Academic journal article Energy Law Journal

Abandon All Hope? Ferc's Evolving Standards for Identifying Comparable Firms and Estimating the Rate of Return

Academic journal article Energy Law Journal

Abandon All Hope? Ferc's Evolving Standards for Identifying Comparable Firms and Estimating the Rate of Return

Article excerpt

Synopsis:

The "comparative risk" standard established by Hope Natural Gas is a basic tenet of estimating regulated rates of return.1 Hope remains the sine qua non for determining whether regulated rates of return set by the Federal Energy Regulatory Commission (FERC) and by state utility regulators are just and reasonable. In the last few years, however, the FERC's approach to setting regulated rates of return has evolved, and this evolution has raised new methodological and legal issues. This article examines how the FERC's approach to setting the rate of return for regulated electric companies and natural gas pipelines has changed over time, most recently including the changes arising out of its Atlantic Path 15, Williston Basin, and Kern River decisions. In this article, we evaluate approaches to determining comparable risk and the limitations of those approaches. We discuss controversies that have arisen in setting the rate of return within what regulators typically refer to as the "zone of reasonableness," and we explore how those controversies are embedded in the overarching meaning of "comparable risk." We also introduce a statistically robust approach that can avoid the more arbitrary aspects of establishing proxy groups. We conclude with recommendations as to how the FERC and other state and federal regulators can lessen these ongoing controversies while ensuring that allowed rates of return are truly "just and reasonable."

I. INTRODUCTION

Under the long-established but unwritten "regulatory compact,"2 a regulated firm agrees that the prices it charges will be set by regulators, and regulators agree that the prices they set will allow the firm to recoup its operating costs plus a reasonable profit. For a regulated firm, "reasonable profit" is defined as the rate of return that is sufficient to attract the capital the firm needs to continue to meet its obligations. Regulators rely on the regulated firm's overall cost of capital to estimate such a rate of return.3

There are two main components to any firm's overall cost of capital: the cost of debt and the cost of equity. The cost of debt generally can be directly measured, but the cost of equity cannot. As a consequence, determining an appropriate return on equity and an overall fair allowed rate of return for a regulated firm is one of the oldest issues in rate regulation.

Beginning in the 1890s, state regulators relied on the "fair value" of a regulated firm's assets to determine the rate of return. This approach culminated in the U.S. Supreme Court decision in Smyth v. Ames,4 and came to be known as the "Fair Value" Doctrine. The Fair Value Doctrine did not last long; it collapsed under its inherent circularity - the value of a regulated firm was whatever regulators said it was.5 A decade later, in Consolidated Gas,6 the Court began to discuss the relationship between risk and return directly; it reasoned that a fair rate of return encompassed a return on invested capital and a return for risk.7

By 1923, in its Bluefleld decision,8 the Court had begun to zero in on the idea of comparable risk, stating as follows:

A public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public equal to that generally being made at the same time . . . in other business undertakings which are attended by corresponding risks, and uncertainties;. . . . The return should be reasonably sufficient to assure confidence in the financial soundness of the utility and should be adequate ... to maintain and support its credit and enable it to raise money necessary for the proper discharge of its public duties.

Two decades later, the principle of basing a regulated utility's return on the financial risks of other comparable firms was firmly established in the Court's 1944 Hope decision, in which die Court stated as follows:

"[T]he return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks. …

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