Appendix — Williams Pipe Line Co. v. Farmers Union Central Exchange, Inc.
Supreme Court brief1984
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FILED
4 AUG 2 {984
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In THE
Supreme Court of the United States
OCTOBER TERM, 1984
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84-185"
ASSOCIATION OF OIL PIPE LINES,
. Petitioner,
FARMERS UNION CENTRAL EXCHANGE, INC., et al.,
FEDERAL ENERGY REGULATORY COMMISSION, and
UNITED STATES OF AMERICA,
Respondents.
WILLIAMS PIPE LINE COMPANY,
- Petitioner,
FARMERS UNION CENTRAL EXCHANGE, INC., et al.,
FEDERAL ENERGY REGULATORY COMMISSION, and
UNITED STATES OF AMERICA,
Respondenis.
TEXAS EASTERN TRANSMISSION CORPORATION,
. Petitioner,
FARMERS UNION CENTRAL EXCHANGE, INC., et al.,
FEDERAL ENERGY REGULATORY COMMISSION, and
UNITED STATES OF AMERICA,
Respondents.
APPENDIX TO
PETITION FOR A WRIT OF CERTIORARI TO THE
UNITED STATES COURT OF APPEALS
FOR THE DISTRICT OF COLUMBIA CIRCUIT
August 2, 1984
(Counsel Listed on Inside Cover)
WILSON - Eres Printinc Co.. Inc. - 789-0096 - WASHINGTON. D.C. 20001
CHARLES E. GRAHAM
JOHN E. COMPSON
KENNETH P. FOUNTAIN
JAMES R. KINZER
Harry L. REED
SIDLEY & AUSTIN
Of Counsel
SULLIVAN & WORCESTER
HALL, EsTILL, HARDWICK,
GABLE, COLLINGSWORTH &
NELSON
Of Counsel
VINSON & ELKINS
Of Counsel
R. EDEN MARTIN *
LAWRENCE A. MILLER
VINCENT F.. PRADA
1722 Eye Street, N.W.
Washington, D.C. 20006
(202) 429-4000
PATRICK H. CORCORAN
1725 K Street, N.W.
Washington, D.C. 20006
Attorneys for Petitioner
Association of Oil Pipe Lines
RoBERT G. BLEAKNEY, JR.*
One Post Office Square
Boston, Massachusetts 02109
(617) 338-2903
DAVID M. SCHWARTZ
RosBert L. CALHOUN
1025 Connecticut Avenue, N.W.
Washington, D.C. 20036
(202) 775-8190
WILLIAM J. COLLINGSWORTH
JOHN S. ESTILL, JR.
Bank of Oklahoma Tower
One Williams Center
Tulsa, Oklahoma 74172
(918) 588-2655
Attorneys for Petitioner
Williams Pipe Line Company
JAMES W. MCCARTNEY
ALBERT S. TABOR, JR.
JOHN E. KENNEDY *
Davip T. ANDRIL
First City Tower
Houston, Texas 77002
(713) 651-2550
BOoLivarR C. ANDREWS
JAMES C. RUTH
Texas Eastern Transmission
Corporation
P.O. Box 2521
Houston, Texas 77252
Attorneys for Petitioner
Texas Eastern Transmission
Corporation
* Counsel of Record
App.
App. B
App.
App.
App.
App.
TABLE OF CONTENTS
Court of Appeals opinion, March 9, 1984 __...
Federal Energy Regulatory Commission De-
cision, November 30, 1982 ..............................
Court of Appeals Judgment, March 9, 1984....
Court of Appeals Order Denying Petitions
for Rehearing, May 4, 1984 ...............0000........
Court of Appeals Order Denying Suggestions
for Rehearing En Banc, May 4, 19864 ..........
Statutory Provisions Involved .......000.00...........
Federal Energy Regulatory Commission In-
vitation to Submit Comments on Rulemaking
Principles for Oil Pipeline Rate Cases, April
EES FPR eO NET eee Tl eOL ECE
Excerpts from Initial Brief of Williams Pipe
Line Company Before Federal Energy Regu-
latory Commission, May 1, 1980 ....................
Excerpts from Transcript of Proceedings
Before Federal Energy Regulatory Com-
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APPENDIX A
UNITED STATES COURT OF APPEALS
FOR THE DISTRICT OF COLUMBIA CIRCUIT
No. 82-2412
FARMERS UNION CENTRAL EXCHANGE, INC., et al.,
PETITIONERS
Vv.
FEDERAL ENERGY REGULATORY COMMISSION,
and UNITED STATES OF AMERICA, RESPONDENTS
WILLIAMS PIPE LINE COMPANY,
ASSOCIATION OF OIL PIPELINES,
GETTY PIPELINE, INC.,
MARATHON PIPE LINE COMPANY,
PHILLIPS PIPE LINE COMPANY,
SUN PIPE LINE COMPANY,
MID-AMERICA PIPELINE COMPANY,
TEXAS EASTERN TRANSMISSION CORPORATION,
ARCO PIPE LINE COMPANY, INTERVENO2S
A-2
No. 83-1130
ASSOCIATION OF OIL PIPE LINES and
WILLIAMS PIPE LINE COMPANY, PETITIONERS
V.
UNITED STATES OF AMERICA and
FEDERAL ENERGY REGULATORY COMMISSION, RESPONDENTS
MARATHON PIPE LINE COMPANY,
FARMERS UNION CENTRAL EXCHANGE, INC., et al.,
MID-AMERICA PIPELINE COMPANY,
BUCKEYE PIPE LINE COMPANY,
TEXAS EASTERN TRANSMISSION CORP.,
HYDROCARBON TRANSPORTATION, INC.,
BELLE FOURCHE PIPE LINE COMPANY,
GETTY PIPELINE, INC.,
SUN PIPE LINE COMPANY,
ARCO PIPE LINE COMPANY, INTERVENORS
No. 83-1131
PHILLIPS PIPE LINE COMPANY, PETITIONER
v.
UNITED STATES OF AMERICA and
FEDERAL ENERGY REGULATORY COMMISSION, RESPONDENTS
FARMERS UNION CENTRAL EXCHANGE, INC., et al.,
GETTY PIPELINE, INC.,
SUN PIPE LINE COMPANY,
MID-AMERICA PIPELINE COMPANY,
ARCO PIPE LINE COMPANY, INTERVENORS
A-3
No. 83-1132
SUN PIPE LINE COMPANY, PETITIONER
V.
UNITED STATES OF AMERICA and
FEDERAL ENERGY REGULATORY COMMISSION, RESPONDENTS
FARMERS UNION CENTRAL EXCHANGE, INC., et al.,
GETTY PIPELINE, INC.,
SUN PIPE LINE COMPANY,
MID-AMERICA PIPELINE COMPANY,
ARCO PIPE LINE COMPANY, INTERVENORS
No. 83-1133
ARCO PIPE LINE COMPANY, PETITIONER
v.
UNITED STATES OF AMERICA and
FEDERAL ENERGY REGULATORY COMMISSION, RESPONDENTS
FARMERS UNION CENTRAL EXCHANGE, INC., et al.,
BELLE FOURCHE PIPE LINE Co.,
GETTY PIPELINE, INC.,
SUN PIPE LINE COMPANY,
MID-AMERICA PIPELINE COMPANY, INTERVENORS
No. 83-1134
MID-AMERICA PIPELINE COMPANY, PETITIONER
v.
UNITED STATES OF AMERICA and
FEDERAL ENERGY REGULATORY COMMISSION, RESPONDENTS
FARMERS UNION CENTRAL EXCHANGE, INC., et al.,
BELLE FOURCHE PIPE LINE Co.,
GETTY PIPELINE, INC.,
SUN PIPE LiNE COMPANY, INTERVENORS
A-4
Petitions for Review of an Order of the
Federal Energy Regulatory Commission
Argued November 18, 1983
Decided March 9, 1984
John M. Cleary with whom Frederick L. Wood was
on the brief for Farmers Union Exchange, Inc., et al.,
petitioner in No. 82-2412 and intervenor in Nos. 83-
1130, 83-1131, 83-1132, 83-1133 and 83-1134.
Robert G. Bleakney, Jr. with whom David M. Schwartz
and Robert .L. Calhoun were on the brief for Williams
Pipe Line Company, petitioner in No. 83-1130 and inter-
venor in No. 82-2412.
Cheryl C. Burke, Neal J. Tonken and Glenn E. Davis
were on the brief for Phillips Pipe Line Company, pe-
titioner in Nos. 83-1131 and intervenor in No. 82-2412.
Paul A. Cunningham, Marc D. Machlin and Arthur
W. Adelberg entered appearances for Sun Pipe Line
Company, petitioner in Nos. 83-1132 and intervenor in
Nos. 82-2412, 83-1130, 83-1131, 83-1133 and 83-1134.
Robert E. Jordan, III, Steven H. Brose, Timothy M.
Walsh and Gerald A. Costello were on the brief for
ARCO Pipe Line Company, petitioner in No. 83-1133
and intervenor in Nos. 82-2412, 83-1130, 93-1131 and
83-1132.
Robert J. Wiggers, Attorney, Depariment of Justice,
with whom John Powers, III, Attorney, Department of
Justice, was on the brief, for United States of America,
respondent in Nos. 82-2412, 83-1130, 83-1131, 83-1132,
83-1133 and 83-1134.
Robert F. Shapiro, Attorney, Federal Energy Regula-
tory Commission, with whom Stephen R. Melton, Acting
General Counsel, Jerome M. Feit, Solicitor, and Andrea
Wolfman, Attorney, Federal Energy Regulatory Commis-
A-5
sion, were on the brief for Federal Energy Regulatory
Commission, respondent in Nos. 82-2412, 83-1130, 83-
1131, 83-1132, 83-1133 and 83-1134.
R. Eden Martin with whom Lawrence A. Miller, How-
ard J. Trienens and Patrick H. Corcoran were on the
brief for Association of Oil Pipelines, intervenor in No. 82-
2412, and petitioner in No. 83-1130. Jules M. Perlberg
and Ronald S. Flagg also entered appearances for As-
sociation of Oil Pipelines.
Joseph W. Craft, III, Thomas E. Ricky, Kristen E.
Cook, Jack W. Hanks and Ronald M. Johnson were on
the brief for Mid-America Pipeline Company, intervenor
in Nos. 82-2412, 83-1130, 83-1131, 83-1132 and 83-1133
and petitioner in No. 83-1134.
James W. McCartney, Albert S. Tabor, Jr., David T.
Andril, Jack E. Earnest and Bolivar C. Andrews were
on the brief for Texas Eastern Transmission Corpora-
tion, intervenor in Nos. 82-2412 and 83-1130.
James F. Bell was on the brief for Marathon Pipe
Line Company, intervenor in Nos. 82-2412 and 83-1130.
Thomas E. Fennell also entered an appearance for Mara-
thon Pipe Line Company.
Frank Saponaro, Jr. was on the brief for Buckeye
Pipe Line Company, intervenor in Nos. 83-1130.
J. Paul Douglas and Jon L. Brunenkant entered ap-
pearances for Getty Pipeline, Inc., intervenor in Nos.
82-2412, 83-1130, 83-1131, 83-1132, 83-1133 and 83-1134.
Walter E. Gallagher and Peter C. Lesch entered ap-
pearances for Hydrocarbon Transportation, Inc., inter-
venor in Nos. 83-1130.
Jack Vickrey was on the brief for Belle Fourche Pipe
Line Company, intervenor in Nos. 83-1130, 83-1133 and
83-1134.
Before: WALD, EDWARDS and STARR, Circuit Judges.
Opinion for the Court filed by Circuit Judge WALD.
A-6
TABLE OF CONTENTS
Page
IL BAackGRounD ....................... abi 8
i, See NE 12
A. The Congressional Purpose in Mandating
“Just and Reasonable” Oil Pipeline Rates....... 13
B. The Economic Context 15
C. Rate Base 18
D. Rate of Return ... : 19
SE A EE 22
III. THE STANDARD OF REVIEW .................................... 24
IV. FERC’s ACTION CONTRAVENES THE STATUTORY
DIRECTIVE TO DETERMINE WHETHER RATES ARE
“JUST AND REASONABLE” 29
V. FERC’s DEcIsIon Lacks A REASONED BASIS ...... 50
A. Rate Base... 51
1. Original Cost Rate Base... 52
a. Parent Guarantees and Capital Struc-
ND icine es 55
b. Comparable Risk Analyses .................. 59
c. The “Front-End Load” Problem ......... 63
d. The Social Costs and Benefits of Tran-
sition to a New Rate Base Formula... 65
2. The Association of Oil Pipelines’ Recom-
mendations 67
Bi 73
1. Risk and Allowable Rate of Return ......... 76
2. The “Inflation Adjustment” and the
“Double Counting” Problem ..................... 78
3. FERC’s “Equity Component” Has No
Meaningful Relation to the Rates of Re-
turn on Book Equity ...... 81
VI. MISCELLANEOUS ISSUES eeiiaehdieititiattatdeisteienini 86
A. Purchase Price of Williams’ Assets... es
B. Systemwide vs. Point-to-Point Rate Regula- )
tion = 87
C. Tax Normalization 90
VII. CONCLUSION 91
A-7
WALD, Circuit Judge: Petitioners, along with the
Department of Justice and the Williams Pipe Line Com-
pany, challenge an order of the Federal Energy Regula-
tory Commission (FERC) on a wide variety of grounds.
The FERC order in question specified the generic rate-
making methodology to be applied to all oil pipelines
pursuant to the Interstate Commerce Act. In its order,
the Commission articulated for the first time its belief
that oil pipeline rate regulation should serve only as a
cap on egregious price exploitation by the regulated pipe-
lines, and that competitive market forces should be re-
lied upon in the main to assure proper rate levels. Fur-
thermore, in devising a specific ratemaking methodology
in accordance with these beliefs, FERC retained the rate
base formula used in the past in oil pipeline ratemaking,
even though this formula had met with severe criticism
from this court in Farmers Union Central Exchange V.
FERC, 584 F.2d 408 (D.C. Cir. 1978), cert. denied sub
nom. Williams Pipe Line Co. v. FERC, 439 U.S. 995
(1979). At the same time, the Commission revised its
rate of return methodology so that the resulting rate
levels would represent ceilings seldom reached in actual
practice.
For the reasons set forth below, we find that the
Commission’s order contravenes its statutory responsi-
bility to ensure that oil pipeline rates are “just and
reasonable.” In addition, we hold that FERC failed both
to give due consideration to responsible alternative rate-
making methodologies proposed during its administrative
proceedings, and to offer a reasoned explanation in sup-
- port of its own chosen ratemaking methodology, and that
therefore the FERC order constitutes impermissible “ar-
bitrary and capricious” agency action. Accordingly, we
remand this case for further proceedings consistent with
this opinion.
A-8
I. BACKGROUND
Williams Pipe Line Company (Williams),’ an inde
pendent common carrier, operates oil pipelines over a
large territory in the midwestern United States. Wil-
liams entered the pipeline business in 1966, when it pur-
chased its operating assets from the Great Lakes Pipe
Line Company. In late 1971 and early 1972, Williams
increased its local rates and initiated new joint rates
with another pipeline company. Those rates are still
at issue today.
Petitioners, various oil producers and refiners that ship
their products through Williams’ pipeline, challenged the
lawfulness of these rates before the Interstate Commerce
Commission (ICC) in 1972. After evidentiary hearings,
the presiding administrative law judge concluded that the
Williams rates were “just and reasonable” within the
meaning of the Interstate Commerce Act, 49 U.S.C.
§1(5), and a three-commissioner division of the ICC
subsequently adopted in full the administrative law
judge’s findings. See 355 1.C.C. 102 (1975).* The full
ICC then reopened the proceedings for reconsideration
“because of the relative dearth of precedent concerning
petroleum pipeline rates, and in view of the substantial
sums of money at issue.” 355 I.C.C. 479, 481 (1976).
Upon reconsideration, the full ICC affirmed the division’s
decision, ruling that “[c]onsiderations of consistency and
fairness require that we adhere to our previously recog-
nized criteria in investigating the rates of particular pipe-
lines,” 355 1.C.C. at 484, and that a pending rulemaking
was “the [proper] proceeding for considering a change”
1 Williams Pipe Line Company formerly did business as Wil-
liams Brothers Pipe Line Company. See 355 1.C.C. 479 (1976).
2 Under 49 U.S.C. §17(1), (2), the ICC may “divide [its]
members... into as many divisions (each to consist of not less
than three members) as it may deem necessary” and “direct
ee
vision... .”
A-9
in the methods for valuating the rate base and for deter-
mining the proper rates of return for oil pipelines. See
355 I.C.C. at 485, 487.
Petitioners then sought judicial review in this court.
In 1977, during the pendency of the appeal, Congress
transferred regulatory authority over oil pipelines to the
newly created Federal Energy Regulatory Commission
(FERC).* In 1978, this court remanded the case to
FERC for reconsideration, in order “to avail ourselves of
some additional expertise before we plunge into this new
and difficult area [of oil pipeline regulation], and to
allow [FERC] to attempt for itself to build a viable
modern precedent for use in future cases that not only
reaches the right result, but does so by way of ratemak-
ing criteria free of the problems that appear to exist in
the ICC’s approach.” Farmers Union Central Exchange
v. FERC, 584 F.2d at 421 (Farmers Union 1). While at
that time this court expressed “unease with the ICC’s
findings regarding rate base, rate of return, and deprecia-
tion costs,” id., based as they were upon “weak and out-
moded .. . products of a bygone era of ratemaking,” * id.
* Department of Energy Organization Act, Pub. L. No. 95-
91, §402(b), 91 Stat. 584 (1977) (codified at 42 U.S.C.
§ 7172(b)), effectuated, Exec. Order No. 12,009, 42 Fed. Reg.
46,267 (Sept. 15, 1977), implemented, 42 Fed. Reg. 55,534
(Oct. 17, 1977).
* The ICC developed its oil pipeline vote methodology in the
early 1940s. In Farmers Union I, this court found “signifi-
cant changes in [both] the relevant legal environment since
the ICC’s 1940’s decisions [and] important economic trans-
formations.” 584 F.2d at 414 (emphasis in original).
More specifically, we found that the ICC methodology—
which attempts to arrive at a valuation rate base—was formu-
lated in an era during which the Supreme Court required rate-
making based upon the “fair value” of the enterprise’s capital.
See, e.g., Missouri ez rel. Southwestern Bell Tel. Co. v. Mis-
sori Pub. Serv. Comm’n, 262 U.S. 276 (1923) ; Smyth v. Ames,
169 U.S. 466 (1898). In 1944, however, “the Supreme Court
A-10
at 418, “{w]hat clinch[ed] our decision to remand [was]
the fact that the agency now charged with [ratemaking]
responsibility, FERC, ha[d] requested a remand so that
it may begin its regulatory duties in this area with a
clean slate,” id. at 421. Accordingly, we remanded so
that FERC could conduct a fresh and searching inquiry
into the proper ratemaking methods to be applied to oil
pipelines.
In February 1979, after Williams had filed other new
rate changes, FERC reopened the remanded case, and
assigned an administrative law judge (ALJ) to hold hear-
ings on the consolidated cases.’ At the prehearing con-
ference, the ALJ bifurcated the proceedings. Phase I was
to devise generic principles for the setting of just and
reasonable oil pipeline rates. Phase II would apply those
principles to the Williams case in particular.* After
seventy-six days of hearings in Phase I, FERC directed
the ALJ to omit an initial decision and to certify the rec-
ord directly to the Commission, and instructed the parties
to submit briefs directly to the Commission.?7 FERC
decisively reversed its field and became openly critical of
talismanic reliance on ‘fair value.’” Farmers Union I, 584
F.2d at 414 (citing FPC v. Hope Natural Gas Co., 320 U.S.
591, 601 (1944)).
Furthermore, we found in Farmers Union I that the eco-
nomic conditions facing the oil pipeline industry had changed
dramatically since the days when the ICC formulated its rate-
making methods. In contrast to the 1940s, “the modern on-
slaught of inflation, petroleum shortages, and reliance on im-
ports, as well as the maturing of the industry itself” all sig-
naled the need to reevaluate the propriety of the old ICC
methodology. Id. at 416.
5 See Williams Pipe Line Co., 6 FERC (CCH) { 61,187 (Feb.
23, 1979).
* See Invitation to Submit Comments on Ratemaking Prin-
ciples for Oil Pipeline Rate Cases (April 11, 1979), reprinted
in Joint Appendix (J.A.) at 240.
7 See 10 FERC (CCH) { 61,023 (January 9, 1980).
A-11
heard oral argument on June 30, 1980. Almost a year then
passed without a FERC decision. Accordingly, Farmers
Union Central Exchange (Farmers Union) filed a mo-
tion in this court to compel agency action, which we dis-
missed upon receiving assurances from FERC counsel
that a decision was forthcoming imminently.* Three
months later, however, in October 1981, FERC ordered a
reargument by the parties on November 19, 1981.°
Eight months after reargument, FERC had still failed
to issue a decision. Upon petition from Farmers Union,
the district court, finding that FERC had abrogated its
statutory responsibilities under both the Interstate Com-
merce Act” and the Administrative Procedure Act,”
ordered FERC to issue a decision within sixty days. This
* See Farmers Union Cent. Exch. v. FERC, No. 76-2138
(D.C. Cir. July 28, 1981). Over five years ago, in deciding
initially to remand this case to FERC, “we rel[ied] on assur-
ances from counsel for FERC that the agency will move this
case through its ratemaking procedures with dispatch.” Farm-
ers Union I, 584 F.2d at 422.
* See 17 FERC (CCH) {9 61,021 (Oct. 2, 1981). The FERC
explained the need for further argument on the grounds that
their prior “deliberations were protracted and inconclusive,”
and that “[o]nly one member of the Commission that heard
the argument and that held the post-argument deliberations”
was still a member of FERC. Id. at 61,037.
10 Under 49 U.S.C. § 15(7), FERC must “give to the hearing
and decision of such questions [of determining just and rea-
sonable rates] preference over all other questions pending
before it and decide the same as speedily as possible.”
11 Under 5 U.S.C. §555(b), an agency must conclude a
matter presented to it “within a reasonable time.” Moreover,
a reviewing court shall “compel agency action unlawfully
withheld or unreasonably delayed.” 5 U.S.C. § 706(1).
12 See Farmers Union Cent. Exch. v. FERC, No. 82-2065
(D.D.C. Aug. 23, 1982) (order to issue a decision) ; see also
id. (Sept. 14, 1982) (findings of fact and conclusions of law
in support of denial of FERC’s motion for a stay pending
appeal).
A-12
court then stayed the district court’s order so that FERC
would be allowed until November 30, 1982 to issue its
decision.”
On November 30, FERC issued Opinion No. 154, the
subject of this appeal. See 21 FERC (CCH) { 61,260
(Nov. 30, 1982). The Department of Justice, representing
the United States as statutory respondent under 28 U.S.C.
§§ 2344, 2348, joined petitioners in seeking reversal of the
FERC opinion.
II. THE FERC OPINION
FERC heralded its Opinion No. 154 (the Williams
opinion) as “the longest and most elaborate” decision it
had ever issued.* The Williams opinion announces
FERC’s intended approach to future oil pipeline rate-
making; thus it is of great importance to oil producers,
refiners, and pipeline owners.
FERC’s essential conclusion in Williams is that rate-
making for oil pipelines should serve only “to restrain
gross overreaching and unconscionable gouging” “ in or-
der to keep rates within the zone of “commercial reason-
ableness,” not “public utility reasonableness.” ** As FERC
said in a related order issued the same day as Williams:
Williams says that oil pipeline rate regulation should
be relatively unobtrusive. It finds competition (both
actual and potential) a far more potent force in this
industry than in the others we regulate. Accord-
ingly, it proposes to rely in the main on market
18 Farmers Union Cent. Exch. v. FERC, No. 82-2065 (D.C.
Cir. Oct. 14, 1982).
14 News Release Accompanying Opinion No. 154, quoted in
Report of the Committee on Oil Pipeline Regulation, 4 Energy
L.J. 148, 143 (1983).
145 Williams Pipe Line Co., 21 FERC (CCH) { 61,260, at
61,597 (Nov. 30, 1982).
16 Jd.
eee
A-13
forces. It views oil pipeline rate regulation as a
modest supplement to rather than a pervasive substi-
tute for the market. The supplement, Williams tells
us, is in the nature of a check on gross abuse.
Trans Alaska Pipeline System, 21 FERC (CCH) { 61,092,
at 61,285 (Nov. 30, 1982). The following summary de-
scribes how FERC reached that conclusion, and how it
translated that conclusion into a particular ratemaking
methodology.
A. The Congressional Purpose in Mandating “Just and
Reasonable” Oil Pipeline Rates
In 1906, Congress adopted the Lodge Amendment to
the Hepburn Act, which extended the definition of com-
mon carrier in the Interstate Commerce Act” to encom-
pass interstate oil pipelines, and, as a consequence, re-
quired pipeline rates to be “just and reasonable.”** In
Williams, FERC embarked on a close study of “the cli-
mate of opinion” that existed when Congress passed the
Lodge Amendment. In doing so, FERC primarily ex-
amined the works of Ida Tarbell, a progressivist of the
turn of the century, who has been credited with “inflam-
[ing] the public’s long-standing hostility to the [Standard
17 Act of June 29, 1906, ch. 3591, § 1, 34 Stat. 584 (codified
as amended at 49 U.S.C. §1(1) (b)) (“The provisions of this
chapter shall apply to common carriers engaged in... [t]he
transportation of oil... by pipe line... .”).
18 See 49 U.S.C. §1(5). Congress recodified the Interstate
Commerce Act as 49 U.S.C. § 10101 et seq. in 1978. Act of
October 17, 1978, Pub. L. No. 95-473, 92 Stat. 18837. However,
the Recodification Act excluded from the general repeal of
prior statutes “those laws [that] vested functions in the Inter-
state Commerce Commission . . . related to the transportation
of oil by pipeline” and “those functions and authority [that]
were transferred [to FERC] by sections 306 and 402(b) of
the Department of Energy Organization Act.” Id. § 4(c), 92
Stat. 1470. The prior statutes therefore still govern FERC’s
authority over oil pipeline rates.
A-14
Oil] combination as nothing before had.” ** FERC con-
cluded that the Lodge Amendment was motivated by the
desire to bust the Standard Oil trust.”
FERC also found that in the early twentieth century
the Standard Oil Company maintained its dominance
over the entire American oi! business by setting its pipe-
line rates at such extraordinarily high levels that access
to the pipelines (and hence to important downstream
markets) was cut off. See 21 FERC at 61,597. From this
observation, FERC concluded that the Congress, in man-
dating that oil pipeline rates be “just and reasonable,”
intended to outlaw only outrageously high rates: “Pro-
hibitive rates were a means to that end [of dominating
American oil markets]. Congress wanted to forbid both
the use of the means and the attainment of the end.
The policy at which it fired was a policy of ‘prohibitive’
pricing.” Id. In the belief that “[t]he phrase in ques-
tion, ‘just and reasonable,’ is a high-level abstraction [, ]
. . . @ mere vessel into which meaning must be poured,”
id. at 61,594, and considering numerous differences in the
reasons for the establishment of a regulatory scheme over
“public utilities,” such as electric companies, as opposed
to “transportation companies,” such as oil pipelines, id.
at 61,591-96, FERC determined that:
the authors of the Hepburn Act’s oil pipeline provi-
sions did not use the words “just and reasonable” in
the sense in which public utility lawyers have used
them since the 1940’s,
19 B. Bringhurst, Antitrust and Oil Monopoly: The Stand-
ard Oil Cases 69 (1979), quoted in Williams, 21 FERC at
61,580. Tarbell wrote a series of nineteen articles on The
History of the Standard Oil Company that appeared initially in
McClure’s Magazine in 1904. See I. Tarbell, The History of the
Standard Oil Co. (D.M. Chalmers ed. 1969).
20 See 21 FERC at 61,582 (“Senator Henry Cabot Lodge
of Massachusetts, the amendment’s sponsor, made it very
plain that the only purpose that he had in mind was to attack
Standard Oil. He was not interested in pipelines generally.
... [The] bill [was] aimed solely at Standard.”).
a ee
Met on 61 doh Na aN a NR Nk te itil te EI tt
A-15
We think that what was meant was not “public
utility reasonableness,” but ordinary commercial
“reasonableness.” To be specific, we discern no in-
tent to limit these carriers’ rates to barebones cost.
What we perceive is an effort to restrain gross over-
reaching and unconscionable gouging.
Id. at 61,597. Thus, on the basis of this historical survey,
FERC interpreted the statutory mandate that oil pipeline
rates be “just and reasonable” to require only the most
lighthanded regulation, with no necessary connection be-
tween revenue recoveries and the cost of service.
B. The Economic Context
FERC next surveyed the changes since 1906 in the
economics of the oil pipeline industry, and determined
that the modern economic environment does not manifest
the same threat of monopolistic practices that bedeviled
Congress in 1906.
Comparing the dollars spent in 1981 in America for
petroleum products to the dollars spent in the same year
for oil pipeline transportation," FERC found that pipe-
line costs are “not very much when viewed in relation to
the nation’s total oil bill.” Further, FERC found that
any savings created by lower pipeline charges would not
21 See 21 FERC at 61,600-01. FERC excluded pipeline
revenues derived from the Trans Alaska Pipeline System
(TAPS)—over half the aggregate pipeline revenues—because
it found it “implausible” that TAPS rates have any consumer
impact and because it had “put that case to one side for indi-
vidualized treatment.” Jd. at 61,600. Viewing TAPS as sui
generis, FERC had decided to address ratemaking principles
for that system in a proceeding independently of Williams.
See Trans Alaska Pipeline Sys., 21 FERC (CCH) { 61,092
(Nov. 30, 1982) ; Trans Alaska Pipeline Sys., 20 FERC (CCH)
7 61,044 (July 12, 1982).
2221 FERC at 61,601. Even excluding TAPS, oil pipeline
charges in 1981 added up to $3.22 billion, a sum that FERC
admitted was “a lot of money.” /d.
A-16
necessarily—or even likely—be passed on to consumers.
See 21 FERC at 61,601-02. FERC therefore concluded
that “[f]rom the consumer’s perspective, oil pipeline rate
regulation is akin to efforts to do something about the
high price of shoes by controlling the pricing of shoe laces
[or] to contain the price of food by seeing to it that the
price of spice is always ‘just and reasonable.’” Id. at
61,601.
FERC also found that, from Congress’ perspective in
1906, oil pipeline rates did in fact make a difference to
the oil consuming public. Reviewing cost and revenue
trends, FERC showed that in the past pipeline charges
comprised as much as sixty-eight percent of what the
oil producer received for crude oil.“ Thus, FERC con-
cluded that although Congress may in 1906 have rea-
sonably been concerned about oil pipeline prices, today
“(p]rohibitive oil pipeline rate structures are now a
problem for the economic historian,” and the “oil pipe-
line rate reform crusade is anachronistic . . . overtaken
by events so that the combatants’ rhetoric is no longer
in touch with reality.” Id. at 61,606-07.
Finally, FERC found that the economic market for oil
pipelines has become competitive since 1906. In contrast
to the industry during the early part of this century,
today “[p]rohibitive pricing has become uneconomic” **
and “[n]jo oil company (not even the largest) is wholly
28 FERC used 1931 data as its earliest point of reference.
According to FERC, 1931 was “the first year for which we
have reliable data,” id. at 61,604, and, in any event, the
“Tn]umbers for 1906... were roughly the same as for 1931,”
id. at 61,694 n.260.
24 Id. at 61,608. FERC reasoned that today pipeline com-
panies seek to maintain their throughput at full capacity.
“That objective,” FERC observed, “is incompatible with the
old tactic of charging more than the traffic would bear and
move freely.” Id. (emphasis in original).
A-17
self-sufficient.” ** Also, FERC appeared to conclude that
the significant decline in the price of pipeline transpor-
tation from 1931-1969 manifests the existence of com-
petition in the pipeline transportation market.”*
In light of all the foregoing considerations, FERC ex-
pressed its belief that the consumer’s interest in low
pipeline rates is “submicroscopic” while the real threat
to the public is underinvestment in needed oil pipelines.”
Accordingly, FERC set down as a guiding principle of
oil pipeline ratemaking that it is “best to err on the side
of liberality” because “the dangers of giving too little
vastly outweigh those of giving too much.” Id. at 61,613.
FERC then turned to apply this general principle to
formulate a ratemaking methodology for oil pipelines.
5 Id. at 61,609. FERC argued that, because every oil com-
pany makes use at some time of pipelines owned by other oil
companies, “few, if any, pipeline owners are able to gouge
their most important customers with impunity.” Jd. Further,
the big oil companies would not allow the independent pipeline
owners “to steal them blind.” Jd. Finally, “since the statute
bars rate discrimination, small shippers are the unintended
incidental beneficiaries of the potential competition among
the giants.” Id.
26 FERC stated: “It is obvious that something has been
holding these rates down. That something must be a market-
place force. The industry labels that force ‘competition.’ The
parties have spent much time and great energy debating this
matter of competition. Each set of protagonists makes valid
points. This is a rather ‘soft’ kind of competition. It appears
to be of a live and let-live kind. But this does not mean that it
is not there.” Id. at 61,608.
27 Id. at 61,613-14. Without reliance on the record or any
other source, FERC simply stated that “[e]verybody agrees
that the nation needs and will need more pipeline plant.” Jd.
at 61,614. No attempt was made to forecast future need for
capacity or to estimate the relationship between rate of re-
turn and attraction of capital for new plant.
A-18
C. Rate Base
Under the old ICC method, an arcane formula, com-
prised chiefly of a weighted average of original cost and
cost of reproduction new, was used to calculate the
pipelines’ “valuation rate base.” *° While admitting that
28 The old ICC formula weights original cost and reproduc-
tion cost according to their relative sizes, and then averages
them. The resulting weighted mean is then reduced for de-
preciation by the “condition percent” method. Next, the re-
sult is inflated by a 6% “going concern” value. Finally,
amounts said to represent the present value of the pipeline’s
land, rights of way and working capital are added. In algebraic
terms the ICC method can be represented :
R O
V=1.06 1 R, + 1 O (CP) +L, + + W
(525) (525) ; | “s ‘s
Where: V =valuation rate base
R, =cost of reproduction new
O, =original cost
CP=condition percent (cost of reproduction
new less depreciation divided by cost of reproduction new)
L, =present value of land
L, =present value of rights of way
W, =working capital
See 21 FERC at 61,696 n.295.
2° The ICC weighting scheme finds its origins in the Supreme
Court opinion in Smyth v. Ames, which held that “[t]he basis
of all calculations as to the reasonableness of rates .. . must
be the fair value of the property being used .. . in order to
ascertain that value, the original cost of construction...
and... the present as compared with the original cost of con-
struction . . . are all matters for consideration.” 169 U.S.
466, 546-47 (1898). Furthermore, in St. Louis & O’Fallon Ry.
Co. v. United States, 279 U.S. 461 (1929), the Supreme Court
disapproved the ICC’s attempt to rely solely on original cost
ratemaking. Of course, in FPC v. Hope Natural Gas, 320 U.S.
591 (1944), the Supreme Court abandoned its strict disap-
proval of original cost ratemaking. See supra note 4. For a
history of the ICC ratemaking formula, see Navarro & Stauf-
fer, The Legal History and Economic Implications of Oil Pipe-
line Regulation, 2 Energy L.J. 291 (1981).
A ee a A ean Bette. NaS cneR
A-19
“Twlere we beginning afresh on a clean slate we might
be inclined to use something different” because the ICC
formula contains “anomalies and inconsistencies” that
result in an inaccurate picture of the pipelines’ cost of
service, id. at 61,616, FERC nevertheless concluded that
the costs of adopting another rate base formula out-
weighed the benefits of such a shift. It therefore chose
to “adhere to the formula [it] inherited from the Inter-
state Commerce Commission.” Jd. at 61,632.
In doing so, FERC expressly rejected two proposed
alternatives to the ICC ratemaking formula. First, the
Commission eschewed original cost ratemaking in the
belief that the chief advantage of such an approach—
the facilitation of comparable earnings analysis—was of
little use in the oil pipeline context, and that the switch
to original cost alternative would create unnecessary
regulatory burdens and social costs. See infra at 52-67.
Second, FERC rejected specific alterations to the ICC
rate base formula proposed by the Association of Oil Pipe
Lines because, in FERCs view, only “relatively insub-
stantial” amounts of money would be affected, and, in
any event, the ICC’s methodological errors tend to com-
pensate roughly for one another. See infra at 67-72.
Thus FERC reaffirmed the ICC rate base method, ad-
mitting it to be “much too blunt or too clumsy for close
work,” but still finding it “pragmatic” and “usable.” 21
FERC at 61,616.
D. Rate of Return
Quoting at length from this court’s opinion in Farmers
Union I, FERC launched its inquiry into rate of return
methods from the premise that “(t]he need for reform is
plain.” * Finding “the parties’ arguments ... so un-
80 Jd, at 61,636-37. FERC noted that this court had similarly
criticized the ICC rate base methodology in strong terms.
FERC downplayed this aspect of the Farmers Union I opinion,
saying “We take a different view. We think the rate base
methodology is still serviceable.” Jd. at 61,706 n.418.
A-20
helpful and the applicable historical tradition . . . so
palpably deficient,” FERC felt “left to [its] own de
vices” to fashion a new rate of return methodology.” It
held that a proper rate of return for oil pipelines should
be comprised of three elements: (1) debt service, (2) a
“full compensatory suretyship premium,” and (3) the
“ ‘veal’ entrepreneurial rate of return on the equity com-
ponent of the valuation rate base.” See 21 FERC at
61,644 (emphasis in original).
The first component, debt service, represents the
amount needed to pay interest on the debt the pipeline
has accumulated. The second component, the suretyship
premium, represents the additional amount that would
have been needed above actual debt service in the ab-
sence of a debt guarantee from the oil pipeline company’s
parent.
The third component, the “entrepreneurial” rate of
return, according to FERC, “follows logically from [the]
basic concept that what the historical background and
contemporary public policy needs call for here is a cap
on gross abuse.” Jd. at 61,645. Accordingly, FERC of-
fered eight different measures for the “entrepreneurial”
rate of return. The measures included the nominal rates
of return on book equity realized over the most recent
81 Td, at 61,644. FERC rejected adopting as a guidepost for
reasonable rate of return the standard set out in a 1941 con-
sent decree that deemed any return on equity in excess of
seven percent of valuation to be an illegal rebate. See United
States v. Atlantic Refining Co., No. 14060 (D.D.C. Dec. 23,
1941) (consent decree), vacated per settlement, United States
v. Atlantic Refining Co., No. 14060 (D.D.C. Dec. 18, 1982).
FERC ruled that “‘rebativeness has no bearing on reasonable-
ness.” 21 FERC at 61,640; see also Mobil Alaska Pipeline Co.
v. United States, 557 F.2d 775, 786 (5th Cir. 1977) (ICC
order appended to opinion) (“‘we do not accept the 1941 con-
sent decree as a standard of reasonableness under the Inter-
state Commerce Act’), aff'd sub nom. Trans Alaska Pipeline
Rate Cases, 486 U.S. 631 (1978).
che Rd PRE en CBP PET cS Cetin HES < ean TM
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A-21
one- or five-year period for (1) the oil industry generally,
(2) American industry generally, or (3) the parent com-
pany or companies, excluding pipeline operations. The
remaining two measures of an entrepreneurial rate of
return took the total returns (dividends plus capital
gains) on a “diversified common stock portfolio” over
(1) the past five years or (2) “the long run—25 years,
50 years, or more.” Jd. Under FERC’s method, the
pipeline would normally be permitted to choose the ap-
plicable rate of return from among these indices.
Once this rate of return is selected, it is adjusted
downward “[t]o avoid overcompensation for inflation.”
Id. at 61,646. FERC’s methodology subtracts from the
selected rate of return the percentage by which the valua-
tion rate base has increased during “the time period that
was looked to in order to derive the appropriate nominal
rate of return.” *
This adjusted rate of return is applied not to book
equity, nor to the percentage of the valuation rate base
represented by the proportion of equity relative to debt
in the oil pipeline’s overall capitalization structure.
Rather, this rate is the allowed return on what FERC
considers to be the “equity component of the valuation
rate base’”—the entire valuation rate base, less the face
amount of debt. See ic. at 61,647-48.
This method, FERC concedes, would result in “hand-
some rate base writeups,” followed by “creamy returns
on book equity.” Id. at 61,650. FERC, however, believed
that such high returns comported with its general rate-
making principles for oil pipelines: “Here we are setting
82 Td. at 61,646. FERC noted that, without a deflator for the
rate of return, the effects of inflation would be double counted
in the rate base, which increases along with the cost of repro-
duction new, as well as in the rate of return, which includes a
component to compensate for inflation and inflation risk.
Ny
A-22
ceilings that will seldom be reached in actual practice.” “
Moreover, the Commission allowed generous returns in
the belief that oil pipeline equityholders were entitled to
the full benefit of appreciation in their leveraged assets,
id. at 61,649, and that the more “austere standard of
fairness applied in the utility field cannot be divorced
from the stringent regulatory controls on abandonment”
which, FERC ruled, do not apply to oil pipelines, id. at
61,650.
E. Other Matters
FERC made three other rulings in Williams that are
challenged in this appeal. FERC held that (1) the origi-
nal cost of transferred pipeline plant—and not its pur-
chase price—should be used in ratemaking, (2) oil pipe-
line rate regulation should generally take place on a
systemwide, rather than point-to-point, basis and (3) the
“tax normalization” method of accounting may be em-
ployed by the oil pipeline companies if they so wish.
First, FERC set down as a general rule that the “pur-
chase price [for pipeline plant] is not entitled to any
recognition at all for any ratemaking purpose.” * There
are two ways in which purchase price might have been
used in oil pipeline ratemaking: (1) as a substitute for
original cost in the rate base, and (2) in calculating the
basis for depreciation expenses. FERC rejected the first
*3 Id. at 61,649. According to the Commission, oil pipeline
regulation “can and should continue to rely far more heavily
on the market” and “should continue to be peripheral to the
pricing process.” FERC continued, “[t]hat peripheral func-
tion relates to situations in which monopolistic pockets, short-
run disequilibria, or other factors produce market prices
that are grossly abusive and socially unacceptable.” Jd.
* Id. at 61,636. According to FERC, exceptions to this gen-
eral rule ..volve “situations in which the transfer of owner-
ship promotes efficiency.” Jd. at 61,705 n.401. On remand,
Williams remains free to show that it falls within this ex-
ception.
A-23
use of purchase price because to do so would create u
systemic incentive for the sale of pipeline plant and the
consequent upward push on rates. See id. at 61,634-35.
Further, to use purchase price in the rate base would
contravene the principle that “a mere change in owner-
ship should not result in an increase in the rate charged
for a service if the basic service rendered itself remains
unchanged.” * FERC similarly rejected the use of pur-
chase price as the basis from which depreciation would
be computed, citing this court’s disapproval in Farmers
Union I of the practice,” and finding no valid justifica-
tion for what it called “this nonchalant, half a loaf, split
the difference” policy of using original cost in the rate
base, while calculating depreciation by reference to pur-
chase prices. Id. at 61,635.
Second, FERC decided to regulate oil pipeline rates on
a systemwide basis. FERC maintained that the alterna-
tive—ruling on the reasonableness of particular rates on
specific routes—would require cost allocation inquiries
that would be “metaphysical inconclusive, and barren.”
Id. at 61,651. Also, FERC believed that systemwide regu-
lation would give freer play to competitive forces in the
oil pipeline industry. FERC restricted its ruling to pipe-
line systems, in contrast to pipeline companies. The rates
of wholly noncontiguous pipeline systems, therefore,
would not be computed by averaging companywide costs.
FEKC further cautioned that a showing that systemwide
rates discriminated against nonowners of the pipeline
would trigger “strict regulatory scrutiny.” Id.
%5 Jd. at 61,635 (quoting Shippers’ Initial Post-Hearing Erief
at 103, reprinted in J.A. at 3760) (emphasis omitted).
*° The ICC had calculated depreciation expenses using the
purchase price of Williams’ pipeline plant. See Williams Pipe
Line Co., 355 1.C.C. 479, 487-88 (1976). In Farmers Union I,
however, this court found this practice to be irrational, based
on blind adherence to accounting principles and subjecting
rates to dramatic changes overnight once a purchase of assets
intervenes. See Farmers Union I, 584 F.2d at 420.
A-24
Third, FERC permitted, but did not require, oil pipe-
line companies to “normalize” their accounts that reflect
accelerated depreciation on equipment for tax purposes.”
FERC permitted the use of the tax normalization method
because “normalization facilitates the comparable earn-
ings analyses basic to the determination of appropriate
rates of return on oil pipeline equity investments.” Id.
at 61,656. However, becayse “[c]ompetitive considera-
tions may lead some pipelines to prefer lower rates... .
now in return for more later,” FERC made the use of
the method elective rather than compulsory. Id.
Finally, FERC prohibited pipelines that choose tax
normalization from including the resulting tax reserve
accounts in their rate bases. Otherwise, “the rate payer
who has paid higher taxes reflecting normalization ac-
counting would be paying the carriers for earnings on
the tax differential even though it was the rate payer
who contributed the differential in the first place.” Id. at
61,657 (quoting San Antonio v. United States, 631 F.2d
831, 847 (D.C. Cir. 1980) ).
Ill. THE STANDARD OF REVIEW
The FERC order before us today is an exercise of its
general ratemaking authority under 49 U.S.C. § 15(1).*
57 See id. at 61,653-57. Under the “tax normalization”
method, “a regulated business accelerates its depreciation
schedule for tax purposes, but figures its tax costs for rate-
making purposes as if it were paying the higher taxes re-
quired by a straight-line depreciation schedule. The difference
between the two amounts is placed in a deferred tax reserve
account, out of which taxes are eventually paid, but on which
the business in the meantime collects interest.” Farmers
Union I, 584 F.2d at 411 n.5.
** We are cognizant that the FERC order did not set a
particular pipeline rate, but instead remanded the Williams
case to the ALJ to set rates in accordance with the ratemaking
principles espoused in the opinion. See 21 FERC at 61,659;
|
A-25
As such, the Williams proceeding constitutes a rulemak-
ing under the Administrative Procedure Act. See 5
U.S.C. §551(4) (defining “rule” to include “the ap-
proval er prescription for the future of rates’). Al-
though section 15(1) provides that the determination as
to the reasonableness of rates shall be made “after full
hearing,” the resulting decision apparently need not be
“on the record,” 5 U.S.C. § 553(c), and therefore the
standards for formal rulemaking do not apply. See
United States v. Florida East Coast Railway Co., 410
U.S. 224 (1973). Accordingly, we review whether
see also supra at 10-11. We nevertheless conclude that this
order is ripe for review.
This court has ruled many times that “[t]he test of finality
for the purposes of review is .. . whether [the order] imposes
an obligation or denies a right with consequences sufficient to
warrant review.” City of Anaheim & Riverside, Cal. v. FERC,
692 F.2d 773, 777 (D.C. Cir. 1982) (quoting Environmental
Defense Fund v. Ruckelshaus, 439 F.2d 584, 589 n.8 (D.C.
Cir. 1971)). The FERC order in Williams alters the legal
relations among the parties. While it does not, by itself, im-
pose a duty on the shippers to pay a particular rate or bestow
a right upon Williams to charge that rate, the order certainly
would have “consequences sufficient to warrant review.” The
order sets down ratemaking principles that would permit
rates within a range significantly different from the range of
rates permitted by other ratemaking schemes.
In addition, under Abbott Laboratories v. Gardner, 387
U.S. 186, 149 (1967), we also must evaluate “the hardship
to the parties of withholding consideration.” In this regard,
we need only remember that Williams has been charging rates
subject to refund for a dozen years. Over five years ago, this
court found it troubling that Williams had “already faced six
years of litigation and continues to face the possibility of repa-
rations back to 1972 should its increased rates ultimately be
found unreasonable.” Farmers Union I, 584 F.2d at 421. Ac-
cordingly, we see no reason to forestall review of the ratemak-
ing principles developed in Phase I of the Williams proceeding.
Otherwise, the ALJ and then the entire body of FERC would
squander more time in Phase II applying what we find to be
legally deficient ratemaking principles.
A-26
FERC’s order in Williams was “arbitrary, capricious,
an abuse of discretion, or otherwise not in accordance
with law.” 5 U.S.C. § 706(2) (A).*
5° Under the Administrative Procedure Act, a reviewing
court must examine whether an agency action is supported by
“substantial evidence” in any case “subject to sections 556 and
557 of [title 5] or otherwise reviewed on the record of an
agency hearing provided by statute.” 5 U.S.C. § 706(2) (E).
In United States v. Allegheny-Ludlum Steel Corp., 406 U.S.
742 (1972), the Supreme Court held that the requirement of
section 1(14) of the Interstate Commerce Act that the ICC
issue car service rules “after hearir , was not the equivalent
of a requirement that such rules be made “on the record after
opportunity for an agency hearing,” 5 U.S.C. § 553(c), and,
consequently, that the trappings of formal proceedings, id.
§§ 556, 557, need not be followed. See also United States v.
Florida E. Coast Ry. Co., 410 U.S. 224 (1973). Based upon
this holding, this court, speaking per curiam and in a footnote,
determined that the requirement of section 15(1) of the Inter-
state Commerce Act that the ICC determine whether rates,
classifications or other practices are just, reasonable or non-
discriminatory only “after full hearing” is similarly not equiv-
alent to the requirement of a decision “on the record.” Asphalt
Roofing Mfrs. Ass’n v. ICC, 567 F.2d 994, 1002 n.5 (D.C. Cir.
1977) (per curiam) ; cf. Food Marketing Institute v. ICC, 587
F.2d 1285, 1289 (D.C. Cir. 1978) (similar analysis of § 316(g)
rulemaking for motor common carrier ratemaking). Further,
from this finding the court also concluded that the “substantial
evidence” standard did not apply to such ICC determinations.
Asphalt Roofing, 567 F.2d at 1002 n.5. The parties, apparently
following the comments in Asphalt Roofing, have not argued
that the substantial evidence test applies in this case.
We note, however, that the substantial evidence test applies
not only to agency proceedings subject to the formal require-
ments of sections 556 and 557 of title 5; in addition, the test
should be employed whenever judicial review is “on the
record of an agency hearing provided by statute.” 5 U.S.C.
§ 706(2) (E). Section 15(1) of title 49 requires FERC to hold
a “full hearing” before issuing orders of the sort issued in
Williams. Also, we conduct this review pursuant to 28 U.S.C.
§ 2347, see Earth Resources Co. v. FERC, 628 F.2d 234 (D.C.
Cir. 1980), which requires review ‘on the record of the plead-
ings, evidence adduced, and proceedings before the agency,
A-27
Under the “arbitrary and capricious” standard, a re-
viewing court must conduct a “searching and careful” ”
inquiry into the record in order to assure itself that the
agency has examined the relevant data and articulated
a reasoned explanation for its action including a “ra-
tional connection between the facts found and the choice
made.” Burlington Truck Lines v. United States, 371
U.S. 156, 168 (1962). As the Supreme Court recently
elaborated :
when the agency has held a hearing... .” Thus, without
ad jressing the question whether the Allegheny-Ludlum holding
should apply when the statutory requirement is for a “full
hearing,” 49 U.S.C. § 15(1), rather than simply a “hearing,”
49 U.S.C. § 1(14), a question left open in Florida East Coast
Railway, 410 U.S. at 248, we are still troubled by Asphalt
Roofing’s truncated treatment of the question whether the sub-
stantial evidence test should be applied in the review of orders
issued pursuant to 49 U.S.C. §15(1). The relevant statutes
suggest to us that our review is “on the record of an agency
hearing provided by statute.” 5 U.S.C. § 706(2) (E). Further-
more, in Allegheny-Ludlum itself, the Supreme Court, while
not expressly invoking APA section 706(2) (E), nevertheless
discussed for ten pages why the ICC’s decision “was supported
by substantial evidence,” despite its holding that the require-
ments of APA sections 556 and 557 were inapplicable. See
406 U.S. at 746-56.
Accordingly, we are reluctant to endorse the Asphalt Roof-
ing footnote. On the other hand, because (1) the parties did
not fully address the question of the proper standard of re-
view, (2) the difference, if any, between the “arbitrary and
capricious” standard and the “substantial evidence” standard
is limited, especially in a regulatory field as empirically-based
as ratemaking, see Ethyl Corp. v. EPA, 541 F.2d 1, 36-37 &
n.79 (D.C. Cir.) (en banc), cert. denied sub nom. E.I. DuPont
de Nemours & Co. v. EPA, 426 U.S. 941 (1976), and (3)
the “arbitrary and capricious” standard is not satisfied in
any event, we need not resolve the issue in this case. See
Dana Corp. v. ICC, 703 F.2d 1297, 1301 (D.C. Cir. 1983).
40 Small Refiners Lead Phase-Down Task Force v. EPA, 705
F.2d 506, 520 (D.C. Cir. 1983) (quoting Citizens to Preserve
Overton Park, Inc. v. Volpe, 401 U.S. 402, 416 (1971)).
A-28
Normally, an agency rule would be arbitrary and
capricious if the agency has relied on factors which
Congress has not intended it to consider, entirely
failed to consider an important aspect of the prob-
lem, offered an explanation for its decision that runs
counter to the evidence before the agency, or is so
implausible that it could not be ascribed to a differ-
ence in view or the product of agency expertise.
Motor Vehicles Manufacturers Association vy. State Farm
Mutual Automobile Insurance Co., 103 S. Ct. 2856, 2867
(1983). Most fundamentally, our task is “to ensure
that the [agency] engaged in reasoned decisionmaking.”
International Ladies’ Garment Workers’ Union v. Dono-
van, 722 F.2d 795, 815 (D.C. Cir. 1983); see American
Gas Association v. FPC, 567 F.2d 1016, 1029-30 (D.C.
Cir. 1977), cert. denied, 435 U.S. 907 (1978).
Agency decisionmaking, of course, must be more than
“reasoned” in light of the record. It must also be true
to the congressional mandate from which it derives au-
thority. Therefore, a reviewing court must be satisfied
that the agency’s reasons and actions “do not deviate
from or ignore the ascertainable legislative intent.”
Ethyl Corp. v. EPA, 541 F.2d 1, 36 (D.C. Cir.) (en
banc) (quoting Greater Boston Television Corp. v. FCC,
444 F.2d 841 (D.C. Cir. 1970)), cert. denied sub nom.
E.I. Du Pont de Nemours & Co. v. EPA, 426 U.S. 941
(1976) ; see 5 U.S.C. § 706(2) (C) (“The reviewing court
shall ... hold unlawful and set aside agency action...
in excess of statutory jurisdiction, authority, or limita-
tions.”). Beyond that, however, we are not at liberty to
substitute our own judgment in the place of the agency’s.
In this sense, the “arbitrary and capricious” standard is
narrow and restricted. See Small Refiner Lead Phase-
Down Task Force, 705 F.2d at 520-21.
The “arbitrary and capricious” standard demands that
an agency give a reasoned justification for its decision to
alter an existing regulatory scheme. See Motor Vehicle
A-29
Manufacturers Association, 103 8S. Ct. at 2866. We are
well aware that changed circumstances may justify the
revision of regulatory standards over time. Indeed, our
initial remand in Farmers Union I was impelled by our
suspicion that prior ICC methods might no longer be use-
ful. See 584 F.2d at 412-20. To acknowledge that circum-
stances have changed, however, is not to eliminate the
burden upon the agency to set forth a reasoned analysis
in support of the particular changes finally adopted.
Furthermore, in light of the purpose of the remand in
Farmer Union I—“to build a viable modern precedent for
use in future cases that not only reaches the right result,
but does so by way of ratemaking criteria free of the
problems that appear to exist in the ICC’s approach” *—
we believe that FERC’s adherence to the old ICC rate
base method also demands a reasoned justification. Cf.
Food Marketing Institute v. ICC, 587 F.2d 1285, 1290
(D.C. Cir. 1978) (courts reviewing agency action after
remand should ensure that “genuine reconsideration of the
issues” took place).
Thus we take up the task of reviewing the Williams
opinion with two objectives in mind. First, we will ex-
amine whether FERC’s actions and supporting ration-
ale comport with its delegated authority to set oil pipe-
line rates at a “just and reasonable” level. Second, we
then will scrutinize the Williams opinion to see whether
FERC considered all relevant factors and demonstrated a
reasonable basis for its decision. See Sierra Club v.
Costle, 657 F.2d 298, 323 (D.C. Cir. 1981).
IV. FERC’s AcTION CONTRAVENES THE STATUTORY
DIRECTIVE TO DETERMINE WHETHER RATES ARE
“JUST AND REASONABLE”
Under section 1(5) of the Interstate Commerce Act, all
rates charged for oil pipeline transportation “shall be just
and reasonable.” Similarly, under section 15(1), Con-
“| Farmers Union I, 584 F.2d at 421.
A-30
gress authorized FERC “to determine and prescribe what
will be the just and reasonable” rate for such transporta-
tion services.
We find that FERC in the Williams decision failed to
satisfy that statutory mandate. We also find uncon-
vincing FERC’s attempts at justifying its novel inter-
pretation of “just and reasonable” rates. First, FERC
sought to establish maximum rate ceilings at a level far
above the “zone of reasonableness” required by the statute.
Second, FERC failed to specify in any detail how “non-
cost” factors, such as the need to stimulate additional
pipeline capacity, might justify its decision to set maxi-
mum rates at such high levels. Third, the legislative his-
tory of the Hepburn Act betrays FERC’s belief that the
“climate of opinion” in 1906 shaped a congressional pur-
pose to impose only very lighthanded rate regulation on
the oil pipelines. Finally, FERC’s reliance on its findings
that oil pipeline rate regulation is (1) unimportant to
consumers at large, and (2) best left to “regulation” by
market forces in most cases, constitutes an improper de-
parture from the basic congressional mandate to ensure
that oil pipeline charges are “just and reasonable.”
Congress delegated ratemaking authority to FERC in
broad terms. Accordingly, “the breadth and complexity
of the Commission’s responsibilities demand that it be
given every reasonable opportunity to formulate methods
of regulation appropriate for the solution of its intensely
practical difficulties.” Permian Basin Area Rate Cases,
390 U.S. 747, 790 (1968). In arriving at a just and rea-
sonable rate, “no single method need be followed.” Wis-
consin V. FPC, 373 U.S. 294, 309 (1963). Indeed, and
more specifically, FERC is not required “to adhere
‘rigidly to a cost-based determination of rates, much less
to one that base[s] each producer’s rates on his own
costs.’”” FERC v. Pennzoil Producing Co., 439 U.S. 508,
517 (1979) (quoting Mobil Oil Corp. v. FPC, 417 U.S.
283, 308 (1974) ).
A-31
On the other hand, the delegation of the power to pre-
scribe rates is accompanied by standards to which FERC,
as delegate, must conform. As Judge Leventhal observed,
“Congress has been willing to delegate its legislative
powers broadly—and courts have upheld such delegation—
because there is court review to assure that the agency
exercises the delegated power within statutory limits.
..”’ Ethyl Corp. v. EPA, 541 F.2d at 68 (Leventhal,
J., coneurring). Surely, FERC enjoys substantial dis-
cretion in its ratemaking determinations; but, by the
same token, this discretion must be bridled in accordance
with the statutory mandate that the resulting rates be
“just and reasonable.” See FPC v. Texaco, Inc., 417
U.S. 380, 394 (1974); Atchison, Topeka & Sante Fe
Railway Co. v. Wichita Board of Trade, 412 U.S. 800,
806 (1973).
The “just and reasonable” statutory standard is, of
course, not very precise, and does not unduly confine
FERC’s ratemaking authority. As this court once ex-
plained, “‘[t]he necessity for an anchor to ‘hold the terms
“just and reasonable” to some recognizable meaning’ is
plain, for the words themselves have no intrinsic meaning
applicable alike to all situations.” City of Chicago Vv.
FPC, 458 F.2d 731, 750 (D.C. Cir. 1971) (quoting City
of Detroit v. FPC, 230 F.2d 810, 815 (D.C. Cir. 1955) ),
cert. denied, 405 U.S. 1074 (1972). We therefore seek
guidance from basic principles developed by the judiciary
in furtherance of its task of assuring that ratemaking
agencies conform to their duty to prescribe just and rea-
sonable rates.
*2During the Hepburn Act debates, Senator Elkins ob-
served: “The words ‘just and reasonable’ furnish a standard
by which the Commission is to be guided or to which it must
adhere. ... This standard is vague, but still it is a standard
because it is a thing judicially ascertainable which the courts
have always recognized it was their right and duty to ascertain
in proper cases.” The Economic Regulation of Business and
Industry: A Legislative History of U.S. Regulatory Agencies
A-32
We begin from this basic principle, well established by
decades of judicial review of agency determinations of
“just and reasonable” rates: an agency may issue, and
courts are without authority to invalidate, rate orders
that fall within a “zone of reasonableness,” where rates
are neither “less than compensatory” nor “excessive.”
See, e.g., FERC v. Pennzoil Producing Co., 489 U.S. at
517; Permian Basin Area Rate Cases, 390 U.S. at 797.
When the inquiry is on whether the rate is reason-
able to a producer, the underlying focus of concern
is on the question of whether it is high enough to
both maintain the producer’s credit and attract capi-
tal. To do this, it must, inter alia, yield to equity
owners a return “commensurate with returns on in-
vestments in other enterprises having corresponding
risks,” as well as cover the cost of debt and other
expenses. . . . [W]hen the inquiry is whether a
given rate is just and reasonable to the consumer,
the underlying concern is whether it is low enough
so that exploitation by the [regulated business] is
prevented.
City of Chicago, 458 F.2d at 750-51 (emphasis in origi-
nal). The “zone of reasonableness” is delineated by strik-
ing a fair balance between the financial interests of the
regulated company and “the relevant public interests,
both existing and foreseeable.” Permian Basin Area Rate
Cases, 390 U.S. at 792; see, e.g., FERC v. Pennzoil Prod-
ucts Co., 489 U.S. at 519; Trans Alaska Pipeline Rate
Cases, 486 U.S. 631, 653 (1978).
The delineation of the “zone of reasonableness” in a
particular case may, of course, involve a complex inquiry
881 (B. Schwartz ed. 1973) (hereinafter “Legislative His-
tory”) ; see also id. at 857 (remarks of Senator Clay) (“We
delegate to the Commission the right to act. We fix a standard
for the Commission—that the rate must be reasonable and just
—and we say to the Commission, ‘You must not go beyond that
standard.’ ’”’).
nicotene pete cme Srencs Bea soediaaie
A-33
into a myriad of factors. Because the relevant costs, in-
cluding the cost of capital, often offer the principal points
of reference for whether the resulting rate is “less than
compensatory” or “excessive,” the most useful and reliable
starting point for rate regulation is an inquiry into costs.
See, e.g., Mobil Oil Corp. v. FPC, 417 U.S. at 305-06,
316; FPC v. Hope Natural Gas Co., 320 U.S. at 602-03.
At the same time, non-cost factors may legitimate a de-
parture from a rigid cost-based approach. See, e¢.g.,
Pennzoil Products, 489 U.S. at 518; Mobil Oil, 417 U.S.
at 308. The mere invocation of a non-cost factor, how-
ever, does not alleviate a reviewing court of its duty to
assure itself that the Commission has given reasoned con-
sideration to each of the pertinent factors. On the con-
trary, “each deviation from cost-based pricing [must be]
found not to be unreasonable and to be consistent with the
Commission’s [statutory] responsibility.” Mobil Oil, 417
U.S. at 308; see Pennzoil Products, 439 U.S. at 518.
Thus, when FERC chooses to refer to non-cost factors in
ratesetting, it must specify the nature of the relevant
non-cost factor and offer a reasoned explanation of how
the factor justifies the resulting rates.
In Williams, FERC departed from these established
ratemaking principles. At the outset, we cannot square
FERC’s statutory responsibilities with its own, quite
novel principle that oil pipeline ratemaking should protect
against only “egregious exploitation and gross abuse,” 21
FERC at 61,649 (emphasis added), “gross overreaching
and unconscionable gouging,” id. at 61,597 (emphasis
added). Rates that permit exploitation, abuse, overreach-
ing or gouging are by themselves not “just and reason-
able.” FERC itself overreaches the bounds of its statu-
tory authority when it permits such oil pipeline rates, so
long as they are not “egregious,” “gross” or “unconscion-
able.” Ratemaking principles that permit “profits too
huge to be reconcilable with the legislative command”
cannot produce just and reasonable rates. Public Service
Commission v. FERC, 589 F.2d 542, 550 (D.C. Cir.
1978).
A-34
We recognize, of course, that “non-cost” factors may
play a legitimate role in the setting of just and reason-
able rates. In Williams, FERC invoked the need to stimu-
late additional oil pipeline capacity as one reason for set-
ting maximum rates at such high levels. See supra at
17. As this court has observed before, “[rjeliance on
non-cost factors has been endorsed by the courts primarily
in recognition of the need to stimulate new supplies.”
Consumers Union v. FPC, 510 F.2d 656, 660 (D.C. Cir.
1974) (footnote omitted) (discussing Permian and Mobil
Oil). However, in this case FERC failed to forecast or
otherwise estimate the dimensions of the need for addi-
tional capacity, and did not even attempt to calibrate the
relationship between increased rates and the attraction of
new capital. See supra note 27.
In the absence of such a reasoned inquiry, we cannot
countenance FERC’s approval of oil pipeline rates which,
by FERC’s own admission, ensure “creamy returns” to
the carriers, 21 FERC at 61,650, and are “far more
generous than those [rates] that [FERC] or other regu-
lators give elsewhere,” id. at 61,646. In a similar con-
text, this court explained:
If the Commission contemplates increasing rates for
the purpose of encouraging exploration and develop-
ment ... it must see to it that the increase is in
fact needed, and is no more than is needed, for the
purpose. Further than this we think the Commission
cannot go without additional authority from Con-
gress.
City of Detroit v. FPC, 230 F.2d 810, 817 (D.C. Cir.
1955), cert. denied sub nom. Panhandle Eastern Pipe
Line Co. v. City of Detroit, 352 U.S. 829 (1956); see
San Antonio v. United States, 631 F.2d 831, 851-52 (D.C.
Cir. 1980) (ICC action, adding seven percent above costs
in setting rates, is arbitrary and capricious because it
lacks “adequate justification for [the] choice of a par-
ticular increment above fully allocated costs”), rev’d on
other grounds sub nom. Burlington Northern, Ince. Vv.
A-35
United States, 103 S.Ct. 1288 (1983); Public Service
Commission Vv. FERC, 589 F.2d at 553-54 (citing cases).
In the Williams proceeding, FERC “made no attempt
at all to verify the accuracy of its prediction that grant-
ing pipeline [rate] incentives will spur increased invest-
ment.” City of Charlottesville v. FERC, 661 F.2d 945,
955 (D.C. Cir. 1981) (Wald, J., concurring). Indeed,
FERC here failed to make its prediction with any spec-
ificity beyond the bald statement that “[e]verybody
agrees that the nation needs and will need more pipe-
line plant.” 21 FERC at 61,614.
FERC also found another basis for its new and liberal
interpretation of “just and reasonable” rates in what it
labeled the “climate of opinion,” prevalent in the early
twentieth century, in favor of dismantling the Standard
Oil trust. FERC believed that Congress initiated rate
regulation of the oil pipelines out of a desire to eliminate
prohibitive pricing practices by the Standard Oil Com-
pany, and from this belief concluded that the “just and
reasonable” standard requires far less stringent rate
regulation than the same statutory standard requires for
other regulated industries, including those industries once
regulated under the very same section of the Interstate
Commerce Act. See supra at 13-15; 21 FERC at 61,578-
99; FERC Brief at 29-44. Accordingly, FERC felt that
the Interstate Commerce Act permitted ratesetting at
levels so high that they weuld “seldom be reached in
actual practice.” 21 FERC at 61,649. We cannot endorse
this interpretation of FERC’s statutory duties.
In some circumstances, the contrasting or changing
characteristics of regulated industries may justify the
agency’s decision to take a new approach to the deter-
mination of “just and reasonable’ rates. See, ¢.g.,
Permian Basin Area Rate Cases, supra. We find, how-
ever, that in this case FERC has not merely developed a
new method for determining whether a rate is “just and
reasonable”; rather, it has abdicated its statutory respon-
sibilities in favor of a method that, by it own description,
A-36
guards against only grossly exploitative pricing practices.
See supra at 33. FERC wrongly assumed that the
statutory phrase “ ‘just and reasonable’... is a mere
vessel into which meaning must be poured.” 21 FERC at
61,594. While we agree that the statutory phrase sets
down a flexible standard, an agency may not supersede
well established judicial interpretation that structures ad-
ministrative discretion under the statute. An agency may
not “pour any meaning” it desires into the statute. To
accept FERC’s view of its own latitude would be tan-
tamount to holding that no standards accompany the dele-
gation of ratemaking authority to FERC, and we think
such a delegation would be impermissible. From the out-
set, however, we noted that the statute prohibits more
than grossly abusive rates.
Furthermore, an examination of the relevant legislative
history reveals that Congress intended to subject oil pipe-
lines to the same general ratemaking principles that ap-
plied to other common carriers. The Hepburn Act of 1906
was enacted primarily to remedy defects in the original
Interstate Commerce Act of 1887. Although the Act as
passed in 1887 provided that “[a]ll charges made for any
service rendered in the transportation of passengers or
property ... shall be reasonable and just; and every
unjust and unreasonable charge for such service is pro-
hibited and declared to be unlawful,” 24 Stat. 379, the
Supreme Court ten years later held that the ICC lacked
authority to prescribe rates, but instead could only declare
whether charges set by the carriers were unreasonable or
unjust in the context of granting reparations to injured
shippers. ICC v. Cincinnati, New Orleans & Texas Pacific
Railway Co., 167 U.S. 479 (1897) (the Maximum Rate
Case) ; see Trans Alaska Pipeline Rate Cases, 436 U.S. at
639. The Hepburn Act remedied this shortcoming by
granting to the ICC express authority to set maximum
rates to be observed by carriers prospectively. See 49
U.S.C. § 15. In this context, the Congress, by amendment
originating in the Senate, adopted the Lodge Amendment,
A-37
which conferred common carrier status upon oil pipelines,
thus subjecting oil pipelines to the ratemaking jurisdiction
of the ICC.
It appears evident from the floor debates that oil pipe-
lines were intended to be treated in the same fashion as
other common carriers under the Interstate Commerce
Act. “It appears to me,” Senator Lodge said in support of
his amendment, “that it is a plain injustice to the rail-
roads of this country to put them all under the Interstate
Commerce Commission, to make the most drastic regula-
tions to control and supervise them, and leave out one of
the greatest article of interstate commerce [i.e., oil trans-
ported through pipelines].” 40 Cong. Rec. 6365 (*906).
“This amendment,” he said a few days later, “makes the
pipelines and the oil companies subject to all the provi-
sions to the bill.” Jd. at 7009. Thus Congress chose con-
sciously to regulate oil pipeline rates in accordance with
the same principles devised contemporaneously in other
provisions of the Hepburn Act, which, as we noted above,
augmented the ICC’s authority over all common carriers.
The legislative history furthermore evidences that the
“just and reasonable” rates prescribed by the Congress in
1906 meant more than a ban on prohibitive pricing. Con-
gress primarily wanted to authorize the ICC to set en-
forceable rates that would permit the carriers to earn a
fair return, while protecting the shippers and the public
from economic harm. As Senator Elkins put it:
[T]he present laws are executed and they are being
enforced vigorously; but this, as I have said before,
is no reason why there should not be the strictest
regulation against excessive rates and abuses of
every kind .... The aim of wise statesmanship
should be to so adjust matters by proper legislation
that the shipper and producer can make a fair profit
on their products, the [carrier] a fair return for
the service rendered, and the consumer get what he
buys at a fair price.
A-38
Legislative History at 879. Discussions of what con-
stituted a just and reasonable rate focused not upon pro-
hibitive pricing practices, but instead on setting a fair
price that would be neither excessive to the shipper nor
threatening to the financial integrity of the carrier. See,
e.g., id. at 854 (remarks of Senator Clay) (Under the
“just and reasonable’ standard, ICC must determine
“whether or not the rate so fixed is confiscatory or not
compensatory for the services performed.) ; id. at 859
(remarks of Senator Clay) (“Can the [ICC’s] power be
exercised either to oppress the roads or che shippers? Can
this power be exercised either to wrong or injure the car-
rier or the shipper? .... Can the Commission fix a rate
that would prevent the railroads from making operating
expenses and denying to them just compensation for the
services performed? I answer, ‘No.’ . . . The object and
purpose of this legislation is to make [carriers] do right
and to make shippers do right.”) ; id. at 880 (remarks of
Senator Culberson) (“[T]he Supreme Court has held that
the words ‘just and reasonable’ have relation both to the
rights of the public and of the companies, and that the
rate must be fixed with reference to the rights of each.’’).
Additional evidence of congressional intent can be found
by examining the decision to delete from the original Hep-
burn bill the requirement that rates be “fairly remunera-
tive” in addition to “just and reasonable.” After quoting
the definition of ‘“remunerative” found in a contemporary
Standard Dictionary—“Affording, or tending to afford,
ample remuneration; giving good or sufficient return;
paying; profitable’—Senator Culbertson questioned
whether the additional phrase served any useful purpose,
and worried whether the phrase might “have exclusive
reference to the interests of the companies,” thus “liberal-
izing the rule [of ‘just and reasonable’ rates] rather than
narrowing it or keeping it where it is under the common
law and under the decisions of the Supreme Court.” See
id. at 880-81. As Senator LaFollette later elaborated:
A-39
The phrase “just and reasonable” has a clear and
well defined meaning in the law. It measures what
the public must pay. It measures all that the carrier
is entitled to receive. ...
The words “fairly remuneracive” are added. What
office are they to serve? For what purpose are they
introduced? Are they to add something to the rate?
If that is the purpose, they should be stricken from
the bill. The carrier is entitled to nothing more than
a just and reasonable rate. If the words “and fairly
remunerative” are not designed to increase the rate,
then they serve no purpose and should go out.
Id. at 906. Eventually, the phrase was deleted from the
bill, in part because the “fairly remunerative” standard
was thought to add nothing to the already established
“just and reasonable” standard,“ and in part out of a
fear that the courts might wrongly interpret the phrase
to permit higher rates.“
43 See, e.g., id. at 648 (remarks of Representative Adamson)
(“The words ‘fairly remunerative’ .. . did not change the sense
{of ‘just and reasonable’] a particle.”) ; id. at 864 (remarks
of Senator Carmack) (“I do not like the words ‘fairly remu-
nerative’ in this bill. They are at best a needless addition to
the words of the present law, which may tend to confuse and
mystify its meaning.’’) ; id. at 881 (remarks of Senator Elkins)
(“It is difficult to say what the words ‘fairly remunerative’
mean; whether they lay down a standard by which the courts
can determine anything. ... The words ‘just and reasonable’
furnish a standard by which the Commission is to be guided or
to which it must adhere.’’) ; id. at 975 (remarks of Representa-
tive Richardson) (discussing conference report) (“Those
words ‘fairly remunerative,’ that were indefinite and without
legal definition or construction, have gone out by Senate
amendment 31.”).
44 See, e.g., id. at 864 (remarks of Senator Carmack) (‘The
very fact that [‘fairly remunerative’] ha[s] been carefully
added may give [the phrase] more than [its] proper signifi-
cance. It will be an indication that Congress was not satisfied
with the words ‘just and reasonable,’ which have received judi-
cial interpretation.”) ; id. at 880-81 (remarks of Senator Cul-
berson) (“Now the committee, or at least the bill-—-whoever
A-40
If the Congress believed that “fairly remunerative”
rates were at best the same as “just and reasonable”
rates, and if there was a prevalent concern that “fairly
remunerative” rates could exceed the proper ratemaking
standard applicable to common carriers, we then find it
highly unlikely that Congress aimed its ratemaking pro-
visions solely toward preventing extraordinary exploita-
tion or prohibitive pricing practices. After all, no “fairly
remunerative” rate would rise to the level of egregious
exploitation. How, then, could a Congress, worried that
the “fairly remunerative” standard might permit exces-
sive rates, at the same time be willing to permit rates at
any level so long as they are not grossly abusive? We
are convinced that the Congress did not intend such a
result.
While we recognize that the legislative history of the
Lodge Amendment contains a number of references to
the Standard Oil Company, we do not believe that those
may be responsible for it—adds the words ‘fairly remunera-
tive’. ... Now, what I desire to ask the Senator is this:
First, what is the purpose of using the additional words ‘fairly
remunerative,’ and if, in his judgment, those words do not have
the effect of liberalizing the rule rather than of narrowing it
or keeping it where it is under the common law and under the
decisions of the Supreme Court, and if the words ‘fairly remu-
nerative’ do not have exclusive reference to the interests of the
companies? And, lastly, I will ask the Senator if he will join
with some of us in striking the words ‘fairly remunerative’
from the bill?”) ; id. (remarks of Senator Elkins) (“I fear in
the use of these words [‘fairly remunerative’] we get into a
wide and unknown sea.”).
45 Many of the comments describe Standard Oil’s lobbying
efforts in opposition to regulation. See, e.g., Legislative His-
tory at 915 (remarks of Senator Lodge) (“I heard within
twenty-four hours after the introduction of my first amend-
ment, on May 28, from the Standard Oil Company. A repre-
sentative of that company came to see me on the following day,
and represented the uselessness and the injustice of this amend-
ment.”) ; id. at 976-77 (remarks of Senator Richardson) (“He
[Senator Tillman] did not; because he says he fears somebody
A-41
references somehow alter the meaning of the language
in the ratemaking provisions of the Interstate Commerce
Act as applied to oil pipelines. First, the nature of the
industry to be regulated is a natural topic for discussion
during debate, and at that time Standard Oil dominated
the industry. Second, there is nothing else in the legisla-
tive history to suggest that the Congress intended the
meaning of “just and reasonable” to be transfigured when
applied to oil pipelines. To rely too heavily on the pop-
will stamp on his forehead the letters ‘S.0.’—‘Standard
Oil.’ ”’) ; id. at 985 (remarks of Senator Tillman) (“I felt that
the influences behind this change were sinister, and that the
large number of telegrams, I will not say all of them, but a
large proportion of them, had been sent here through the in-
strumentality and at the instance of the Standard Oil Com-
pany.”’). Other comments refer to Standard Oil’s dominance of
the oil pipeline market. See, e.g., id. at 916 (remarks of Senator
Lodge) (“There are practically two great companies that
control pipe lines engaged in interstate commerce. One is
Standard Oil, which is said, roughly, to control 90 per cent.
I do not know whether that is correct or not.”) ; id. at 917
(remarks of Senator Lodge) (“There is an arrangement of
prorating, which I do not profess to understand, but the net
result is that no oil can come into the territory of New Eng-
land, practically, except the Standard Oil, and that, I under-
stand, happens also in regions of the South and the South-
west.”’).
*° Indeed, the evidence is to the contrary. See, e.g., id. at 917
(original language of Lodge Amendment) (oil pipelines “shall
be considered and heid to be common carriers within the mean-
ing and purpose of this act’) (emphasis added) ; supra at 37
(remarks of Senator Lodge) (“This amendment males the
pipelines and the oil companies subject to all the provisions to
the bill”) (emphasis added). Furthermore, when Congress
wished to exclude oil pipelines from a provision of the Hep-
burn Act, it did so expressly. The original prohibition against
any “common carrier” transporting its own commodities was
deliberately restricted to apply only to “railroads.” See, €.g.,
Legislative History at 966 (conference report); id. at 969
(same) ; id. at 978 (remarks of Representative Richardson)
(“I do not think, Mr. Speaker, that in the attitude of a con-
feree I ought to yield when I thought in good judgment and
common sense that a pipe line ought to be allowed to carry its
A-42
ular “climate of opinion” in 1906 as evidence of the
congressional intent underlying the Interstate Commerce
Act would be unwise. See generally Dickerson, Statu-
tory Interpretation: Dipping into Legislative History,
11 Hofstra L. Rev. 1125 (1983). Indeed, the motives of
legislators are uniformly disregarded in the pursuit for
statutory meaning; it is the purpose or intent behind the
statutory provision itself that is relevant. See 2A Suther-
land’s Statutes and Statutory Construction §48 (C.
Sands 4th ed. 1973 & 1983 Supp.). Thus, even assum-
ing arguendo that it was the popular spirit of trust bust-
ing that aroused the 1906 Congress, it does not follow
that Congress devised a response directed solely and nar-
rowly toward prohibitive pricing. Congress provided
that oil pipelines, as common carriers, could lawfully
charge only “just and reasonable” rates; it did not enact
a special antitrust or prohibitive pricing provision for
oil pipelines. Whatever the historical context of the Hep-
burn Act, we think that FERC’s statutory interpreta-
tion overlooks the broad terms of the principal source of
legislative intent, the statute itself. Even if the problem
Congress addressed was prohibitive pricing, the solution
ultimately devised requires that oil pipeline rates be
just and reasonable.
Finally, FERC believed that the changes since 1906 in
the economics of oil pipelines also justified its novel inter-
pretation of its statutory responsibilities under the In-
terstate Commerce Act. FERC determined that the cost
of pipeline transportation, velative to the price of oil,
had become so insignificant that close regulation was not
required. See supra at 15-17. In addition, FERC found
that competition in the oil pipeline business had served
own product. We made them common carriers, and that, I
thought, was far enough to go.”) ; id. at 985 (remarks of Sen-
ator Tillman) (‘The effect of this change from ‘common car-
rier’ to ‘railroad’ and now to ‘railroad company’ is easily under-
stood .... The words ‘common carrier’ embraced pipe lines.
The words ‘railroad companies,’ of course, leaves those out.”).
A-43
to keep prices down. See supra at 17. FERC therefore
concluded that oil pipeline ratemaking “can and should
rely far more heavily on the market” and that rate regu-
lation should be “peripheral to the pricing process.” 21
FERC at 61,649. Accordingly, in FERC’s opinion, oil
pipeline ratemaking should merely set “ceilings that...
will seldom be reached in actual practice.”
We believe that this apologia for virtual deregulation
of oil pipeline rates oversteps the proper bounds of
agency discretion under the “just and reasonable” stand-
ard. First, the fact that oil prices have skyrocketed does
not repeal the statutory requirement that oil pipeline
rates must be just and reasonable.’ Whether the pur-
pose of oil pipeline rate regulation is “consumer protec-
tion” or “producer protection,” ** the statute requires
meaningful rate regulation. As the ICC acknowledged,
the statutory command controls, despite any dilution in
direct impact on the consuming public:
In determination of the question whether rates are
lawful, we cannot attach any controlling weight to
the fact that [the pipeline] or their beneficial owners
47 FERC emphasized its belief that it was not “free to de-
regulate this [oil pipeline] industry.” 21 FERC at 61,599. As
we have noted above, however, FERC’s ratemaking principles
diverge much too seriously from the “just and reasonable”
standard to be in harmony with the statutory mandate. Fur-
thermore, ratemaking that sets charges at levels “seldom...
reached in actual practice’ and which is “peripheral to the
pricing process” is at best a hair’s breadth from total deregula-
tion.
*8 On the one hand, FERC declared that “[ol]il pipeline rate
regulation is not a consumer-protection measure. It probably
was never intended to be. It is and was a producer-protection
measure.” 21 FERC at 61,584. On the other hand, when
FERC began its examination of the unimportance to the pub-
lic of the cost of oil pipeline transportation, FERC stated, “we
look at it through the consumer’s glasses. We do so because we
are ourselves consumers and because they are the people we
are here to protect.” Jd. at 61,599.
A-44
[the parent companies] have seen fit to pay charges
from one pocket to the other or to operate their
common-carrier and industrial property in such a
manner that the carrier system is virtually a plant
facility of the larger producing, manufacturing, and
selling industry. These facts, if they be facts, are
immaterial . . . whatever the relations between the
pipelines and the oil companies which beneficially
own them, Congress requires all rates tendered to
the public by these common carriers to be just and
reasonable, and no more.
Reduced Pipe Line Rates and Gathering Charges, 243
I.C.C. 115, 141 (1940). Despite recent legislative pro-
posals to deregulate the oil pipeline industry, Congress
has not as yet altered its command to FERC.*® Accord-
ingly, the fact that the price of oil to *he ultimate con-
sumer dwarfs the price of oil pipeline transportation
“does not excuse deviation from the just and reasonable
standard, for not even ‘a little unlawfulness is per-
mitted.’ Consumers Federation of America, 515 F.2d
at 358 n.64 (quoting FPC v. Texaco Inc., 417 U.S. 380,
399 (1974) ).
Second, we find FERC’s largely undocumented reliance
on market forces ® as the principal means of rate regu-
49 In 1982, Congress considered companion bills S. 1626 and
H.R. 4488, which would have deregulated oil pipeline rates.
The 97th Congress adjourned, however, with the bills still in
committee.
50 FERC’s evaluation of competition in the oil pipeline in-
dustry is not entirely clear:
It is obvious that something has been holding these
rates down. That something must be a marketplace force.
The industry labels that force “competition.” The parties
have spent much time and great energy debating this mat-
ter of competition. Each set of protagonists makes valid
points. This is a rather “soft” kind of competition. It ap-
pears to.be of a live and let-live kind. But this does not
A-45
lation to be similarly misplaced. It is of course elemen-
tary that market failure and the contro: of monopoly
power are central rationales for the imposition of rate
mean that it is not there. Nor does it necessarily negate a
finding of considerable potency.
21 FERC at 61,608. Our task of interpreting FERC’s finding
is seriously impaired by the Commission’s decision to omit an
initial decision by the ALJ, see 10 FERC (CCH) { 61,023
(Jan. 9, 1980), coupled with its virtually complete failure to
make any express references to the extensive record compiled
in this case. In fact, FERC pronounced that its “massive rec-
ord” in which “[e]xperts discoursed on risk, on competition”
was “beside the point.” 21 FERC at 61,628. Such nonchalance
cannot be countenanced when the Commission then goes on to
rely on a factual finding as to competition in devising its rate-
making scherne. Judicial review in such circumstances de-
mands that the agency set out the basis in the record for its
critical findings. See, e.g., Motor Vehicles Mfrs. Ass’n, 103
S. Ct. at 2870; Permian Basin Area Rate Cases, 390 U.S. at
792.
Moreover, since in the oil pipeline industry “[a] national
geographic market leads to meaningless results, since trans-
portation is regional, at least,” Coburn, The Case for Petro-
leum Pipeline Deregulation, 3 Energy L.J. 225, 245 (1982),
we agree with the Justice Department that to have any rele-
vance at all, competition must be evaluated in terms of discrete
regional markets. See Justice Dep’t Brief at 44. FERC itself
acknowledged that “actual and potential” competition in the oil
pipeline industry is not “omnipresent,” 21 FERC at 61,627 &
61,702 n.360, and that intramodal competition is “often supple-
mented”—not “always supplemented”—by intermodal competi-
tion, id. at 61,627. Our review of the record reveals only
anecdotal evidence of intermodal competition on certain pipe-
line routes. Furthermore, the principal evidence put forward
by FERC in its brief to support its finding of intermodal com-
petition—the decrease in oil pipelines’ market share for petro-
leum transportation—can be explained chiefly by the increase
in foreign imports transported by water. See J.A. at 939 (tes-
timony of Richard J. Barber Assocs.). This trend therefore
appears to reflect world oil resource availability more than true
intermodal competition.
Finally, we note that when Congress amended the Interstate
Commerce Act to account for competition in the rail carrier
A-46
regulation. See S. Breyer, Regulation and Its Reform
15-16 (1982). As Representative Knapp expounded in
1906:
It has been stated that rate making is the most
complicated and difficult work connected with trans-
portation. Doubtless that has been correctly stated,
but whether so or not, it certainly is one of the most
important. The contention that competition is a reg-
ulator of freight rates is not, in the main, tenable.
That, by reason of combinations, has gradually
ceased to be a controlling factor, and can not now,
except in limited and exceptional cases, be depended
upon, as cortrolling in regulating rates.
Legislative History at 677. The courts have echoed this
observation, noting that “[i]n subjecting producers to
regulation because of anti-competitive conditions in the
industry, Congress could not have assumed that ‘just
and reasonable’ rates could conclusively be determined
by reference to market price.” FPC v. Texaco, 417 US.
at 399; see, e.g., Tennessee Gas Pipelin v. FERC, 606
F.2d at 1114.
We recognize that the market price of oil could, “in
an individual case, coincide with just and reasonable
rates” and may “be a relevant consideration in the set-
ting of area rates; it may certainly be taken into account
along with other factors.” FPC v. Texaco, 417 U.S. at
399 (citations omitted). The Williams opinion, however,
goes far beyond what we regard as rational or permissi-
industry, the amendment required the ICC to make a specific
finding that a particular rail carrier did not have ‘market
dominance” before deregulating the carrier. See 49 U.S.C.
§ 10709. We do not believe that the unamended oil pipeline
rate provisions of the Interstate Commerce Act, which do not
make any provision for deregulation, would reqilire any less
of a particularized showing before competition might be prop-
erly taken into account.
A-47
ble assumptions about the relationship between “just and
reasonable” rates and the market price.™
51In Farmers Union I, this court noted that oil pipelines
“have none of the special obligations imposed upon the ve-
hicular regulatees under the Act [e.g., railroads and motor
carriers] concerning acquisitions, mergers, corporate affiliates,
uniform cost and revenue accounting, issuance of securities,
and corporate or financial reorganizations.” 584 F.2d at 413.
Accordingly, we found that “we may infer a congressional in-
tent to allow a freer play of competitive forces among oil pipe-
line companies than in other common carrier industries and,
as such, we should be especially loath uncritically to import
public utilities notions into this area without taking note of
the degree of regulation and of the nature of the regulated
business.” Jd. FERC cited this passage in support of its
approach to oil pipeline retemaking. See 21 FERC at 61,599;
FERC Brief at 48. In addition, FERC noted its lack of au-
thority over abandonment of service, and argued:
To begin with, it is fairly obvious that a regulatory
scheme that permits the regulatees to abandon service
whenever they find the regulators’ decisions about prices
unpalatable isn’t worth very much. That kind of regula-
tion gives the regulatees a veto power over the actions of
the regulators. It is as iull of holes as a Swiss cheese and
is arguably tantamount to no regulation at all.
21 FERC at 61,690 n.217. We think FERC misconstrued the
significance of the Farmers Union I passage and overstated
the significance of its lack of abandonment authority.
First, the passage from Farmers Union I concludes that
there is no “mandatory approach to ratemaking” discernible
from the Interstate Commerce Act. In context, therefore, the
passage reflects the principle, followed here, see supra at 30-33;
infra at 71, 85, that neither strict original cost-based “public
utilities notions” nor the valuation methods suggested by the
Valuation Act, 49 U.S.C. § 19a, must necessarily be adhered
to in deriving oil pipeline rates. Furthermore, giving “freer
play [to] competitive forces” is not equivalent to permitting
rates that fall outside the “‘zone of reasonableness.” See supra
at 33-34. Competitive forces are given freer play by permitting
companies to decide for themselves whether to enter a geo-
graphic territory already served by another pipeline company
(which would be unlawful without regulatory consent in a
utility industry having exclusive service territories). Simi-
A-48
FERC’s methodology, by its own admission, merely sets
“ceilings seldom reached in actual practice,” and permits
“creamy returns” to oil pipelines. As we have explained
above, such ratemaking does not comport with FERC’s
statutory responsibilities. FERC’s methodology, therefore,
exposes a range of permissible prices that would exceed
the “zone of reasonableness” by definition, unless competi-
tion in the oil pipeline market drives the actual prices
back down into the zone. But nothing in the regulatory
scheme itself acts as a monitor to see if this occurs or to
check rates if it does not. That is the fundamental flaw
in the Commission’s scheme. See Texaco, Inc. v. FPC, 474
F.2d 416, 422 (D.C. Cir. 1972), approved in relevant part
and vacated on other grounds, 417 U.S. 380 (1974).
Congress may indeed have imposed the requirement
that rates be “just and reasonable” in order to restore the
“true” market price—the price that would result through
the mechanism of a truly competitive market—for pur-
chasers of the regulated service or goods. See, e.g., FPC
larly, pipeline companies may abandon service at will (which
would be unlawful for many other utilities). But Farmers
Union I should not be read to support a theory that market
forces can be a complete substitute for regulation of the oil
pipeline rates.
Second, we disagree with FERC’s appraisal that regulation
without abandonment control “is arguably tantamount to no
regulation at all.” The extremely high sunk costs involved
with initiating oil pipeline service render a decision to abandon
that service a weighty one indeed. So long as the pipeline re-
ceives a just and reasonable rate for its service, it will be
afforded an opportunity to derive a fair profit. Even if the
oil pipelines do not receive everything they would like—even
if they do not make “creamy returns” on their investment—
they are still unlikely to “abandon service whenever they find
the regulators’ decisions unpalatable,” especially considering
FERC’s view that oil pipeline capacity is needed to serve the
oil companies which, in turn, own many of the pipelines. In
this context, FERC is too modest about its own powers; the
oil companies do not possess “veto power” over FERC’s rate
decisions.
A-49
v. Texaco, 417 U.S. at 397-98; FPC v. Sunray DX Oil Co.,
391 U.S. 9, 25 (1968). In setting extraordinarily high
price ceilings as a substitute for close regulation, FERC
assumed that, with the wide exposed zone between the
ceiling and the “true” market rate, existing competition
would ensure that the actual price is just and reasonable.
Without empirical proof that it would, this regulatory
scheme, however, runs counter to the basic assumption of
statutory regulation, that “Congress rejected the identity
between the ‘true’ and the ‘actual’ market price.” FPC v.
Texaco, 417 U.S. at 399. In fact, FERC’s “ ‘regulation’
by such novel ‘standards’ is worse than an exemption sim-
pliciter. Such an approach retains the false illusion that
a government agency is keeping watch over rates, pursu-
ant to the statute’s mandate, when it is in fact doing no
such thing.” Texaco v. FPC, 474 F.2d at 422.
Moving from heavy to lighthanded regulation within
the boundaries set by an unchanged statute can, of
course, be justified by a showing that under current cir-
cumstances the goals and purposes of the statute will be
accomplished through substantially less regulatory over-
sight. See Black Citizens for a Fair Media v. FCC, 719
F.2d 407, 413 (D.C. Cir. 1983). We recognize that this
court has sanctioned dramatic reductions in regulatory
oversight under, for example, the FCC and ICC licensing
provisions, both of which require that the licensee operate
in accordance with the “public interest.” See id.; National
Tours Brokers Association v. ICC, 671 F.2d 528, 531-32
(D.C. Cir. 1982). In both cases, this court found that the
agency adequately assured meaningful enforcement of the
public interest standard. See Black Citizens, 719 F.2d at
413-14; National Tours, 671 F.2d at 533. In other cases,
this court has refused to sanction administrative attempts
to reduce regulation in the absence of a showing that the
goals and dictates of statutes were not being honored. See
International Ladies’ Garment Workers’ Union v. Dono-
van, 722 F.2d 795 (D.C. Cir. 1983) ; Action on Smoking
A-50
and Health v. CAB, 699 F.2d 1209 (D.C. Cir.), swpple-
mented, 713 F.2d 795 (D.C. Cir. 1983).
In this case, FERC failed to show that the rates result-
ing from its newly articulated ratemaking principles
would necessarily satisfy the “just and reasonable” stand-
ard. FERC set rate ceilings which, if reached in practice,
would admittedly be egregiously extortionate and then
failed to demonstrate that market forces could be relied
upon to keep prices at reasonable levels throughout the
oil pipeline industry. As a result, we find that FERC’s
action contravenes its statutory responsibilities under the
Interstate Commerce Act.
V. FERC’s DEcISION LACKS A REASONED BASIS
In the foregoing analysis, we found the general rate-
making principles that guided FERC in the Williams
opinion to be “in excess of statutory jurisdiction, author-
ity, or limitations,” 5 U.S.C. § 706(2)(C), and “not in
accordance with law,” id. § 706(2)(A). Because “an
agency’s action must be upheld, if at all, on the basis ar-
ticulated by the agency itself,” we would remand this case
to FERC on the basis of the foregoing considerations
alone. Motor Vehicle Manufacturers Association, 103 S.
Ct. at 2870; see SEC v. Chenery Corp., 382 U.S. 194, 196
(1947). As independent grounds for our decision today,
however, and in light of the apparent need for judicial
guidance in this case,"* we further hold that the Williams
opinion was not “the product of reasoned thought and
based upon a consideration of relevant factors.” Specialty
Equipment Market Association v. Ruckelshaus, 720 F.2d
124, 132 (D.C. Cir. 1983). Accordingly, we now turn
52 At oral argument, counsel for Farmers Union specifically
asked this court to provide better guidance to FERC in the
event of a remand. We hope that the following discussion will
assist FERC in the speedy disposition of this case, which al-
ready has taken far too long. See supra at 11-12.
A-51
to examine the particulars of FERC’s oil pipeline rate-
making formula.
A. Rate Base
In Williams, FERC decided to adhere to the rate base
formula it inherited from the ICC. See 21 FERC at
61,632. It gave no rational justification for doing so, how-
ever. FERC acknowledged that “rigorous logic and
Euclidean consistency are not the system’s most striking
features,” and that the formula is “much too blunt and
much too clumsy for close work.” It nevertheless con-
cluded that the ICC method is “usable” because oil pipe-
line ratemaking “is not close work.” Id. at 61,616. This
is not a sufficient justification.”
It is well established that an agency has a duty to con-
sider responsible alternatives to its chosen policy * and to
give a reasoned explanation for its rejection of such alter-
natives. See, e.g., Motor Vehicle Manufacturers Associa-
tion, 103 S. Ct. at 2869-71; International Ladies’ Gar-
ment Workers’ Union, 722 F.2d at 815. This responsibil-
ity becomes especially important when the agency admits
53 FERC also thought “it would probably be best to continue
to stick to the rate base status quo until Congress addresses
itself to the oil pipeline scene as a whole.” 21 FERC at 61,632.
This purported justification runs contrary to the purposes of
remand in Farmers Union I. See supra at 29.
% The “arbitrary and capricious” standard does not “broadly
require an agency to consider all policy alternatives in reaching
decision.” Motor Vehicle Mfrs. Ass’n, 103 S. Ct. at 2871
(emphasis added). Agency action “cannot be found wanting
simply because the agency failed to include every alternative
device and thought conceivable by the mind of man... regard-
less of how uncommon or unknown that alternative may have
been.” Vermont Yankee Nuclear Power Corp. v. NRDC, Inc.,
435 U.S. 519, 551 (1978). The alternatives to the ICC rate
base formula discussed herein, however, are significant and
viable, and were fully discussed during the Williams proceec-
ing.
A-52
its own choice is substantially flawed. We find that
FERC failed to satisfy this duty with respect to certain
proposed modifications in the rate base formula.
1. Original Cost Rate Base
Many parties to the Williams proceeding—including the
FERC staff, the Department of Energy, the Justice De-
partment, Farmers Union Central Exchange—advocated
the calculation of oil pipeline rate bases by reference to
original cost. These witnesses called for the rejection of
the old ICC methodology, because its use of a weighted
average of original cost and replacement cost, see supra
at 18, “lacks any economic rationale.” *
Despite explicit concessions as to the shortcomings of
the ICC rate base formula and the recognized advantages
of a rate base formula derived from original cost,°’ FERC
55 See, e.g., Joint Appendix (J.A.) at 2195 (testimony of Mr.
Ileo on behalf of Farmers Union) ; id. at 2266 (testimony of
Mr. Roseman on behalf of Justice Dep’t) ; id. at 3199, 3203
(testimony of Mr. Manheimer on behalf of FERC staff) ; id.
at 3206-07 (testimony of Mr. Maruszewski on behalf of FERC
staff) ; Exhibits 204-1 to 204-13 (testimony of Mr. Liversidge
on behalf of Dep’t of Energy) ; Exhibits 205-1 to 205-7 (testi-
mony of Mr. Wilson on behalf of Dep’t of Energy).
56 J.A. at 2203 n.8 (testimony of Mr. Ileo) (quoting testi-
mony of Dr. Charles Phillips in TAPS case) ; see also id. at
2249 (testimony of Mr. Roseman) (It is “hard, if not impossi-
ble, to ascribe any specific economic meaning” to rate base
calculated by ICC methods) ; id. at 3208 (testimony of Mr.
Maruszewski) (ICC method contains “flawed factors,” and,
therefore, “I think of no circumstances under which I would
advocate the application of the 1.C.C.’s methodology.”). See
generally Navarro & Stauffer, supra note 29, at 309-10 (con-
cluding that “the relationships among the ICC valuation, the
FERC depreciated rate base, the replacement cost, and the eco-
nomic value are capricious” ).
57 Indeed, FERC acknowledged that the ICC method con- _
tained “anomalies and inconsistencies” that render the formula
“too clumsy for close work.” 21 FERC at 61,616. As to an
A-53
rejected the original cost alternative. FERC offered four
reasons for this decision. First, FERC wished to avoid
the “headache” of analyzing the significance of guaran-
tees—given by many parent oil companies to their sub-
sidiary oil pipeline companies—in the estimation of the
“true” capital structure of oil pipelines.** See 21 FERC
original cost alternative, FERC acknowledged its “ ‘objectivity,
which makes it easily ascertainable, and comparative freedom
from manipulation—wnot inconsiderable virtues.’ Even more
important for our purposes,” FERC continued, “‘is the. . . fact
that the language of American finance is an original cost lan-
guage.” Id. at 61,618 (emphasis in original) (quoting H.
Kripke, The SEC and Corporate Disclosure: In Search of a
Purpose 184 (1979)). This feature of original cost ratemaking
gives regulators “the best fighting chance of approximating
the regulated entities’ cost of capital.” Jd. at 61,619; see
Edelman, Rate Base Valuation and Its Effect on Rate of Re-
turn for Utilities, Pub. Util. Fort., Sept. 2, 1982, at 46.
58 Under the Atlantic Refining Co. consent decree, see supra
note 31, a shipper-owned pipeline could pay no more than
seven percent of pipeline valuation to its parent company in
annual dividends on equity. To increase return on total capi-
tal, the shipper-owned pipelines began to rely heavily on debt
financing, thereby reducing the equity base (and increasing
the net return on equity) while treating the interest on the
debt as a cost unrestricted by the consent decree. See Exxon
Pipeline Co./Exxon Co., U.S.A., An Analysis of the Rates of
Return on Petroleum Pipeline Investments, reprinted in Oil
Pipelines and Public Policy, 261, 273-75 (E. Mitchell ed. 1979).
In the wake of the consent decree, many pipeline companies
had extraordinarily high debt-to-equity ratios; ratios of debt
to total assets often reached 80 to 90 percent. See Hearings
Pursuant to S. Res. 45, Market Performance and Competition
in the Petroleum Industry Before the Special Subcomm. on
Integrated Operations of the Senate Comm. on Interior and
Insular Affairs, 93d Cong., Ist Sess. (statement of Stewart
C. Myers).
To expand the debt capacity of its pipelines, the parent oil
companies would enter into direct debt guarantees or “through-
put and deficiency” agreements with their pipeline subsidi-
aries. Under a throughput and deficiency agreement, the par-
A-54
at 61,620-22. Second, FERC believed that the major regu-
latory benefit that might be derived from a switch to
original cost accounting—the facilitation of comparable
earnings analysis in relation to other businesses with a
comparable risk to the pipelines—would not be useful in
oil pipeline rate regulation, because the oil managers, as
“professional risk takers,” have ingrained attitudes to-
ward risk and return unlike any other public utility
investors. Third, an original cost rate base, without
modification for inflation, would result in high initial
rates that would decline as the rate base depreciates.
FERC believed that competition in the oil pipeline busi-
ness might prevent the pipelines from collecting the high
initial rates, thereby preventing them from reaping their
appropriate return on investment. See id. at 61,628-29.
Finally, FERC found that any benefits resulting from
changes in the rate base formula would not “warrant
the social costs entailed,” id. at 61,631, specifically, the
construction of “transitional rate bases... for each of
the many common carrier oil pipelines,” id. at 61,704
n.376. We find that none of FERC’s explanations for its
ent companies promise to ship, or cause to be shipped, through
the pipeline their pro rata share of oil, sufficient to ensure that
the pipeline will generate enough revenue to meet its debt
service payments and operating expenses. In addition, these
agreements obligate the parent companies to provide the pipe-
line with cash “deficiency payments” if, for whatever reason
—even if the pipeline is inoperable—the pipeline cannot meet
its expenses due. See 21 FERC at 61,698 n.323; G. Wolbert, Jr.,
U.S. Oil Pipe Lines 242-46 (1979). By this method, the parent
companies reduce the risk associated with the debt securities
of the pipeline, and thereby increase their ability to finance
the pipeline with such high levels of debt.
The consent decree was vacated soon after the Williams
opinion was issued. See supra note 31. On remand, FERC can
reexamine the issue of parent guarantees in light of any new
financing trends that have emerged since the consent degree
was vacated.
A-55
rejection of an original cost rate base satisfies accepted
standards of reasoned decisionmaking.”
a. Parent Guarantees and Capital Structure
Because of parent companies’ debt guarantees and
“throughput azd deficiencies” agreements, many shipper-
owned pipelines are able to obtain debt financing more
cheaply and in greater amounts than would be possible
in the absence of such agreements. See supra note 58.
Further, since cost of equity virtually always exceeds
cost of debt, the greater the pipelines’ debt ratio, the
59 In its brief, FERC stated that it had concluded that “‘re-
tention of traditional valuation methodology was preferable to
original cost to avoid a disincentive for future investment in
oil pipelines.” FERC Brief at 62. However, the method of
rate base calculation does not by itself determine the incentive
for future investment; the rate of return also plays a part.
Under original cost accounting, the rate of return is set with
an eye toward ensuring that an incentive exists to invest in
the regulated enterprise. Indeed, FERC stated that “our anal-
ysis suggests that in an appreciable number of instances
original cost may very well mean higher rates,” and that
“Twlith respect to many existing lines, it is hard to imagine
any rate of return short of one that looks like a license to print
money that would allow returns commensurate with those now
deemed legitimate.” 21 FERC at 61,625 & id. at 61,701 n.348.
Higher rates translate into greater investment incentives.
Moreover, FERC was careful to declare that its discussion was
“not [meant] to say that the [original cost] model would not
work for oil pipelines.” Jd.
At one point, FERC indeed intimated that, on the contrary,
original cost ratemaking would result in lewer rates (and thus
lower investment incentives) over the long run and that “[b]e-
cause original cost rate bases fall so sharply as properties age
and because pipeline plant lasts so long, this will be true how-
ever high rates of return may be.” Jd. This problem results
from the “front end load” phenomenon, and would be elimi-
nated by trending the rate base. See infra at 63-64. Further-
more, we find it difficult, if not impossible to square this anal-
ysis with FERC’s previous assertion that original cost rate-
making “may very well mean higher rates.”
A-56
lower its overall cost of capital. See United States v.
FCC, 707 F.2d 610, 613 (D.C. Cir. 1983). Accordingly,
as FERC recognized in its establishment of a “surety-
ship premium,” see supra at 20, the “real” cost of capital
to a pipeline that benefits from such parent guarantees
is greater than its apparent cost of capital.
Regulatory agencies have often assessed a regulated
company’s true cost of capital by constructing hypotheti-
cal capital structures, and then applying the normal costs
of equity and debt to the hypothetical mix of securities.
See Communications Satellite Corp. v. FCC, 611 F.2d
883, 902-09 (D.C. Cir. 1977) (citing numerous cases in-
volving water, gas, electric and telephone utilities). By
this method, regulatory agencies ensure that the derived
‘rate is “just and reasonable”:
Although the determination of whether bonds or
stocks should be issued is for management, the
matter of debt ratio is not exclusively within its
province. Debt ratio substantially affects the manner
and cost of obtaining new capital. It is therefore an
important factor in the rate of return and must
necessarily come within the authority of the body
charged by law with the duty of fixing a just and
reasonable rate of return.
Id. at 903 (quoting New England Telephone & Telegraph
Co. v. State, 98 N.H. 211, 220, 97 A.2d 213, 220 (1958) ).
In the case of oil pipelines, the hypothetical capital struc-
ture would be approximated by estimating the capacity
of the pipeline to support debt in the absence of its par-
ents’ guarantees. See 21 FERC at 61,621.
FERC refused to adopt an original cost rate base in
part because it believed that the attendant necessity for
constructing hypothetical capital structures would be “a
laborious exercise in guesswork, a venture ‘into the un-
known and unknowable.’” Id. at 61,622 (quoting Chris-
tiana Securities Co., 45 SEC 649, 668 (1974)). In
FERC’s view, such an inquiry would be:
A-57
a perfect field day for regulatory economists. Pro-
fessor A would testify that he thinks 70% debt and
30% equity right. Professor B would say 53% debt
and 47% equity. Professor C would come on strong
for 50-50. Miss D from an eminent Wall Street in-
vestment banking firm would testify that her com-
puter tells her that 65% equity and 35% debt are
the right mix. Mr. E from an even more eminent
investment banking firm would have numbers of his
own.
Id. at 61,622. In part to avoid such an inquiry, FERC
chose to avoid an original cost rate base.
This explanation runs counter not only to the proven
practice of FERC and many regulatory agencies® but
also to FERC’s own commentary later in the Williams
opinion. As we have explained above, the technique of
hypothesizing capital structures for oil pipelines would
account for the increased capital costs associated with
financing a pipeline in the absence of guarantees from
the parents. Later in the Williams opinion, FERC de-
6° For discussions and examples of the use of hypothetical
capital structures in the context of utility ratemaking, see Com-
munications Satellite Corp. v. FCC, 611 F.2d 883, 902-09 (D.C.
Cir. 1977) ; V. Brudney & M. Chirelstein, Cases and Materials
on Corporate Finance 372-86 (1979). Also, under 26 U.S.C.
§ 285, the Secretary of the IRS is authorized to prescribe rules
“to determine whether an interest in a corporation is to be
treated for [tax] purposes... as stock or indebtedness.”
FERC’s discussion in Williams appears to contradict sum-
marily its holding in Kentucky W. Va. Gas. Co., 2 FERC
7 61,139 (Feb. 16, 1978). In FERC’s words, “[w]hen, as in
the present case, the use of the actual capital structure would
result in excessive costs to the consumer or inadequate returns
to the investor, some other capital structure must be used.”
Id. at 61,325; see also Michigan Gas Storage, 56 FPC 3267,
3273 (1976) (“the Commission must exercise its expertise and
discretion in choosing the most appropriate capitalization’”’) ;
Florida Gas Transmission Co., 47 FPC 341, 363 (1972) (“a
utility should be regulated on the basis of its being an inde-
pendent entity ; that is a utility should be considered as nearly
as possible on its own merits and not on those of its affiliates”).
A-58
vises its “suretyship premium” to compensate for the
parents’ guarantees of pipeline debt. FERC, however,
appeared confident that any difficulties with estimating
the value of this premium could be surmounted:
Credible expert testimony by persons associated with
the rating services, the investment banking fra-
ternity, and the credit insurance industry as well as
by academics who have made a specialty of the bond
market [can] establish[] that absent the parents’
guarantee [what] the pipeline would have had to
ae
Id. at 61,644.
We cannot square FERC’s apparent confidence in its
ability to estimate a pipeline’s “suretyship premium”
with its extreme skepticism about its ability to construct
hypothetical capital structures. After all, the “surety-
ship premium” represents merely the differential between
a pipeline’s actual cost of capital and what its cost of
capital would have been absent the parent guarantees.
Thus the “suretyship premium” measures the same in-
cremental cost of capital to the pipeline as the hypotheti-
cal capital structures that FERC felt incapable of esti-
mating. The basis for FERC’s preference for its “surety-
ship premium” approach, and for its aversion to hypo-
thetical capital structures is therefore unclear. The de-
cision to reject original cost accounting on the basis of
this preference and aversion appears arbitrary, and, in
any event, lacks sufficient explanation.
Moreover, even assuming that FERC’s preference for
its suretyship premium approach could be explained, its
rejection of original cost ratemaking because of that pref-
erence relies on the assumption that original cost rate-
making is necessarily tied to hypothetical capital struc-
tures and necessarily incompatible with its newly devised
“suretyship premium.” However, FERC never gave any
reason at all why this assumption is valid. Indeed, we see
no reason why FERC could not account for the parent
A-59
guarantees by using a suretyship premium added to an
original cost ratemaking formula.
If FERC, in the exercise of informed discretion, decides
that the suretyship premium approach is more reliable or
easier to administer than hypothetical capital structures,
then it should state why.“ As of now, neither FERC nor
any of the parties has provided such an explanation.
Even if they did so, however, we still would not under-
stand why the hypothetical capital structure method must
be used with original cost ratemaking, or why the
“suretyship premium” approach cannot be used with
original cost ratemaking.
b. Comparable Risk Analyses
FERC discerned still “more fundamental problems” as-
sociated with the use of original cost ratemaking, beyond
the estimation of appropriate capital structures. As typi-
cally applied under the “just and reasonable” standard,
original cost ratemaking attempts to set the rate of re-
turn for a regulated enterprise at the same level as the
rate of return of an unregulated enterprise with similar
associated risks. See, e.g., FPC v. Hope Natural Gas Co.,
320 U.S. 591, 603 (1944) (“By that standard [of ‘just
and reasonable’ rates] the return to the equity owner
should be commensurate with returns on investments in
other enterprises having corresponding risks.”) ; Bluefield
Water Works & Improvement Co. v. Public Service Com-
mission, 262 U.S. 679, 692 (1923) (“A public utility is
entitled to such rates as will permit it to earn a return
. . . equal to that generally being made at the same time
and in the same general part of the country on invest-
ments in other business undertakings which are attended
61 Tn this discussion, we do not review the wisdom or reason-
ableness of the “suretyship premium” approach. Rather, we
review FERC’s decision to reject original cost ratemaking on
the basis of its aversion to the use of nypothetical capital
structures.
A-60
by the same risks and uncertainties.”) ; A. Priest, Prin-
ciples of Public Utility Regulation 191-94 (1969). FERC,
however, believed that such a risk inquiry was not useful
or relevant to oil pipeline ratemaking. In FERC’s view,
oil company managers—who own many oil pipelines—are
a special breed of risk takers, who demand “a fair chance
of earning as much on a pipeline as they would be likely
to earn on something else in the unregulated sector” re-
gardless of risk. 21 FERC at 61,623.% Accordingly,
FERC rejected original cost ratemaking in part because
the conventional ratemaking inquiry that its use facili-
tates—the inquiry into risk—was, according to FERC,
not helpful in oil pipeline ratemaking.
We think that this argument not only lacks any evi-
dentiary support, it also lacks economic common sense. In
neither the Williams opinion nor in its briefs to this court
62 In FERC’s opinion, the proper rates for oil pipelines “‘can-
not be gleaned from columns of figures about realized rates of
return in this, that, and the other industry.” 21 FERC at
61,624. Instead, FERC believed that in oil pipeline ratemak-
ing, much turns on the “culture,” “habits of mind,” and “in-
grained behavior patterns” inherent in the oil industry and
its “attitudes toward risk and return.” Jd. According to
FERC, oil company managers:
are professional risk takers. ... Why should they invest
in pipelines if pipelines are unlikely to be as remunerative
as petrochemicals, filling stations, natural gas exploration,
molybdenum mines, mahogany forests, contraceptive pills,
mail order chains, department stores, or other outlets for
capital that look attractive?
That question is not answered by saying that those
businesses are riskier than pipelines. ... That oil pipe-
lines are relatively risk-free will not be enough to induce
integrated oil companies and profit-maximizing conglom-
erates to commit funds. They also need some assurance
that they have a fair chance of earning as much on a pipe-
line as they would be likely to earn on something else in
the unregulated sector.
Id. at 61,623.
A-61
does FERC cite any evidentiary basis for its conclusion
that oil managers will invest in only high return enter-
prises. In fact, the record is chock full of testimony re-
garding the risks of the oil pipeline business and the cor-
responding appropriate rate of return.“ Furthermore,
63 See, e.g., J.A. at 254 (testimony of Vernon T. Jones, Presi-
dent and Director of Williams Pipe Line Co.) (“It is my pur-
pose to present this Commission a clear explanation of the need
to maintain adequate rates of return that are commensurate
with the risks of owning oil pipelines and to differentiate in-
dependent oil pipelines and their inherently greater risks.”’) ;
id. at 699-701 (testimony of Charles F. Phillips, Jr. on behalf
of Williams) (‘the more appropriate approach to determining
the cost of common equity is the comparable earnings approach
.. . 1¢ must produce a return on the investment of its equity
holders that is at least equal to the return that would be pro-
duced by an alternative investment of comparable risk’’) ; id.
at 719-35 (testimony of Ulysses J. LeGrange, President and
Director of Exxon Pipeline Co.) (discussing risks of oil pipe-
lines and calling for a rate of return “on the current value of
pipeline assets by comparison with returns on alternative in-
vestment opportunities of comparable riskiness”’) ; id. at 868-
87 (testimony of Dean B. Taylor, President of Phillips Pipe
Line Co. and Seaway Pipe Line Co.) (“My testimony will, I
believe, demonstrate that oil pipelines experience tremendous
risks, and competition, and therefore are entitled to higher
returns than monopoly utilities.”) ; id. at 995 (testimony of
Kenneth J. Arrow on behalf of Ass’n of Oil Pipelines) (“The
risky investment will . . . be undertaken in preference to the
riskless investment when the expected rate of return on it
exceeds (or at least equals) the required expected rate of re-
turn appropriate to its riskiness.”’) ; id. at 1027 (testimony of
Raymond B. Gary, managing director of Morgan Stanley &
Co.) (“The required rate of return for investment in a particu-
lar real or financial asset depends solely on the risks associated
with the investment.”’) ; id. at 1840 (testimony of William B.
Bush, President of Marathon Oil Co.) (‘““What we can do is
confront. and cope with this growing pyramid of ‘old’ and ‘new’
risks realistically. To do so, however, the industry must be
afforded the opportunity to earn a rate of return that reflects
the real world [risks].”). The foregoing list is merely a sam-
pling from a long list of witnesses who testified about risk with
an aim to influencing the returns allowed by FERC. While
A-62
major studies of the oil pipeline industry have concluded
that the oil company managers decide whether to invest in
a particular pipeline only after an examination of whether
the expected returns match the associated risks:
When appraising the economic viability of a pro-
posed pipeline venture, the approach taken is similar
to that used by investors in general; it is what may
be termed as required rate of return analysis. An
oil company has widespread operations with nu-
merous investment opportunities bearing different
degrees of risk. Because of this, each investment,
including pipelines, must be examined individually,
and its expected rate of return compared with the
opportunity rate of return of other prospective in-
vestments with comparable risk characteristics.
G. Wolbert, Jr., U.S. Oil Pipelines 156 (1979) (footnotes
omitted); see Exxon Pipeline Co./Exxon Co., U.S.A.,
Rates of Return on Petroleum Pipeline Investments, re-
printed in Oil Pipelines and Public Policy 261, 268-69
(E. Mitchell ed. 1979) (“ ‘The required rate of return on
an investment opportunity depends on the riskiness of
the investment. The greater the riskiness of the invest-
ment, the more the return demanded by investors.’ ’’)
(quoting E. Solomon & J. Pringle, Introduction to Finan-
cial Management 332 (1977) ).
ICC oil pipeline ratemaking precedents also belie
FERC’s novel notions about the relationship between risk
and required return in the industry. FERC’s notion that
the oil companies demand high returns, no matter how
low the risk, represents a radical departure from the ICC
practice of evaluating risk and estimating the required
return accordingly. See, e.g., Reduced Pipe Line Rates
and Gathering Charges, 272 I.C.C. 375, 381 (1948) ; Min-
nelusa Oil Corp. Vv. Continental Pipe Line Co., 258 I.C.C.
some of these witnesses advocated a continuation of the valua-
tion rate base, see id. at 719-35 (testimony of Ulysses J.
LeGrange), none of them argued that risk was irrelevant to
the investment decisions of oil managers.
A-63
41, 51 (1944); Reduced Pipe Line Rates and Gathering
Charges, 248 1.C.C. 115, 181 (1940). Similarly, in 1978
this court called on FERC to reexamine the “complex of
relevant factors” in determining the proper rates of re-
turn for oil pipelines, including the hazards prevailing in
the pipeline business. See Farmers Union I, 584 F.2d at
419.
We thus find no basis to support, and overwhelming
evidence to contradict, FERC’s finding that comparable
risk analysis has no important role in oil pipeline rate
regulation. We therefore believe that FERC’s rejection of
original cost ratemaking on the basis of that finding is
arbitrary and capricious.
ce. The “Front-End Load” Problem
FERC next offered another, independent reason for re-
jecting original cost ratemaking: the “front-end load”
problem.“ See supra at 54. However, FERC itself
acknowledged that this problem could be solved by using a
trended, inflation-sensitive original cost rate base:
[W]e find the case for an inflation-sensitive oil pipe-
line rate base strong.
6 An untrended cost rate base, which does not increase
with inflation, has nowhere to go but down as it is depreciated.
Therefore the resulting rates decline, and “since under infla-
tion the dollars are declining in value, the real price is de-
clining even faster.” Streiter, Trending the Rate Base, Pub.
Util. Fort., May 18, 1982, at 32. Consequently, the rates of
old pipelines will be lower than the rates of newer pipelines,
even though the service they provide is equivalent. See 21
FERC at 61,628. Moreover, FERC maintained that under
original cost ratemaking the initial high rates could never be
recovered because shippers would go elsewhere for transpor-
tation at a lower rate. Id. Thus the pipelines might never
recover their full cost of service as set by original cost rate-
making, which assumes that the rates set will actually be col-
lected. This problem is termed the “front-end load” problem.
A-64
Such a rate base mitigates original cost regula-
tion’s income-bunching effect. It does not necessarily
follow that the [old ICC rate base formula] is the
ideal solution to the front-end load, income-bunching
problem. Were we writing on an absolutely clean
slate, were we beginning afresh in a brave new
world, were pipelines a novelty that had just made
their appearance, we would fashion an inflation-
sensitive, anti-bunching rate base policy simpler and
more logical than the ICC’s.
21 FERC at 61,630. According to FERC, this “simpler
and more logical” method would “[kJeep[] the rate base
in tune with the general price level by linking it to the
consumer price index or to the gross national product.”
Id. The trended original cost method of calculating rate
bases, as discussed by witnesses in the Williams proceed-
ing and other experts, fits this description. See, ¢.g., J.A.
at 1508-12 (testimony of Stewart C. Myers on behalf of
Marathon Pipe Line Co.); J.A. at 1957 (testimony of
David A. Roach on behalf of MAPCO) ; Streiter, Trending
the Rate Base, Pub. Util. Fort., May 12, 1982, at 32; cf.
J.A. at 1677-1702 (testimony of Michael C. Jensen on
behalf of ARCO Pipe Line Co.) (describing “inflation-
adjusted original cost” method, the results of which are
“equivalent to adjusting the rate base and depreciation
by the unprojected inflation”). Indeed, at one point,
FERC declared that if it were “beginning afresh on a
clean slate [it] might be inclined to use something .. .
along the lines suggested by Marathon’s witness Meyers
[sic].” 21 FERC at 61,616. Marathon’s witness Myers
recommended the use of a trended original cost rate base
if the old ICC method were to be abandoned. See J.A. at
1427, 1499. Thus FERC acknowledged that the front-end
load problem could be solved, by adjusting an original cost
rate base for inflation. Accordingly, FERC could not have
reasonably relied upon the “front-end load” problem as a
basis for rejecting the admittedly “simpler and more
logical” trended original cost alternative.
A-65
d. The Social Costs and Benefits of Transition to
a New Rate Base Formula
Although a trended original cost approach would evi-
dently be “simpler and more logical than the ICC’s,” 21
FERC at 61,630, FERC in the end rejected this alterna-
tive because of the “social costs entailed” in a transition
from one rate base formula to another. See supra at 54.
FERC specified these “social costs” in an accompanying
footnote:
Transitional rate bases would have to be constructed
for each of the many common carrier oil pipelines.
That would be a formidable, a difficult, and a costly
endeavor. The task could be by-passed by using the
most recent valuation (or in the alternative the cost
of reproduction new less depreciation element of that
valuation) as the transitional rate base. But then
how much substantive change would there really be
for existing pipelines? We conclude the change
would be far more costly than it is worth.
Id, at 61,704 n.3876. We are reluctant to sanction the
rejection of an admittedly more logical and accurate rate
base formula on the basis of the conclusionary statement
that the construction of “transitional rate bases” would
be too costly. First, FERC failed to give a reasoned basis
for its assumption that “[t]ransitional rate bases would
have to be constructed” at all. Regulated industries have
no vested interest in any particular method of rate base
calculation. See FPC vy. Natural Gas Pipeline Co., 315
U.S. 575, 586 (1942). Accordingly, as FERC acknowl-
edged, a switch to a new rate base formula would not dis-
rupt protected pipeline property. So long as the resulting
rates are reasonable, the oil pipeline companies should
have no difficulty maintaining their financial integrity.
We are therefore at a loss to understand FERC’s trepida-
tion about a change in its regulatory n.»thod. Similarly,
when this court granted FERC’s request to remand this
case “so that it may begin its regulatory duties in this
area with a clean slate,” Farmers Union I, 584 F.2d at
A-66
421, we specifically advised that the pipelines’ reliance on
an outdated rate base formula should not justify a con-
tinuation of the error. Rather, “the solution is not to
perpet(ujate that reliance but to end it prospectively,
without allowing reparations based on its occurrence in
the past.” Jd. at 419. We still adhere to that principle
today.”
Second, FERC never explained why the construction of
transitional rate bases would be so formidable a task. It
is not self-evident why the calculation of such rate bases
would entail more regulatory costs than the calculation of
rate bases under the arcane ICC formula.” Furthermore,
®° FERC took issue with this court’s analysis, declaring that
“[w]hatever [FERC’s] briefs may have said back in 1977 and
1978 and however jaundiced the court’s view of the ICC’s
methodology, the fact is that that methodology has been in
place for a long time and that drastic conceptual changes would
be disruptive.” 21 FERC at 61,703 n.373. Needless to say,
any departure from the status quo that might limit the pipe-
lines’ ability to earn high profits can be expected to frustrate
their “entrepreneurial expectations.” Jd. Of course, the idea
of rate regulation usually encompasses to some degree the
frustration of the desires of the regulated business to make
large profits. We therefore do not find compelling the fact
that “the people who built the nation’s oil pipeline plant must
have been influenced in large measure by the presence in this
field of a regulatory methodology far more permissive and
much more indulgent than anything that we know of else-
where.” Id. at 61,626. As FERC observed, the [CC rate meth-
odology was subject to judicial review only once, in Farmers
Union I, supra, where it received sharp criticism.
We believe FERC’s principal duty under the statute is to
ensure “just and reasonable” rates. Accordingly, the frustra-
tion of the expectation that this excessively “permissive” and
“indulgent” methodoicgy would continue in force is a “factor[]
which Congress has not intended [FERC] to consider.” Motor
Vehicles Mfrs. Ass'n, 103 S. Ct. at 2867. We therefore do not
condone FERC’s reliance on these expectations.
* Because original cost is already a part of the old ICC
rate base formula, we assume that FERC has original cost data
available for the oil pipelines. See supra note 28.
A-67
the formulation of a method for calculating transitional
rate bases involves questions no more complex than those
confronting FERC regularly.
Finally, regardless of the regulatory or social costs en-
tailed, FERC appeared to reject alternatives to the ICC
_ formula because it found “no clear showing” that chang-
ing the methodology would “produce substantial social
benefits.” Id. at 61,626; see also id. at 61,703 n.373. This
finding, however, apparently relies upon FERC’s ante-
cedent findings that oil pipeline ratemaking should merely
set price ceilings that would seldom be reached in actual
practice, and that comparable risk analysis would not be
helpful to the ratemaking inquiry for oil pipelines. How-
ever, we have found those antecedent findings to be defec-
tive. See supra at 32-34, 59-63. As a result, we likewise
disapprove of FERC’s finding that a new rate base for-
mula could not produce any substantial social benefit.
After carefully reviewing the bases put forward by
FERC for rejecting the original cost alternative, we hold
that FERC failed to “examine the relevant data and arti-
culate a satisfactory explanation for its action.” Motor
Vehicle Manufacturers Association, 103 S. Ct. at 2866.
In our view it did not offer a reasoned explanation for
adhering to an admittedly antiquated and inaccurate
formula, but rather a host of unconvincing excuses that
fail to add up to a rational choice.
2. The Association of Oil Pipelines’ Recommendations
The Association of Oil Pipelines (AOPL) endorsed the
ICC valuation approach to rate base calculations. See
J.A. at 3870 (AOPL Opening Brief to FERC). AOPL,
however, did not endorse the ICC approach in all its de-
tails. Instead, it asked FERC to make the following alter-
ations to the ICC formula:
(1) caleulate reproduction costs for current ex-
penses by reference to the current year’s price index,
A-68
or to an average of the indices for the most recent
past year, the current year, and the next future
year. Under the ICC method, costs are estimated by
reference to a five-year “period index” consisting of
the current year, one future year and three past
years. APOL contended that this methed understates
actual current costs in times of inflation.
(2) increase the allowance for interest during
construction employed in calculating the reproduction
cost of pipeline assets. AOPL believed the six per-
cent allowance was far too low to cover the prevail-
ing rates to be paid during construction.
(3) calculate the present value of land and rights-
of-way to account for their real appreciation in value
over time. The ICC method calculates the “present
value” of land at fifty percent of original cost and
rights-of-way at original cost less depreciation. The
AOPL claimed that such methods seriously under-
value the real present value of land and rights-of-
way.
(4) adjust the construction damage allowance to
reflect inflation up to the current year. AOPL
argued that the ICC method, which adjusted the fig-
ures for inflation only from 1947 to 1953, under-
states actual costs.
(5) adjust the amounts assigned for pipe coating
to reflect present prices. AOPL criticized the ICC
method, which adjusted such costs for inflation only
from 1947 to 1963.
(6) once the foregoing alterations are made, elim-
inate the six percent “going concern value” escalator
to total valuation.
See J.A. at 3915-17 (AOPL Opening Brief). AOPL
argued that these modifications “would improve the ac-
curacy of the valuation rate base.” Id. at 3917.
FERC rejected AOPL’s proposals, finding that (1) only
“relatively insubstantial” amounts were at stake, (2) the
A-69
six percent going concern value roughly compensates for
methodological errors elsewhere, and (3) the old ICC
method should not be altered without first engaging in a
notice and comment rulemaking on the proper method of
calculating depreciation. See supra at 19. AOPL argues
to this court that FERC’s rejection of its proposals was
arbitrary and capricious agency action because it was
“not supported by reasoned findings based on the evidence
of record.” AOPL Brief at 35-39. We agree.
We note at the outset that FERC failed, both in the
Williams opinion and in its briefs to this court, to provide
any factual basis in the record for its conclusion that “the
sums involved are relatively insubstantial.” 21 FERC at
61,631. On the other hand, AOPL cites unrebutted testi-
mony in the record that the use of the ICC’s “period
indices” results in “consistently and substantially under-
stated current valuations.” J.A. at 1180 (testimony of
John A. Jeter of Arthur Anderson & Co.). This same
witness provided further unrebutted testimony that the
ICC’s allowance for interest during construction should be
“much higher” in order to reflect current interest levels.
See id. at 1183-85. Furthermore, in its brief, FERC
states that the ICC rate base formula “significantly un-
dercounts for interest during construction, several other
construction-related elements, and the value of land.” ”
Indeed, in the Williams opinion FERC conceded that the
AOPL proposals “may well be warranted” prospectively.
21 FERC at 61,631.
FERC, however, felt that the need for change was
“far from pressing” because it believed that the six percent
going concern value in a rough way compensated for the
other flaws in the ICC methodology. Thus FEPC rejected
all of AOPL’s objections on the grounds that the over-
counting due to the going concern value—which would
*7 FERC Brief at 70 (emphasis added). FERC said that
this significant undercounting, however, justifies the existence
of the six percent going concern value. But see infra at 70.
A-70
by itself be “pure water,” id.—was in effect cancelled
out by the undercounting created by the methodological
features that gave rise to the rest of AOPL’s objections.
In basic terms, FERC reasoned that a series of in-
accuracies is permissible because another inaccuracy sys-
tematically compensates for the prior errors. Such an
approach, of course, assumes that the two errors are in
fact predictably related to one another so that the antici-
pated self-correction will actually take place. In this case,
however, FERC failed to make any finding to assure
that the errors will offset each other. Especially when,
as here, the proposed methodological adjustments appear
easy to make, and the methodological defects are discrete,
clear and acknowledged, FERC indulged an unreasonable
presumption that its two wrongs would in practice render
a right result. In the absence of any explanation of what
warrants such an assumption, we find FERC’s rejection
of the AOPL proposals te be arbitrary and capricious.
Neither did FERC explain why its decision on the
AGPL proposals should be delayed until it could conduct
a nctice and comment rulemaking on depreciation meth-
ods. FERC merely deciared that “it would be wrong to
alter *he status quo without looking at the whole picture.”
Id. at 61,632. It is not at all apparent, however, why a
decision on the AOPL proposals should be considered so
intimately related to depreciation policy. FERC offered
no rationale for its assumption that the changes proposed
by AOPL should not be made separately from the deci-
sions on depreciation policy. In fact, all of AOPL’s pro-
posals would apparently improve the accuracy of the rate
base formula, regardless of the particular depreciation
method employed. Thus, the adoption of the AOPL pro-
posals would not seem to have any significant bearing
on the future consideration of depreciation policy alterna-
tives. FERC also made other similar adjustments to the
rate base formula without examining “the whole picture.”
See FERC Brief at 71 n.81. Moreover, FERC expressly
A-71
declined to commit itself to ever conducting a rulemaking
on depreciation issues:
To be fruitful, such a rulemaking should be pre-
ceded by intensive staff studies. The whole endeavor
would be costly and time-consuming. Would it be
worth the cost?
This question calls for further reflection. This is
neither the time nor the place for that. We can
ponder the point on another day.
21 FERC at 61,632. While we recognize that an adminis-
trative agency may exercise its informed discretion in
deciding whether to proceed on a given issue by way of
rulemaking or adjudication, see, e.g., NLRB v. Bell Aero-
space Co., 416 U.S. 267, 294 (1974); SEC v. Chenery
Corp., 332 U.S. 194, 203 (1947), we believe that in this
case FERC failed entirely to make any such choice.
Instead, FERC decided to delay implementation of the
AOPL proposals, which it said were “well taken” and
were deserving of “a hard look,” id. at 61,631, until it
could conduct a seemingly unrelated depreciation rule-
making, which it then said might never take place. Such
self-contradictory, wandering logic does not constitute an
adequate explanation for its rejection of admittedly valu-
able proposals.
In sum, we hold that FERC failed to explain ade-
quately its rejection of both the original cost alternative
and AOPL’s proposed alterations. We emphasize that this
holding does not go to the wisdom or efficacy of the ICC
rate base formula, although the Williams opinion does
not provide a cogent defense of it. Rather, our decision
68 The ICC rate base formula has also been severely criti-
cized because of its reliance on reproduction cost, which has
been called “an economically meaningless application of up-to-
date prices to out-of-date properties.” Bonbright, Principles of
Public Utility Rates 277 (1961); see 21 FERC at 61,721-22
(Comm’r Hughes, dissenting in part and concurring in part).
Reproduction cost neglects technological change, and therefore
A-72
here turns on the inadequacies manifest in the decision-
making process followed by FERC.
does not necessarily represent what the owner could receive
for selling the plant (because cheaper modern alternatives
might be available), nor does it necessarily represent what
the owner would spend today to build a plant with the same
function. In the past, reproduction cost also has not exhibited
a consistent correlation with inflation, as measured by the
consumer price index and the gross national product deflator.
See id. at 61,725. Furthermore, the ICC formula applies
variable weights to the original cost and reproduction cost
components: each component is in effect weighted by itself.
See supra note 28. As a result of the variable weights, the
ICC valuation can never be expected to track true reproduction
cost or replacement value, even if the reproduction cost escala-
tion index tracked inflation perfectly. See Navarro, Petersen
& Stauffer, A Critical Comparison of Utility-Type Ratemaking
Methodologies in Oil Pipeline Regulation, Bell. J. Econ., Spring
1981, at 392, 397; Farmers Union I, 584 F.2d at 419 n.29.
In addition, by retaining the ICC methodology, FERC ac-
cepted, at least for the time being, the mismatch between the
method of depreciation used to determine the cost of service
expense and the “condition percent” method used to determine
depreciation for rate base purposes. See 21 FERC at 61,632.
“Unfortunately, the condition percent does not bear any well-
defined relationship to the accounting concept of depreciation
. . - [nJor does the use of the condition percent track the
economic concept of depreciation.” Navarro & Stauffer, supra
note 29, at 300 (emphasis in original).
These features of the ICC rate base formula have led experts
to call it “nothing less than bizarre; it is a mysterious collec-
tion of seemingly unrelated components that, through the
wonders of jurists’ algebra, miraculously distill into a single
sum.” Id. at 296. These features have been the subject of
criticism throughout the most recent Williams proceeding, and
drew the attention of this court in Farmers Union I. FERC,
however, failed to provide any reasoned defense to these
criticisms, beyond its belief—misguided by its impermissible
interpretation of “just and reasonable” rates—that oil pipeline
rate regulation can tolerate such “anomalies and inconsist-
encies.” 21 FERC at 61,616. Thus FERC in its Williams
opinion also “entirely failed to consider an important aspect
of the problem” of rate bases. Motor Vehicle Mfrs. Ass’n,
103 S. Ct. at 2867.
A-73
Even in the absence of such infirmities in FERC’s
method of choice among rate base methods, our review
would still include scrutiny of the rate of return meth-
odology, to see whether the selected rate of return, applied
in combination with the selected rate base, leads to a
reasonable result. As FERC observed, the agency must
assure that “the combination of rate base and rate of
return provides a[n] . .. acceptable end result.” 21
FERC at 61,616. We now proceed to examine whether
FERC engaged in reasoned decisionmaking when it chose
its rates of return for use in oil pipelines ratemaking.
B. Rate of Return
FERC divided its rate of return into three components:
(1) debt service, (2) the suretyship premium, and (3)
the “ ‘real’ entrepreneurial rate of return on the equity
component of the valuation rate base.” 21 FERC at
61,644. The debt service element, which represents the
cost of interest and repayment of indebtedness, gives rise
to no objections from the parties, and need not detain us.
The suretyship premium similarly demands little com-
ment apart from our previous observations that it re-
quires much of the same kind of theorizing involved with
the use of hypothetical capital structures. See supra at
55-59. Farmers Union believes that FERC “erred when
it assumed that such a premium is an ‘add on’ to the cost
of capital without comparing pipeline and parent com-
pany risk.” Farmers Union Brief at 59 n.1. Our reading
of the Williams opinion, and FERC’s representations to
this court, however, convince us that FERC made no such
assumption, and, accordingly, pipelines must show that
the guarantees reduce perceived investor risk in order to
establish their entitlement to and extent of a suretyship
premium. See 21 FERC at 61,621, 61,644, 61,711 nn.
492, 493; FERC Brief at 72-73.
Only the “real entrepreneurial rate of return on the
equity component of the valuation rate base” remains.
A-74
FERC began its discussion of this component from the
premise that ‘“‘[i]t seems obvious to us that allowed real
rates of return on oil pipeline equity investments should
be appreciably higher than those the Commission awards
to natural gas pipelines and to wholesalers of electric
energy.” 21 FERC at 61,645. Considering that “oil com-
panies [and the owners of the independent pipelines]
have lots of places to put their money, ... and that the
social need in this field is for returns high enough to
induce the construction of new pipelines and to avert the
premature abandonment of old ones,” FERC enumerated
the following eight measures of the rate of return on
equity:
(i) Realized nominal rates of return on the book
value of shareholders’ equity in the oil in-
dustry generally over the past 5 years;
(ii) Realized nominal rates of return on the book
value of shareholders’ equity in the oil in-
dustry generally over the past year;
(iii) Realized nominal rates of return on share-
holders’ book equity in American industry
generally over the past 5 years;
(iv) Realized nominal rates of return on share-
holders’ book equity in American industry
generally during the most recent year;
(v) The particular parent or parents’ realized
nominal rate of return on total non-pipeline
book equity over the past 5 years;
(vi) The particular parent or parents’ realized
nominal rate of return on total non-pipeline
book equity in most most recent fiscal year;
(vii) Total returns (dividends plus capital gains)
on a diversified common stock portfolio over
the past 5 years ...; and
(viii) Total returns (dividends plus capital gains)
on a diversified common stock portfolio over
the long run—25 years, 50 years, or more....
A-75
See 21 FERC at 61,645. FERC further held that “it
would normally be proper to choose the measure most
favorable to the particular carrier or carriers involved.”
Id.
Although most of these rates of return are expressed in
terms of return on the book equity of unregulated com-
panies, i.e., on the basis of original cost, FERC’s
methodology would nevertheless apply them, after an
adjustment for “inflation,” to the equity component of
the ICC valuation rate base. Moreover, under FERC’s
methodology, the “equity component” is equal to the total
valuation rate base, less the face value of the outstanding
debt. See supra at 21. By this approach, the entire
amount of appreciation in the rate base is allocated to
the “equity component,” while none of it is allocated to
the debt component.
We frankly cannot locate the rhyme nor reason of this
rate of return methodology; nor is it based upon a con-
sideration of all relevant factors in oil pipeline rate-
making. To begin with, FERC offered no rational ex-
planation that linked its regulatory purposes with its
chosen rate of return indices. FERC made no attempt to
estimate the risks involved with oil pipeline operations,
and therefore could not reasonably estimate the rate of
return required to maintain a viable oil pipeline industry.
Moreover, in summary form, with a more elaborate dis-
cussion below, the “inflation adjustment” to the selected
rates of return does not reliably compensate for the
appreciation to the valuation rate base, and, therefore,
overcompensation for inflation is not reliably prevented.
6° Book equity is the original paid-in capital contribution of
equity shareholders plus any retained earnings. It therefore
represents the net underlying value of the company’s assets
in original cost terms. See, e.g., B. Ferst & S. Ferst, Basic
Accounting for Lawyers § 2.06, at 73 (3d ed. 1975) ; J. Gentry,
Jr. & G. Johnson, Finney & Miller’s Principles of Accounting
372 (8th ed. 1980).
A-76
FERC’s willingness to permit the oil pipeline companies
to choose among a wide variety of rate of return indices
only makes these defects worse. FERC’s method of calcu-
lating the “equity component” of the rate base further
enlarges the allowable returns without good reason. As a
result, the total returns allowable under FERC’s meth-
odology have no discernible regulatory significance beyond
the fact that they are bound to be very large. FERC
does not even offer an explanation of why its ratemaking
formula sets “a cap of gross abuse,” let alone a just and
reasonable rate.
1. Risk and Allowable Rate of Return
As previously discussed, FERC made no effort to study
and estimate the risks associated with oil pipeline opera-
tions. Accordingly, FERC offered no reason to believe
that the risks associated with the unregulated enter-
prises from which it derived its rates of return were
equivalent to the risks of running an oil pipeline.” Be-
7 For instance, FERC would look to the rate of return of the
“particular parent or parents’ ” total non-pipeline operations.
Obviously, there are no assurances that the returns to, say,
Exxon’s non-pipeline operations—which include its office sys-
tems manufacturing, oil exploration, etc.—would reflect the
risks of an oil pipeline. Furthermore, because many pipelines
are owned jointly by a number of oil companies, it appears
that the pipeline could select the “particular parent” with the
most lucrative non-pipeline operations over the relevant period.
Neither is there any assurance that the profits of the “oil
industry generally,” or the “total returns (dividends plus
capital gains) on a diversified common stock portfolio” in a
sustained bull market would reflect a pipeline’s properly de-
served return. Also, although the rates of return on “Ameri-
can industry generally” would apparently represent the aver-
age risk enterprise, FERC did not establish that the risks of
oil pipelines fall above or below or around the average level
of risk in American industry generally. Finally, because the
FERC method permits pipelines to select for themselves the
applicable rate of return index, all that is required to throw
the method entirely out of kilter with a reasonable rate
methodology is merely one excessively high index level.
A-77
cause the level of risk associated with an enterprise de-
termines the returns it requires to attract capital, see
supra at 59-63, FERC never established a reasonable con-
nection between its stated purpose to preserve the fi-
nancial integrity and economic viability of oil pipelines
and its selected rate of return indices.
FERC attempted to establish such a connection by
arguing:
If the returns do not exceed those being realized
somewhere or other in a roughly comparable segment
of the economy’s unregulated sector, it is hard to
see how they can be branded extortionate or abusive.
Our relative permissiveness makes the risk prob-
lem more manageable. Can even the riskiest of pipe-
lines argue that it is so hazardous that it is entitled
to more than anyone makes any place else?
21 FERC at 61,645-46 (emphasis in original). The first
sentence of this passage lacks any semblance of valid
reasoning from the record. FERC never even attempted
to estab
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