United States: Appeals Court Upholds FERC's ROE Approach

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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