On May 10, the U.S. Court of Appeals for the District of
Columbia Circuit rejected Southern California Edison's
challenge to the Federal Energy Regulatory Commission's
(FERC's or Commission's) setting the company's base
return on equity (ROE) for three transmission projects using the
median, rather than the midpoint, of a zone of reasonableness. The
zone was established using the ROEs of a group of companies facing
similar risks. At the same time, the court sent the matter back to
the Commission for further proceedings because FERC had updated the
base ROE using data produced after the record had closed, without
providing Edison an opportunity to challenge FERC's updating
methodology.
Background
In 2007, FERC approved transmission rate incentives for three
transmission upgrades proposed by Edison, including adders to the
base ROE for the three projects. Edison subsequently proposed a
base ROE of 11.5 percent for each project, based on the midpoint of
the zone of reasonableness of Edison's proxy group. This would
have resulted in overall ROEs, taking into account the incentive
adders, of 13.25 percent for two of the projects and 12.75 percent
for the remaining project. The Commission established paper hearing
procedures to address Edison's proposal and, in an April 2010
order, set the base ROE at 10.55 percent. In doing so, the
Commission used the median, rather than the midpoint, of the range
of ROEs of a different representative proxy group, resulting in a
base ROE nearly 100 basis points lower than proposed by
Edison.
Although FERC historically has used the midpoint for setting the
ROE for electric utilities and the median for natural gas
pipelines, beginning in 2008 FERC determined that it would use
the median as the measure of the ROE for a single electric utility
of average risk.[1] The Commission accordingly
determined that the appropriate ROE was 10.55 percent and, after
applying its policy of updating the ROE by adjusting for the yields
on 10-year constant-maturity U.S. Treasury bonds, set the final
base ROE for the three projects at 9.54 percent. Edison
unsuccessfully sought rehearing and then appealed the FERC order to
the U.S. Court of Appeals for the D.C. Circuit.
The Court Decision
The court found that the Commission had adequately explained its
reasoning for changing its policy with respect to using the median,
rather than the midpoint, of the zone of reasonableness for a
single electric utility. The court noted that the Commission
provided three reasons: The median lessens the impact of atypical
outliers in the proxy group, gives consideration to more than just
the companies at the top and bottom of the group, and has important
advantages over the mean and midpoint approaches in determining
central tendency (i.e. the center of the distribution). FERC
explained that when an ROE is to apply to a diverse group of
companies, such as was the case in a proceeding establishing ROEs
for a group of transmission owners participating in a regional
transmission organization, it needs to consider the entire range of
results yielded by the proxy group. The court noted with approval
FERC's reasoning that, with respect to a diverse group of
utilities, it is less concerned about distortions that may occur as
a result of the highest or lowest number, and therefore using the
midpoint is more appropriate. Because that reasoning does not apply
to a single electric utility, the court affirmed FERC's use of
the median in the case of Edison's proposed ROE. In doing so,
the court also rejected Edison's argument that a "just and
reasonable" rate is a zone and not a point and therefore both
the midpoint and the median meet the statutory standard. The court
found instead that the Commission has discretion regarding the
methodology by which it determines whether a rate is just and
reasonable. Because, in this case, FERC determined that the median
methodology is preferable, it could validly reject Edison's
proposal to use the midpoint without having to assess the justness
or reasonableness of that methodology.
The court, however, agreed with Edison that FERC should have given
the utility the opportunity to respond when the Commission took
official notice, after the record had closed, of the average
10-year U.S. Treasury bond yields during the period when the rates
were in effect (the so-called locked-in period). The Commission
used that information to reduce Edison's base ROE by more than
100 basis points. Edison challenged that action on rehearing,
arguing that U.S. Treasury bond yields were not a valid proxy for
its private cost of capital due to the unusual economic conditions
prevailing in late 2008. FERC, though, refused to consider
Edison's argument, citing its general rule that evidence cannot
be introduced for the first time on rehearing. The court was not
persuaded, finding that Edison had made the necessary showing that
it could contest the significance of the Commission's
officially noticed information, and remanded the matter to FERC to
address Edison's arguments opposing the Commission's
updating methodology.
Lessons
The court's decision affirming FERC's use of the median,
rather than the midpoint, of a zone of reasonableness represents
the first time a court has confirmed the Commission's use of
this methodology for determining the ROE of a single electric
utility. Going forward, all electric utilities submitting a
proposed ROE on a stand-alone basis will be required to adhere to
the new policy, absent the ability to articulate a compelling
reason to deviate from it. As is evident from this case, using the
median instead of the midpoint can have a material effect on the
ROE, with a correspondingly large revenue impact. In addition,
because the court expressly affirmed FERC's discretion to
select the methodology used to determine the point within the zone
of reasonableness that yields a just and reasonable rate, this
decision appears to undercut any argument that a utility can rebut
a challenge to its existing ROE simply because it continues to fall
within the zone. It remains to be seen whether this decision will
be a precursor to an industry-wide reassessment of existing ROEs,
potentially triggering numerous complaint proceedings seeking to
lower ROEs to reflect the Commission's current
methodology.
Our attorneys have significant experience advising clients on
designing and implementing cost-of-service rates for regulated
utilities, including complex rate of return issues, as well as
litigating those issues in contested rate proceedings. A
well-designed rate filing can mitigate the risks associated with
FERC's ratemaking policies. If you have any questions
concerning the court's decision specifically or ratemaking
issues generally, please contact any of the attorneys listed in
this alert.
Footnote
[1] The midpoint in this context is the value that is halfway between the highest and lowest ROEs in the proxy group (i.e., the average of the highest and lowest). The median is the ROE in the group that separates the top half from the bottom half. In determining the ROE for a broad group of electric utilities with diverse risks and business profiles, FERC continues to use the midpoint of the zone.
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