The United States Court of Appeals for the District of Columbia Circuit, in an April 14 opinion, granted petitions for review – filed by the New England Transmission Owners, as well as “Petitioners Massachusetts and various consumer-side stakeholders” (referred to as customers) – regarding the base return on equity (ROE) for the Transmission Owners, which are a group of privately owned utilities that provide transmission services in New England.
As noted in the opinion, FERC in 2006 established the base ROE for the Transmission Owners at 11.14%, relying on a zone of reasonableness, determined in a discounted cash flow analysis, of 7.3% to 13.1%.
The customers in 2011 filed a section 206 complaint with FERC alleging that the Transmission Owners’ 11.14% base ROE had become unjust and unreasonable, the court said, noting that the complaint was premised on the customers’ contention that the Transmission Owners’ capital costs had declined since the base ROE was established in 2006 due to changes in the capital markets.
Section 206 of the Federal Power Act (FPA) requires FERC to determine whether an existing rate is “unjust, unreasonable, unduly discriminatory or preferential,” the court noted, adding that only after having made the determination that the utility’s existing rate fails that test may FERC exercise its section 206 authority to impose a new rate.
Applying a newly created discounted cash flow zone of reasonableness of 6.1% to 13.2%, an administrative law judge (ALJ) concluded that the Transmission Owners’ 11.14% base ROE was unjust and unreasonable, the court said. Then, using the midpoint of the newly determined zone of reasonableness, the ALJ set the Transmission Owners’ base ROE at 9.7%, the court said.
On review of the ALJ’s decision, FERC adopted a new two-step discounted cash flow (DCF) methodology for determining an electric utility’s just and reasonable ROE, the court said, adding that applying the two-step methodology, FERC created a new zone of reasonableness of 7.03% to 11.74%.
In the instant proceeding, the court said, the Transmission Owners and customers do not challenge FERC’s use of the two-step methodology or the resulting zone of reasonableness. Instead, they object to FERC’s placement of the Transmission Owners’ base ROE within that newly determined zone of reasonableness, the court said.
Because the existing 11.14% base ROE fell within FERC’s newly determined zone of reasonableness, the Transmission Owners argued that FERC lacked statutory authority under section 206 to change the existing base ROE, the court said.
FERC rejected that argument, saying that “the DCF zone of reasonableness does not establish a continuum of just and reasonable base ROEs, any one of which the utility would equally be free to charge to ratepayers; rather, only the single point approved by the commission within the DCF zone of reasonableness is the just and reasonable base ROE.”
The court added that the midpoint of FERC’s newly determined zone of reasonableness was 9.39%, and while FERC typically sets a utility’s base ROE at the midpoint of the zone of reasonableness, the Transmission Owners argued that a base ROE at 9.39% would fail to meet certain capital attraction standards.
FERC agreed, noting that all “methods of estimating the cost of equity,” including the discounted cash flow analysis, “are susceptible to error when the assumptions underlying them are anomalous.”
The court added that because it had “less confidence” in the results of its discounted cash flow analysis, FERC considered “additional record evidence” to inform its placement of the Transmission Owners’ new base ROE within the zone of reasonableness. The court said that FERC stressed that it was “not depart[ing] from [its] use of the DCF methodology; rather [it] use[d] the record evidence to inform the just and reasonable placement of the ROE within the zone of reasonableness established in the record by the DCF methodology.”
FERC considered such alternative analyses as risk premium analysis, and concluded that they “corroborate[d] [its] determination that placement [of the base ROE] at a point above the midpoint was warranted,” the court said.
Because it traditionally uses measures of central tendency to determine an appropriate return in ROE cases, FERC set the Transmission Owners’ base ROE at the midpoint of the upper half of the newly determined zone of reasonableness – 10.57%, the court said.
FERC held that “both of the burdens of proof under FPA section 206 can be satisfied using a single ROE analysis – one that generates an ROE that both is below the existing ROE (thus demonstrating that the existing ROE is excessive) and that also is a just and reasonable ROE (thus demonstrating what the new ROE should be),” the court said.
Since the newly determined zone of reasonableness reduced the upper end of the zone from 13.1% to 11.74%, FERC reminded the Transmission Owners that their total ROE – base ROE plus any incentives – must remain within the zone of reasonableness, the court said.
The Transmission Owners asserted that they were not given adequate notice that the incentives would be at issue and argued that FERC’s decision to cap previously approved incentives therefore did not come within section 206 and violated the Due Process Clause and the Administrative Procedure Act.
FERC said that it was merely following its well-established policy that a utility’s total ROE – including any incentives – is “capped” at the upper end of the zone of reasonableness, the court added, noting that the Transmission Owners and customers each filed petitions for review.
In addressing the Transmission Owners’ petition, the court noted that section 206 required FERC to make an explicit finding that the Transmission Owners’ existing rate was unjust and unreasonable before proceeding to set a new rate, and that in this case, FERC failed to make such a finding.
“FERC misunderstood and misapplied its dual burden under section 206,” the court said, noting that section 205 – which enables a utility to propose changes in its own rates – and section 206 are “related but distinct” provisions of the FPA.
A finding that an existing rate is unjust and unreasonable is the “condition precedent” to FERC’s exercise of its section 206 authority to change that rate, the court said, adding that section 206 therefore imposes a “dual burden” on FERC. Without a showing that the existing rate is unlawful, FERC has no authority to impose a new rate, the court said.
In determining that its “single ROE analysis” satisfied both of its burdens under section 206, FERC relied on the general principle that it is the commission’s duty to translate the “abstract concept” of reasonableness into a “concrete rate,” and it is that rate – “not the abstract concept” – that governs the rights of the utility and the consumers, the court noted.
The zone of reasonableness creates a broad range of potentially lawful ROEs rather than a single just and reasonable ROE, meaning that FERC’s finding that 10.57% was a just and reasonable ROE, standing alone, “did not amount to a finding that every other rate of return was not,” the court said.
Because it was a section 206 proceeding, instead of a section 205 proceeding, FERC bore the burden of making an explicit finding that the existing ROE was unlawful before it was authorized to set a new lawful ROE, the court said.
FERC “made no effort” to explain what circumstances rendered the Transmission Owners’ existing rate unlawful, and instead concluded that the existing 11.14% base ROE was unlawful solely because it had determined that 10.57%, which was “a numerical value below the existing numerical value,” was a just and reasonable base ROE, the court said.
“Because FERC’s single ROE analysis failed to include an actual finding as to the lawfulness of Transmission Owners’ existing base ROE, FERC acted arbitrarily and outside of its statutory authority in setting a new base ROE for Transmission Owners,” the court said.
Among other things, the court said that the customers’ petition is also well taken, adding that after performing its analysis, FERC abandoned its traditional use of the midpoint of the zone of reasonableness in setting the Transmission Owners’ base ROE, and instead picked the midpoint of the upper half of the zone of reasonableness as the new base ROE. However, the court said, FERC did not set forth a rational connection between the record evidence and its placement of the base ROE.
The court said that it vacates FERC’s orders and remands the case for proceedings.
A FERC spokesperson told TransmissionHub on April 19 that the commission has no comment on the court opinion.