC, 719 F.2d 407, 413 (D.C.Cir.1983). We recognize that this court has sanctioned dramatic reductions in regulatory oversight under, for example, the FCC and ICC licensing provisions, both of which require that the licensee operate in accordance with the "public interest." See id.; National Tours Brokers Association v. ICC, 671 F.2d 528, 531-32 (D.C.Cir.1982). In both cases, this court found that the agency adequately assured meaningful enforcement of the public interest standard. See Black Citizens, 719 F.2d at 413-14; National Tours, 671 F.2d at 533. In other cases, this court has refused to sanction administrative attempts to reduce regulation in the absence of a showing that the goals and dictates of statutes were not being honored. See International Ladies' Garment Workers' Union v. Donovan, 722 F.2d 795 (D.C.Cir.1983); Action on Smoking and Health v. CAB, 699 F.2d 1209 (D.C.Cir.), supplemented, 713 F.2d 795 (D.C.Cir.1983).
In this case, FERC failed to show that the rates resulting from its newly articulated ratemaking principles would necessarily satisfy the "just and reasonable" standard. FERC set rate ceilings which, if reached in practice, would admittedly be egregiously extortionate and then failed to demonstrate that market forces could be relied upon to keep prices at reasonable levels throughout the oil pipeline industry. As a result, we find that FERC's action contravenes its statutory responsibilities under the Interstate Commerce Act.
V. FERC'S DECISION LACKS A REASONED BASIS
In the foregoing analysis, we found the general ratemaking principles that guided FERC in the Williams opinion to be "in excess of statutory jurisdiction, authority, or limitations," 5 U.S.C. § 706(2)(C), and "not in accordance with law," id. § 706(2)(A). Because "an agency's action must be upheld, if at all, on the basis articulated by the agency itself," we would remand this case to FERC on the basis of the foregoing considerations alone. Motor Vehicle Manufacturers Association, 103 S.Ct. at 2870; see SEC v. Chenery Corp., 332 U.S. 194, 196, 67 S.Ct. 1575, 1577, 91 L.Ed. 1995 (1947). As independent grounds for our decision today, however, and in light of the apparent need for judicial guidance in this case,
A. Rate Base
In Williams, FERC decided to adhere to the rate base formula it inherited from the ICC. See 21 FERC at 61,632. It gave no rational justification for doing so, however. FERC acknowledged that "rigorous logic and Euclidean consistency are not the system's most striking features," and that the formula is "much too blunt and much too clumsy for close work." It nevertheless concluded that the ICC method is "usable" because oil pipeline ratemaking "is not close work." Id. at 61,616. This is not a sufficient justification.
It is well established that an agency has a duty to consider responsible alternatives to its chosen policy
1. Original Cost Rate Base
Many parties to the Williams proceeding — including the FERC staff, the Department of Energy, the Justice Department, Farmers Union Central Exchange — advocated the calculation of oil pipeline rate bases by reference to original cost.
Despite explicit concessions as to the shortcomings of the ICC rate base formula and the recognized advantages of a rate base formula derived from original cost,
Because of parent companies' debt guarantees and "throughput and deficiencies" agreements, many shipper-owned pipelines are able to obtain debt financing more cheaply and in greater amounts than would be possible in the absence of such agreements. See supra note 58. Further, since cost of equity virtually always exceeds cost of debt, the greater the pipelines' debt ratio, the lower its overall cost of capital. See United States v. FCC, 707 F.2d 610, 613 (D.C.Cir.1983). Accordingly, as FERC recognized in its establishment of a "suretyship premium," see supra at 1496, the "real" cost of capital to a pipeline that benefits from such parent guarantees is greater than its apparent cost of capital.
Regulatory agencies have often assessed a regulated company's true cost of capital by constructing hypothetical capital structures, and then applying the normal costs of equity and debt to the hypothetical mix of securities. See Communications Satellite Corp. v. FCC, 611 F.2d 883, 902-09 (D.C.Cir.1977) (citing numerous cases involving water, gas, electric and telephone utilities). By this method, regulatory agencies ensure that the derived rate is "just and reasonable":
Id. at 903 (quoting New England Telephone & Telegraph Co. v. State, 98 N.H. 211, 220, 97 A.2d 213, 220 (1953)). In the case of oil pipelines, the hypothetical capital structure would be approximated by estimating the capacity of the pipeline to support debt in the absence of its parents' guarantees. See 21 FERC at 61,621.
FERC refused to adopt an original cost rate base in part because it believed that the attendant necessity for constructing hypothetical capital structures would be "a laborious exercise in guesswork, a venture `into the unknown and unknowable.'" Id. at 61,622 (quoting Christiana Securities Co., 45 SEC 649, 668 (1974)). In FERC's view, such an inquiry would be:
Id. at 61,622. In part to avoid such an inquiry, FERC chose to avoid an original cost rate base.
This explanation runs counter not only to the proven practice of FERC and many
Id. at 61,644.
We cannot square FERC's apparent confidence in its ability to estimate a pipeline's "suretyship premium" with its extreme skepticism about its ability to construct hypothetical capital structures. After all, the "suretyship premium" represents merely the differential between a pipeline's actual cost of capital and what its cost of capital would have been absent the parent guarantees. Thus the "suretyship premium" measures the same incremental cost of capital to the pipeline as the hypothetical capital structures that FERC felt incapable of estimating. The basis for FERC's preference for its "suretyship premium" approach, and for its aversion to hypothetical capital structures is therefore unclear. The decision to reject original cost accounting on the basis of this preference and aversion appears arbitrary, and, in any event, lacks sufficient explanation.
Moreover, even assuming that FERC's preference for its suretyship premium approach could be explained, its rejection of original cost ratemaking because of that preference relies on the assumption that original cost ratemaking is necessarily tied to hypothetical capital structures and necessarily incompatible with its newly devised "suretyship premium." However, FERC never gave any reason at all why this assumption is valid. Indeed, we see no reason why FERC could not account for the parent guarantees by using a suretyship premium added to an original cost ratemaking formula.
If FERC, in the exercise of informed discretion, decides that the suretyship premium approach is more reliable or easier to administer than hypothetical capital structures, then it should state why.
FERC discerned still "more fundamental problems" associated with the use of original cost ratemaking, beyond the estimation of appropriate capital structures. As typically applied under the "just and reasonable" standard, original cost ratemaking attempts to set the rate of return for a regulated enterprise at the same level as the rate of return of an unregulated enterprise with similar associated risks. See, e.g., FPC v. Hope Natural Gas Co., 320 U.S. 591, 603, 64 S.Ct. 281, 288, 88 L.Ed. 333 (1944) ("By that standard [of `just and reasonable' rates] the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks."); Bluefield Water Works & Improvement Co. v. Public Service Commission, 262 U.S. 679, 692, 43 S.Ct. 675, 679, 67 L.Ed. 1176 (1923) ("A public utility is entitled to such rates as will permit it to earn a return ... 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 the same risks and uncertainties."); A. Priest, Principles of Public Utility Regulation 191-94 (1969). FERC, however, believed that such a risk inquiry was not useful or relevant to oil pipeline ratemaking. In FERC's view, oil company managers — who own many oil pipelines — are a special breed of risk takers, who demand "a fair chance of earning as much on a pipeline as they would be likely to earn on something else in the unregulated sector" regardless of risk. 21 FERC at 61,623.
We think that this argument not only lacks any evidentiary support, it also lacks economic common sense. In neither the Williams opinion nor in its briefs to this court does FERC cite any evidentiary basis for its conclusion that oil managers will invest in only high return enterprises. In fact, the record is chock full of testimony regarding the risks of the oil pipeline business and the corresponding appropriate rate of return.
G. Wolbert, Jr., U.S. Oil Pipelines, 156 (1979) (footnotes omitted); see Exxon Pipeline Co./Exxon Co., U.S.A., Rates of Return on Petroleum Pipeline Investments, reprinted in Oil Pipelines and Public Policy 261, 268-69 (E. Mitchell ed. 1979) ("`The required rate of return on an investment opportunity depends on the riskiness of the investment. The greater the riskiness of the investment, the more the return demanded by investors.'") (quoting E. Solomon & J. Pringle, Introduction to Financial Management 332 (1977)).
ICC oil pipeline ratemaking precedents also belie FERC's novel notions about the relationship between risk and required return in the industry. FERC's notion that the oil companies demand high returns, no matter how low the risk, represents a radical departure from the ICC practice of evaluating risk and estimating the required return accordingly. See, e.g., Reduced Pipe Line Rates and Gathering Charges, 272 I.C.C. 375, 381 (1948); Minnelusa Oil Corp. v. Continental Pipe Line Co., 258 I.C.C. 41, 51 (1944); Reduced Pipe Line Rates and Gathering Charges, 243 I.C.C. 115, 131 (1940). Similarly, in 1978 this court called on FERC to reexamine the "complex of relevant factors" in determining the proper rates of return for oil pipelines, including the hazards prevailing in the pipeline business. See Farmers Union I, 584 F.2d at 419.
We thus find no basis to support, and overwhelming evidence to contradict, FERC's finding that comparable risk analysis has no important role in oil pipeline rate regulation. We therefore believe that FERC's rejection of original cost ratemaking on the basis of that finding is arbitrary and capricious.
c. The "Front-End Load" Problem
FERC next offered another, independent reason for rejecting original cost ratemaking: the "front-end load" problem.
21 FERC at 61,630. According to FERC, this "simpler and more logical" method would "[k]eep[] the rate base in tune with the general price level by linking it to the consumer price index or to the gross national product." Id. The trended original cost method of calculating rate bases, as discussed by witnesses in the Williams proceeding and other experts, fits this description. See, e.g., J.A. at 1508-12 (testimony of Stewart C. Myers on behalf of Marathon Pipe Line Co.); J.A. at 1957 (testimony of David A. Roach on behalf of MAPCO); Streiter, Trending the Rate Base, Pub. Util. Fort., May 12, 1982, at 32; cf. J.A. at 1677-1702 (testimony of Michael C. Jensen on behalf of ARCO Pipe Line Co.) (describing "inflation-adjusted original cost" method, the results of which are "equivalent to adjusting the rate base and depreciation by the unprojected inflation"). Indeed, at one point, FERC declared that if it were "beginning afresh on a clean slate [it] might be inclined to use something ... along the lines suggested by Marathon's witness Meyers [sic]." 21 FERC at 61,616. Marathon's witness Myers recommended the use of a trended original cost rate base if the old ICC method were to be abandoned. See J.A. at 1427, 1499. Thus FERC acknowledged that the front-end load problem could be solved, by adjusting an original cost rate base for inflation. Accordingly, FERC could not have reasonably relied upon the "front-end load" problem as a basis for rejecting the admittedly "simpler and more logical" trended original cost alternative.
d. The Social Costs and Benefits of Transition to a New Rate Base Formula
Although a trended original cost approach would evidently be "simpler and more logical than the ICC's," 21 FERC at 61,630, FERC in the end rejected this alternative because of the "social costs entailed" in a transition from one rate base formula to another. See supra at 1512. FERC specified these "social costs" in an accompanying footnote:
Id. at 61,704 n. 376. We are reluctant to sanction the rejection of an admittedly more logical and accurate rate base formula on the basis of the conclusionary statement that the construction of "transitional rate bases" would be too costly. First, FERC failed to give a reasoned basis for its assumption that "[t]ransitional rate bases would have to be constructed" at all. Regulated industries have no vested interest in any particular method of rate base calculation. See FPC v. Natural Gas Pipeline Co., 315 U.S. 575, 586, 62 S.Ct. 736, 743, 86 L.Ed. 1037 (1942). Accordingly, as FERC acknowledged, a switch to a new rate base formula would not disrupt protected pipeline property. So long as the resulting rates are reasonable, the oil pipeline companies should have no difficulty maintaining their financial integrity. We
Second, FERC never explained why the construction of transitional rate bases would be so formidable a task. It is not self-evident why the calculation of such rate bases would entail more regulatory costs than the calculation of rate bases under the arcane ICC formula.
Finally, regardless of the regulatory or social costs entailed, FERC appeared to reject alternatives to the ICC formula because it found "no clear showing" that changing the methodology would "produce substantial social benefits." Id. at 61,626; see also id. at 61,703 n. 373. This finding, however, apparently relies upon FERC's antecedent findings that oil pipeline ratemaking should merely set price ceilings that would seldom be reached in actual practice, and that comparable risk analysis would not be helpful to the ratemaking inquiry for oil pipelines. However, we have found those antecedent findings to be defective. See supra at 1502-03, 1515-16. As a result, we likewise disapprove of FERC's finding that a new rate base formula could not produce any substantial social benefit.
After carefully reviewing the bases put forward by FERC for rejecting the original cost alternative, we hold that FERC failed to "examine the relevant data and articulate a satisfactory explanation for its action." Motor Vehicle Manufacturers Association, 103 S.Ct. at 2866. In our view it did not offer a reasoned explanation for adhering to an admittedly antiquated and inaccurate formula, but rather a host of unconvincing excuses that fail to add up to a rational choice.
2. The Association of Oil Pipelines' Recommendations
The Association of Oil Pipelines (AOPL) endorsed the ICC valuation approach to rate base calculations. See J.A. at 3870 (AOPL Opening Brief to FERC). AOPL, however, did not endorse the ICC approach in all its details. Instead, it asked FERC to make the following alterations to the ICC formula:
See J.A. at 3915-17 (AOPL Opening Brief). AOPL argued that these modifications "would improve the accuracy of the valuation rate base." Id. at 3917.
FERC rejected AOPL's proposals, finding that (1) only "relatively insubstantial" amounts were at stake, (2) the six percent going concern value roughly compensates for methodological errors elsewhere, and (3) the old ICC method should not be altered without first engaging in a notice and comment rulemaking on the proper method of calculating depreciation. See supra at 1496. AOPL argues to this court that FERC's rejection of its proposals was arbitrary and capricious agency action because it was "not supported by reasoned findings based on the evidence of record." AOPL Brief at 35-39. We agree.
We note at the outset that FERC failed, both in the Williams opinion and in its briefs to this court, to provide any factual basis in the record for its conclusion that "the sums involved are relatively insubstantial." 21 FERC at 61,631. On the other hand, AOPL cites unrebutted testimony in the record that the use of the ICC's "period indices" results in "consistently and substantially understated current valuations." J.A. at 1180 (testimony of John A. Jeter of Arthur Anderson & Co.). This same witness provided further unrebutted testimony that the ICC's allowance for interest during construction should be "much higher" in order to reflect current interest levels. See id. at 1183-85. Furthermore, in its brief, FERC states that the ICC rate base formula "significantly undercounts for interest during construction, several other construction-related elements, and the value of land."
FERC, however, felt that the need for change was "far from pressing" because it believed that the six percent going concern value in a rough way compensated for the other flaws in the ICC methodology. Thus FERC rejected all of AOPL's objections on the grounds that the over -counting due to the going concern value — which would by itself be "pure water," id. — was in effect
In basic terms, FERC reasoned that a series of inaccuracies is permissible because another inaccuracy systematically compensates for the prior errors. Such an approach, of course, assumes that the two errors are in fact predictably related to one another so that the anticipated self-correction will actually take place. In this case, however, FERC failed to make any finding to assure that the errors will offset each other. Especially when, as here, the proposed methodological adjustments appear easy to make, and the methodological defects are discrete, clear and acknowledged, FERC indulged an unreasonable presumption that its two wrongs would in practice render a right result. In the absence of any explanation of what warrants such an assumption, we find FERC's rejection of the AOPL proposals to be arbitrary and capricious.
Neither did FERC explain why its decision on the AOPL proposals should be delayed until it could conduct a notice and comment rulemaking on depreciation methods. FERC merely declared that "it would be wrong to alter the status quo without looking at the whole picture." Id. at 61,632. It is not at all apparent, however, why a decision on the AOPL proposals should be considered so intimately related to depreciation policy. FERC offered no rationale for its assumption that the changes proposed by AOPL should not be made separately from the decisions on depreciation policy. In fact, all of AOPL's proposals would apparently improve the accuracy of the rate base formula, regardless of the particular depreciation method employed. Thus, the adoption of the AOPL proposals would not seem to have any significant bearing on the future consideration of depreciation policy alternatives. FERC also made other similar adjustments to the rate base formula without examining "the whole picture." See FERC Brief at 71 n. 81. Moreover, FERC expressly declined to commit itself to ever conducting a rulemaking on depreciation issues:
21 FERC at 61,632. While we recognize that an administrative agency may exercise its informed discretion in deciding whether to proceed on a given issue by way of rulemaking or adjudication, see, e.g., NLRB v. Bell Aerospace Co., 416 U.S. 267, 294, 94 S.Ct. 1757, 1771, 40 L.Ed.2d 134 (1974); SEC v. Chenery Corp., 332 U.S. 194, 203, 67 S.Ct. 1575, 1580, 91 L.Ed. 1995 (1947), we believe that in this case FERC failed entirely to make any such choice. Instead, FERC decided to delay implementation of the AOPL proposals, which it said were "well taken" and were deserving of "a hard look," id. at 61,631, until it could conduct a seemingly unrelated depreciation rulemaking, which it then said might never take place. Such self-contradictory, wandering logic does not constitute an adequate explanation for its rejection of admittedly valuable proposals.
In sum, we hold that FERC failed to explain adequately its rejection of both the original cost alternative and AOPL's proposed alterations. We emphasize that this holding does not go to the wisdom or efficacy of the ICC rate base formula, although the Williams opinion does not provide a cogent defense of it.
Even in the absence of such infirmities in FERC's method of choice among rate base methods, our review would still include scrutiny of the rate of return methodology, to see whether the selected rate of return, applied in combination with the selected rate base, leads to a reasonable result. As FERC observed, the agency must assure that "the combination of rate base and rate of return provides a[n] ... acceptable end result." 21 FERC at 61,616. We now proceed to examine whether FERC engaged in reasoned decisionmaking when it chose its rates of return for use in oil pipelines ratemaking.
B. Rate of Return
FERC divided its rate of return into three components: (1) debt service, (2) the suretyship premium, and (3) the "`real' entrepreneurial rate of return on the equity component of the valuation rate base." 21 FERC at 61,644. The debt service element, which represents the cost of interest and repayment of indebtedness, gives rise to no objections from the parties, and need not detain us.
The suretyship premium similarly demands little comment apart from our previous observations that it requires much of the same kind of theorizing involved with the use of hypothetical capital structures. See supra at 1513-14. Farmers Union believes that FERC "erred when it assumed that such a premium is an `add on' to the cost of capital without comparing pipeline and parent company risk." Farmers Union Brief at 59 n. 1. Our reading of the Williams opinion, and FERC's representations to this court, however, convince us that FERC made no such assumption, and, accordingly, pipelines must show that the guarantees reduce perceived investor risk in order to establish their entitlement to and extent of a suretyship premium. See 21 FERC at 61,621, 61,644, 61,711 nn. 492, 493; FERC Brief at 72-73.
Only the "real entrepreneurial rate of return on the equity component of the valuation rate base" remains. FERC began its discussion of this component from the premise that "[i]t seems obvious to us that allowed real rates of return on oil pipeline equity investments should be appreciably higher than those the Commission awards to natural gas pipelines and to wholesalers of electric energy." 21 FERC at 61,645. Considering that "oil companies [and the
See 21 FERC at 61,645. FERC further held that "it would normally be proper to choose the measure most favorable to the particular carrier or carriers involved." Id.
Although most of these rates of return are expressed in terms of return on the book equity of unregulated companies, i.e., on the basis of original cost,
We frankly cannot locate the rhyme nor reason of this rate of return methodology; nor is it based upon a consideration of all relevant factors in oil pipeline ratemaking. To begin with, FERC offered no rational explanation that linked its regulatory purposes with its chosen rate of return indices. FERC made no attempt to estimate the risks involved with oil pipeline operations, and therefore could not reasonably estimate the rate of return required to maintain a viable oil pipeline industry. Moreover, in summary form, with a more elaborate discussion below, the "inflation adjustment" to the selected rates of return does not reliably compensate for the appreciation to the valuation rate base, and, therefore, overcompensation for inflation is not reliably prevented. FERC's willingness to permit the oil pipeline companies to choose among a wide variety of rate of return indices only makes these defects worse. FERC's method of calculating the "equity component" of the rate base further enlarges the allowable returns without good reason. As a result, the total returns allowable under FERC's methodology have no discernible regulatory significance beyond the fact that they are bound to be very large. FERC does not even offer an explanation of why its ratemaking formula
1. Risk and Allowable Rate of Return
As previously discussed, FERC made no effort to study and estimate the risks associated with oil pipeline operations. Accordingly, FERC offered no reason to believe that the risks associated with the unregulated enterprises from which it derived its rates of return were equivalent to the risks of running an oil pipeline.
FERC attempted to establish such a connection by arguing:
21 FERC at 61,645-46 (emphasis in original). The first sentence of this passage lacks any semblance of valid reasoning from the record. FERC never even attempted to establish that the relevant segments of the economy's unregulated sector were in fact "roughly comparable" to the oil pipelines. If the enterprises were "roughly comparable," the reference to them might be justified. FERC, however, assumed, without explanation, the existence of that factual predicate in order to justify its selected rate of return indices. Unfortunately, this assumption is not supported by any sound explanation based on the record, and therefore this attempted justification rests on nothing more than a blind, conclusionary assertion of "rough comparability."
The second paragraph in this passage makes use of a non sequitur. In preceding paragraphs, FERC had permitted the oil pipelines to choose a rate of return for themselves from a buffet bedecked with those found in a wide variety of lucrative unregulated enterprises. It is therefore pure illogic to assume that the "risk problem" is the spectre that the oil pipelines might claim entitlement to even greater rewards. As we have discussed above, the real "risk problem" with FERC's methodology — the problem FERC entirely failed to address — lies in whether FERC's selected indices grossly overestimate the risks and needed returns prevailing in the oil pipeline business.
2. The "Inflation Adjustment" and the "Double Counting" Problem
The problem of "double counting" for the effects of inflation, once in the rate base and again in the rate of return, has plagued oil pipeline ratemaking for some
FERC attempted to eliminate the double counting problem by subtracting an "inflation allowance" from the nominal rate of return before applying it to the "inflation-sensitive" ICC valuation rate base. See 21 FERC at 61,646-47. Because the nominal rates of return are derived from original cost accounting, see supra at 74, they include a premium to compensate investors for the expected future rate of inflation. However, because the ICC valuation rate base is, according to FERC, already "inflation-sensitive," FERC's method should deduct from the nominal rate of return the percentage by which the valuation rate base has been "written up" during "the relevant period." Id. at 61,647. FERC defined "the relevant period" to be "the time period that was looked to in order to derive the appropriate nominal rate of return." Id. at 61,712 n. 511. For example, if the nominal rate of return were set by reference to returns on shareholder book equity over the most recent year, that nominal rate would be reduced by the percentage amount that the valuation rate base had increased over the most recent year. In this way FERC believed it could "avoid overcompensation for inflation." Id. at 61,646.
Farmers Union, among others, objects to this "inflation adjustment" on the ground that it does not compensate for actual inflation. It put forward strong evidence, including calculations made by Commissioner Hughes in his separate statement, to show that the valuation rate base does not track inflation in any predictable manner.
FERC in a footnote anticipated such a criticism, and responded: "Suppose that [the ICC formula] does lead to an overly generous allowance for inflation in the rate base. What of it? The rate of return on equity is reduced by the precise amount of the overstatement." 21 FERC at 61,712 n. 513. This defense is sound, as far as it goes. Speaking precisely, FERC's "inflation adjustment" does not operate as an adjustment to compensate for the effects of inflation; rather, it operates as an adjustment to compensate for the effects of rate base appreciation, which, if left in the calculus, would lead to "double counting."
Unfortunately, however, and without explanation, FERC decided that the needed adjustment should be determined by reference to rate base appreciation during "the time period that was looked to in order to derive the appropriate nominal rate of return." See supra at 1524. This time period could range from "the most recent year" only, to "the long run — 25 years, 50 years, or more." 21 FERC at 61,645; see supra at 1522. The allowable returns to the pipeline, by contrast, reflect the entire appreciation in the rate base over the life of the pipeline's assets. The "inflation adjustment," therefore, will not necessarily reflect the full rate of write up reflected in the rate base. Furthermore, it is likely that the "inflation adjustment" will leave in the final rates significant "double counting," because under FERC's method the oil pipelines are empowered to select for themselves the applicable rate of return index, and, as a corollary, they also select the time period relevant to calculating the "inflation adjustment." Accordingly, the FERC methodology allows the oil pipeline companies to select a time period during which the rate base appreciated at a slower rate than average. In this way, the FERC method permits the regulated companies to select the rate of return index that will result in an adjustment that understates the actual overall rate base appreciation. In Commissioner Hughes' words, the FERC method "invites an enormous amount of gamesmanship. Eight rate of return options are suggested, some with multiple choices of time periods. The inflation/valuation variance gives an exciting new twist to a pipeline's choice among the candidates. Thus a firm might choose to base its return one year on stock market performance after a bull market, and in its next filing switch to a high oil company comparison which might be offset by a small increase in its own valuation." 21 FERC at 61,726 (Hughes, Comm'r, dissenting in part and concurring in part).
3. FERC's "Equity Component" Has No Meaningful Relation to the Rates of Return on Book Equity
Even more capricious was FERC's application of the rates of return, representing revenues on the book equity of unregulated companies, to what FERC called the "equity component of the valuation rate base." As noted above, FERC's notion of the equity component includes the original paid-in equity of the pipeline plus the entire write up in the rate base. See supra at 1522. For example, consider an oil pipeline, originally financed with $900,000 debt and $100,000 equity. The original cost of the pipeline is one million dollars. Over time, the pipeline's valuation rate base increases to, say, $1,500,000. Under FERC's method, the equity component of the rate base amounts to $600,000, six times its book equity, even though the valuation rate base as a whole has appreciated only by half. Thus, FERC's method magnifies the "equity component" of the rate base to spectacular proportions, especially in an industry as highly debt-leveraged as the oil pipelines.
Assuming arguendo that the "inflation adjustment" accurately compensates for the rate of rate base appreciation, which it does not, see supra at 1524-25, such an adjustment would compensate only for the appreciation attributable to the portion of the rate base financed by the paid-in capital of equityholders. It would never compensate for the fact that FERC includes the entire appreciation on the rate base — attributable to both the equity and debt components of the pipeline — in its "equity component." Accordingly, FERC's method ensures that the allowable revenues for oil pipelines will exceed the revenues earned by its selected unregulated companies by the extent to which the pipelines' "equity component" exceeds the portion of the rate base financed through equity investments. Cf. 21 FERC at 61,712 n. 519 (under the "more austere standard of fairness," FERC "would trend only the equity portion of the rate base for inflation"). In most cases, this difference will be very large.
Indeed, FERC provides no analysis of why its application of its selected rates of return to an unrelated measure of rate base equity should keep "a cap on gross abuse" in the resulting rates, not to mention the lack of any assurance that the resulting rates will be "just and reasonable." Commissioner Hughes appears to have rightly characterized FERC's game as Dialing for Dollars instead of The Price is Right. See 21 FERC at 61,730 n. 4 (Hughes, Comm'r, dissenting in part and concurring in part). We cannot condone such a ratemaking methodology, which assures nothing except that permissible rate levels will be very high.
In an attempt to defend the mismatch between its selected rates of return (on book equity) and its "equity component of the valuation rate base," FERC claimed that its method of calculating the "equity component" gives the equityholders the full benefit of debt leveraging. Just as a seller of a house benefits from the entire appreciation of the value of the house regardless of the amount of debt that financed the original purchase, FERC believed that so, too, should the equityholders in oil pipelines receive an "equity kicker" in their rate base. See 21 FERC at 61,648-50. This analysis overlooks the fact that oil pipeline companies are in fact free to sell their assets, and thereby enjoy the full benefit of debt leveraging in the difference
While the determination of a fair rate of return cannot and should not be constrained to the mechanical application of a single formula or combination of formulas, the ratemaking agency has a duty to ensure that the method of selecting appropriate rates of return are reasonably related to the method of calculating the rate base. See, e.g., FPC v. Hope Natural Gas Co., 320 U.S. 591, 605, 64 S.Ct. 281, 289, 88 L.Ed. 333 (1944); Dayton Power & Light Co. v. Public Utilities Commission, 292 U.S. 290, 311, 54 S.Ct. 647, 657, 78 L.Ed. 1267 (1934); NEPCO Municipal Rate Committee v. FERC, 668 F.2d 1327, 1342 (D.C.Cir.1981), cert. denied, 457 U.S. 1117, 102 S.Ct. 2928, 73 L.Ed.2d 1329 (1982). Our disapproval of FERC's decision to retain the ICC rate base formula, see supra at 1520-21, did not turn on the substantive validity of the rate base calculations. FERC may adopt any method of valuation for rate base purposes so long as the end result of the ratemaking process is reasonable. See, e.g., FPC v. Natural Gas Pipeline Co., 315 U.S. 575, 586, 62 S.Ct. 736, 743, 86 L.Ed. 1037 (1942); NEPCO Municipal Rate Committee v. FERC, 668 F.2d at 1333; Washington Gas Light Co. v. Baker, 188 F.2d 11, 18 (D.C.Cir.1950), cert. denied, 340 U.S. 952, 71 S.Ct. 571, 95 L.Ed. 686 (1951). Rather, our disapproval arose out of the FERC's failure to give a reasoned explanation for its rejection of responsible rate base alternatives. We now find, however, as a result of the foregoing considerations, that the combination of FERC's rate base and rate of return methodologies does not produce an acceptable "end result." Accordingly, we disapprove FERC's ratemaking methodology on this additional basis.
VI. MISCELLANEOUS ISSUES
A. Purchase Price of Williams' Assets
As discussed supra at 1497, FERC rejected the Williams Company's attempts to use the purchase price of its assets in its rate base and depreciation basis calculations. FERC soundly held that the use of purchase price instead of original cost in rate base calculations would engender an undue incentive to trade pipeline assets at a high price, which, under a purchase price regime, would increase allowable rates.
B. Systemwide vs. Point-to-Point Rate Regulation
As discussed supra at 1497, FERC decided in Williams to regulate oil pipeline rates on a systemwide, rather than a point-to-point basis. FERC did so by way of a short discussion, on the assumption that the ICC had in the past given "scant attention to particular rates on specific routes." 21 FERC at 61,650. Farmers Union objects to this ruling. It challenges FERC's interpretation of past ICC precedents, citing ICC cases in which rates were determined by reference to specific point-to-point movements and their related costs and valuations. See Farmers Union Brief at 69. Farmers Union also noted that the Interstate Commerce Act requires "every unjust and unreasonable charge ... [to be] prohibited and declared to be unlawful." 49 U.S.C. § 1(5) (emphasis added). Finally, it contends that systemwide rate regulation could shield rate discrimination from proper remedy.
Our review of relevant ICC precedents shows that past oil pipeline proceedings have included attempts to set rates "computed on a detailed allocation of costs to the proper section of the pipe-line system." Petroleum Rail Shippers' Association v. Alton & Southern Railroad, 243 I.C.C. 589, 663 (1941); see Minnelusa Oil Corp. v. Continental Pipe Line Co., 258 I.C.C. 41, 54-55 (1944). In both proceedings, the ICC allocated the operational costs of transportation from each originating station, averaged as to distance and weighted as to volume, to every terminal in the relevant system. Because oil pipelines rates are charged on a point-by-point basis, such cost allocation ensures that the costs of providing service over a given territory will be recovered only from the companies that use that particular service. See Minnelusa Oil Corp., 258 I.C.C. at 53 ("Operating conditions of defendant pipe lines in Rocky Mountain territory are more difficult than those of pipe line in territory east thereof,
However, we need not decide this issue at this time, because FERC made its decision prematurely. The ALJ identified the following issue for consideration during Phase I of the Williams proceeding:
J.A. at 242 (Invitation to Submit Comments) (emphasis added). The ALJ designated this question as a "rate base issue." Id. at 241. FERC's ruling, however, went well beyond the determination of the rate base issue, and decided further to abandon all cost allocation to particular pipeline segments, calling the allocation inquiry "metaphysical, inconclusive and barren." 21 FERC at 61,651. Previous ICC cases make clear that the question whether to "determine rate base upon a system-wide or upon a segmented basis" is separate from the question whether costs should be allocated to particular pipeline segments. In those prior ICC cases, the rate base valuation was not broken down into line sections, but the ICC nevertheless proceeded to allocate costs to the proper sections of the pipeline. See Minnelusa Oil Corp., 258 I.C.C. at 54; Petroleum Rail Shippers' Association, 243 I.C.C. at 663. The rate base issue goes to the determination of the proper valuation units upon which a rate of return will be earned, and accordingly constitutes a proper element of the Phase I inquiry, which centered on how to calculate allowable revenue requirements for an oil pipeline. The cost allocation issue, by contrast, determines the fair distribution of the burdens of meeting those revenue requirements among the oil pipeline's customers. See Bonbright, Principles of Public Utility Rates 291-93 (1961). Thus, the cost allocation issue is more properly characterized as a question of rate design. See, e.g., Second Taxing District v. FERC, 683 F.2d 477, 480 (D.C.Cir.1982); Cities of Batavia v. FERC, 672 F.2d 64, 80 (D.C.Cir.1982).
The ALJ, however, expressly deferred rate design issues until Phase II of the proceedings. See J.A. at 243 (Invitation to Submit Comments) ("A number of additional issues, such as `rate design' ... were suggested.... Those suggestions were not adopted because, in most instances, the issues raised appear to be more appropriate for consideration in Phase II of this proceeding."); id. at 245 (remarks of ALJ at outset of prehearing conference) ("Someone also raised the question of rate design. I consider those Phase II issues. Those issues tend to vary with the particular pipeline."). Accordingly, we find that FERC decided an issue not properly before it.
C. Tax Normalization
As discussed supra at 1498, FERC decided in Williams to permit oil pipeline companies to decide for themselves whether or not to use tax normalization accounting, but in any event prohibited companies that choose normalization from including the resulting tax reserve accounts in their
We think that this challenge misses the mark. Regardless of whether an oil pipeline may include tax reserve accounts in its rate base, tax normalization accounting would permit it to benefit from accelerated depreciation without having to flow those benefits through to its customers. Unregulated companies, of course, do not concern themselves with rate bases, and yet they choose accelerated depreciation solely because it permits them to defer a tax burden. The oil pipeline companies that choose normalization accounting also enjoy the benefit of tax deferral. The amount in the resulting deferred tax account can earn interest even if it is not included in the rate base. Accordingly, we reject AOPL's notion that FERC's ruling "completely eliminates" any normalization benefit.
VII. CONCLUSION
For the reasons set forth above, we remand this case to FERC. We hope and expect that FERC will accord to this case the high priority that it deserves. In light of its excessive long pendency, this case should be disposed of in a reasonably speedy manner. FERC may find it necessary to take additional evidence in light of this court's opinion, but in any event, FERC already has the benefit of an extensive record and should be able to issue a new order within the next twelve months.
We emphasize that FERC should give serious and thoughtful consideration to the admittedly difficult problems presented by this case. Throughout this opinion we intended to provide some important and basic guideposts to assist FERC in that mission. Most fundamentally, FERC's statutory mandate under the Interstate Commerce Act requires oil pipeline rates to be set within the "zone of reasonableness"; presumed market forces may not comprise the principal regulatory constraint. Departures from cost-based rates must be made, if at all, only when the non-cost factors are clearly identified and the substitute or supplemental ratemaking methods ensure that the resulting rate levels are justified by those factors. In addition, the rate of return methodology should take account of the risks associated with the regulated enterprise. It should not be forgotten, too, that the choice of a proper rate of return is only part of what should be an integrated ratemaking method, and accordingly FERC must carefully scrutinize the rate base and rate of return methodologies to see that they will operate together to produce a just and reasonable rate.
In all these respects, the original cost methodology, a proven alternative, enjoys advantages that should not be underestimated. FERC should reexamine this alternative, and others, in this proceeding which, after all, was instituted in order to take a fresh and searching inquiry into the proper ratemaking method for oil pipelines. In this way, we hope that FERC can meet its statutory responsibilities without any further undue delay.
So ordered.
FootNotes
More specifically, we found that the ICC methodology — which attempts to arrive at a valuation rate base — was formulated in an era during which the Supreme Court required ratemaking based upon the "fair value" of the enterprise's capital. See, e.g., Missouri ex rel. Southwestern Bell Tel. Co. v. Missouri Pub. Serv. Comm'n, 262 U.S. 276, 43 S.Ct. 544, 67 L.Ed. 981 (1923); Smyth v. Ames, 169 U.S. 466, 18 S.Ct. 418, 42 L.Ed. 819 (1898). In 1944, however, "the Supreme Court decisively reversed its field and became openly critical of talismanic reliance on `fair value.'" Farmers Union I, 584 F.2d at 414 (citing FPC v. Hope Natural Gas Co., 320 U.S. 591, 601, 64 S.Ct. 281, 287, 88 L.Ed. 333 (1944)).
Furthermore, we found in Farmers Union I that the economic conditions facing the oil pipeline industry had changed dramatically since the days when the ICC formulated its ratemaking methods. In contrast to the 1940s, "the modern onslaught of inflation, petroleum shortages, and reliance on imports, as well as the maturing of the industry itself" all signaled the need to reevaluate the propriety of the old ICC methodology. Id. at 416.
See 21 FERC at 61,696 n. 295.
This court has ruled many times that "[t]he test of finality for the purposes of review is ... whether [the order] imposes an obligation or denies a right with consequences sufficient to warrant review." City of Anaheim & Riverside, Cal. v. FERC, 692 F.2d 773, 777 (D.C.Cir.1982) (quoting Environmental Defense Fund v. Ruckelshaus, 439 F.2d 584, 589 n. 8 (D.C.Cir.1971)). The FERC order in Williams alters the legal relations among the parties. While it does not, by itself, impose a duty on the shippers to pay a particular rate or bestow a right upon Williams to charge that rate, the order certainly would have "consequences sufficient to warrant review." The order sets down ratemaking principles that would permit rates within a range significantly different from the range of rates permitted by other ratemaking schemes.
In addition, under Abbott Laboratories v. Gardner, 387 U.S. 136, 149, 87 S.Ct. 1507, 1515, 18 L.Ed.2d 681 (1967), we also must evaluate "the hardship to the parties of withholding consideration." In this regard, we need only remember that Williams has been charging rates subject to refund for a dozen years. Over five years ago, this court found it troubling that Williams had "already faced six years of litigation and continues to face the possibility of reparations back to 1972 should its increased rates ultimately be found unreasonable." Farmers Union I, 584 F.2d at 421. Accordingly, we see no reason to forestall review of the ratemaking principles developed in Phase I of the Williams proceeding. Otherwise, the ALJ and then the entire body of FERC would squander more time in Phase II applying what we find to be legally deficient ratemaking principles.
We note, however, that the substantial evidence test applies not only to agency proceedings subject to the formal requirements of sections 556 and 557 of title 5; in addition, the test should be employed whenever judicial review is "on the record of an agency hearing provided by statute." 5 U.S.C. § 706(2)(E). Section 15(1) of title 49 requires FERC to hold a "full hearing" before issuing orders of the sort issued in Williams. Also, we conduct this review pursuant to 28 U.S.C. § 2347, see Earth Resources Co. v. FERC, 628 F.2d 234 (D.C.Cir.1980), which requires review "on the record of the pleadings, evidence adduced, and proceedings before the agency, when the agency has held a hearing...." Thus, without addressing the question whether the Allegheny-Ludlum holding should apply when the statutory requirement is for a "full hearing," 49 U.S.C. § 15(1), rather than simply a "hearing," 49 U.S.C. § 1(14), a question left open in Florida East Coast Railway, 410 U.S. at 243, 93 S.Ct. at 820, we are still troubled by Asphalt Roofing's truncated treatment of the question whether the substantial evidence test should be applied in the review of orders issued pursuant to 49 U.S.C. § 15(1). The relevant statutes suggest to us that our review is "on the record of an agency hearing provided by statute." 5 U.S.C. § 706(2)(E). Furthermore, in Allegheny-Ludlum itself, the Supreme Court, while not expressly invoking APA section 706(2)(E), nevertheless discussed for ten pages why the ICC's decision "was supported by substantial evidence," despite its holding that the requirements of APA sections 556 and 557 were inapplicable. See 406 U.S. at 746-56, 92 S.Ct. at 1945-50.
Accordingly, we are reluctant to endorse the Asphalt Roofing footnote. On the other hand, because (1) the parties did not fully address the question of the proper standard of review, (2) the difference, if any, between the "arbitrary and capricious" standard and the "substantial evidence" standard is limited, especially in a regulatory field as empirically-based as ratemaking, see Ethyl Corp. v. EPA, 541 F.2d 1, 36-37 & n. 79 (D.C.Cir.) (en banc), cert. denied sub nom. E.I. DuPont de Nemours & Co. v. EPA, 426 U.S. 941, 96 S.Ct. 2663, 49 L.Ed.2d 394 (1976), and (3) the "arbitrary and capricious" standard is not satisfied in any event, we need not resolve the issue in this case. See Dana Corp. v. ICC, 703 F.2d 1297, 1301 (D.C.Cir.1983).
21 FERC at 61,608. Our task of interpreting FERC's finding is seriously impaired by the Commission's decision to omit an initial decision by the ALJ, see 10 FERC (CCH) ¶ 61,023 (Jan. 9, 1980), coupled with its virtually complete failure to make any express references to the extensive record compiled in this case. In fact, FERC pronounced that its "massive record" in which "[e]xperts discoursed on risk, on competition" was "beside the point." 21 FERC at 61,623. Such nonchalance cannot be countenanced when the Commission then goes on to rely on a factual finding as to competition in devising its ratemaking scheme. Judicial review in such circumstances demands that the agency set out the basis in the record for its critical findings. See, e.g., Motor Vehicles Mfrs. Ass'n, 103 S.Ct. at 2870; Permian Basin Area Rate Cases, 390 U.S. at 792, 88 S.Ct. at 1373.
Moreover, since in the oil pipeline industry "[a] national geographic market leads to meaningless results, since transportation is regional, at least," Coburn, The Case for Petroleum Pipeline Deregulation, 3 Energy L.J. 225, 245 (1982), we agree with the Justice Department that to have any relevance at all, competition must be evaluated in terms of discrete regional markets. See Justice Dep't Brief at 44. FERC itself acknowledged that "actual and potential" competition in the oil pipeline industry is not "omnipresent," 21 FERC at 61,627 & 61,702 n. 360, and that intramodal competition is "often supplemented" — not "always supplemented" — by intermodal competition, id. at 61,627. Our review of the record reveals only anecdotal evidence of intermodal competition on certain pipeline routes. Furthermore, the principal evidence put forward by FERC in its brief to support its finding of intermodal competition — the decrease in oil pipelines' market share for petroleum transportation — can be explained chiefly by the increase in foreign imports transported by water. See J.A. at 939 (testimony of Richard J. Barber Assocs.). This trend therefore appears to reflect world oil resource availability more than true intermodal competition.
Finally, we note that when Congress amended the Interstate Commerce Act to account for competition in the rail carrier industry, the amendment required the ICC to make a specific finding that a particular rail carrier did not have "market dominance" before deregulating the carrier. See 49 U.S.C. § 10709. We do not believe that the unamended oil pipeline rate provisions of the Interstate Commerce Act, which do not make any provision for deregulation, would require any less of a particularized showing before competition might be properly taken into account.
21 FERC at 61,690 n. 217. We think FERC misconstrued the significance of the Farmers Union I passage and overstated the significance of its lack of abandonment authority.
First, the passage from Farmers Union I concludes that there is no "mandatory approach to ratemaking" discernible from the Interstate Commerce Act. In context, therefore, the passage reflects the principle, followed here, see supra at 1501; infra at 1520, 1527, that neither strict original cost-based "public utilities notions" nor the valuation methods suggested by the Valuation Act, 49 U.S.C. § 19a, must necessarily be adhered to in deriving oil pipeline rates. Furthermore, giving "freer play [to] competitive forces" is not equivalent to permitting rates that fall outside the "zone of reasonableness." See supra at 1502-03. Competitive forces are given freer play by permitting companies to decide for themselves whether to enter a geographic territory already served by another pipeline company (which would be unlawful without regulatory consent in a utility industry having exclusive service territories). Similarly, pipeline companies may abandon service at will (which would be unlawful for many other utilities). But Farmers Union I should not be read to support a theory that market forces can be a complete substitute for regulation of the oil pipeline rates.
Second, we disagree with FERC's appraisal that regulation without abandonment control "is arguably tantamount to no regulation at all." The extremely high sunk costs involved with initiating oil pipeline service render a decision to abandon that service a weighty one indeed. So long as the pipeline receives a just and reasonable rate for its service, it will be afforded an opportunity to derive a fair profit. Even if the oil pipelines do not receive everything they would like — even if they do not make "creamy returns" on their investment — they are still unlikely to "abandon service whenever they find the regulators' decisions unpalatable," especially considering FERC's view that oil pipeline capacity is needed to serve the oil companies which, in turn, own many of the pipelines. In this context, FERC is too modest about its own powers; the oil companies do not possess "veto power" over FERC's rate decisions.
To expand the debt capacity of its pipelines, the parent oil companies would enter into direct debt guarantees or "throughput and deficiency" agreements with their pipeline subsidiaries. Under a throughput and deficiency agreement, the parent companies promise to ship, or cause to be shipped, through the pipeline their pro rata share of oil, sufficient to ensure that the pipeline will generate enough revenue to meet its debt service payments and operating expenses. In addition, these agreements obligate the parent companies to provide the pipeline with cash "deficiency payments" if, for whatever reason — even if the pipeline is inoperable — the pipeline cannot meet its expenses due. See 21 FERC at 61,698 n. 323; G. Wolbert, Jr., U.S. Oil Pipe Lines, 242-46 (1979). By this method, the parent companies reduce the risk associated with the debt securities of the pipeline, and thereby increase their ability to finance the pipeline with such high levels of debt.
The consent decree was vacated soon after the Williams opinion was issued. See supra note 31. On remand, FERC can reexamine the issue of parent guarantees in light of any new financing trends that have emerged since the consent degree was vacated.
At one point, FERC indeed intimated that, on the contrary, original cost ratemaking would result in lower rates (and thus lower investment incentives) over the long run and that "[b]ecause original cost rate bases fall so sharply as properties age and because pipeline plant lasts so long, this will be true however high rates of return may be." Id. This problem results from the "front end load" phenomenon, and would be eliminated by trending the rate base. See infra at 1516-17. Furthermore, we find it difficult, if not impossible to square this analysis with FERC's previous assertion that original cost ratemaking "may very well mean higher rates."
FERC's discussion in Williams appears to contradict summarily its holding in Kentucky W. Va. Gas. Co., 2 FERC ¶ 61,139 (Feb. 16, 1978). In FERC's words, "[w]hen, as in the present case, the use of the actual capital structure would result in excessive costs to the consumer or inadequate returns to the investor, some other capital structure must be used." Id. at 61,325; see also Michigan Gas Storage, 56 FPC 3267, 3273 (1976) ("the Commission must exercise its expertise and discretion in choosing the most appropriate capitalization"); Florida Gas Transmission Co., 47 FPC 341, 363 (1972) ("a utility should be regulated on the basis of its being an independent entity; that is a utility should be considered as nearly as possible on its own merits and not on those of its affiliates").
Id. at 61,623.
We believe FERC's principal duty under the statute is to ensure "just and reasonable" rates. Accordingly, the frustration of the expectation that this excessively "permissive" and "indulgent" methodology would continue in force is a "factor[] which Congress has not intended [FERC] to consider." Motor Vehicles Mfrs. Ass'n, 103 S.Ct. at 2867. We therefore do not condone FERC's reliance on these expectations.
In addition, by retaining the ICC methodology, FERC accepted, at least for the time being, the mismatch between the method of depreciation used to determine the cost of service expense and the "condition percent" method used to determine depreciation for rate base purposes. See 21 FERC at 61,632. "Unfortunately, the condition percent does not bear any well-defined relationship to the accounting concept of depreciation ... [n]or does the use of the condition percent track the economic concept of depreciation." Navarro & Stauffer, supra note 29, at 300 (emphasis in original).
These features of the ICC rate base formula have led experts to call it "nothing less than bizarre; it is a mysterious collection of seemingly unrelated components that, through the wonders of jurists' algebra, miraculously distill into a single sum." Id. at 296. These features have been the subject of criticism throughout the most recent Williams proceeding, and drew the attention of this court in Farmers Union I. FERC, however, failed to provide any reasoned defense to these criticisms, beyond its belief — misguided by its impermissible interpretation of "just and reasonable" rates — that oil pipeline rate regulation can tolerate such "anomalies and inconsistencies." 21 FERC at 61,616. Thus FERC in its Williams opinion also "entirely failed to consider an important aspect of the problem" of rate bases. Motor Vehicle Mfrs. Ass'n, 103 S.Ct. at 2867.
Finally, we note that this magnification effect would have been reduced, although not eliminated, if FERC had used hypothetical capital structures instead of the suretyship premium. In the absence of the parent guarantees, the oil pipelines would not have been able to use debt leveraging to such an extraordinary degree; accordingly, the hypothetical capital structure would consist of less debt and more equity, and the leveraging effect would be reduced in the calculation of the "equity component" of the rate base. In this way, then, FERC indirectly failed to meet its traditional purpose of considering each regulated company "as nearly as possible on its own merits and not on those of its affiliates." Florida Gas Transmission Co., 47 F.P.C. 341, 363 (1972). This purpose, of course, formed the rationale for FERC's inclusion of a "suretyship premium" in the rate of return.
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