Petition — Potomac Electric Power Co. v. Public Service Commission
Supreme Court brief1979
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Gupreme Court, U,
FILED
JUL 30 1979
IN THE MICHAL RODAK, JR, CLERR
Supreme Court of the United States
OcTOBER TERM, 1979
No. Y9-153
Potomac ELEctric Power CoMPANY,
Petttioner,
Wi
PvusBLic SERVICE COMMISSION OF THE
District oF CoLUMBIA,
PEOPLE’S CoUNsEL OF THE District oF CoLUMBIA,
Respondents.
—_—
PETITION FOR A WRIT OF CERTIORARI TO THE
DISTRICT OF COLUMBIA COURT OF APPEALS
Epwarp A. CAINE
LAWRENCE A. GOLLOMP
ALLEN C. BARRINGER
Wiiu1AM Dana SHAPIRO
1900 Pennsylvania Avenue, N.W.
Washington, D.C. 20068
(202) 872-2890
Wiiu1AM C. GARDNER
Houston and Gardner
615 F Street, N.W.
Washington, D.C. 20004
Attorneys for Potomac Electric
Power Company
Washington, D.C.
July 30, 1979
Press or Byron 8. Apams Painting, Inc., WAsHInoron, D. C.
i
CERTIFICATE OF SERVICE
I hereby certify that I have this 30th day of J uly,
1979 served a copy of this Petition for a Writ of Cer-
tiorari to the District of Columbia Court of Appeals,
by mailing three copies thereof, together with a copy
of this certificate of service, postage prepaid, to counsel
for all parties of record, as follows:
Brian Leperer, Esquire
People’s Counsel of the District of Columbia
1012 14th Street, N.W.
Washington, D.C. 20005
MELVIN WasHINGTON, Esquire
Assistant Corporation Counsel
Public Service Commission of the District
of Columbia
1625 I Street, N.W.
Washington, D.C. 20006
Epwarp A. CAINE
ee en NM Pt mene SO
ke Hh ATS ncaa C8 tt het OO BES Neal. hw ot re Rak
A er eee.
I.
II.
The Commission’s Unreasonable Refusal to Con-
sider the Most Current Data Presented in the
Record or to Otherwise Deal with the Demon-
strated Severe Attrition in Pepco’s Earnings
Guaranteed that Pepco Could Have No Oppor-
tunity to Karn Its Authorized Rate of Return and
Thereby Confiscated Pepco’s Property Without
Substantive Due Process and Without Compen-
Err ee eee On eee ee ee ee Ee
Arbitrary Utility Rate Regulation and Partisan
Rate Case Review by State Courts Are Inimical
to the National Economy and to the Country’s
Ability to Cope With the National Energy Crisis .
ba a ere ten eee See ere
APPENDICES : .
Appendix A, District of Columbia Public Service Com-
mission Final Opinion and Order (Order No. 5739)
(November 12, 1975) ........ ee eeee eee cece cece
Appendix B, District of Columbia Public Service Com-
mission Order No. 5759 Denying Applications for
Reconsideration (January 12, 1976) .............
Page
. Cmenemn TOW oo sc ccc cscs ecrescccccencccctecens 1
JUMMROTION onc cccc ca ccccccccccccccevoccvesecsesss 2
QUESTION PRESENTED ......-.seeeeeeeeee errr eeeeees 2
ConsTITUTIONAL PROVISIONS INVOLVED ......+-+++e+08> 2
STATEMENT OF THE CASE ..... ee cece eee ee ee eeeeeeees 3
A. The Proceedings Before the Commission ..... 3
B. The Proceedings in the Court Below ........- 5
REASONS FOR GRANTING THE WRIT ......--- eee eeeeeees 6
14
17
la
iv
Index Continued
Page
Appendix C, Opinion and Order of a Panel of the Dis-
trict of Columbia Court of Appeals (December 9,
TOUT) . ...dcvdcececkeusneueeenuneeeeeee lc
Appendix D, En Banc Opinion and Order of the Dis-
trict of Columbia Court of Appeals (May 1, 1979) . 1d
CITATIONS
CasEs:
FPC v. Hope Natural Gas Co., 320 U.S. 597 (1944)...5, 7,8
FPC v. Natural Gas Pipeline Co., 315 U.S. 575 ...... 12, 16
People’s Counsel v. Public Serv. Comm’n, 399 A.2d 43
(DOC. App. OUD) is cidcccctecazagsseeeeaees 13
Permian Basin Area Cases, 390 U.S. 747 (1968) . .5, 7, 8, 16
Potomac Electric Power Co. v. Fublic Serv. Comm’n,
A.2d —— (Docket No. 10909, D.C. March 16,
1979), reh. en banc denied (May 8, 1979) ......... 14
Telephone Users Ass’n v. Public Serv. Comm’n, 304
A.28 398 (D.C. Ap. WEG oscc ss cinkewedears vas 4
West Ohio Gas Co. v. Public Util. Comm’n, 294 U.S. 79
ee ey 13
Washington Gas Light v. Baker, 188 F.2d 11 (D.C. Cir.
1950), cert. denied, 340 U.S. 952 (1951) .......... 8
Washington Public Interest Organization v. Public
Serv. Comm’n, 393 A.2d 71 (0.0. 1978), reh. en
banc denied, Docket No. 12017 (May 3, 1979) ..... 14
CoNSTITUTION AND STATUTES:
Constitution of the United States
US. Comat. GU Yi. i 0.050 00s0dntnbasannees 2, 3, 12
Federal Power Act 16 U.S.C. 824(d)(e) (1976) ...... 8,15
Natural Gas Act 15 U.S.C. 717 (c)(d) (1976) ........ 8,15
28 US.C. $ SBR) CECE) evccnccctndsapeunsaeepaas 2
Vv
Citations Continued
District or CoLumBia CopE:
D.C. Code Ann. § 43-301 (1973)
D.C. Code Ann. § 43-401 (1973)
D.C. Code Ann. § 43-411 (1973)
eee
IN THE
Supreme Court of the United States
OcToBER TERM, 1979
No. 79-
Potomac ELEcTric PowreR CoMPANY,
Petitioner,
v.
PUBLIC SERVICE COMMISSION OF THE
District oF CoLUMBIA,
ProrLe’s COUNSEL OF THE District oF CoLUMBIA,
Respondents.
PETITION FOR A WRIT OF CERTIORARI TO THE
DISTRICT OF COLUMBIA COURT OF APPEALS
Petitioner, Potomac Electric Power Company
(Pepco), respectfully prays that a writ of certiorari
issue to review the opinion and judgment of the Dis-
trict of Columbia Court of Appeals in Docket No.
10490 entered en bane on May 1, 1979 affirming a de-
cision of the Public Service Commission of the District
of Columbia (Commission) issued November 12, 1975
and vacating the opinion and judgment of a three-
judge panel of that Court entered on November 9, 1977
which had reversed and remanded the decision of the
Commission.
OPINIONS BELOW
The en bane opinion of the District of Columbia
Yourt of Appeals is reported at 402 A.2d 14 (D.C.
2
1979) and is reprinted infra at Appendix D. That
opinion vacated the opinion and judgment of a three-
judge panel of the Court reported at 380 A.2d 126
(D.C. 1977) and reprinted infra at Appendix C, which
reversed and remanded an opinion and order of the
Public Service Commission of the District of Colum-
bia. The opinion and order of the Commission is re-
ported at 11 P.U.R. 4th 215 (P.S.C. D.C. 1975) and
is reprinted infra at Appendix A. The Commission’s
unreported order denying Pepco’s Application for Re-
consideration is reprinted tnfra at Appendix B.
JURISDICTION
The judgment of the District of Columbia Court of
Appeals was entered on May 1, 1979. This petition for
a writ of certiorari was filed within ninety days of that
date. The jurisdiction of this Court is invoked undér
28 U.S.C. § 1257(3) (1976).
QUESTION PRESENTED
By guaranteeing that Pepco can have no opportu-
nity to earn its authorized rate of return in the Dis-
trict of Columbia, which the Commission itself specifi-
cally found was necessary to attract capital, has the
Commission confiscated Pepeo’s property without sub-
stantive due process of law and without just compensa-
tion in violation of the Fifth Amendment to the United
States Constitution ?
CONSTITUTIONAL PROVISIONS INVOLVED
The due process and just compensation clauses of the
Fifth Amendment to the Constitution of the United
States:
No person ... shall be deprived of life, liberty,
or property, without due process of law; nor shal]
ee ee ee
3
private property be taken for public use, without
just compensation.
STATEMENT OF THE CASE
This case concerns the Constitutional obligation of
a regulatory commission, in the context of a financially
deteriorating industry, to permit a utility a reasonable
opportunity to earn the rate of return which the com-
mission itself has found to be just and reasonable and
necessary to attract capital in order to provide the
electricity demanded by the community it serves.
A. Proceedings Before the Commission
Pepeo is engaged in the generation, transmission,
distribution and sale of electric energy in the Wash-
ington, D.C. metropolitan area, and is subject to the
regulatory jurisdiction of the Public Service Commis-
sion of the District of Columbia (Commission), the
Maryland Public Service Commission, and the Vir-
ginia State Corporation Commission with respect to
retail rates. Pepeo also is regulated by the Federal
Knergy Regulatory Commission (FERC) in connec-
tion with its wholesale electric sales.
On December 20, 1974, Pepco filed an application
with the Commission for an increase in its retail rates
for the sale of electricity in the District of Columbia,
designed to increase annual revenue in the District by
some $50 million, based on the Company’s costs of
providing service in the District of Columbia in 1974.
Prior to the start of the hearings on its application,
Pepeo twice sought emergency interim increases in its
rates in an effort to stem the further severe deteriora-
4
tion in the Company’s financial condition which was
taking place while its permanent rate application was
awaiting hearings before the Commission. In each in-
stance, the Commission summarily denied Pepco’s
application.
Hearings were ultimately held from June 4 through
July 24, 1975 and, on July 18, 1975, Pepeo filed with
its rebuttal testimony updated data reflecting actual
operating results during the twelve months ended June
30, 1975. Due to the continuing deterioration of
Pepco’s operating results in the District, the updated
data demonstrated an increased revenue requirement
of some $57 million, rather than the $50 million orig-
inally requested. This updated presentation clearly
showed that Pepco had experienced continuing attri-
tion in earnings since its original rate application was
filed."
On November 12, 1975, the Commission by a two-to-
one vote issued its opinion and order which authorized
an increase of $27.7 million in Pepco’s gross operating
revenue based upon the Company’s 1974 cost of service
data, rather than the more current 1975 data submitted
by Pepeo. Had the Commission applied the precise rate-
‘Broadly speaking, attrition is defined as the inability of a
utility to earn the levels of return found by the regulatory com-
mission to be required to maintain financial integrity and to attract
capital on reasonable terms. See e.g. Telphone Users Ass’n v. Public
Serv. Comm’n, 304 A.2d 293, 298 (D.C. 1973), cert. denied 415
U.S. 933 (1974). In the practical ratemaking context, attrition gen-
erally is caused by inflationary pressures causing rate base invest-
ment, expenses, or these two elements of the ratemaking formula
in combination, to increase at a rate which outstrips the rate of in-
crease in revenue,
_eee eee oss
5
making formula which it approved in this case to the
more current data submitted by Pepeo, Pepco would
have been authorized to increase its rates by $48 mil-
lion, rather than by the $27.7 million computed by the
Commission in reliance upon plainly outdated 1974 in-
formation. The Commission made no use of the more
current data available to it in setting rates which
would become effective in 1976.
Commissioner Stratton issued a lengthy dissenting
opinion, focusing principally on the majority’s failure
to set rates at a level which would be sufficient to per-
mit Pepco a reasonable opportunity to earn the rate of
return on its investment during the period when the new
rates would be in effect (in 1976), a level of return on
investment which the Commission itself found in the
same order to be required to attract necessary capital.
(Appendix A at 44a)
On December 12, 1975, Pepco filed an Application
for Reconsideration of the Commission’s final decision
which was denied by the Commission on January 12,
1976.
B. The Proceedings in the Court Below
On appeal, a three-judge panel of the District of
Columbia Court of Appeals, after examining the end
result of the Commission’s opinion and order in con-
formity with FPC v. Hope Natural Gas Co., 320 U.S.
091, 602-3 (1944) concluded on November 9, 1977 that
there was a ‘“‘clear showing” of a due process violation.
Adhering to the standards of review enunciated by this
Court in the Permian Basin Area Rate Cases, 390
U.S. 747, 791-92 (1968), the panel of the Court of Ap-
peals found the end result of the Commission’s deci-
6
sion unreasonable in overall effect and in specific ele-
ments:
This court has adhered to the standards of re-
view thus enunciated on several occasions. In the
instant case, we have examined the overall effect
of the Commission’s opinion, and find it to be
unjust and unreasonable in that it deprived Pepco
of the opportunity to earn a fair rate of return by
improperly disregarding the latest relevant his-
torical data of record pertaining to the company’s
operations. Examination of the elements of the
opinion reveals several findings and conclusions
- which are unreasonable, arbitrary, or capri-
cious. These include the Commission’s refusal to
utilize the most recent test period in the record,
its failure to account for continuing attrition, and
its refusal to recognize certain known changes
which occurred after the originally proposed eal-
endar 1974 test period. (Appendix C at 8c-9c)
The panel of the Court of Appeals further concluded
that,
(Bly arbitrarily disregarding actual, historical
and uncontroverted data submitted as evidence by
Pepco during the course of the hearing, the Com-
mission all but guaranteed that the company would
not be able to approach earning the rate of return
it authorized. (Appendix C at 10c)
After hearing reargument en banc, the Court of
Appeals, with the majority of the panel which origi-
nally heard the case dissenting, vacated the opinion of
the panel and affirmed the opinion of the Commission
on May 1, 1979.
REASONS FOR GRANTING THE WRIT
A reviewing court has the obligation to assess the
‘“‘end result’? of the Commission’s final rate order.
7
FPC v. Hope Natural Gas Co., 320 U.S. 591 (1944).
This Court stated in Hope.
Under the statutory standard of ‘just and rea-
sonable’’ it is the result reached not the method
employed which is controlling. . . . It is not theory
but the impact of the rate order which counts. If
the total effect of the rate order cannot be said to
be unjust and unreasonable, judicial inquiry un-
der the Act is at an end. Jd. at 602.
This Court in the Permian Basin Area Rate Cases,
390 U.S. 747, 791-92 (1968), set forth explicit responsi-
bilities of a reviewing court with respect to a utility
commission order:
First it must determine whether the Commis-
sion’s order viewed in light of the relevant facts
and of the Commission’s broad regulatory duties,
abuses or exceeded its authority. Second, the
court must examine the manner in which the Com-
mission has employed the methods of regulation
which it has itself selected, and must decide
whether each of the order’s essential elements
is supported by substantial evidence. Third, the
court must determine whether the order may rea-
sonably be expected to maintain financial integ-
rity, attract necessary capital, and fairly compen-
sate investors for the risks they have assumed,
and yet provide appropriate protection to the rele-
vant public interests, both existing and forseeable.
The Court of Appeals fell far short of meeting its
responsibilities as mandated in Hope and Permian
Basin. The result is that this Court’s opinions are be-
ing severely eroded. The Court of Appeals totally
failed to meet its obligation to assess the consequences
of the Commission’s order. In fact, the Court of Ap-
peals’ en bane opinion never even addressed the issue
8
which was raised by Pepco and which formed the focus
of the panel’s earlier decision, that the Commission had
violated Pepco’s constitutional rights by setting rates
at a level that denied it any opportunity to earn the
authorized fair rate of return during the period the
new rates were to be in effect.
The Commission’s Unreasonable Refusal To Consider The Most
Current Data Presented In The Record Or To Otherwise Deal
With The Demonstrated Severe Attrition In Pepco’s Earnings
Guaranteed That Pepco Could Have No Opportunity To Earn Its
Authorized Rate Of Return And Thereby Confiscated Pepco's
Property Without Substantive Due Process And Without Just
Compensation
The standard of the Public Service Commission Law
with respect to ratemaking in general is that rates
established must be just and reasonable (43 D.C. Code
Ann. $§ 301, 401, 411 (1973)). This standard is the
same in all respects as that embodied in the Natural
Gas Act and the Federal Power Act.’ In order to give
effect to this standard of just and reasonable rates, the
Commission must balance the interest of consumers
with the interest of investors. It is the ‘“‘end result”’
which must be reasonable. Hope, supra; Permian
Basin, supra.
Utility ratemaking traditionally uses an historical
test period adjusted for known changes to provide a
representative basis for the setting of rates for pros-
pective electric service. But an historical test period is
a proper ratemaking tool only when it can be used to
*15 U.S.C. §§717(e) and (d) (1976); 16 U.S.C. §§ 824(d) and
(e} (1976) ; Washington Gas Light v. Baker, 188 F.2d 11, 14 (D.C.
Cir. 1950), cert. denied, 340 U.S. 952 (1951).
9
forecast with reasonable accuracy the future relation-
ship among revenue, expenses, rate base investment,
and rate of return, thereby providing a proper basis
for future rates.
As recounted in detail in the three-judge panel’s de-
cision below, the record before the Commission showed
that the originally proposed calendar 1974 test period
had become irrelevant as a predictive tool for setting
rates for the future by the time hearings were com-
menced, much less concluded. The revenue, expense and
rate base relationships had changed drastically during
the period between December 31, 1974 and June 30,
1975 because of substantial increases in rate base and
all other costs of providing service.
To reflect the changed conditions, Pepco assembled
actual results of operation for the twelve months ended
June 30, 1975. Pepeo’s undated test period data were
filed with the presentation of its rebuttal case. The 1975
financial data were introduced and received into evi-
dence at the hearings before the full Commission with-
out objection by any party. The presentation clearly
showed a serious attrition problem facing Pepco in
1975."
* Pepco was faced with a rapidly deteriorating financial situation
with return on common stock equity in the District dropping to
6.09% as compared with the authorized return of 13% and average
yield of over 10% on A-rated utility bonds. Earnings per share of
common stock had declined to $1.14, below the annual dividend
level, and interest coverage was only 1.89 times, thereby jeopardiz-
ing Pepeo’s bond ratings. Pepco could not legally issue preferred
stock because it could not meet the charter coverage. The ability to
sell common stock was severely limited because it yalue hovered at
par value, the jegal limit below which is cannct be issued. As a
result, Pepeo was foreclosed from financing its minimum construc-
tion program with permanent capital.
10
Nevertheless, the Commission refused to make use
of the most recent available test period on the record
before it and based its revenue determination on the
stale 1974 test period.
The effect of this unreasonable refusal to make use
of the more current data presented by Pepco was ex-
tremely substantial. Had the Commission applied the
precise ratemaking formula which it had approved in
this case to the actual 1975 data in the record, the re-
sult would have been a $48 million rate increase, in-
stead of the $27.7 million granted on the basis of the
stale 1974 data.
The Commission even refused unaccountably to ad-
just the unrepresentative 1974 data to reflect known
1975 changes in costs, revenue, and investment, all of
which were properly in evidence, and were much more
representative of conditions prevailing when the new
rates were finally placed into effect.
The Court of Appeals en banc merely dismissed the
failure to use the updated test year as a matter of ‘‘dis-
cretion.”’ It observed that the Commission should
‘select a test year that appears likely to be representa-
tive of the future’ (Appendix D, at 10d), never look-
ing to see if the Commission had, in fact, done so, when
in fact the uncontroverted evidence of actual 1975 con-
ditions proved conclusively that the 1974 data were
outdated.
Calling this ‘‘the majority’s ‘hear no evil, see no evil’
approach to this case,” dissenting Judge Harris ob-
served that “it would be difficult for me to conceive of
a rate case in which the agency’s action could more
readily be seen to be erroneous than this case.” (Ap-
pendix D at 29d) The majority opinion brushed the
11
dissent aside as not worthy of rebuttal due to its ‘‘un-
fortunate tone.’’ (Appendix D at 28d)
The fact is that the more current data was in the
record, available to the Commission, and demonstrated
on its face the inaccuracy of ‘‘predictive’”’ rates based
on the older, stale data. This was not only apparent,
but argued vehemently by Pepco below. The prece-
dents of this Court required the Commission to base
its decision directly on the updated data, or instead
to reflect the updated data in adjustments to the earlier
test period and the ultimate end result of the order.
The unconstitutional deficiency was to fail to do either.
The Commission’s refusal to make use of the most
recent available data on the record before it was in
conflict with the fundamental ratemaking principle
that test periods must be representative of the period
during which the rates will be in effect, as discussed
infra. The en banc Court of Appeals’ error was to fail
to look critically at the relationship between the evi-
dence cited by, and the ‘‘end result’’ announced by, the
Commission, sweeping aside its three-judge panel’s
careful analysis in the process, and holding that the
Commission had unbridled discretion in the matter.
This case is extraordinary in that the District of Co-
lumbia Court of Appeals in this, its first major public
utility rate case, has ignored the fundamental legal
principles of ratemaking and this Court’s decisions
with respect to ratemaking in such a way as to compel
the dissenters to echo this lament of Commissioner
Stratton, the dissenter on the three-member Commis-
sion:
‘“‘TIn failing to acknowledge and deal with the fact
that operating and capital requirements per unit
12
of sales have risen, and continue to rise, faster
than revenues, the Commission has taken a step
that can only bring regulation in the District of
Columbia into disrepute among the fair-minded
and knowledgeable.’’ (Appendix D at 38d)
The dissenting Commissioner below noted,
For, if ever a record demonstrated attrition, this
one does. If ever a record called for realistic steps
to deal with attrition, this one does. If there was
ever a demonstration of the failure of revenue
growth to keep up with the growth of expenses
and investment, it appears in the record spread
before the Commission in this case, where there is
data not only for the test year but also for the nine
months following—data which the Commission
accepted into the record, I had thought, for the
purpose of reaching a decision that took account
of the real world as it was revealed to us by the
operating results of the company during the pen-
dency of the case. (Appendix A at 65a-66a)
The fact remains that the Commission’s failure to
use the most current data in the record in combination
with its refusal to make adequate allowance for attri-
tion in the face of a ‘‘declining trend’’ in earnings
guaranteed that Pepco could not conceivably ever ap-
proach the authorized rate of return the Commission
itself specifically found to be required to attract capi-
tal. That ratemaking approach directly contravenes the
due process and just compensation clauses of the Fifth
Amendment. FPC v. Natural Gas Pipeline Co., 315
U.S. 575, 585 (1942).
13
Indeed, this Court has already recognized the evils
of stale test year data in regulation of essential utility
services:
We think the adoption of a single year as an
exclusive test or standard imposed upon the com-
pany an arbitrary restriction in contravention of
the Fourteenth Amendment and of ‘the rudiments
of fair play’ made necessary thereby. [Citation
omitted] The earnings of the later years were ex-
hibited in the record and told their own tale as to
the possibilities of profit. To shut one’s eyes to
them altogether, to exclude them from the reckon-
ing, is as much arbitrary action as to build a sched-
ule upon guesswork with evidence available. West
Ohio Gas Co. v. Public Util. Comm’n of Ohio, 294
U.S. 79, 81-82 (1935) (emphasis supplied).
The Court of Appeals itself has asserted the same
principle in another case even so recently as this year.
People’s Counsel v. Public Serv. Comm’n, 399 A.2d 43,
51 n.14 (D.C. 1979) :
A test year must be representative of future
conditions. The Commission is required to make
appropriate adjustments to test year results that
are unrepresentative to account for changed con-
ditions not reflected in test year data. City of
Evansville v. Southern Indiana Gas & Elec. Co.,
339 N.E. 2d 562, 575 (Ind. Ct. App. 1975).
Pepeo introduced all the relevent evidence in its
possession and requested the Commission to consider
the evidence of overwhelming and continuing attrition
and provide a solution which offered Pepco a reason-
able opportunity to earn the rate of return the Com-
mission itself held was necessary to attract capital—
whether through use of the updated test period, use of
a full end-of-period rate base investment amount, au-
14
thorization of a specific dollar attrition, recognition of
the current factual situation when weighing adjust-
ments to the stale 1974 test period, or adoption of a
combination of remedies. All such remedies were denied
—even though the Commission specifically found that
‘‘attrition is still with us.”’
II
Arbitrary Utility Rate Regulation And Partisan Rate Case Review
By The State Courts Are Inimical To The National Economy And
To The Country's Ability To Cope With the National Energy Crisis
This case is not an isolated aberration. In the Dis-
trict of Columbia, it is one of three Pepco cases decided
and finally announced by the Court of Appeals within
a one-week period, all dealing with various aspects of
utility ratemaking and all guaranteeing that the utility
has no opportunity to earn the rate of return specifi-
cally found by the regulatory body to be required to
attract necessary capital.‘ It is the manifestation in the
District of Columbia of a pervasive non-federal regula-
tory and judicial attitude towards utility rates which
the Court’s dissenters condemned as follows:
One result of the majority’s resolution of this ap-
peal seems regrettably inescapable: The Commis-
sion will conclude that virtually any treatment of
a utility which purports to be ‘‘pro-consumer”’ in
* Washington Public Interest Organization v. Public Serv.
Comm ’n, 393 A.2d 71 (D.C. 1978), reh. en banc denied, Docket No.
12017 (May 3, 1979) ; Potomac Electric Power Co. v. Public Serv.
Comm’n, —— A.2d —— (Docket No. 10909, D.C. March 16, 1979),
reh. en banc denied (May 8, 1979), each of which is the subject of
petitions for writs of certiorari concurrently filed herewith.
15
nature is likely to escape perceptive judicial re-
view. (Appendix D at 29d)
* * ” *
If the Commission arbitrarily refuses to achieve
the requisite delicate balance between consumer
and investor interests, it is not oniy violating the
utility’s constitutional rights, it is grievously
harming the true long-range interest of consumers
as well. ... That is precisely what occurred in this
ease. (Appendix D at 37a-38d)
It is common knowledge that since the early 1970’s,
electric utility efficiencies of scale have been overshad-
owed by inflation, mounting environmental restric-
tions, greater expense for scarce land, and sharply ris-
ing fuel costs. Due to the limited nature of federal rate
regulation of electric utilities,’ almost all resulting
major electric rate increases have been debated, de-
cided and reviewed at the state level.
Federal regulation in the energy field (such as con-
ferred by the Natural Gas Act, 15 U.S.C. §§ 717 et seq.
(1976), on the Federal Energy Regulatory Commis-
sion) is the subject of extensive political commentary
and attention, and has brought on significant appellate
responsibilities. This Court has acknowledged its re-
sponsibility not only to ensure a ‘‘flexible’’ regulatory
framework, but also adequate judicial oversight of the
° The Federal Power Act, 16 U.S.C. §§ 791, et seq. (1976), con-
fers jurisdiction in the Federai Energy Regulatory Commission
(FERC) over wholesale transactions in interstate commerce. The
rates paid by retail customers, and all jurisdiction over the expan-
sion of generation facilities required to serve them, are regulated
solely by the states. FERC jurisdiction is thus limited to perhaps
only 10% of all sales of electricity.
16
constitutional boundaries to that ‘‘flexible” regulation.
Natural Gas Pipeline, supra, at 586; Permian Basin,
supra, at 792.
The imperatives are no less significant in the regu-
lation of electric utilities. The financial health of the
industry has deteriorated to precarious levels and the
states are experimenting with flexible, sometimes inno-
vative, and sometimes unconstitutional regulatory
schemes and practices. Each state’s decision is not
‘‘unique”, even if viewed in isolation; the themes recur.
Pepeo submits that this Court should signal at this
critical point that it has not abandoned its oversight
of constiutional safeguards in the operation of perhaps
the most crucial component of our private economy,
particularly in these times of energy crisis and ram-
pant inflation.
Pepco submits that the standards of regulation and
regulatory oversight embodied in this case below are
as clearly deficient as any this Court will be presented
in the future. The issues have been thoroughly and
forcefully explored below, particularly in the dissent
to the Commission’s opinion (Appendix A), the opin-
ion and concurring opinion of the three-judge panel of
the Court of Appeals (Appendix C at 1c-83c), and in
the dissent to that Court’s en banc opinion. (Appendix
D at 29d-38d)
17
CONCLUSION
The Commission’s order, viewed in its entirety, pro-
duced an arbitrary result that deprived Pepco of its
property without due process or just compensation.
The Commission first established the rate of return it
specifically found to be necessary to attract capital and
then, by using its arbitrary refusal to consider current
operating data, absolutely guaranteed that Pepco
could have no opportunity to earn it. The en banc opin-
ion of the Court of Appeals has perpetuated that un-
constitutional result. For the foregoing reasons, Pepco
urges this Court to grant this petition for a writ of
certiorari to the District of Columbia Court of Ap-
peals, that this Court reverse the en banc decision of
the Court of Appeals and that this Court reinstate the
three-judge panel’s decision which reversed and re-
manded the orders of the Commission.
Respectfully submitted,
Epwarp A, CAINE
LAWRENCE A. GOLLOMP
ALLEN C. BARRINGER
WILLIAM DANA SHAPIRO
1900 Pennsylvania Avenue, N.W.
Washington, D.C. 20068
(202) 872-2890
WILLIAM C. GARDNER
Houston and Gardner
615 F Street, N.W.
Washington, D.C. 20004
Attorneys for Potomac Electric
Power Company
Washington, D.C.
July 30, 1979
APPENDIX
la
Appendix A
PUBLIC SERVICE COMMISSION OF THE DISTRICT OF
COLUMBIA
1625 I Street, N.W., Washington, D. C. 20006
Order No. 5739
November 12, 1975
IN THE MATTER OF
Application of POTOMAC ELECTRIC )
POWER COMPANY for an increase in)
its retail rates for the sale of ) Formal Case No. 630
electric energy )
FINAL OPINION AND ORDER
BEFORE THE COMMISSION: Ruth Hankins-Nesbitt, Chair-
person; H. Mason Neely, Vice
Chairman; and William R.
Stratton, Commissioner
Procedural History
This case had its genesis in the December 20, 1974 ap-
plication by Potomac Electric Power Company (PEPCO)
for increased rates annually for retail electric service
amounting to $48,243,000 and subsequently increased to
$50,832,000 in the District of Columbia. On January 9,
1975, the Commission gave public notice of the filing and
content of the PEPCO application and of the scheduling
of a February 19, 1975 prehearing conference. This pre-
hearing conference, rescheduled for February 20, 1975 by
Commission notice dated January 27, 1975, was then re-
scheduled for March 7, 1976 (Commission Notice, Febru-
ary 18, 1975), and again rescheduled for and held on May
6, 1975.
By Supplemental Notice of Prehearing dated April 18,
1975, the Commission urged parties having common inter-
ests to endeavor to arrange consolidated presentations,
and directed all parties to prepare and file with the Com-
mission prior to the prehearing a statement of issues pro-
posed to be addressed, the number of witnesses and the
subject matter of their testimony, and a proposed proce-
dural schedule.
By Order No. 5718, May 20, 1975, the Commission
granted intervention to some thirteen parties: The Office
of Peopie’s Counsel; Department of Highways and Traffic,
District of Columbia Government; All-Electric Customers
of the District of Columbia (AC/DC); Apartment and Office
Building Association of Metropolitan Washington, Inc.;
Consumers Urging Rate Equity; D.C. Power; Friendship
House; General Services Administration; League of Wom-
en Voters; All Souls Church; Washington Public Interest
Organization and Dr. and Mrs. Henry Kalmus. The Com-
mission also announced in Order No. 5718 its acceptance
of the issues designated by the parties as relevant and
material to the ultimate issue of just and reasonable rates;
and fixed procedural dates for the entire case, beginning
with a hearing on June 4, 1975 and concluding with oral
argument on September 3, 1975. By Public Notice dated
June 2, 1975, two additional hearings were scheduled to
obtain citizen expression. Although minor adjustments in
hearing dates were found necessary and were made, hear-
ings in this case were concluded on schedule.
During the pendency of its basic application, PEPCO
twice sought interim rate increases (by applications dated
March 12, 1975 and July 3, 1975). Both applications were
dismissed by the Commission (Order No. 5707, April 7,
1975; Order No. 6725, July 11, 19765).
3a
Also during the pendency of this proceeding, two other
formal cases were consolidated with this case. By Order
No. 5703, March 25, 1975 PEPCO’s application for ap-
proval of an environmental surcharge (Formal Case No.
629) was denied and the issue added to this case. By Order
No. 5714, May 5, 1975, the Commission dismissed a com-
pliant against PEPCO by the D.C. Government insofar as
it sought reconsideration of prior orders or reparations for
past overcharges, but consolidated with this case issues
raised by the complaint with respect to the lawfulness of
existing PEPCO rates.
The Commission held 22 days of hearings in this case,
which produced a transcript of 2,923 pages; and in addition
received from the parties 130 exhibits. Briefs were filed
by: The Office of People’s Counsel; Department of High-
ways and Traffic, District of Columbia Government; All-
Electric Customers of the District of Columbia (AC/DC);
Apartment and Office Building Association of Metropoli-
tan Washington, Inc.; Consumers Urging Rate Equity;
D.C. Power; Friendship House; General Services Admin-
istration; League of Women Voters; All Souls Church;
Washington Public Interest Organization and Dr. and
Mrs. Henry Kalmus.
The Case In General
At the outset, we must observe that this decision will
be the fourth decision by this Commission in the past six
years on rate increase applications by PEPCO. We make
this observation not by way of criticism of either PEPCO
or our regulatory predecessors, but rather as an expression
of our deep concern that the time, effort and expense in-
volved in the 1970, 1972, and 1973 PEPCO cases appears
to have been ineffectual in solving the economic problems
of this utility. We are faced again in this case, as was the
Commission in the 1973 PEPCO case, with the assertion
by PEPCO that no matter what rate of return the Com-
mission allows, PEPCO.will not be able to earn it unless
=
4a
the Commission includes an inflation allowance in the rate
of return, adopts an end of period rate base, includes all
claimed items of investment and expense, approves a new
fuel clause, adds a separate allowance for attrition, or se-
lects some combination of several of these items.
We are aware of the well settled principle of utility reg-
ulation that it is the end result of the regulatory process
that must meet the test of justness and reasonableness.
We are also aware of the corollary to that principle, that
we are not bound to follow any particular methodology in
reaching our ultimate conclusion. And while we are desir-
ous in the interest of both sound regulation and a finan-
cially sound utility of avoiding the almost annual PEPCO
rate increase application, a desire that might suggest rad-
ical departure from historical regulatory principles and
methodologies, we are not convinced that experimentation
in these uncertain economic times would be in the best
interest of the ratepayers in the District of Columbia.
In this context, we must and do recognize, as do all
parties in this proceeding, the presence of unusual circum-
stances in the year 1974. More specifically, as the record
shows, PEPCO’s operating results and earnings picture in
early 1974 approached quite closely the picture drawn by
this Commission in its 1973 PEPCO case order. In fact
PEPCO's own financial data indicates that for the 12
months ended July 1974 it achieved earnings per share of
$1.86, a ratio of earnings to fixed charges of 2.74 times,
and a return on average common stock equity of 12.2
percent. The Commission's 1973 order found 12.5 percent
to be a reasonable return on equity.
The latter part of 1974, however, witnessed a sharp and
steady decline in the PEPCO financial results. Viewing the
record as a whole, two factors stand out as perhaps the
principal causes of this decline: (1) energy conservation
resulted in a substantial decrease in the number of kilowatt
5a
hours sold at retail by PEPCO in 1974; and (2) a substan-
tial decrease in the energy and capacity sold by PEPCO
to the Pennsylvania, New Jersey, Maryland (PJM) Pool,
of which PEPCO is a member. Had these two dramatic
changes not occurred, the need for a rate increase appli-
cation by PEPCO may very well have been eliminated.
Together, the two changes represented an order of mag-
nitude decrease in PEPCO’s gross revenue of some
$65,000,000.
We see no evidence of record which persuades us that
there will be a return to past normalcy in the near term
future in either or both of these items. Although 1975
operating data, of which we may take official notice, indi-
cates a resumption of a growth trend in retail kilowatt
hour sales, it appears that the over 60% reduction in PJM
sales is continuing and thus the two factors tend to offset
each other to some degree. Thus, while 1974 was indeed
an unusual year for PEPCO when compared to the 1970-
1973 period, the record indicates that 1974 level condi-
tions, rather than those prevailing in 1973, are more rep-
resentative of conditions reasonably expected to exist in
the future.
A look at the future, therefore, indicates a new and
different ‘‘normalcy” on which our predictions of things to
come may properly be based. With that base, we believe
that adherence to traditional regulatory concepts will give
reasonable assurance of achieving the desired end result.
We shall therefore follow that course here, and will now
proceed to consider and determine the major issues of rate
of return, rate base, expenses and rate structure.
Rate Of Return
Our analysis of the rate of return issue in this proceeding
will begin at the beginning, ie, with a summary of the
testimony of record on this subject.
6a
Not unexpectedly, there is little variation in the evidence
of record in respect of return requirements on (or capital
cost of) debt and preferred stock. The relatively minor
differences in expert opinion presented to us result not
from differences in the precise mathematical calculations
of the embedded costs of these senior securities, but rather
from the inclusion or exclusion of short term debt and the
use of different points in time to make the calculations,
i.e, embedded costs as of the time the testimony was
prepared (early or mid-1975), or on pro forma costs antic-
ipated to exist at year-end 1975. As indicated, the differ-
ences are minor, with calculated embedded costs ranging
from 6.93% to 7.15%, and embedded costs of preferred
within a range of 7.83% to 7.88%.
Similarly, equally minor differences arise in the expert
witnesses views on PEPCO’s capital structure. It appears
from the record that the experts are in general agreement
that PEPCO’s capital structure consists of approximately
56% debt, 12% preferred stock, and 32% equity.
Expectedly, there are wider differences of opinion
among the experts on the cost of (or return requirement
on) PEPCO’s common stock. It is to that issue that we
must devote primary attention.
PEPCO’s principle rate of return witness was L. Sanford
Reis, who recommended a rate of return for PEPCO of
9.75% to 10.0%. Mr. Reis, whose qualifications as an ex-
pert witness on the subject of rate of return are beyond
question, has testified frequently before this Commission.
In his prior appearances, Mr. Reis’ basic approach to the
determination of return on equity has been of ‘‘comparable
earnings.” As we understand his testimony in this case,
he continues to rely primarily on that approach, although
he has also offered for consideration other methods which
he used essentially as checks on or verification of the com-
parable earnings method. In arriving at his conclusion, Mr.
Reis studied the realized return on common equity of 13
7a
“comparison” companies and of PEPCO. His analysis
showed that realized returns on average common stock
equity have declined substantially since 1969, and that
PEPCO's performance during that period has been well
below the ‘‘comparison”’ companies.
It was Mr. Reis’ view that the return required to attract
equity necessarily increases by at least as much as the
increase in debt costs, and because of the greater risk
inherent in equity, probably more. Mr. Reis also noted the
undisputed fact of institutional investor disenchantment
with utility securities in general, the impact of attrition on
equity earnings, and the need to'attract outside capital to
finance even PEPCO’s drastically curtailed construction
program. Consideration of all these factors, according to
Mr. Reis, leads to the conclusion that PEPCO should be
afforded an opportunity to earn between 15.5% and 16.0%
on its common stock capital. Given today’s economic con-
ditions and trends, it was Mr. Reis’ view that a ‘‘stated’’
return on equity in that range should permit PEPCO to
actually realize an equity return of approximately 14.0%
to 14.5%.
People’s Counsel offered rate of return testimony
through witness Edgar Bernstein, a former member of this
Commission, now a consulting economist, who has pre-
sented testimony in a substantial number of utility rate
cases before Federal and State Commissions. As with Mr.
Reis, Mr. Bernstein’s qualifications as an expert witness
in the rate of return field are unchallenged. Mr. Bernstein,
as did Mr. Reis, also selected a group of companies which
he considered to be comparable to PEPCO. Unlike Mr.
Reis, however, Mr. Bernstein used his comparable com-
panies (and FPC electrics) to develop earning price ratios.
To the arithmetically calculated earnings price ratios, Mr.
Bernstein added an adjustment for the cost of flotation
and pressure of 10%, and a second upward adjustment for
future earnings growth and to accommodate market price
at a reasonable margin above book value. On the basis of
8a
his analysis, Mr. Bernstein concluded that a reasonable
return on PEPCO’s equity would be 11.5% to 12.5%. Add-
ing the cost of senior securities, Mr. Bernstein concluded
that a fair rate of return to PEPCO would be 8.70%, ap-
plied to an average net investment rate base for 1974,
excluding construction work in progress (CWIP). Should
the Commission include construction work in progress in
the rate base and use an end of period rate base for pur-
poses of determining revenue requirements, Mr. Bern-
stein’s recommended rate of return is no higher than 8.5%.
In his view, adoption of that regulatory approach would
significantly reduce investor’s risk.
People’s Counsel witness Peter Karpoff, while not offer-
ing a full rate of return study, did submit a recommenda-
tion that the rate of return found reasonable by the Com-
mission be applied to a capital structure consisting of
embedded amounts of outstanding debt and preferred
stock and the aggregate market value of outstanding com-
mon stock or its book value, whichever is higher.
The General Services Administration (GSA) on behalf
of the Federal government as a customer, offered a rate of
of return evidence through its witness Jerome Nicholas.
Mr. Nicholas has testified for GSA in the last two PEPCO
rate cases, and his approach to a rate of return in this case
is essentially similar to his prior testimony. Mr. Nicholas
uses essentially a comparable earnings approach, in which
he reviewed and analyzed published financial data on bond
yields, bond yield averages, prime interest rates, returns
on equity; and compared financial data of 21 operating
electric companies, including PEPCO, in terms of before
and after tax interest coverages, experienced returns on
common equity, growth in net income available for com-
mon equity, and debt ratios. On the basis of his analysis,
Mr. Nicholas concluded that a fair and reasonable rate of
return for PEPCO would be 8.75 percent, a figure which
includes a return on equity of 12.18%.
9a
The rate of return witness for the Commission staff in
this case was David A. Kosh. Mr. Kosh’s long and distin-
guished career as a rate of return witness includes innu-
merable appearances before this Commission and other
State and Federal reguiatory bodies, and although the dis-
counted cash flow (DCF) methodology employed by Mr.
Kosh has been the subject of differences of opinion, we are
aware of no instance in which Mr. Kosh’s qualifications as
an expert witness have been questioned.
Simply stated, the DCF approach to a determination of
the cost of equity is expressed in terms of a formula: the
cost of equity is equal to dividend yield plus its anticipated
growth. In applying the DCF formula in this case Mr.
Kosh made several different analyses of the experienced
growth of PEPCO and a group of eight companies which
he considered similar to PEPCO, and on the basis of his
analysis of annual rates of growth in dividends and book
value per share concluded that a 3.0% annual growth rate
for PEPCO and a 3.47% average annual growth rate for
the eight similar electric operating companies could rea-
sonably be expected by investors.
Similar analyses were made by Mr. Kosh in order to
develop the dividend yield figure. Using the figures thus
developed in the DCF formula, Mr. Kosh concluded that
what he termed the “equity capitalization rate’’ for
PEPCO was 11.75%. According to Mr. Kosh, however, the
equity capitalization rate is a “‘bare bones” cost of equity,
a rate insufficient to allow the sale of common stock at a
price above book value, a fact which in the long run would
result in dilution. It was Mr. Kosh’s view that earnings on
equity should be at a level which would tend, for the near
term future at least, to keep market price about 20% above
book value.
To achieve this result, Mr. Kosh made detailed studies
of a group of 45 electric utilities in which he analyzed the
10a
relationship between the rate earned on book and the mar-
ket/book ratio. These studies lead Mr. Kosh to the conclu-
sion that if PEPCO in fact earned, and if investors were
persuaded that PEPCO were to continue to earn, at a rate
of 13% on equity its market price would tend to be ap-
proximately 20% above book value. In ivir. Kosh’s view,
the 1.25% increase in the bare bones cost of equity figure
would be sufficient to cover the cost of financing and pres-
sure and to accommodate an anticipated further decline in
market price in the near term future. Mr. Kosh’s ultimate
conclusion was that a fair rate of return would be 9.1%, a
return which he found would provide an after tax coverage
of interest of 2.3 times and a fixed charge coverage of 1.8
times, coverages which he concluded were both safe and
an indication that 9.1% is indeed a fair rate of return.
Discussion And Conclusion
The ease of summarization of testimony on the rate of
return issue is matched by the ease with which equitable
legal principles may be stated. The classic tests of Blue-
field and Hope* remain valid. To be fair and reasonable, a
rate of return must be sufficient to protect the financial
integrity of the company, to maintain its credit and attract
its capital, and to provide investors a return in line with
that available from investments having comparable risks.
While these principles may appear to be investor oriented,
equally well settled is the principle that in reaching a con-
clusion on rate of return we have an obligation to protect
the customer interest in rates that while sufficient to as-
sure investor confidence are not excessive. It is, in short,
this delicate balancing of investor and customer interest
* Bluefield Water Works & Improv. Co. v. West Virginia Pub-
lic Service Commission, 262 US 679, PUR1923D 11, 67 L Ed.
1176, 43 S Ct. 675; Federal Power Commission v. Hope Nat. Gas
re (1944) 320 US 591, 51 PUR NS 193, 88 L Ed. 333, 64 S Ct.
lla
which we must strive to achieve, a balance which is often
stated cannot be achieved by use of simple mathematics
or mathematical formula. We are bound, or course by the
evidence of record in this case, and it is on that evidence
that we must make our judgment as to a fair rate of return
for PEPCO. We are not bound, however, by the recom-
mendation or methodology of any particular expert wit-
ness, and we must acknowledge here, as this Commission
has in prior cases, our unwillingness or perhaps our ina-
bility to accept in total the methodology of any one wit-
ness. We recognize and we emphasize the essentially judg-
mental approach of each of the rate of return witnesses
who testified in this case. The selection of comparable
companies, for example, a process utilized by each of the
four principal rate of return witnesses here, is almost en-
tirely a matter of judgment. The appearance of objectivity
introduced by the use of criteria for determining compar-
ability is indeed an appearance, for the selection of criteria
themselves involves basically an exercise in judgment.
Needless to say the selection of criteria and the selection
of comparable companies can produce widely varied end
results.
These comments, directed particularly to the use of the
comparable earnings approach, are equally applicable to
the DCF formula or the use of earnings/price ratios. These
two approaches to determing rate of return on equity sug-
gest mathematical precision. However, each involves an
exercise in judgment in the selection of companies and the
selection of time periods to be analyzed in order to provide
the mathematical data which is then substituted for the
terms of DCF formula, or which appear in earnings/price
ratio calculations.
Our emphasis on the judgmental aspect of these matters
should not be construed as a rejection of that factor. In-
deed, it is that factor and that factor alone which we must
utilize in reaching our own conclusion as to a fair rate of
return for PEPCO. It is in short our judgment that must
12a
be translated into a mathematical figure; and on this re-
cord, it is our judgment that a fair rate of return for
PEPCO is 9.1%.
We reach this conclusion for the following reasons. At
the outset, determination of the cost of debt and the cost
of preferred stock present no real problem. These are
embedded costs and can be determined with mathematical
precision. There are, it is true, differences in the experts’
conclusions in this case.
With regard to embedded costs of debt capital, the
mathematical result of an analysis of PEPCO’s debt out-
standing as of December 31, 1974, is 6.89%. The experts
are agreed, however, that this figure must be adjusted to
reflect the retirement in August, 1975, of some $10 million
in debt securities carrying a 2.87% rate of interest. Mr.
Reis and Mr. Kosh would further adjust debt cost in an-
ticipation of a planned new 1975 issue by PEPCO of some
$50 million in debt securities, with each witness arriving
at a year-end 1975 cost of debt of 7.11%. To that cost, Mr.
Kosh would add .4% to recognize as a cost of capital the
compensating bank balances maintained by PEPCO to in-
sure lines of bank credit.
In determining the cost of debt that we have used in
reaching our rate of return conclusion, we have recognized
and accepted known changes from the December 31, 1974,
figure. In this regard, we are aware, both from our own
records and from reports submitted to us by PEPCO, of
which we may take official notice, that the $50 million debt
issue anticipated by Messrs. Reis and Kosh was not made.
Rather, it appears that PEPCO chose to meet its projected
1975 capital needs through short term borrowings, largely
in the commercial paper market. Given these facts, it
would be inappropriate to use the pro forma December 31,
1975 debt costs as precisely estimated by Messrs. Reis
and Kosh. Rather, we have adjusted the calculated 1974
embedded debt cost to reflect only the August, 1975, debt
13a
retirement and our conclusion that compensating balances
are properly considered in cost of capital computations.
The arithmetic of these adjustments produces a figure of
6.97%, a figure which we will round to 7% in recognition
of the fact that at current costs of debt capital, any new
debt issue by PEPCO will necessarily increase its embed-
ded figure.
We come next to the cost of preferred stock. After the
April, 1975, sale of preferred stock, the cost of that portion
of PEPCO’s capital structure is calculated at 7.83% (Bern-
stein), 7.84% (Reis) or 7.88% (Kosh). It appears that the
difference between the 7.83% and 7.84% calculations of
Mr. Bernstein and Mr. Reis, respectively, and Mr. Kosh’s
7.88% is accounted for by Mr. Kosh’s inclusion and re-
pricing of convertible preferred. Mr. Kosh’s rationale for
this treatment begins with the observation that converti-
ble preferred carries the characteristics of both fixed cost
and equity capital, giving the owner a valuable option.
Exercise of this option, according to Mr. Kosh, would act
to dilute the earnings of existing shareholders; and repric-
ing the convertible issue at straight preferred stock cost
at the time of issue reflects true economic costs.
We find Mr. Kosh’s reasoning persuasive, and we have
therefore used 7.88% as the cost of PEPCO’s preferred
stock.
With regard to capital structure, our calculations indi-
cate a current capital structure of approximately 55.4%
debt and 12.3% preferred. Thus for purposes of determin-
ing rate of return for PEPCO our calculations reflect 55.4%
debt at a cost of 7.0%, and 12.3% preferred stock at a cost
of 7.88%.
We turn then to the more difficult task of determining
the cost of common equity. As we have noted above, while
it is possible to mathematically calculate the actually re-
alized earnings on equity, there is no mathematical formula
by which we could reach the magic number that will make
l4a
PEPCO common siock sufficiently attractive to investors
to assure its purchase in the money markets.
Our review of the expert opinion testimony offered us
begins with the recognition that it is not our function to
determine the market price of PEPCO stock or to guar-
antee to investors a fair return on their stock. Rather, our
role is to set retail rates reasonably designed to produce
revenue which, if produced, would afford the Company an
opportunity to achieve a reasonable return.
Viewing our function in this light, we must reject Mr.
Bernstein's assertion that the cost of equity capital in this
year 1975 is in a range below the 12.5% found reasonable
by this Commission for PEPCO in 1973. We note in this
connection that PEPCO’s current cost of debt is approxi-
maiely 10% and that PEPCO’s preferred stock offering in
April of 1975 was sold at a cost of 11.25%. We note also
that in 1973 PEPCO sold common stock at approximately
$15.00 per share, in 1974 at approximately $11.12, and
1975 at approximately $10.63 per share. The increased
cost of senior securities and the decline in the amount
investors are willing to pay for common stock of PEPCO
are persuasive to us that investors today are demanding
a higher return on equity investments than they were two
years ago.
We are also unpersuaded that we should fix rates to be
paid by District of Columbia customers of PEPCO on the
basis of the ‘‘stated” return on equity proposed by Mr,
Reis. In addition to what seems to us a patent unfairness
to the District of Columbia ratepayers, we are troubled by
two other points in Mr. Reis’ testimony. First we believe
that there are enough intangibles and uncertainties in-
volved in the determination of the cost of equity without
adding, as Mr. Reis did, an additional judgmental allow-
ance of 1.5% to accommodate anticipated inflation or to
reflect PEPCO’s past inability to earn its authorized rate
of return. Our second difficulty with Mr. Reis’ testimony
15a
is, not unexpectedly, in the area of his selection of ‘‘com-
parable’ companies. We note, for example, substantial var-
iations in achieved earnings among the companies selected,
with the highest rate being earned in each year being at
least 47% above the lowest. The use of an average neces-
sarily obscures the variation, but is not persuasive that
the average is comparable to PEPCO. We also note that
of the 13 companies Mr. Reis selected only 4 that were
regulated on the same basis as PEPCO, i.e., original cost,
a fact that further weakens the assertion of comparability.
Having rejected the two extremes, we turn now to the
testimony offered by Mr. Kosh. We are aware, of course,
that the DCF method used by Mr. Kosh has been both
praised and criticized by the regulatory bodies over the
years. We recognize, as we have indicated, that the DCF
appearance of mathematical certainty is illusory, since the
end result produced by the DCF formula is entirely de-
pendent upon the judgment used in selecting the growth
and dividend factors. It is in the area of judgment, rather
than the use of the DCF formula, that we are impressed
with Mr. Kosh’s testimony. We find persuasive, for ex-
ample, Mr. Kosh’s point that the cost of equity is deter-
mined in the market rather than a comparison of earnings
on book equity. We are also persuaded that the criteria
used by Mr. Kosh in selecting comparison companies tend
to eliminate to a substantial degree subjectivity and pos-
sibly bias in selections. We also agree that use of a recent
period (also favored by Mr. Reis) provides a sounder indi-
cation of investors’ expectations of earnings and dividends
(and growth in each) than does, for example, the 1967-1974
period used by Mr. Bernstein. While today’s investors may
indeed research the history of a company, perhaps even
from its beginning, it is our view that investors are more
strongly influenced by the company’s performance in re-
cent years. Moreover, although predictions of the future in
these troubled economic times is most difficult, we are
convinced that experience during these times is a better
16a
indicator of the future than a company’s performance in
the calmer times of the late 1960's.
We conclude, therefore that in order to attract equity
capital, a return on equity of 13% is required by PEPCO;
and we find an equity return at that level to be fair and
reasonable.
That our judgment on the evidence of record arrives at
the same result as that reached by Mr. Kosh should not
be construed as a suggestion that Messrs. Reis, Bernstein
and Nicholas have been of no help to the Commission. On
the contrary, we have found the testimony of those wit-
nesses invaluable in the formation of our own judgment in
this case, and without their testimony we would have faced
a difficuit, if not impossible task in our effort to achieve
that balance between customer and investor interest which
is in the final analysis our function in making a rate of
return determination.
To sum up this point, it is our conclusion that PEI CO’s
embedded cost of debt is 7%, its embedded cost of pre-
ferred stock is 7.88%, and its required return on equity is
13%. Application of these percentages to PEPCO’s exist-
ing capital structure of 55.4% debt, 12.3% preferred, and
32.3% equity produces a calculated overall rate of return
requirement of 9.05%. The precision of these calculations
however, is both comforting and disturbing. In today’s
money markets, for example, there is no reason to believe
that PEPCO could issue new debt or new preferred at the
calculated embedded costs of those securities, and no
doubt that any new issue of senior securities will increase
those embedded costs. While we are reluctant to attempt
to predict the future costs of debt and preferred stock, we
cannot ignore current costs. We will therefore adjust the
mathematically arrived at 9.05% rate of return to 9.1%, a
future which in our judgment is just and reasonable under
today’s economic condition.
17a
Rate Base
Having disposed of the difficult rate of return issue we
now turn our attention to the question of what is the
proper rate base to be used in determining PEPCO’s rev-
enue requirements for retail service in the District of Col-
umbia. Here we begin with the proposition that PEPCO’s
system, which, serves customers in Virginia and Maryland
as well as in the District of Columbia, is a unified, inte-
grated electrical system. Generating plants and transmis-
sion lines, wherever physically located, are used to serve
all PEPCO customers regardless of their geographical lo-
cation.
Pricer to 1970, PEPCO’s operations in all three jurisdic-
tions were regulated on a unified basis, with no effort being
made to allocate costs or expenses among the jurisdictions.
In 1970 however, this Commission, concerned that the
more rapid suburban Maryland growth might have created
a jurisdictional imbalance to the prejudice of customers
within the District of Columbia, required PEPCO to make
a jurisdictional allocation study. In the 1972 and 1973
cases similar studies were made by PEPCO, with all being
found acceptable by this Commission.
We had in this case a jurisdictional allocation study,
again prepared by PEPCO, and again utilizing essentially
the same technique used in prior cases. This technique,
known as the average and excess demand method, is one
of three methods found generally acceptable by regulatory
bodies. As explained by PEPCO witness, Frank Walters,
the average and excess demand method involves essen-
tially an allocation among jurisdictions of generation and
transmission plant on the basis of average jurisdictional
demands, a second allocation on the basis of peak de-
mands, and a combining of the factors developed by these
two calculations to produce the final percentage factor,
which is then applied to the plant to be allocated.
18a
Mr. Walters also presented for the record the results of
an allocation on the basis of coincident and non-coincident
peak demand, results which vary only a miniscule amount
from the result reached by the average and excess demand
method.
Other than the PEPCO study, which was reviewed and
accepted by the Commission Staff, no other jurisdictional
allocation studies were presented for the record in this
case. There are suggestions in the record, however, sug-
gestions which are more strenously argued on brief (par-
ticularly by the D. C. Department of Highways and Traff-
ic) that because of the undisputed higher growth in de-
mand in the suburban areas, all production plant installed
by PEPCO since 1970 should be assigned to those areas.
We have several problems with this suggestion. First,
as a purely factual matter the suggestion as stated ignores
the fact of actual use of this more recently installed plant
in serving customers in the District of Columbia. Secondly,
the suggestion appears to ignore the fact that the average
and excess demand method of allocation does reflect the
more rapid suburban growth, as demonstrated by the de-
clining share assigned to the District of Columbia in each
of the years in which studies utilizing this method have
been submitted to us. Third, while we are urged to make
a “pragmatic’’ adjustment in recognition of the fact of
steadily increasing unit cost of production plant, even
pragmatic adjustments must be based on some supporting
rationale. We are offered none on this record. Rather than
arbitrarily adjust the jurisdictional allocation study, we
believe it more appropriate to recognize the increasing unit
cost of plant, a major contributing factor to the phenom-
enon called ‘‘attrition’’, in dealing with the rate structure
issues that have been presented in this case. In our view,
demand and cost causation are not peculiar to suburban
customers, and those customers in the District of Colum-
bia who contribute substantially to PEPCO peak demand
Cn
19a
and who use the more recently constructed production
plant should in all fairness shoulder their share, but no
more than their share, of the burden of increased cost. We
will therefore again accept the average and excess demand
method of jurisdictional allocation, and deal with the prob-
lem of demand causation and peak load responsibility in
our determination of appropriate rate schedules.
The next issue we must address under the heading of
rate base is the perennial question of whether to use av-
erage or end of period figures. There is not, and indeed
there cannot be, any question on this record that PEPCO
has experienced a decline in earnings in the latter half of
1974 and that this declining trend shows no signs of a
reversal. This fact, of course, does not in and of itself
demonstrate the presence of ‘‘attrition.”” As the Commis-
sion said in the last PEPCO rate case ‘‘while a decline in
rate of return may be the result of attrition, it may with
equal validity be said to result from other factors, e.g.,
imprudent investment or excessive expenses.”
As we have indicated in our preliminary views, it ap-
pears to us that the major factors contributing to
PEPCO’s decline in earnings were the reduction in kilowatt
sales to retail customers and the significant drop in sales
to PJM. Putting these two factors aside, however, the
record is clear that the increase in investment costs per
unit of output noted in our last decision has continued;
and in this case not only is this fact demonstrated by the
actual dollar investment figures in the record but it is
confirmed, we believe, by the vigorous advocacy on the
part of consumer intervenors of the use of marginal or long
run incremental cost figures for rate making purposes. The
underlying theory of this advocacy is that the cost of new
production plant is higher than the average embedded cost
of that plant. Thus, while we are urged by some parties to
match revenue, expense and rate base by using average
rate base figures, we find little support in the record for
20a
those recommendations. In short, we are persuaded that
attrition is a phenomenon that is still with us, and we will
therefore now, as we have in the past, use an end of period
rate base, with appropriate adjustments, in order to com-
pensate for the presence of attrition.
The point is made by PEPCO that use of an end of
period rate base will only partially reflect the “attrition”
in earnings that has taken place since our 1973 PEPCO
decision. We are not persuaded, however, that the decline
in earnings has been due solely to attrition, but has in
large part been due to the drop in sales noted previously.
Since sales to retail customers appear to have resumed a
somewhat normal growth pattern, and since sales to PJM
appear to have leveled off to a large degree, and since
PEPCO has substantially reduced its construction budget,
it appears reasonable to conclude that attrition in the fu-
ture may play a less significant role than it has in the past.
A number of adjustments to rate base have been pre-
sented for consideration by our Staff and by several of the
intervening parties in this case. People’s Counsel witness
McCabe, for example, with the support of other consumer
parties, has urged elimination of construction work in
progress from the rate base and substitution of an allow-
ance for funds used during construction (AFUDC). Our
Chief Accountant, Mr. Manheimer, noting the unusually
large amounts included in construction work in progress
at year end, has recommended averaging construction
work in progress over the test period. Intervenor All Souls
Unitarian Church has urged that PEPCO’s investment in
the Douglas Point Nuclear station be eliminated from rate
base. Mr. Manheimer also recommends that we average
materials and supplies over the test period, and that we
eliminate amounts reflecting preliminary surveys, land
transactions undistributed, prepaid insurance, and com-
pensating bank balances, in our calculation of rate base.
2la
We have given most serious consideration to all of these
recommendations. We are disposed to agree with our Staff
and accept Mr. Manheimer's recommendation for the use
of an average amount of construction work in progress and
an average amount in the materials and supplies account
in rate base as more representative of the flow of dollars
in and out of the accounts. The record shows wide fluctua-
tions in these accounts over time and a substantial in-
crease in fuel inventories in 1974, resulting from stockpil-
ing due to the unusual fuel market in that year. The
amounts at the end of the period in both accounts appear
to be abnormally high. In view of PEPCO’s projected re-
duction in its construction program and the reduction in
fuel inventory in 1975, we -do not believe that the end
period figures can be called representative of anticipated
future conditions. The adjustment of materials and sup-
plies is consistent with the Commission's treatment ac-
corded to this item in Formal Case No. 610.
With regard to Mr. McCabe’s recommendation that con-
struction work in progress be excluded from rate base (a
recommendation subsequently modified to permit 10% of
plant in service to be included as a construction work in
progress allowanc.) we are disturbed by two factors. First,
the 10% allowance appears to us to be wholly arbitrary
and without foundation. Second, we would note that in-
cluding CWIP in rate base without AFUDC and capital-
izing AFUDC but excluding CWIP from rate base produce
about the same ultimate result. Essentially, only the tim-
ing is different; but in the long run, use of AFUDC may
result in a greater overall cost to the customer than inclu-
sion in the rate base of construction work in progress.
Projects begun in the period between rate cases, for ex-
ample, earn no return under the CWIP approach, and if
placed in service prior to the next rate case appear in rate
base at the actual cost of the project. Were AFUDC used,
the same project would appear in rate base at the cost of
the project plus capitalized interest, and ratepayers would
8 aS
22a
be required to provide a return in that higher cost. In
consideration of all factors, we believe that the interest of
both customer and investor would be better served by
continuing our long standing practice of allowing PEPCO
to include construction work in progress in its rate base.
With regard to the Douglas Point nuclear project, there
is no question but that substantial funds have been in-
vested in that project, and that nuclear projects require an
extraordinarily long lead time required to plan and com-
plete. We understand and appreciate the views expressed
by All Souls witness Father Millard in support of his rec-
ommendation that the $28.6 million already invested in
Douglas Point now be excluded from rate base. In consid-
eration of current fuel uncertainties and the 8 year or
longer lead time, however, we are not convinced that we
should at this time declare the nuclear project imprudent
or unnecessary.
We are disposed to agree with our Chief Accountant
that amounts reflecting preliminary surveys and undistri-
buted land transactions should not be included in rate |
base. As Mr. Manheimer has pointed out, there is no cer-
tainty that any of these amounts will be transferred to
plant in service and for that reason we believe their exclu-
sion is appropriate. Similarly, we agree with Mr. Manhei-
mer that prepaid insurance premiums and compensation
bank balances should be excluded from rate base, since
insurance premiums are expensed over time and compen-
sating bank balances are in our view more properly a part
of the cost of money and have been included in our calcu-
lations of fair rate of return.
For these reasons, then, and having considered all data
and recommendations of record, we find the appropriate
District of Columbia rate base to be $650,091,000, as
shown on Attachment A, Page 1.
To achieve a 9.1% rate of return on a rate base of
$650,091,000, PEPCO’s operations must produce a return
23a
of $59,158,000, as shown on Attachment A, Page 3. We
turn now to consideration of observed expenses and oper-
ating results, from which we may determine the amount
of revenues needed to produce this net return.
Expenses And Operating Results
On this record, few if any questions were raised about
the income, expense, and operating results recorded on the
PEPCO’s books. A number of adjustments in those figures
were proposed however, some by PEPCO, some by our
Staff, and some by intervenor parties.
Among these adjustments, the one with the most sub-
stantial dollar impact was PEPCO’s proposal for a new
depreciation rate. PEPCO’s current depreciation rate of
2.94% was approved in 1971 on the basis of a study re-
quired by and performed for the Commission. In this case,
PEPCO presented a new depreciation study prepared by -
its witness Ritter, a well recognized expert on the subject
of depreciation. Mr. Ritter also prepared the study for the
Commission in 1971.
That portion of Mr. Ritter’s study relating to traffic
signal and street light plant was sharply criticized by the
D.C. Department of Highways and Traffic. Portions of the
study were also questioned by GSA, and Mr. Ritter’s en-
tire study was considered unacceptable by People’s Coun-
sel. The Commission's Chief Accountant, Mr. Manheimer,
however, testified that he and his satff had reviewed Mr.
Ritter’s study and found it to have been done in a manner
consistent with prior depreciation studies of PEPCO as
approved by this Commission and in accordance with ac-
cepted practices and procedures. Mr. Manheimer also rec-
ommended acceptance of the study and its results by the
Commission, for the reason that accuracy in depreciation
rates and depreciation accounting are of great importance
today in view of the substantial additions to plant made
by PEPCO in recent years. As Mr. Manheimer pointed
out, PEPCO’s plant in service, now about $1.5 billion,
24a
increased by about $600 million in the last years. Sound
regulation requires, in our opinion, that depreciation rates
and the resulting depreciation reserve be neither overstat-
ed nor understand, particularly when we are dealing with
figures of this magnitude.
We are troubled somewhat by PEPCO’s departure from
past practice in instituting a depreciation study on its own
initiative. Past practice has been for the Commission to
order depreciation studies at times of the Commission’s
own choosing, and we remain convinced that sound and
effective regulation requires control by the Commission
over the amount, direction and timing of depreciation rate
changes. We will accept the PEPCO depreciation study in
this instance, but henceforth our past practice of ordering
depreciation studies is to be followed.
The change in depreciation expense resulting from the
change in depreciation rate necessitates a change in the
depreciation reserve. PEPCO has proposed an appropriate
adjustment to the depreciation reserve figure, and we will
accept that adjustment.
A second rate making adjustment having significant
dollar impact was PEPCO’s proposal that it be permitted
to ‘‘normalize”’ the four percent investment tax credit over
the full anticipated use of the assets giving rise to the
credit, ie, some thirty-one years. In prior PEPCO cases,
this Commission has recognized the fact that investment
tax credits in any particular year may vary widely from
credits from the year before or the year following. Our past
practice has been to require an averaging of investment
tax credits over first a four-year period, and in more recent
decisions over a six-year period. PEPCO now contends
that the six-year averaging convention would not ade-
quately normalize fluctuations in the investment tax cred-
it, and that therefore full asset life normalization is nec-
essary. PEPCO’s proposal is vigorously opposed by Peo-
ple’s Counsel on two grounds: first, as unnecessary to even
25a
out fluctuations; and second, as merely a device to enhance
PEPCO’s internal cash generation and its earnings quality
by making ratepayers involuntary lenders to PEPCO.
We find no evidence in the record that persuades us that
it is necessary to extend the six-year convention to thirty-
one years for the purpose of smoothing out variations in
year to year investment tax credit. We are therefore dis-
posed to agree in part with the position taken by People’s
Jounsel on this point and will use the six-year convention
as approved by the Commission in the prior PEPCO de-
cision (Formal Case No. 596); and although we recognize
PEPCO’s desire to improve its earnings through any and
all avenues of relief that might be available to it, we will
undertake to fulfill our responsibility to PEPCO through
more direct means, rather than requiring the ratepayer to
advance substantial sums of money to PEPCO over the
next thirty years.
People’s Counsel has proposed two other adjustments
to test year operating results which we find less persu-
asive. The first of these, which would recognize the uncon-
troverted fact that PEPCO’s sales to retail customers were
significantly lower in 1974 than 1973, suggests an increase
of approximately $6 million in operating income to reflect
this sales decline. We have two problems with this propos-
al: first, we find no evidence in this record on which to
base a conclusion that operating results in 1975 will
achieve 1973 levels of retail kilowatt hour sales, much less
reflect a growth in sales over 1973 at the growth rate
existing in the 1970-1973 period; second, even if there were
such evidence, the amount to be added to operating income
in the test year is, on this record, speculative at best.
It is possible, of course, to mathematically calculate a
revenue figure if we were to assume a specific number for
revenue per kilowatt hour of sales. The problem here is
that we do not know and cannot determine when, to which
customers, and at what rates these hypothetical additional
26a
kilowatt hours would have been sold. Additionally, as
PEPCO points out, revenues cannot be adjusted without
calculating the expenses that would have been incurred in
producing those additional revenues. To the revenue un-
certainties we have noted must be added the further un-
certainties of fuel and other expenses, perhaps offset in
part by additional sales to PJM. These expense hypothet-
icals would convert such a mathematical exercise to pure
speculation. We decline to indulge in that speculation.
People’s Counsel also proposes an adjustment to oper-
rating results to give effect to weather normalization.
While we have no conceptual difficulty with the concept
of weather normalization, and recognize it as an adjust-
ment quite commonly made in the gas utility field, we are
not persuaded that such adjustment is appropriate, in any
case, for an electric utility. It is not appropriate in this
case. The record here suggests, in fact, the impossibility
of defining ‘‘normal” weather conditions for a utility such
as PEPCO, since a review of the 20-30 year weather aver-
rages shows a deviation in yearly experience of greater
than 6 percent in each year but three and in excess of 10
percent in fourteen of the 22 years examined, with an
average deviation of 16 percent.
Another adjustment, proposed both by People’s Counsel
and our Chief Accountant, would annualize test year in-
terest expense to reflect changes in expense brought about
by changes in the Company’s debt securities, thereby re-
ducing income taxes. We believe this adjustment, recog-
nizing as it does a known change, is appropriate. It will be
made. In addition, we will accept the Staff adjustment
which places commitment fees “below the line.”’
PEPCO has proposed two additional adjustments: first,
that its wage and salary expense figure be increased to
reflect a new union contract, and to acknowledge increases
normally given management employees during the year;
second, that its tax expense be increased to reflect an
27a
anticipated change in the District of Columbia gross re-
ceipts tax rate.
We are persuaded that the wage and salary increase for
unionized employees is a proper factor for adjustment in
this proceeding. With respect to union wage increases, it
is a fact of labor management contract life that PEPCO is
obligated, in an amount certain, to increase wages of its
craft employees. With regard to management salary in-
creases, we do not agree that the adjustment requested by
PEPCO should be made. We are persuaded that the un-
certainties as to amount, timing, and fact of these project-
ed increases are such that the proposed adjustment cannot
be made.
With regard to the proposed adjustment for a gross
receipts tax increase, we may take official notice of the
fact that the District of Columbia gross receipts tax rate
has now been changed from 5% to 6%. Since the tax rate
change is now both known and effective, we will make the
appropriate adjustment.
Additionally, although not requested by PEPCO, we
must take official notice of the fact that the District of
Columbia corporate franchise tax rate has now been in-
creased to 9%, and we are constrained to also adjust our
tax computations to reflect that change.
PEPCO has also requested that it be authorized to pass
on to District of Columbia customers, as an operating
expense, that portion of payments made to the State of
Maryland’s environmental trust fund properly allocable to
the consumption of electricity in the District of Columbia.
While we are troubled by the proposition that District of
Columbia customers should provide funds to the State of
Maryland, we are persuaded that, as revised, the Maryland
Environmental Trust Fund is not a tax by Maryland on
District of Columbia residents but rather is an appropriate
and necessary PEPCO operating expense. Since the basis
28a
for payment is power and energy generated in Maryland,
a substantial portion of which is used in the District of
Columbia, we believe that the portion of this operating
expense represented by energy consumed within the Dis-
trict of Columbia, we believe that the portion of this op-
erating expense represented by energy consumed within
the District should be properly be borne by District of
Columbia ratepayers. We are not persuaded however, that
D.C. residents should be required to pay the 1.5% collec-
tion fee provided by the Maryland statute, and we shall
therefore disallow that amount. We intend to keep this
entire matter under review, and our action here is without
prejudice to our right to reach a different conclusion should
changes in circumstances occur which, in our judgment,
would warrant a different judgment.
At this point, then, having concluded that a 9.1% rate
of return on a District of Columbia rate base of
$650,091,000 requires a return of $59,158,000, and that
PEPCO operating results, as adjusted in accordance with
our conclusions, indicate a realization under currently ef-
fective rates of some $12,302,000 less than required, we
turn now to the question of rate schedules and rate levels
which will afford PEPCO an opportunity to achieve that
level of earnings. Giving effect to taxes, this additional net
income equates to some $27.7 million in additional reve-
nues.
Rate Level And Rate Structure
Of all the issues in this proceeding, the issue of rate
structure drew the most attention.
PEPCO’s proposed rate structure follows, in large part,
the trend toward rate simplification and rate flattening
that has prevailed over the past several years. Offered for
our consideration were also a variety of proposals from
customer intervenor parties, most of which have as a cen-
tral theme the proposition that rates should be set on the
29a
basis of long run incremental costs. Specific criticism of
PEPCO’s proposed rate structure was offered, insofar as
their particular interests were involved, by the Apartment
and Office Building Association, the General Services
Administration, the D.C. Department of Highways and
Traffic, and the AC/DC Committee, which spoke for the all
electric residential customers in the District of Columbia.
Turning first to the proposition that long run incremen-
tal cost should be the basis for retail rates we must ac-
knowledge the confusion on this record arising from the
apparent use of the terms ‘‘marginal” and “long run incre-
mental” as interchangeable. As we understand it, marginal
costs and long run incremental costs are not synonomous,
yet these concepts appear to be so used by some intervenor
witnesses. Given our understanding of these concepts, i.e.,
that marginal costs include essentially only the out of
pocket costs of supplying an additional unit of output,
whereas long run incremental cost includes the additional
cost of capital investment required for the additional unit,
we find the recommendations and arguments of People’s
Counsel and residential intervenor groups persuasive on
this point. To the degree that increased demand requires
the installation of additional production capacity, at higher
than existing embedded unit costs, it appears that long
run incremental costs should be considered in establishing
rate schedules.
Implicit to us in the theory of long run incremental cost
pricing are the concepts of peak load and time of day
pricing, both of which also appeal to us in the light of the
current costs of producing and delivering electric energy
in the District of Columbia. The theory that those who
cause the costs should bear them seems to us to be not
only good economics and sound regulatory practice, but is
fair and equitable as a matter of common sense. We recog-
nize, of course, that long run incremental costs may be
difficult to determine with great precision, but by the same
30a
token we do not believe that rate making is an exact sci-
ence or that rates must or may be set to recover precise
costs in each instance. There are, as the record in this case
clearly shows, other factors which must enter into the
development of just and reasonable rates.
All parties to this proceeding appear to recognize the
presence of three componei:is of cost in producing and
distributing electric energy: (1) customer cost, which in-
cludes meter reading, billing and connection costs, costs
which are incurred whether the customer uses any or no
energy; (2) demand cost, which includes generation, trans-
mission and distribution capacity cost which may vary
with kilowatt demand but generally reflects the total cost
of capacity committed by the utility to provide service to
its customers whether used or not; (3) energy costs, which
include essentially the operating and maintenance cost as-
sociated with supplying a given number of kilowatt hours
and which vary directly with the amount of energy pro-
duced and consumed.
Each of these cost components has felt the effect of
inflation, and were each to be priced today at its long run
incremental cost, the impact on existing rate schedules
would be staggering.
We find persuasive the theory that the demand compo-
nent of electric rates should be set with reference to long
run incremental costs. We are troubled, however, by vari-
ations shown by the record in the definition of long run
incrementai cost. We are further troubled by the apparent
assumption that rates based on long run incremental cost
should be applied to all units of consumption, which by
definition reflect average costs generally different from
and lower than the long run incremental cost.* In short,
* This was demonstrated by the excessive revenue produced
under the LRIC rate proposals advanced by several intervenors.
3la
the concept of long run incremental costs, as we under-
stand it, is the cost of additional units of output. And if
additional, it necessarily follows that there exists a base
to which the addition can be made. Thus, while we are in
agreement with the theory, its full implementation on this
record at this time does not appear possible. We do not
have an adequate showing of base costs, particularly by
customer class nor do we have on this record a satisfactory
definition or calculation of long run incremental costs.
Nevertheless, we do believe that the evidence of record
is adequate to strongly support the studies currently un-
derway by PEPCO and the further studies which we shall
direct PEPCO to make. We also believe the record sup-
ports a beginning now, rather than at the conclusion of
PEPCO’s proposed studies, of a movement in the direction
of long run incremental cost pricing.
In this context we believe that PEPCO’s proposal to
flatten the summer residential rate is a step in the right
direction. We note and agree with the recommendation of
People’s Counsel witness KARPOFF that a single rate for
all residential consumption be adopted higher in summer
and lower in winter. Given the increased and increasing
unit costs associated with the provision of electric service,
we see no justification for continuation of volume discount
rates. Moreover, energy conservation remains a national
goal, and in our judgment flat rates will help achieve that
goal. Additionally, with respect to the residential class of
customers, we remain of the view expressed in our last
PEPCO case that basic use of residential electric service
in the District of Columbia has not caused and does not
contribute to the need for new and increased plant invest-
ment by PEPCO. The average consumption of energy in
the District of Columbia for residential customers is 450
KWH per month. For this reason, and in an effort to
encourage energy conservation without penalizing essen-
tial use, we will require that no part of the base rate in-
crease authorized shall be applied to monthly residential
32a
consumption below 450 kilowatt hours. To the degree that
this may require a shift in revenue requirements, we will
direct that the amount involved be spread among all cus-
tomer classes in proportion to the percentage increase for
each class proposed by PEPCO.
For the same reasons, we also believe this flat rate prin-
ciple should be applied to the commercial low voltage rate
structure. PEPCO’s proposed increase in the demand
charge for large power users is also, in our judgment, a
step in the right direction, since it tends to flatten the
conbined demand and energy schedule. Again, in regard to
large power customers, the record indicates the existence
of graphic demand meters currently in service for most of
these large customers, meters however, that for the most
part measure kilowatts of demand rather than kilowatt
hours. We believe that these large customers should be
put on a peak load, time of day, rate schedule and we shall
therefore direct PEPCO to proceed forthwith to obtain and
install appropriate meters and associated equipment for
these large customers, to complete that installation within
a period of one year from the date of this order and to file
sufficiently in advance of the expiration of the one year
period a new tariff to reflect time of day, peak load pricing.
We are persuaded that the existing and proposed rate
schedules are inappropriate in their application to all-elec-
tric residential customers in the District of Columbia and
may also be inappropriate in their application to residential
tenants living in apartment houses which receive electric-
ity under the general services schedule. We are aware of
the problem involved in apartment metering, where the
apartment building may contain, in addition to residential
units, commercial units. We do not believe, however, that
the problem is insurmountable, and we shall therefore di-
rect PEPCO to immediately conduct a study of the apart-
ment segment of the general services class to determine
33a
whether discrimination exists between residential apart-
ment tenants (who are users but not customers) and cus-
tomers under the residential schedule. The possibility of »
discrimination and adverse impact on low income residents _
was graphically portrayed in this case by the testimony of
Lincoln-Westmoreland Housing witness Hindrichs, and
PEPCO may wish to consider beginning its study with an
analysis of that project.
The results of this study, which will be designed in
consultation with an agent to be appointed by the Com-
mission, shall be reported to the Commission within six
months of the date of this order, and the Company shall
simultaneously forward its proposals, if any, for establish-
ment of a new or changed classification of residential users
and a new tariff.
With regard to the all-electric customers we do not be-
lieve that further study is required. The evidence of record
is sufficient, we believe, to permit the immediate prepara-
tion and filing of a new tariff schedule for this class which
reflects the off-peak nature of the electric heating load,
and relates the return earned from this customer class to
the Company’s return from all residential customers as a
class. We shall direct PEPCO to do so promptly. In this
connection the Company is urged to consider an optional
time-of-day peak load pricing tariff for these customers.
Additionally, we are persuaded that the all-electric con-
cept, initially introduced as a promotional effort, no longer
serves the public interest. The new schedule for the all-
electric customer will be available only to those customers
receiving that type of service on the effective date of the
tariff, and shall specifically provide that no new customers
will be added after that date.
The ultimate goal of this and all rate making proceed-
ings is a tariff structure and rate design that will be eq-
uitable to all of PEPCO’s customers, provide the overall
revenue to be allowed and, to the extent practicable, attain
34a
other broad objectives advocated here and elsewhere such
as conservation of energy, optimum allocation of re-
sources, independence from foreign energy suppliers, re-
duction in capacity needs, and relief to low and fixed in-
come consumers. At this time, it is clear that many of the
views expressed in this proceeding are without the benefit
of adequate factual data on the manner in which various
proposed rate reforms would be implemented, whether
they would accomplish desired objectives, and their impact
upon customers. Further study is required to evaluate the
desirability and feasibility of attaining any or all such
objectives through reforms in utility rates.
In addition to the particular study heretofore specified,
we will by subsequent order direct PEPCO to undertake
a study of the feasibility and efficiency of implementing
various proposed rate making theories and rate forms on
its system including average cost pricing, marginal cost
pricing, long-run and short-run incremental cost pricing,
peak load pricing, time-of-day pricing, flat rates, ‘lifeline’
rates, inverted rates, service charge in rates, and such
other rate forms as may warrant consideration.
There remains the issue of rates for street lighting and
traffic signals in the District of Columbia. On this item,
we have carefully reviewed the record and the numerous
contentions advanced by the D. C. Department of High-
ways and Traffic. Among the Department’s contentions
are that PEPCO has “doubled counted” equipment and
facilities allocated to street lighting service; has improp-
erly applied the composite depreciation rate to those facil-
ities; has failed to recognize the load characteristics and
patterns of street lighting demand; has used an unjustified
“burning hour”’ calculation for non-metered service; and
has improperly allocated expenses on the basis of lumen
output rather than actual operating and maintenance
costs.
35a
We have thoroughly reviewed the somewhat voluminous
record on these points, but find little, if any, factual sup-
port for many of the Department's contentions.
Our review also indicates that most, if not all of the
contentions urged on us in this proceeding are similar to
if not identical with contentions raised by the Department
in previous proceedings. We remain of the view that ap-
plication of the composite depreciation rate is proper, that
PEPCO’s allocation of investment and expense to street
lighting is appropriate, and that many of the Department’s
contentions, even if persuasive, would have no measurable
effect on street lighting rate schedules.
Two points urged by the Department, however, are per-
suasive. Its witness, Basaran, points out, for example, an
apparent discrimination in the treatment of the Depart-
ment in terms of the “burning standard’’ for unmetered
street lights. The Department is currently billed for energy
used in these installations on the basis of 4200 burning
hours per year. Other customers are billed on a luwer
“burning standard.’’ The study on which this standard is
based appears to have been conducted in Maryland some
five to eight years ago. The age of the study and the
criticism of its results convince us of its inapplicability to
today’s circumstances. We shall therefore direct PEPCO
to undertake a new study of burning hours in the District
of Columbia, and pending its completion to bill the De-
partment for this category of service on the basis of a
burning standard no higher than the 4033.8 hours it uses
for Maryland street lighting.
We are also concerned with regard to the question of
our authority to allow charges for energy for street lighting
in excess of 2 cents per kilowatt hour. Our position on this
matter has been clearly stated in the Commission’s April
9, 1975 letter to the chairmen of the cognizant Congres-
sional committees and the City Council, ie., “We believe
it is the intent of the Congress that the Commission’s
a
36a
jurisdiction in this area be exclusive and plenary. . .”. Our
letter further stated our approval of the currently effective
street lighting tariff rate of 2 cents per kilowatt hour plus
the fuel adjustment surcharge, and pointed out the diffi-
culties in properly distributing increased revenue require-
ments in the face of an appropriations limitation on one
class of service.
We are informed that efforts to clarify this matter have
been undertaken. Until the question is resolved, however,
we believe that unilateral action on our part might be both
presumptious and counter-productive. We shall therefore
require continuation of the existing tariff for street light-
ing energy pending definitive Congressional action.
As a general observation, we believe that many of the
Department-PEPCO difficulties are the resulting of mis-
understanding and we believe that much can be accom-
plished by a continuation and intensification of discussions
between PEPCO and the Department. We urge that this
be done.
The final problem of significance in the rate structure
area is the question of PEPCO’s proposal for a new fuel
adjustment charge. Under its proposal, PEPCO would re-
move from the base rates the entire cost of fuel and include
that cost as a separate charge, offset in part by credits
resulting from the sale of energy and capacity to the PJM
system.
The short answer to PEPCO’s proposal, in our judg-
ment, is that it is wholly unfair to PEPCO’s customers. As
observed repeatedly on the record in this proceeding, the
PEPCO proposal totally removes any incentive for reduc-
ing or minimizing fuel costs; and although we may main-
tain constant surveillance over PEPCO’s operations in this
area we are of the view that retention of the profit motive
would perhaps be a more powerful incentive to reduce costs
than our regulatory supervision. We will therefore disap-
prove the PEPCO proposal for a new fuel adjustment
37a
clause, and direct PEPCO to continue in effect its present
fuel adjustment clause, modified to include only increases
in costs reflected in Account 151, which includes only the
cost of fuel, transportation, and related items. The cost of
such items as disposal of ash, fuel handling and fuel pro-
curement will be reflected in base rates.
Miscellaneous
There remains one item which does not fit neatly into
the categories of rate of return, rate base, expenses, oper-
ating results and rate structure. This item is the conten-
tion of the Washington Public Interest Organization
(WPIO) that PEPCO’s revenue requirments to reduced
because of a realized gain from the sale and transfer of
PEPCO property previously devoted to public service. We
are aware of course, of the judicial opinion on which the
WPIO contention is used.* We do not, however, view that
decision as controlling in this case. Apart from the ques-
tion of jurisdiction (our decisions are not subject to review
by the United States Court of Appeals for the District of
Columbia Circuit), we believe that the unique factual sit-
uation presented to the court in that case is not present
here. The properties in question in this case, which PEPCO
has placed ‘“‘below the line” were not acquired at a price
below book value, nor under any special circumstances
such as existed at the time of enactment of the D. C.
Transit franchise act. Nor has there been an accounting
treatment which would lay a basis for ratepayers to claim
an interest in these properties. Accordingly, we find the
exception to established regulatory principles recognized
in the Democratic Central Committee’s case inapplicable.
Treatment in accordance with the Company’s handling
of this matter is in accordance with the F.P.C. Uniform
System of Accounts which this Commission has adopted,
* Democratic Central Committee v. WMATC, 485 F.2d 786 (D.
C. Cir. 1973).
38a
thereby establishing its policy on this issue An ex post
facto change in this policy would be inapprop:iate.
Findings Of Fact And Conclusions
The Commission finds and concludes on the evidence of
record the following:
1. That the use of an end-of-period rate base with
adjustments to average construction work in progress
and materials and supplies is appropriate.
2. That the year ended December 31, 1974 is an ap-
propriate test period and that PEPCO’s District of
Columbia rate base as of December 31, 1974 is
$650,091,000, as shown on Attachment A, Page 1.
3. That the test period operating results, as adjusted,
show operating income for the period of $46,856,000,
as shown on Attachment A, Page 2.
4. That a fair rate of return to PEPCO is 9.1 percent
and that this figure, related to the rate base of
$650,091,000 indicates a revenue deficiency of
$12,302,000.
5. That in order to realize a 9.1 percent rate of return
on its test year rate base, the Company must increase
its District of Columbia operating revenues by
$27,657,000 after allowing for taxes as shown on At-
tachment A, Page 3.
6. We find, pursuant to Rule 17.1, that the increase
is cost justified and does not reflect future inflation-
ary expectations; it is the minimum required to assure
continued, adequate and safe service and to provide
for necessary expansion to meet future requirements;
it is intended to achieve the minimum rate of return
necessary to attract capital at reasonable costs and
yet not impair the credit rating of PEPCO; and it
takes into account expected and obtainable productiv-
ity gains.
39a
We conclude, therefore, that PEPCO shou'd prepare and
submit for our approval rate schedules consistent with this
opinion which are reasonable and appropriate in this de-
cision.
THEREFORE IT IS ORDERED:
Section 1. That PEPCO should be authorized to file
and put into effect rate schedules calculated to pro-
duce approximately $12,302,000 additional net in-
come;
Section 2. That to produce this amount of addition-
al net income, PEPCO rate schedules should be de-
signed to produce some $27.7 million additional gross
revenue;
Section 3. That PEPCO should be authorized, and
it is hereby authorized, to prepare and file, subject to
our approval, rate schedules which comply with our
findings and directions and which are calculated to
produce $27.7 million additional revenue; provided
however that:
(a) Said rate schedules shall not provide for any
increase over current rates for the first 450 kilowatt
hours of electricity sold to customers under the
residential rate schedule, and
(b) A separate schedule of rates shall be submit-
ted which shall be applicable solely for existing all-
electric residential customers.
Section 4. That, by not later than one year from
the date of this Order PEPCO shall have installed
meters at the facilities of its large power customers
which are designed to operate pursuant to a peak load,
time of day rate schedule.
Section 5. That, in addition to the rates otherwise
to be filed pursuant to Section 3 above, PEPCO shall
40a
also file with the Commission a new tariff schedule
applicable to those customers specified in Section 4
above which shall be based upon time of day, peak
load pricing principles. Said tariff schedule shall be
filed at a date sufficiently in advance of the one-year
deadline set in Section 4 above so as to give the Com-
mission reasonable opportunity to review and act
upon said tariff schedule by the one-year deadline.
Section 6. That PEPCO shall undertake a study of
the apartment house segment of the general service
customer class in order to determine whether an un-
reasonable discrimination exists between apartment
house residents (receiving service pursuant to the gen-
eral services rate schedule) and customers receiving
service under the residential schedule. PEPCO shall
submit said study to the Commission by not later
than six months from the date of this Order.
A True Copy By the Commission:
/s/ Ruth Hankins-Nesbitt
Chairperson
Chief Clerk
Majority Opinion By:
Ruth Hankins-Nesbitt, Chairperson
H. Mason Neely, Vice Chairman
Dissent Opinion By:
William R. Stratton, Commissioner
4la
ATTACHMENT A
POTOMAC ELECTRIC POWER COMPANY
FORMAL CASE NO. 630
DISTRICT OF COLUMBIA
RATE BASE FOR THE YEAR ENDED
DECEMBER 31, 1974
Electric plant in service
Experimental electric plant
Electric plant held for future use
Electric plant acquisition adjustments
Construction work in progress
Materials and supplies
Cash working capital
Accumulated provision for depreciation
Accumulated provision for amortization
Customer advances for construction
Accumulated deferred income taxes
Total Rate Base
NOTE:
' average
$655,274,000
2,915,000
2,355,000
142,000
104,356,000
28,448,000'
11,958,000
(151,717,000)
(234,000)
(6,000)
(3,400,000)
$650,091,000
42a
POTOMAC ELECTRIC POWER COMPANY
FORMAL CASE NO. 630
DISTRICT OF COLUMBIA
OPERATING REVENUES, EXPENSES AND NET
OPERATING INCOME
TEST YEAR ENDED DECEMBER 31, 1974
Operating revenues 190,054,000
Operating expenses:
Operation and maintenance expenses 99,333,000
Depreciation expense 19,666,000
Amortization expense 78,000
Taxes—other 18,651,000
Federal income taxes 5,470,000
Total operating expenses 143,198,000
Net operating income $46,856,000
Pro forma Rate of Return 7.21%
43a
POTOMAC ELECTRIC POWER COMPANY
FORMAL CASE NO. 630
COMPUTATION OF ADDITIONAL REVENUE
REQUIREMENT
APPLICABLE TO THE DISTRICT OF COLUMBIA
Net Rate Base $650,091,000
Return at 9.1% $59,158,000
Net Utility Operating Income $46,856,000
Deficiency in return $12,302,000
Complement of Composite Tax Rate 44.48%
Additional Revenue Requirement $27,657,000
es + sn:
45a
PUBLIC SERVICE COMMISSION OF THE DISTRICT OF
COLUMBIA
1625 I Street, N. W., Washington, D. C. 20006
November 12, 1975
IN THE MATTER OF
Application of POTOMAC ELECTRIC )
POWER COMPANY for an Increase in)
its Retail Rates for the Sale of ) Formal Case No. 630
Electric Energy )
Dissenting Opinion Of Commissioner Stratton
With today’s decision the Commission takes a giant
step—backwards. Backwards into the rate-making ethos
of a departed era when the harsh realities of an uncertain
energy environment, and rampant inflation were not with
us. Today’s decision denies the reality, abundantly dem-
onstrated in the record, of remorseless price escalation in
virtually every component of the cost of service, and by
doing so insures the prompt relitigation of all the issues in
this case.
The real issue in this case is whether this Commission
can so demonstrate its understanding of this utility and
the world in which it must exist as to issue a rate order
under which the utility can operate for a reasonable period
of time without returning to us in quest of higher rates.
This we have failed to do. Our failure is rooted in our denial
of known and inexorable upward pressures on operating
and capital costs, with which revenues must keep pace if
a utility is to fulfill its service obligation.
ee ee a a er ee 2 Pe oe 4 3
;
‘
46a
I
These considerations of inflation and uncertai
rtaint
best have been addressed in dealing with the pelos
ra hype which requires separate consideration in
adition st year rate-makin i i
Fanci & as practiced by this
To understand the attrition effect one must i
that the test year approach to rate-making is a iiauitting
methodology, as it must be, since rates are made for the
future. The test year approach is implemented as follows:
a recent 12-month period (calendar 1974 in this case) is
selected as the test year; financial results of that year’s
operations are used as the base data in the analytical pro-
cess; known changes are reflected as pro-forma adjust-
ments to the test year operating results; rates are estab-
lished at a level that, applied to test year usage, will pro-
duce sufficient revenue to cover test year expenses as
adjusted and provide the funds necessary to produce a fair
rate of return on the adjusted test year rate base.
The purpose of this exercise, and its theoretical justifi-
cation it must be emphasized, is not that nga da pid
reasonable if in the test year they would have produced a
fair return, or that the increase in revenues that would
have produced a fair return in the test year is ipso facto
the increase that will do so in the future. The test year
approach assumes—and this is vital to an understandin
of it—that the relationship among revenues, expenses ion
_rate base that obtained in the test year will continue into
the future. Only if this assumption ; i i
ption is valid does it foll
that rates which would have produced a fair rate of aii
ys test year will produce a fair rate of return in the
. If this assumption as to continuance of relationships
olds true, an increase in sales revenues will be accom-
panied by an equivalent increase in expenses and in rate
47a
base; and the utility will earn at the authorized rate not-
withstanding the differences in experienced future reve-
nues, expenses and rate base from those of the test year.’
If test year relationships among revenues, expense and
rate base Jo not continue into the future, then the rates
ordered on the assumption the relationship will continue
are ineffective to produce’ - results contemplated by the
order.
If revenues rise faster than both expenses and rate base,
excessive returns are produced; if revenues rise faster than
expenses (and rate base does not rise enough to require
application of the excess funds thus produced to meet the
fair return requirement on rate base) excessive return is
produced; or, if revenues rise faster than rate base (and
expenses do not rise enough to absorb the excess funds
thus generated) an excessive return results.
Conversely, if rate base and expenses both rise faster
than revenues a return deficiency results. A return defi-
ciency also results if the faster rate of increase is. experi-
enced only in rate base or only in expenses, unless the
revenue shortfall resulting from the faster increase in one
cost component is offset by slower than anticipated in-
creases in the other. This erosion of return by cost com-
ponent increases that outpace revenue increases is known
as attrition.
' To illustrate: if R=revenues, E=expenses and B=rate base,
the rate of return is found by the formula [R-E]+B. If revenue
rises by 10% to 1.1R the test year approach assumes that ex-
penses an! rate base will maintain their relationship to revenues
and also rise by 10%, i.e. to 1.1E and 1.1B. In this situation
earned rate of return will be found by the formula [1.1R-1.1E]+
1.1B. Dividing through by 1.1 the formula is again expressed [R-
E]+B producing the same rate of return as authorized on the
basis of test year data.
48a
The attrition effect has been felt in the electric utility
industry for the past five years, as is illustrated by the
results of a recent survey comparing authorized rates of
return for the industry with actual earnings:
1970 1971 1972 1973 1974
Equity Return
Authorized 11.97% 12.09% 12.33% 12.2% 13.01%
Return Earned 11.76% 11.64% 11.74% 11.45% 10.96%
As these figures show, actual earned returns i
have declined, even as state regulatory commis boils ad
authorized ever higher rates of return based on a test year
Obviously the rate of growth in expenses and rate base
has exceeded the rate of revenue growth, and the effect
has been felt on earnings as demonstrated by inability of
the industry to achieve earnings that approach levels
found reasonable by regulators. PEPCO is no exception.
Obviously the revenue/expense/rate base relati ip i
dynamic. The relationship that existed in the oe aie is
never exactly maintained in the future. To that extent the
test year device is imperfect, but, like democracy, it is
probably better than the alternatives. This imperfection is
compensated for in some measure by adjusting test year
data in order that it better mirror the future, typically by
taking into account known changes that are not fully re-
flected in test year data, such as annualizing a wage in-
crease that occurred part way through the test year, there-
by recognizing a level of expense that will continue
throughout an entire future year. Sometimes test year data
are adjusted to take account of events occurring after the
test year; a wage increase occurring during the pendency
of a rate case might be an example. Some such adjust-
ments have been made in this case.
However, the assumption that the revenue/expense/rate
base relationship expressed by the adjusted test year data .
49a
upon which this order is based will continue for a reason-
able period into the future is not valid. This order assumes
lower expenses and rate base in relation to revenue than
will occur. The record abundantly demonstrates, and the
majority decision acknowledges, the increasing expense
and the increasing rate base required to produce a unit of
sales, and the 1975 data admitted into the record bear this
out.
The Commission itself has acknowledged the present
invalidity of the revenue/expense/rate base continuity as-
sumption in its solemn finding that attrition does in fact
exist for this company, no other finding being possible on
the record in this case. Where I part company with the
Commission is in its treatment of the attrition malady for
which the remedy prescribed lies somewhere between a
placebo and blood-letting.
Il.
The Commission purports to countervail the rate base
attrition effect? by granting an end-of-period rate base for
lant in service.’ Since the value of plant-in-service at the
end of the test year was more than the average value of
this component of rate base, this has the effect of increas-
ing the jurisdictional rate base by about 14.6 million dol-
lars,‘ which at the authorized 9.1% rate of return including
? As pointed out above, attrition can result either from increas-
es in rate base at a faster rate than revenues or increases in
expenses at a faster rate than revenues, or, of course, both in
combination. I will deal with the two effects seperately.
’ Under traditional test year rate-making a weighted average
rate base for plant-in-service would ordinarily be used in order to
match test year revenues and expenses to the related investment.
: Figures in Thousands
End of period rate
Average rate base 632,610 base 655,274
Less depreciation 143,628 Less depreciation 151,717
Net plant in service 488,982 Net plant in service 503,577
Difference: $14,575,000
ia i a a i a a ee as
50a
provision for taxes, increases the revenue requirement by
some 2.8 million dollars.
To express this in terms of the earlier theoretical dis-
cussion of test year rate-making, the Commission has ac-
cepted the view that the future relationship between rev-
enues and rate base is more properly expressed by the
relationship between test year revenues and the end-of-
period plant in service rate base than that between test
year revenues and the (lower) average plant in service. Or,
put more simply, it will more likely require a greater in-
vestment in plant in service in the future to produce a
dollar of revenues than it did, on average, in the test year.
The relationship of D. C. sales of $190,054,000 is thus to
an investment of $503,557,000 rather than $488,982,000,
an increase from $2.57 in plant in service needed to produce
a dollar of revenue to $2.65. Thus did the right hand give,
but what of the left hand?
II. A.
There was a downward rate base adjustment in the ma-
terials and supplies account of 9.4 million dollars, with a
concomitant reduction in the revenue requirement of 1.9
million dollars. The basis for this adjustment (which, it
will be remembered, affects the critical relationship which
test year rate-making is designed to produce) is the Com-
mission's acceptance of the conclusion of its accounting
witness that the average test year balance in the materials
and supplies account ($66,296,000 “‘. . . . will be more rep-
resentative of materials and supplies usage.” than the con-
clusion of the Company’s financial witness than an end-of-
period balance of $88,177,000 would be more representa-
tive of the amount of inventory in the future.’ The staff
* The difference between these figures, $21,881,000, is a system
figure, the jurisdictional allocation process makes the vena
figure for the District of Columbia $9,389,000.
5la
witness went on to support the averaging approach by
noting that inventories fluctuate and the balance in the
account at any particular time may be misleading. This
proposition may be conceded. The question is not whether
inventories fluctuate, but what figure they will fluctuate
around during the future period when the rates established
in this order will be in effect. It begs the question to
discuss fluctuations, or to compare the appropriate treat-
ment of this account for an electric utility with that of a
gas utility, especially when in other contexts—such as
treatment of compensating bank balances where the con-
siderations are exactly the same for gas and electric utili-
ties—we have reached differing results.
The error of the staff’s position is seen to be more glar-
ing when one considers that the principal item in the ma-
terials and supplies account is fuel, the price of which rose
throughout 1974 to levels which have only just begun to
level off. To predict the future, the value of the inventory
at the end of the year 1974 would seem to be the one to
pick rather than the 1974 average which includes fuel
bought at 1973 prices, an era that is never to return.
But the Commission was not compelled to select be-
tween the conjecture of the company and the conjecture
of the staff. We have accepted into the record monthly
operating statements and balance sheets for the first eight
months of 1975, and these were available to us as we
deliberated upon this case. I had thought our purpose in
accepting current financial reports was to permit us to
make a better informed decision. Are we free to decline the
opportunity to do so? I think not. Balance sheet figures
for the materials and supplies account from January 1973
through August 1975 appear in footnote® together with
running 12-month totals and monthly average balances.
They demonstrate an average balance in the account for
the first eight months of 1975 of slightly over $79 million,
52a
POTOMAC ELECTRIC POWER COMPANY
Formal Case No. 630
Moving 12 Months Average Materials & Supplies
Month
1973 Jan.
Feb.
Mar.
Apr.
May
June
1974 Jan.
1975 Jan.
Monthly
Balance
36,101,194
35,768,162
38,570,144
39,213,497
40,709,193
39,566,422
38,882,160
38,906,292
41,779,374
43,836,441
47,438,741
39,215,495
41,595,105
47,229,003
54,563,959
60,474,935
67,048,383
67,843,292
70,736,490
74,288,950
81,066,707
81,194,291
82,871,245
88,073,144
88,390,036
88,422,992
85,660,167
84,461,874
82,441,275
77,942,234
73,755,987
(Figures in Thousands)
12 Month
Totals
479,987,115
485,481,026
496,941,867
512,935,682
534,197,120
560,536,310
588,813,680
620,668,010
656,050,668
695,338,001
732,695,851
768,128,355
816,986,004
863,780,935
904,974,924
936,071,132
960,058,071
975,450,963
985,549,405
988,568,902
12 Month
Average
39,998,926
40,456,752
41,411,822
42,744,640
44,516,427
46,711,359
49,067,807
51,722,334
54,670,889
57,944,833
61,057,988
64,010,696
68,082,167
71,981,745
75,414,577
78,005,928
80,004,839
81,287,580
82,129,117
82,380,742
53a
a figure based on fact. I believe we are required to accept
this figure, now that it is available, rather than the staff's
$66 million or the company’s $88 million in the absence of
a showing that the $79 million average balance of 1975 to
date is more unrepresentative of the future than $66 or
$88 million
The classic argument to be made against this adjust-
ment is that it violates the test year concept because it
accepts data outside the test year to vary test year figures.
This is fallacious. Test year data are always adjusted to
reflect known changes and this data is certainly known.
The purpose of adjusting the test year for known changes
is to make it more useful as a predictive tool. To reject this
opportunity to improve our inputs in the face of the evi-
dence outlined above reflects not only a misunderstanding
of the purpose and proper techniques for test year rate-
making, but is an act that is inconsistent with Commis-
sion’s finding that this is an attrition-afflicted company
since, contrary to the evidence, it establishes a revenue/
rate base relationship that will produce a revenue shortfall.
The majority has actually built attrition into the decision.
II. B.
Other downward rate base adjustments with which I
disagree have also been made: removing $5.7 million’ in
survey and land acquisition costs from rate base, and re-
ducing the rate base cash working capital account by $4.7
million as a result of denying rate base treatment to com-
pensating bank balances. These are both issues over which
reasonable people can differ, and I could accept the Com-
mission decisions on these items if they did not represent
reversals of the position taken by the Commission the last
time it addressed these issues. As I read this and prior
7 The D. C. allocable share of a system total of $10.6 million in
these accounts.
54a
cases, no new arguments have been advanced on either
side of either proposition, and I am therefore unwilling to
join the Commission in confessing the error of its earlier
considered determination of these matters, even though I
might have qualified my agreement with the Commission's
decision in Case 596 to accept the survey and land acqui-
sition item in rate base. This is said in order to make two
points: first, I believe our decisions should demonstrate
consistency and fidelity to our established policies in the
absence of changed circumstances; second, disallowance of
the $5.7 million dollar land and survey item has a down-
ward revenue requirement effect of $1.2 million thereby
further offsetting the attrition allowance.
II. C.
But where the Commission has erred, and erred most,
gravely, is in accepting the staff suggestion that only the
average amount of construction work in progress (CWIP)
be included in rate base.°
® The average balance allocable to the District of Columbia in
the CWIP account during the test year was $104.3 million. At
year end the District’s share of the balance in the account was
$131.8 million. The CWIP account is a “‘holding’’ account into
which the rising investment is an element of utility plant is
booked during the time it is under construction. Once construc-
tion is completed and the plant is put in service the related
investment is transferred from the CWIP account to the plant-
in-service account where it remains during the operating life of
the plant. The balance in the CWIP account fluctuates during
the year, rising as construction investment is booked into it and
falling as plant goes into service and the related investment is
transferred to the plant in service account. During the test year,
there were no significant transfers out of the CWIP account but
substantial construction costs were booked into it. For that rea-
son the balance at year’s end was significantly higher than the
average balance in the account.
55a
The Commission’s order discussed the two approaches
(CWIP and AFUDC in regulatory shorthand) that com-
missions use to insure that the carrying costs of the in-
vestment in utility plant while it is under construction are
recovered. Under CWIP plant is carried in rate base while
it is under construction; under AFUDC plant does not
enter rate base until it goes in service. Under the CWIP
approach today’s rates must cover the carrying costs of
the investment in plant under construction, whereas under
the AFUDC approach these costs are not recognized and
translated into rates until the plant goes into service. So,
on a short-range view of the matter rate payers may be
said to be better off when a Commission follows the
AFUDC approach where the piper’s recompense is de-
ferred. A long-range view of the issue tends to lead to the
conclusion that the CWIP approach favors ratepayers. In
any event, both ratepayers and utilities seem to be adher-
ents of the bird-in-hand school; utilities favor CWIP, which
produces current cash flow, while ratepayers’ representa-
tives favor AFUDC, which leaves dollars in consumer s
pockets today, leaving tomorrow to take care of itself. It
was this verity that led People’s Counsel and other inter-
venors to mount a vigorous effort to cause the Commission
to reverse its long-standing policy and shift from CWIP
to AFUDC. This was one of two big dollar issues in the
case,’ for if CWIP could be removed from an end-of-period
rate base, rate base would decline by almost $132 million,
and the revenue deficiency (if any remained) would be lower
by almost $12 million—not small change, that.
It was onto this battlefield that the staff’s accounting
witness ventured with the recommendation that the Com-
mission take the average of CWIP ($104.3 million) rather
than the end-of-year figure ($131.8 million) in establishing
the company’s rate base.
° The other relates to the Fuel Adjustment Clause, and is dis-
cussed later. 2
56a
The reason originally advanced in support of this pro-
posal, that it would put CWIP treatment on a par with
AFUDC, is flawed, as will be demonstrated. In fact, as
cross-examination of the staff witness developed, the rec-
ommendation was offered with no other purpose than to
point out to the Commission a path through the thorny
thicket created by the challenge to inclusion of any CWIP
in rate base.
As to including CWIP in rate base, the Commission has
by this decision reaffirmed its policy of including it. That
we were right to do so is best revealed by the nationwide
movement of regulatory commissions to follow our lead
and switch from AFUDC to CWIP even though it requires
higher-than-otherwise rate increases at a time when infla-
tion is exacting a heavy toll on consumers.
Where error has crept in is in acceptance of the average
of CWIP in rate base. The staff witness argued that using
an average CWIP balance would, “.... place the method
employed by PEPCO [CWIP] on an equal basis with the
AFUDC accounting convention. ...’’ His point was that
under the AFUDC approach the interest which is capital-
ized during construction and ultimately added to rate base
to be amortized by the ratepayers is computed in a way
that takes into account the fact that the balance in the
construction account fluctuates from month to month. Un-
der an end-of-year CWIP approach this refinement does
‘not exist, and at first glance it appears that use of the
AFUDC, weighted-average approach would in fact intro-
duce an element of refinement and rationality to the CWIP
convention. But this initially appealing conclusion is quick-
ly rejected when one examines the underlying rationale
which the AFUDC and CWIP techniques share—namely
to provide reimbursement for the carrying costs of an in-
vestment in utility plant while it is under construction. As
the majority opinion points out: the AFUDC plant enters
rate base at its cost plus the sum of all interest necessary
57a
to carry the investment during the construction period,
which is not so with CWIP where recovery of a goodly
portion of these carrying costs is never made. If the ob-
jective is to bring the result of applying one accounting
technique (CWIP) into parity with the other (AFUDC) the
task is to make adjustments that more nearly lead to total
recovery of interest costs under CWIP, not the opposite,
which is the effect of the Commission’s order accepting
this recommendation.
The point just made is both exotic and elusive; perhaps
an example will help. PEPCO’s Chalk Point #3 unit was
under construction during 1974. Being under construction,
the related investment was carried in the CWIP account,
and, hence, was not recognized as plant-in-service and
brought into rate base in this case. Nor, because CWIP
was averaged, is the total investment in this plant brought
into rate base under the CWIP rubric. In May 1975,*
Chalk Point #3 was put into service and $160 million in
related investment was transferred from the CWIP ac-
count to the plant-in-service account where it will not earn
a return (as “plant-in-service’”’) until the next rate case
when the Commission will, as it must, include the whole
$160 million in the plant-in-service rate base. Meanwhile,
the portion of this investment that has been “averaged
out” by the Commission’s decision is not permitted to earn
a return—and this result flows from Commission applica-
tion of an accounting technique, which is claimed to bring
about recovery of construction related interest costs!
Thus seen, it was manifestly unreasonable to use the
lower, average CWIP balance in establishing rate base. In
this connection, it bears mention that in a holding account
such as CWIP an end-of-period balance is not necessarily
higher or lower than an average balance. The balance rises
incrementally as construction investments are made and
falls as plant goes into service, so, while the end-of-period
* After the test year, but during pendency of the case.
58a
balance on December 31, 1974 was higher than the aver
balance during the year, the opposite would have been the
case if a June 30, 1975 test year were used because in May
1975 the Chalk Point plant (which raised the average bal-
ance in the account in the preceding months) was put in
service thereby reducing the end-of-period balance in the
CWIP account.
The timing of when a plant goes into service is inde-
pendent of rate case filings or selections of what 12-month
period shall constitute the test year—or should be. Query
whether the Commission would have adopted an average
CWIP balance if a June 30, 1975 test year had been used
in this case, when to do so would h i
i ne ave meant a higher total
If one concedes our agency expertise, the CWIP-aver-
aging decision must be deemed to be an informed decision.
Since it is clearly wrong, and the circumstances point to
only one other explanation for it—namely an expediency
perpetrated in the interest of holding down rates it must
be seen as arbitrary and is, on that basis, probably revers-
ible error.
One obvious way to deal with this matter under test
year rate-making was to adjust plant-in-service upwards
and CWIP downwards for the known change that occurred
when Chalk Point #3 went into service.
I discuss the CWIP issue in the rate base attrition sec-
tion of this opinion because this Commission includes
CWIP in rate base, and therefore the figure selected as
representative of CWIP affects the critical revenue/ex-
pense/rate base relationship.
The effect of using average CWIP in the rate base under
the circumstances of this case is to reduce the D. C. rate
base by $27.5 million with a resultant decrease in the rev-
enue requirement of some $5.5 million, an amount that
59a
more than offsets the attrition allowance granted by per-
mitting an end-of-period rate base for plant in service. This
of course is directly contradictory to the Commission’s
finding of attrition.
II. D.
This is probably the point at which to compare the rate
base adjustments made in this case with those made in
our last case involving the Company, Case 596 decided
about two years ago. In that case, upon a finding of attri-
tion, an end-of-year rate base was selected. The Commis-
sion then gave end-of-year treatment to all items included
in rate base, not only plant in service as in this case. In
this case two significant components of rate base, con-
struction work in progress, and materials and supplies
have been averaged, and the survey and land item has
been disallowed in its entirety. Placing the rate base in
this case on the same basis as Case 596 would have re-
sulted in a rate base of $692,593,000 and not $650,090,000
as found by the Commission. To equate the two, the fol-
lowing should be added to the Commission’s D. C. rate
base:
Land Surveys $ 5,659,000
CWIP 27,455,000
Materials and Supplies 9,389,000
Total $ 42,503,000
The comparison between the last case and this one is of-
fered to raise the question whether the rate base attrition
being felt by the Company today is so different from that
felt in 1973 as to call for different treatment by the Com-
mission. This Commission has never dealt with the attri-
tion issue in quantitative terms although techniques to
measurement of the attrition effect and tailor a measured
response are available. I would like to see us move in this
direction.
60a
Ill
Attrition, it will be remembered, takes two forms, ex-
pense attrition and rate base attrition, each brought about
by increases in those components at a faster rate than
revenues. They may combine in a cumulative way or in an
offsetting way. The prior discussion relates principally to
rate base attrition.
"As regards expense attrition, I am generally in accord
with the way this Commission has dealt with the energy
utilities under our jurisdiction. This has been by accept-
ance of carefully monitored, automatic adjustments to
rates to reflect fluctuations in fuel and purchased gas
costs. These are the major expense items for energy utili-
ties, and recent history has revealed them to be the least
predictable. Establishing a fixed fuel expense/revenue re-
lationship under test year rate-making would have been
fallacious and events have demonstrated the correctness
of our decision not to attempt it. The remaining expense
items have historically been more controllable and stable
than fuel and hence more amenable to the test year rate
making formulation. By adjusting for the post-test year
wage increase in this case we have moved toward estab-
lishing the appropriate relationship of wage expense to
revenues and maintain the validity of the test year ap-
proach to that item, especially if one accepts the compa-
ny’s claim that employment levels are as low as is prudent
with safe and reliable operations and that new and replace
ment hiring is carefully controlled. It may be that the
future will bring sufficient volatility to other major ex-
pense categories—wages, taxes, and supplies particu-
larly—as to cause the Commission to consider automatic
adjustments in rates to deal with changes in expense other
than fuel. That day should not come before the Commis-
sion is equipped to measure the operating and financial
efficiency of the utilities, however. The quest for these
competencies has begun among thoughtful and forward-
6la
looking regulatory bodies and we should associate our-
selves with it.
Returning to consideration of the expense attrition issue
as it developed in this case one finds that it centered
around the automatic fuel adjustment clause. The Com-
pany proposed a comprehensive revision of the clause, the
principal change begin a proposal to account for the finan-
cial results of the Company's transactions on the PJM
interchange grid in a manner that would reflect these fi-
nancial results in the fuel surcharge element of rates rather
than in the base rate as they are now. This was the second
issue of major financial moment in the case. The Commis-
sion has rejected the Company's proposal; I would have
accepted it with modification which Iwill outline below.
Since the majority opinion does not discuss the issue
except in the broadest terms and purports to decide it
upon some unexplained conception of fairness, I think an
explanation of the issue might be in order for those who
are disposed to examine the consequences of the Commis-
sion’s decision on this point.
PEPCO buys and sells power and energy over the PJM
grid, an electrical interconnection among several utilities
in the mid-Atlantic area. The most important transations
on this grid are the so-called “economy energy’ transac-
tions in which, to oversimplify a little bit, utilities buy and
sell electricity in order to achieve the lowest possible cost
of sales. Transactions are made at a price midway between
the (lower) cost of generation at the selling utility and the
(higher) cost of generation at the purchasing utility. Thus,
if the selling utility’s current cost of generation is 2.0¢ per
kilowatt-hour (2.0¢/kwh) and the purchasing utility’s cur-
rent cost is 3.0¢/kwh the transaction is made at 2.5¢/kwh,
thereby providing energy to the purchasing company at a
cost 0.5¢/kwh lower than it would incur if it generated it
itself, and offering a sales incentive of 0.5¢ to the selling
company.
62a
For reasons related to mix of generating plant and asyn-
chronization of system peaks of the utilities connected to
PJM, PEPCO has historically sold more electricity each
year on the grid than it has bought, althoigh there are
times when it is a purchaser. These transactions are not
insignificant; during the 1974 test year PEPCO sold
4,823,553,000 kwh of energy more than it bought (by con-
trast, I used about 6,100 kwh of energy in my house during
the test year). These sales produced a “profit” of about
$41.5 million, a figure derived as follows: 4,823,553,000
kwh sold at an average price of 3.31¢/khw =
$111,481,000
less cost of generation at 1.45¢/kwh 69,941,000
$ 41,540,000
The word profit above is placed in quotation marks be-
cause these net proceeds do not emerge as profits on the
accounting statements. Under the accounting treatment
ordained by the Commission the gross margin earned on
interchange transactions is applied as an offset against
expenses in the test year calculations used to establish the
revenue requirement, which, in turn, determines the level
of rates.
At this point I again remind the readers of the purpose
of test year rate-making: to predict financial relationships
expected to obtain in the future period when rates will be
in effect. But—as should be obvious—there is no relation-
ship whatsoever between PEPCO’s net “profit” on PJM
transactions and the jurisdictional operating expenses
against which they are offset. PEPCO’s margin of reve-
nues over expenses earned on the PJM is related to the
volume of business done in PJM and the prices at which
this business is transacted. If PEPCO’s PJM margins
move in equilibrium with the changes in revenue/expense/
rate base presumed by the test year then no harm is done
by treating them as we do. But if not, the validity of the
63a
test year as a predictive device is diminished and with it
the integrity of today’s order.
There can, of course, be no demonstration in advance
that PEPCO’s PJM margins will move with the other else-
ments of the test year relativity equation. To the contrary.
The uncontradicted evidence in this case is that PEPCO’s
total PJM margin will decline in the future both in terms
of volumes of business transacted (other PJM companies
have added generating capacity that will make them more
self-sufficient) and in the margin earned on the transac-
tions made (much of this new capacity is efficient, low-cost
generation which will narrow the difference in the cost of
generation between PEPCO and the purchasing utility).
E.g., if the purchaser’s generating cost is not 3¢ but 2.4¢/
kwh and the seller’s cost is 2.0¢/kwh the transaction is at
2.2¢/kwh which produces a margin to the seller of .2¢/kwh;
so, even if the same volume is transacted the profit will be
only 40% of what it would have been at a 3.0¢/kwh pur-
chaser’s cost.
Let us now consider the effect of this on test year rate-
making. On the basis of the test year data used in this
case, PEPCO’s D. C. expenses are understated by $17.3
million,’ which represents the amount by which test year
expenses were reduced because of the offset related to
PJM transactions. J.e., absent the PJM offset, PEPCO’s
operating expenses would be $160.5 million and not $143.2
million as shown on Attachment A, page 2. This expense
figure relates to $190 million in D. C. revenues, and is the
significant figure in establishing the test year revenue/
expense relationship. If D. C. revenues rise 5% next year
and expenses also rise 5% the revenue/expense relationship
established by the text year will be maintained and all will
be well. But it must be remembered that the expense figure
is derived after deduction of the PJM “profit.” In short,
©The D. C. share of the $41.5 million total.
64a
operating expenses are 4s low as they are because the PJM
net is as high as it is. If PJM net declines, the offset to
expenses declines and stated expenses rise on that account
alone, thereby making it impossible for the utility to
achieve the return authorized by the Commission.
As I mention above, PJM revenues do not vary in re-
lationship to PEPCO’s revenues, expenses or rate base. It
is, therefore, conceptually inappropriate to incorporate the
PJM experience into test year rate-making. This theoreti-
cal problem is not significant if it can be shown that its
effect will be neutral or negligible in the future period
during which rates will be in effect. The difficulty in this
case is that this has not been done. Not only has it not
been done, but the 1975 operating results accepted into
the record in this case reveal that the D. C. share of PJM
offsets to date for 1975 is lower, as predicted. In fact it is
only about $4.1 million as compared with $11.7 million for
the comparable 1974 period used in the test year. This $7.6
million dollar difference translates directly into rates. Is it
any wonder that this issue was hard fought?
PEPCO’s proposal was to remove the accounting for
PJM transactions from the test year operating expense
calculation, and, instead apply the PJM profits as a direct
offset to the fuel adjustment surcharge which is added on
to base rates. This would eliminate the distorting effect of
the volatile PJM offset on the test year rate-making pro-
cess just as the Commission has done with fuel costs. I
believe that if there had not been immediate and signifi-
cant consequences for rates, the Commission would have
accepted this change because of its theoretical soundness
and its contribution to an enduring order in this case." On
that basis, I would have had the Commission’s decision on
"The Company deserves no kudos for waiting to make this
proposal until the presumed political consequences attendant on
its mp overwhelmed the Commission's will to consider it
on it’s ts.
65a
this issue go the other way, not only because I subscribe
to the reasoning advanced eerlier, but because I feel that
the “fairness” the Commission extends to ratepayers by
its decision need extend no farther than insuring that they
get 100% of the benefit of profits earned by PEPCO on
the PJM—as they would if these profits are offset against
the fuel adjustment surcharge. Moreover, as I hope a read-
ing of the foregoing has demonstrated, the Commission by
denying that future PJM margins will be lower in the face
of uncontradicted testimony, and actual evidence of oper-
ations which proves it, has brought about expense attrition
and not countered it, which is our obligation. The majori-
ty’s reliance on the argument that moving PJM account-
ing to the fuel adjustment charge removes the profit in-
centive to earn as much as possible from interchange trans-
actions is misplaced; treatment of interchange margins can
be accounted for in a manner that will retain the financial
incentive to maximize the gross margin on this business. |
IV
By following the traditional test-year rate-making ap-
proach in this case without making an appropriate allow-
ance for attrition, the Commission assumes that the dis-
torted revenue/expense/rate base relationship in which this
order is rooted will apply in 1976 and beyond, so long as
this order is in effect. At the same time, protestations of
bewilderment are entered at the fact that this is this com-
pany’s fourth rate case in six years. The reason is obvious:
increases in expense and rate base outpaced the increases
in revenue after the 1970, 1972 and 1973 rate cases, as
they will do after the 1975 case in the absence of an order
that recognizes that fact and allow for it. Unhappily, the
Commission has done no more in this case than to set the
stage for lamentations over the company’s fifth rate re-
quest, which is sure to come in the near future. For, if ever
a record demonstrated attrition, this one does. If ever a
record called for realistic steps to deal with attrition, this
66a
one does. If there was ever a demonstration of the failure
of revenue growth to keep up with the growth of expenses
and investment, it appears in the record spread before the
Commission in this case, where there is data not only for
the test year but also for the nine months following—data
which the Commission accepted into the record, I had
thought, for the purpose of reaching a decision that took
account of the real world as it was revealed to us by the
operating results of the company during the pendency of
the case.
Vv
If there is strength in this order it is in its rate design
aspects, where first steps are taken in what must be an
evolutionary process to restructure PEPCO’s rates using
costs as the primary basis for rate making while taking
account of the potential of rates to alter demand so as to
achieve whatever improvement in load factor may be
brought about by economically justificable pricing tech-
niques. Our order for a cost of service study, which a
Commission appointed agent will help design and monitor,
is a first step, and our order to the company to poise itself
to implement a time-of-day rate for the 750 large customers
who use 54% of the energy is step two." In the interest of
creating customer classes of more homogeneous character-
istics we also direct the company to identify the apartment
customers in its commercial class with a view to ascertain-
ing their load characteristics and perhaps incorporating
apartments into the residential class. Two possible deter-
rents exist: first, many apartment structures are partly
commercial and it may be infeasible to split the electric
service in the building; second, some apartment dwellers
may now actually be enjoying rates that are lower, not
'? Although this order is out of phase in presuming that the
company can recommend cost-based time-of-day rates before the
cost study is completed. Hopefully, this will be adjusted.
67a
higher, than residential rates if their dwelling structure is
an efficiently managed, large General Service schedule cus-
tomer.
I have pointed out earlier the conceptual fallacy of in-
cluding net interchange transactions as an offset to fuel
expenses within the test-year concept and the attrition-
exacerbating effect of the Commission’s failure to move
this item to the FAC. It also seems to me that there are
some other aspects of the fuel adjustment clause that
should have been dealt with.
I believe that if we did nothing else we should have put
the Fuel Adjustment Clause FAC on a ‘‘zero basis’’ (i.e.
collecting the entire cost of fuel in the FAC) in order to
eliminate the confusion engendered by having part of the
fuel costs in the base rate and part in the Fuel Adjustment
Clause.'® We all remember the distortions introduced into
the debate on the fue! clause last year when the Fuel Ad-
justment Charge rose at a faster rate than the rise in the
cost of fuel itself. This problem was the direct result of
having part of the fuel costs hidden in the base rate, and
it led to massive public confusion. No party to the case
disagreed with moving to a zero-based FAC. Moreover, it
would be a step in the direction of 3-part rates favored by
the Commission since it would establish an energy com-
ponent to rates.
As to the company’s proposal to move the Fuel Adjust-
ment Clause charges to an estimated basis in order to
match expenses and revenues, I believe the Commission
was correct to retain the present procedure, which involves
a collection lag, rather than adopt the company’s proposal
to use estimated costs and then adjust them after the fact.
‘3 Under the present rate structure, continued by the Commis-
sion in this case, the charge for each kilowatt hour of electricity
sold includes 6/10¢ for fuel. Only the fuel cost in excess of .6¢/
kwh is collected in the fuel adjustment surcharge.
68a
Keeping a short lag in the billing is a financial lever that
induces the company to minimize its fuel cost in order that
its carrying charges are minimized. Moreover, keeping a
lag will eliminate the problem of collecting almost 13 mil-
lion dollars in deferred fuel costs from the rate payers,
which would be necessary if the company’s proposal to
accelerate the billing had been accepted.
Finally, the issue was raised as to whether the slightly
lower multiplier for high voltage customers should be re-
tained in the FAC to account for electrical efficiency of the
system. I believe it should be because the company has
given no reason for abandoning it other than ‘“‘simplifica-
tion”.
The Commission’s determination that there shall be no
rate increase at all for residential rates up to 450 kwh/
month is utterly baffling to me. On October 30—less than
two weeks ago—the Commission presented unanimous tes-
timony to the D.C. Council in opposition to a lifeline rate
bill. Yet, on November 11 we ordered implementation of
lifeline rates. As everyone knows lifeline rates bestow in-
discriminately a subsidy that is generally agreed to be
merited only by the poor. Lifeline rates are the antithesis
of cost-causation as the basis for rate-making. This order
is also subject to the criticism that income redistribution
is a function appropriately confided to legislatures using
taxes as the vehicle to accomplish the task—not a result
to be accomplished by regulatory bodies using utility rates
as a device. A former Chairman of this Commission,"* while
recognizing the existence of conscious cross-subsidization
in utility rates sounded a note of caution:
“All in all, therefore, there is nothing wrong in leav-
ing to regulation the power to make a judgment that
“George A. Avery, Esquire. ‘‘Social and Economic Factors Un-
derlying Current Trends in Rate Design’’, Proceedings of the
Symposium on Rate Design Problems of Regulated Industries,
p.59, Foster Associates, Inc., 1975.
69a
the economically disadvantaged should be protected
in some measure from the increasing cost of Electric-
ity. The decision as to how that judgment should be
exercised in particular cases must be left to those
charged with the responsibility for fixing rates on the
basis of record facts.
“However, this latter observation raises another
point which merits some consideration. While the reg-
ulatory process can be used to effect income redistri-
bution, there is some question whether the social
judgments involved should be made by appointed of-
ficials with a relatively narrow scope of responsibility
or should be left to elected representatives directly
answerable to the people. The question is particularly
acute where the appointed regulator has been given
no legislative guidance on the issue involved’’** (em-
phasis mine).
Chairman Avery there describes the situation in this ju-
risdiction, where lifeline rate legislation is now pending. I
for one do not have the temerity to anticipate the outcome
of the legislative process, and would not have tried to do
so in this order.
The limits of the “reasonable, just and nondiscrimina-
tory” standard upon our discretion were tested in the last
rate case involving this company, and a similar order as to
residential rates was upheld.'* Nevertheless, 1 am con--
cerned that this decision may have carried the degree of
subsidization of residential customers beyond the limits of
discretion we enjoy under our statute. Moreover, the sub-
sidy involved, about $1.8 million as I calculate it, must be
borne in part by apartment-house dwellers. I believe our
consumer constituency is broader than the single-family
residential class.
‘6 Tbid. p. 71.
‘6 Apartment House Council vs. PSC (D.C.C.A., 1975).
70a
I accept the flattening of summer residential rates as
sound ratemaking, but the combination of no increase and
flat rates for the winter residential rate and flat-rating the
low voltage commercial schedule jeopardizes achievement
of the overall revenue goal by shifting recovery of costs to
tailblocks, a danger pointed out by the Commission’s eru-
dite witness on rate structures, Mr. James Lim.
VI
It cannot be demonstrated that the rate of return found
reasonable by the Commission in this case fails the sta-
tutory test, and I support it even though it is in the low
range, because I am not convinced that the ability to at-
tract capital (one of PEPCO’s problems) bears any neces-
sary relationship to the company's authorized rate of re-
turn in today’s investment climate. Investors, rather, eval-
uate the expected actual earnings and the quality of those
earnings. Therefore, my concern was that in this case we
would adhere to our CWIP policy which produces a flow
of green dollars and not bookkeeping entries, and that we
would squarely address the question of what is required
to counteract attrition and give the company an opportu-
nity to earn the return we authorized. If we had addressed
and dealt with that latter question I think a rate of return
on equity as low as what is authorized in this case could
have been justified. For me the question is whether, attri-
tion having been found, the Commission is required to
forecast it, even on the basis of historical projections, and
relate its return allowance to a quantitative finding. This
we did not do in this case, partly because of the failure of
the company to develop an adequate record on the subject.
To sum up, the Commission's order posits an economic
enviroment reminiscent of the early 1960's. In failing to
acknowledge and deal with the fact that operating and
capital requirements per unit of sales have risen, and con-
tinue to rise, faster than revenues the Commission has
Tla
taken a step that can only bring regulation in the District
of Columbia into disrepute among the fairminded and
knowledgeable.
At a minimum, the rate base should have been estab-
lished at $693 million; and the credits for PJM
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