Amicus Curiae Brief — Duquesne Light Co. v. Barasch

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ina Supreme Court, Ug,

A HILED

No. 87-1160

IN THE

Supreme Court of the United States

OCTOBER TERM, 1987

DUQUESNE LIGHT COMPANY

AND

PENNSYLVANIA POWER COMPANY,

Appellants,

V.

DAVID M. BARASCH,

CONSUMER ADVOCATE, et a/.,

Appellees.

On Appeal from the Supreme Court of Pennsylvania

BRIEF OF

PENNSYLVANIA ELECTRIC ASSOCIATION

AS AMICUS CURIAE IN SUPPORT OF APPELLANTS

Rex E. LeEe*

DaviD W. CARPENTER

Sidley & Austin

1722 Eye Street, N.W.

Washington, D.C. 20006

(202) 429-4266

VINCENT BUTLER

RICHARD A. FLATI

DaAviD T. EVRARD

Pennsvivania Electric Association

800 N. Third Street

Harrisburg, Pennsylvania 17102

(717) 257-5854

Attorneys for Pennsylvania Electric

Association As Amicus Curiae

*Counsel of Record

MAY 3 1988

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TABLE OF CONTENTS

QUESTION PRESENTED........... Se —

TABLE OF CONTENTS .. oo... ccccccccccccccsssennen il

TABLE OF AUTHORITIES .......................-. ill

INTERESTS OF AMICUS CURIAE .................. |

STATEMENT OF FACTS . ....ccccccceccsceuasnee 2

SUMMARY OF ARGUMENT....................... 6

ABISUBEIINE «oo 0050000860000 50n a 8

I. The Pennsylvania Statutes Violate The Fifth And

Fourteenth Amendments .....................5. 9

A. Pennsylvania’s Statutory Scheme Is A Per Se Vi-

olation Of The Federal Constitution.......... s)

1. All Firms Must Have The Opportunity To

Be Compensated For Carrying Out Statu-

tory Duties That Benefit The Public...... 10

2. A Utility May Not Be Denied A Return Of

And On Its Prudent Investment Unless It Is

Otherwise Compensated For The Risks

And Expenditures That It Incurs ........ 12

B. There Is No “Consumer Interest” Or Other

State Interest That Could Possibly Justify This

Interference With The Property Rights Of Penn-

sylvania Utility Investors ................... 18

II. The Court Should Adopt The Brandeis Prudent In-

vestment Standard As The Constitutional Bench-

BP 21

eee

TABLE OF AUTHORITIES

CASES: PAGE(S):

Armstrong v. United States, 364 U.S. 40 (1960) .......

Barasch v. Pennsylvania Public Utility Commission, 505

Pa. 606, 482 A.2d 1274 (1984)... 6. een

Bluefield Water Works & Improvement Co. vy. Public

Service Commission, 262 U.S. 679 (1923) ..........

Citizens Action Coalition of Indiana, Inc. v. Northern

Indiana Public Service Co., 485 N.E.2d 610 (Ind.

1985), appeal dismissed and cert. denied, 476 U.S.

ates nn se6bcccces Ee ea

Cleveland Electric Illuminating Co. vy. Public Utilities

Commission, No. 82-165 (Ohio July 7, 1982), appeal

dismissed, 459 U.S. 1094 (1983). .......000 000005.

Cleveland Electric Illuminating Co. v. Public Utilities

Commission, 4 Ohio St. 3d 107, 447 N.E.2d 746, ap-

peal dismissed, 464 U.S. 802 (1983) ............

Colorado Interstate Gas Co. v. FPC, 324 U.S. 581

ee cc ccc nccccrccccccvces

Federal Power Commission v. Hope Natural Gas Co., 320

es cc cc caste ccccesesecce

Federal Power Commission v. Memphis Light, Gas &

Water Division, 411 U.S. 458 (1973) 2... 0.00000 06.

Jersey Central Power & Light Co. v. FERC, 810 F.2d

EE wc ccs ccc cccecccccesccces

Kansas Gas & Electric Co. vy. State Corp. Commission,

239 Kan. 483, 720 P.2d 1063 (1986), probable juris-

diction noted, 107 §. Ct. 1281, appeal dismissed under

ee

Keystone Bituminous Coal Association v. De Benedictis,

I, occa cs ccccccccccccccess

Market Street Railway Co. v. Railroad Commission of

California, 324 U.S. 548 (1945) 0.0.0... cc eee ee.

6, 9

22

22

22

20, 22

passim

20

16, 22

21

18

14

iv

CASES: PAGE(S):

McCardle vy. Indianapolis Water Co., 272 U.S. 400

DEN ss 66:4 6 Shen es bb eneebenenlaceeeans 14

Minnesota Rate Cases, 230 U.S. 352 (1913) .......... 14

Nollan vy. California Coastal Commission, 107 S. Ct.

Se UES 4 5 vocncntcchendaswabuisaseeesneeet 19, 21

Office of Consumers’ Counsel v. Public Utilities Commis-

sion, 67 Ohio St. 2d 153, 423 N.E.2d 820 (1981), ap-

peal dismissed, 455 U.S. 914 (1982). ...... 0.00000 22

Pennell v. City of San Jose, 108 S. Ct. 849 (1988) ..... 20

Pennsylvania Central Transportation Co. v. City of New

we Perret eee 11

Pennsylvania Public Utility Commission v. Pennsylvania

Gas & Water Co., 492 Pa. 326, 424 A.2d 1213 (1980),

cert. denied, 454 U.S. 824 (1981) ............0005- 6

Permian Basin Area Rate Cases, 390 U.S. 747 (1968) .. 20

Petition of Public Service Commission of New Hamp-

shire, No. 87-311 (N.H. Jan. 26, 1988) ............ 22

Smyth v. Ames, 169 U.S. 466 (1898) .... 0.6... e eee passim

State of Missouri ex rel. Southwestern Bell Telephone Co.

v. Public Service Commission, 262 U.S. 276 (1923) .. passim

Toledo Edison Co. v. Public Utilities Commission, 12

Ohio St. 3d 143, 465 N.E.2d 886 (1984) ........... 22

Washington Gas & Light Co. v. Baker, 188 F.2d 11

(D.C. Cir. 1950), cert. denied, 340 U.S. 952 (1951)... 16, 17

West Ohio Gas Co. v. Public Utilities Commission, 294

Si ..6cncs cinemanwen beetle ueeeeoes 7,17

Willcox v. Consolidated Gas Co., 212 U.S. 19 (1909)... 14

STATUTES: PAGE(S):

66 Pa. C.S. § 1311 2... cece cece ccc eeecreeecescecces 6

G6 Pa. C.B. § USDOL 2... cece cccccccvccvevcccccccccess 3

ADMINISTRATIVE DECISIONS:

Investigation of the Need for Additional Electric Generating

and Transmission Facilities, 46 Pa. P.U.C. 23 (1972).... 3

OTHER AUTHORITIES:

A. Kahn, The Economics of Regulation (1970) ........... 15

No. 87-1160

IN THE

Supreme Court of the United States

OCTOBER TERM, 1987

DUQUESNE LIGHT COMPANY

AND

PENNSYLVANIA POWER COMPANY,

Appellants,

Vv.

DAVID M. BARASCH,

CONSUMER ADVOCATE, et a/.,

Appellees.

On Appeal from the Supreme Court of Pennsylvania

BRIEF OF

PENNSYLVANIA ELECTRIC ASSOCIATION

AS AMICUS CURIAE IN SUPPORT OF APPELLANTS

INTERESTS OF AMICUS CURIAE!

The Pennsylvania Electric Association is a trade association of

electric utilities. Its members are eleven investor-owned utilities

that provide electric service to the public in Pennsylvania.’ These

companies supply approximately 98 percent of the electricity con-

sumed in the state and provide service to approximately 95 per-

cent of the state’s residential, commercial, and industrial custom-

ers.

'Each of the parties to this appeal has consented to the filing of this

amicus curiae brief. These consents have been filed with the Court.

2The members of the Pennsylvania Electric Association are: Citizens’

Electric Co., Duquesne Light Co., Metropolitan Edison Co., Pennsy]l-

vania Electric Co., Pennsylvania Power & Light Co., Pennsylvania Pow-

er Co., Philadelphia Electric Co., Pike County Light & Power Co., UGI

Corporation, Wellsboro Electric Co., and West Penn Power Co.

2

Each member company of the amicus association is engaged in

transmitting or distributing electricity within designated fran-

chised service areas in the state. Each is regulated by the Penn-

sylvania Public Utility Commission, which sets the rates for each

company. Each company is further under a statutory duty to

provide service to any customer in its service area and to con-

struct or obtain generating capacity that is adequate to serve

present, and anticipated future, demand. To carry out these stat-

utory duties, each of these utilities must be afforded an opportu-

nity to charge rates that recover all its reasonable expenses as well

as provide a reasonable return on investment.

Amicus has a direct and substantial interest in this case. The

Pennsylvania Supreme Court has held that a utility may consti-

tutionally be denied recovery of and on a $50 million investment

that was reasonably made to carry out a statutory duty, whenev-

er, with the benefit of hindsight, the investment is deemed not to

have been “used and useful.’ The court so held, despite the fact

that the electric utilities were also denied any opportunity to be

compensated for the risks that such prudent expenditures would

be disallowed. The net result is that Pennsylvania has assured

that utility investors will not be fairly compensated for their rea-

sonable costs of conducting business, including capital costs. Un-

less reversed, the Pennsylvania Supreme Court's decision will

jeopardize the ability of Pennsylvania utilities to attract capital

and provide adequate service to the public.

STATEMENT OF FACTS

A single “stubborn fact’ of finance controls this case. Penn-

sylvania has imposed a duty on electric utilities to make

multimillion dollar investments for the benefit of ratepayers, and

then denied those utilities—and the investors who own them—

any opportunity to be compensated for the costs of complying

with that duty.

Electric utilities in Pennsylvania are under statutory obliga-

tions to serve any customer within their service areas at state-reg-

ulated rates. 66 Pa.C.S. § 1501. To carry out this duty, electric

utilities must assure that they will have adequate generating ca-

pacity to meet the annual “peak” demands of customers, plus a

reasonable reserve margin. Otherwise, there will be “brownouts,”

“blackouts,”’ and customer service curtailments. When faced with

the possibility or probability that future growth in demand may

create shortages, Pennsylvania electric utilities do not have the

option available to firms in unregulated markets. They may not

decline to make investments required to meet the anticipated de-

mand on the ground that the likely rewards do not justify the

risks. They have the statutory obligation to make affirmative ef-

forts to construct or otherwise obtain sufficient generating capac-

ity.

Pennsylvania made this statutory duty explicit in 1972 and

1973. The Pennsylvania Public Utility Commission was con-

cerned that Pennsylvania electric utilities were not constructing

the new plants that would be needed under the then-prevailing

forecasts for future growth in customer demand. Those forecasts

predicted that demand would continue to grow by five to seven

percent annually, as it had since World War II. J.S. App. 16h.

The commission ordered Pennsylvania utilities to make “imme-

diate preparations . . . to increase installed capacity until a reliable

reserve of 20% above forecasted loads was reached.” /nvestiga-

tion of the Need for Additional Electric Generating and Transmis-

sion Facilities, 46 Pa. P.U.C. 23, 24 (1972).

To carry out their state law duties, Pennsylvania utilities had

to act on the basis of forecasts relating to the distant future. This

is so because a new generating facility has to be planned 10 to 15

years in advance and requires projections of long-term load

growth.’ In consequence, the only certainty when such projec-

‘It takes seven to nine years to plan and build a coal fired plant, and

ten to twelve years for a nuclear plant. Here, it is undisputed that

nuclear power represented the lowest cost alternative for the Pennsyl-

vania utilities when the planning decisions were made. J.S. App. 17h.

4

tions are made is that they will often turn out to be wrong. For

this reason, construction and capacity planning decisions of elec-

tric utilities are subject to constant adjustments.

The Pennsylvania Public Utility Commission found—and it is

undisputed—that the expenditures that appellants made to carry

out the duties imposed by state law were eminently reasonable.

Indeed, it would have been imprudent—and threatened ratepayer

interests—if the utilities had failed to make these expenditures.

In planning the CAPCO nuclear plants, the Pennsylvania utilities

acted on the basis of the best information available. They chose

what was indisputably the least cost alternative at that time. It

was only because of unforeseen, and unforeseeable, changes in

circumstances that the plants subsequently appeared to be unnec-

essary, and that it became prudent to cancel the plants in 1980.

J.S. App. 16h-19h.

Moreover, no actual construction ever began. Work on the

plant was limited to the preliminary engineering and siting stud-

ies that must occur before actual construction can begin. These

expenditures put Pennsylvania utilities in a position in which they

could have proceeded with the construction of the new plants ‘n

1980 if the plants continued to appear needed. Because interven-

ing events reduced the need for the plants, they could be—and

were—prudently cancelled before any construction occurred. J.S.

App. 17h-19h. All agree that the engineering and siting costs

were prudently incurred, and that the plants were prudently can-

celled. Jd.

Despite these facts, Pennsylvania has now blocked its utilities

from receiving any compensation for the over $50 million that

appellants reasonably expended on the four CAPCO plants.

The two Pennsylvania utilities were in no way compensated,

directly or indirectly, for these expenditures over the eight-year

period in which the expenditures were made. The utilities were

not allowed to treat the engineering and siting studies as current

“expenses” that would be recovered as outlays were made over

this period. Instead, the utilities were required to treat these ex-

penditures as “investments” by “capitalizing” them and record-

ing them in a separate account. The net effect was to exclude

these amounts from the utilities’ rates during this period and to

defer their recovery to a future date. Between 1972 and 1980,

rates were set as if the expenditures had never been made between

1972 and 1980.

In this case, the Pennsylvania Supreme Court has construed an

intervening Pennsylvania statute to require that present and fu-

ture rates also be set as if the $50 million had never been spent.

It held that expenditures that are not deemed to be currently

“used and useful” may not be recovered, regardless of how pru-

dent they were at the time they were made and regardless of any

other considerations. Under the court’s authoritative construc-

tion of the Pennsyivania statute, these expenditures “shall not, in

any way whatsoever, be included in the rates charged.” J.S. App.

14a. The utilities may not receive a return “of and on” their

investment by amortizing it over a period of years and receiving

a return on the unamortized balance each year. The utilities may

not even receive a return “of” their investment by amortizing it,

but receiving no return on the unamortized balance. Nor may

these amounts be recovered through any other mechanism.

In contrast, Pennsylvania has sharply limited the ability of

utilities to benefit from investments and expenditures that are

deemed “used and useful.’’ Under Pennsylvania law, a utility can

be, and is, limited to recovery of reasonable out-of-pocket ex-

penses and a return on the net original cost (original cost less

depreciation) of the utility’s investment—and has no judicially

enforceable right to obtain any greater return.* Thus, the “rate

‘The Pennsylvania Supreme Court has held that the Pennsylvania

statutes in effect when the rate orders were entered do not entitle utilities

to rates that “go beyond [allowing a fair return on the] original cost” of

the utility’s property, and that there are no statutory or judicially en-

(Footnote continued on next page)

6

bases”’ of the two Pennsylvania utilities involved in this case were

determined on the basis of each’s net original cost. See J.S. App.

3c (adopting “original cost measure of value”’ to determine utility

rate base); Se (same).

SUMMARY OF ARGUMENT

The Pennsylvania statutory scheme is unconstitutional, both

on its face and as applied to the two utilities who are the

appellants in this case. Pennsylvania here required its utilities to

spend millions of dollars to plan new generating facilities for the

benefit of the public and then denied the utilities any form of

compensation for prudent expenditures made to carry out this

statutory duty. This epitomizes the conduct that it is a per se

violation of the Fifth and Fourteenth Amendments. See Arm-

strong v. United States, 364 U.S. 40, 49 (1960).

Pennsylvania reached this unconstitutional result by confusing

two separate and distinct methods of setting utility rates. Under

the “fair value’’/“‘used and useful” standard of Smyth v. Ames,

169 U.S. 466 (1898), utilities are denied any return on invest-

ments that are not “used and useful,” but are fully compensated

for the risk of such disallowances because they are entitled to

supernormal returns on other investments. Under the “prudent

investment” test of Justice Brandeis, utilities receive a return on

(Footnote continued from previous page)

forceable standards under which a method more favorable to the utility

could be required. Pennsylvania Public Utility Commission vy. Pennsyl-

vania Gas & Water Co., 492 Pa. 326, 424 A.2d 1213, 1221 & 1219-22

(1980), cert. denied, 454 U.S. 824 (1981). The utility commission thus

lawfully refuses to consider any other method of valuation. See Barasch

v. Pennsylvania Public Utility Commission, 50S Pa. 606, 482 A.2d 1274

(1984), rev'g, Pennsylvania Gas & Water Co. v. Pennsylvania Public

Utility Commission, 72 Pa. Commw. 331, 456 A.2d 1126 (1983).

In 1984, Pennsylvania codified this rule by enacting a statute that

provides that the valuation of utility property “shall be the original cost

of the property when first devoted to the public service less the applica-

ble accrued depreciation.”’ 66 Pa.C.S. § 1311(b); J.S. App. 201.

-

all prudent investments, whether or not they are “used and use-

ful,” and the utilities cannot receive a supernormal return on any

investment, no matter how beneficial. See State of Missouri ex rel.

Southwestern Bell Telephone Co. vy. Public Service Commission,

262 U.S. 276, 289-312 (1923) (Brandeis, J., concurring). See Fed-

eral Power Commission v. Hope Natural Gas Co., 320 U.S. 591

(1944).

Here, Pennsylvania selectively adopted only those elements of

each test that disadvantage utilities. Pennsylvania limited utilities

to the minimal allowable return on “used and useful” investments

(under a prudent investment standard) and denied any return on

other prudent investments made for the benefit of ratepayers (un-

der a “fair value” standard). Because it is inevitable that some

prudent investments will be deemed not to be “used and useful”

—and excluded—the Pennsylvania scheme assures that utilities

are not compensated for expenditures, and risks, they are

statutorily required to incur. This mixing of distinct methods to

guarantee a shortfall is per se unconstitutional. See West Ohio Gas

Co. v. Public Utilities Commission, 294 U.S. 63 (1935).

The Pennsylvania Supreme Court’s decision is one of many

recent state supreme court decisions that rest on the belief that

the Federal Constitution authorizes an amorphous “balancing” of

a generalized (and boundless) consumer interest in lower rates

against an investor interest in having a fair opportunity to recover

all prudent costs. That is not, and cannot be, the law.

Amicus submits that there is one approach that will now secure

constitutional values and protect this Court’s docket: adopt Jus-

tice Brandeis’s prudent investment test as the constitutional

benchmark. The Court should make it explicit that a state may

not depart from this approach, unless the state affirmatively dem-

onstrates that it has fairly compensated utility investors for the

risk that prudent investments will be disallowed by permitting

above-cost returns on other investments. Correlatively, the Court

8

should reiterate that there is no generalized consumer interest in

lower rates that can justify denying utilities an opportunity to

recover all amounts prudently invested for the benefit of

ratepayers.

ARGUMENT

This amicus curiae brief makes two principal points. First, un-

der any view of this Court’s prior decisions, the Pennsylvania

statutory scheme is unconstitutional, both on its face and as ap-

plied to the two appellant utilities. As authoritatively construed

by the Pennsylvania Supreme Court, the Pennsylvania statutes

deny the two Pennsylvania utilities any possibility of being fairly

compensated for expenditures, and risks, that the utilities were

under a state-created duty to incur for the benefit of the public as

a whole. This is a per se violation of the Fifth and Fourteenth

Amendments. In any event, Pennsylvania’s own enactments

make it explicit that there is no “consumer interest”’ or other state

interest that could possibly justify this interfeience with the prop-

erty rights of utility investors.

Second, the Pennsylvania Supreme Court’s decision in this case

is a product of the confusion that arises from the coexistence of

two separate and distinct means of setting utility rates, each of

which is constitutionally permissible when consistently applied.

The first is the “fair [market] value’’/“‘used and useful” standard

of Smyth v. Ames, 169 U.S. 466 (1898), and its progeny. It is

sound as a matter of theory, but has proven to be impractical of

fair and consistent application unless market value is equated

with reproduction cost, or some proxy for it. The second is the

prudent investment test of Justice Brandeis,’ which is the foun-

dation of Federal Power Commission v. Hope Natural Gas Co.,

‘State of Missouri ex rel. Southwestern Bell Telephone Co. v. Public

Service Commission, 262 U.S. 276, 289-312 (1923) (Brandeis, J., concur-

ring).

9

320 U.S. 591 (1944), and its progeny. This test can be readily

applied to protect all legitimate investor and consumer interests.

In amicus’s view, both this case and the experience of the past

decade demonstrate that there is now only one way to implement

the values of the Fourteenth Amendment in this sensitive and

increasingly contentious area: adopt Justice Brandeis’s standard

as the constitutional benchmark. The Court should make it ex-

plicit that utilities are entitled to a fair opportunity to recover all

reasonable expenses and to earn a return of, and on, all prudent

investment. States should be entitled to depart from the strict

prudent investment standard only if they affirmatively demon-

strate that some other mechanism has been adopted that ade-

quately compensates utility investors for the risks and expendi-

tures they are required to incur. Correlatively, the Court should

reiterate that a generalized “consumer interest”’ in lower rates is

not itself sufficient justification for denying a utility an opportu-

nity to earn a return of and on any investment found to be pru-

dent.

I. The Pennsylvania Statutes Violate The Fifth And Fourteenth

Amendments.

A. Pennsylvania’s Statutory Scheme Is A Per Se Violation

Of The Federal Constitution.

The provisions of the Fifth and Fourteenth Amendments that

protect private property are “designed to bar Government from

forcing some people alone to bear public burdens which, in all

fairness and justice, should be borne by the public as a whole.”

Armstrong v. United States, 364 U.S. 40, 49 (1960). The Pennsy]-

vania statutes are a stark, clear violation of these provisions.

Pennsylvania has imposed a statutory duty on utilities to make

massive expenditures for the benefit of the public as whole. Penn-

sylvania has now adopted rules that assure that even the most

prudent of such expenditures will not be recovered from the pub-

iic “in any way whatsoever”’ if—as will inevitably sometimes be

10

the case—the investments can be deemed not to be “used and

useful” on the basis of hindsight.

The inevitable “end result’ of the Pennsylvania scheme is that

Pennsylvania utilities will experience multi-million dollar

shortfalls. By simultaneously limiting each utility to a return of

and on the original cost of its “used and useful” investments and

denying the utility any return of (or on) other prudent invest-

ments, the state has guaranteed that the two utilities—and the

investors who own them— may not recover their original prudent

investment. Here, a $100 million shortfall results solely from the

utilities’ compliance with a statutory duty imposed for the benefit

of the public.°®

The Pennsylvania scheme would be invalid as applied to any

person. It is starkly invalid as applied to a regulated utility.

1. All Firms Must Have The Opportunity To Be Compen-

sated For Carrying Out Statutory Duties That Benefit

The Public.

The unconstitutionality of the statutory scheme is vividly dem-

onstrated by the facts of this case. The expenditures were made

to carry out a state-created duty. The Pennsylvania utilities did

not have the options available to unregulated firms. They were

not free to decide that the probable returns from the investments

in the CAPCO plants did not justify the risks of proceeding. They

had an obligation to make “immediate preparations” to build the

plants, and all agree that the utilities acted with the utmost pru-

dence in fulfilling that obligation.

*The two utilities’ capitalized expenditures exceeded $50 million on

the day the plants were cancelled. If the utilities were to recover the

present value of that $50 million over ten years, they would have to

receive some 100 million in nominal dollars over the ten year period.

See J.S. App. 19h-20h. Whatever the method chosen, the utilities will

not be “made whole” in an economic sense unless they receive the

present value of the $50 million figure.

11

Further, these “immediate preparations” were ordered precise-

ly because, in the state’s judgment, they would confer real and

tangible benefits on Pennsylvania consumers, whether or not the

plants ended up being built. The engineering and siting expendi-

tures were necessary prerequisites to the actual construction of

the new generating facilities that would have been essential if the

then-prevailing forecasts of future consumer demand had turned

out to be correct. The expenditures were thus akin to an insur-

ance policy purchased for the benefit of ratepayers. The expendi-

tures put the Pennsylvania utilities in a position in which they

could have built the plants and met the consumer demand if the

forecasts had materialized. The expenditures assured consumers

that future demand would be met.

What Pennsylvania has done here is no different from ordering

a utility to buy fire insurance for the benefit of ratepayers and

thereafter blocking the utility from recovering the premiums on

the ground that no fire occurred, and the insurance therefore was

not really needed.

This would be a violation of the Fourteenth Amendment even

if appellants were not utilities. It is elementary that a state may

not constitutionally impose a statutory duty to engage in conduct

for the benefit of the public, while prohibiting a property owner

from being fairly compensated for the resulting costs. In Pennsyl-

vania Central Transportation Co. v. City of New York, 438 U.S.

104 (1978), for example, the state landmark law had imposed a

Statutory duty on the property owner to keep the facade of a

landmark building “in good repair.” All nine members of the

Court agreed that there would have been an unconstitutional

“taking” of property if the state were preventing the landowner

from recovering the expenses resulting from this obligation, plus

a “reasonable return” on investment in the parcel. /d. at 120 n.21

& 121 n.23; accord id. at 146-47 & n.9 (Rehnquist, J., dissenting

on other grounds).

This principle applies with special force to regulated utilities.

12

2. A Utility May Not Be Denied A Return Of And On Its

Prudent Investment Unless It Is Otherwise Compensat-

ed For The Risks And Expenditures That It Incurs.

The Pennsylvania Supreme Court's holding rests on a misap-

prehension of settled law. The court conceded, as it must, that

the Federal Constitution would have required Pennsylvania to

allow the utilities to earn a return of, and on, the amounts pru-

dently invested in the CAPCO plants if they had been completed

and in fact used to provide service to the public. However, it held

that the fact that the plants were not built—and are thus not

“used and useful”—permits the state to deny any recovery of, or

on, expenditures that the utilities were required to make. This

holding confuses two distinct methods of protecting the constitu-

tional rights of utility investors: the “fair value”’/*used and use-

ful’ standard of Smyth v. Ames, and the prudent investment

standard of Justice Brandeis. By selectively adopting only those

elements of each test that disadvantage utilities, Pennsylvania has

committed a per se violation of the Federal Constitution.

The Smyth and Brandeis approaches represent two separate

and distinct means of implementing the central value protected

by the Fifth and Fourteenth Amendments. Each recognizes the

legitimacy of the state’s interest in regulating public utilities and

ordering the devotion of private property to public service. See

Smyth v. Ames, 169 U.S. 466, 546 (1898). The natural monopoly

character of aspects of utility businesses creates the possibility of

monopolistic pricing and other exploitative practices. Maximum

price regulation and the obligation to serve all persons on non-

discriminatory ter:ns can prevent those practices—and operate as

a surrogate for the operation of a competitive marketpiace.

At the same time, the use of elected or politically-appointed

bodies to set the prices at which private property will be used by

the public inherently creates the serious possibility that utility

investors will be unfairly singled out to bear burdens that the

ratepaying public should bear, contrary to the central purpose of

13

the Fifth and Fourteenth Amendments. Thus, each line of deci-

sions holds that restrictions on utilities must be accompanied by

corresponding assurances that the utility will be guaranteed an

opportunity to be fairly compensated for the duties, and risks,

that it is required to incur. The risks and opportunities for re-

wards must balance out. That is the regulatory compact.

Smyth v. Ames, and its progeny, prescribed one means of strik-

ing this constitutional balance. The Court’s opinion, authored by

the first Justice Harlan, analogized the submission to public utili-

ty regulation to a taking of property by eminent domain, and

required that rates be set to provide a return of the “fair [market]

value” of the physical assets deemed “taken:” that is, the plant

that was “used and useful” in the enterprise. 169 U.S. at 546-47.

In theory, Smyth’s “fair value” standard mimics the operation of

a competitive market. To the extent utilities’ investments in

plants are good ones (because they produce benefits in excess of

their costs), the utility is “rewarded” with an opportunity to earn

an “‘above-cost” return: that is, a fair return on the “market

value” of the plant. To the extent utilities’ investments turn out

to be bad ones (because the plants are cancelled or abandoned

before being fully depreciated or because they were acquired or

built at inflated prices), the utilities suffer because a return on the

plants’ “fair [market] value” is no return, or a below-cost return.

Under Smyth, the risks and opportunities for rewards are bal-

anced, much as they are in a competitive market.

Whatever its theoretical appeal, the Smyth test proved imprac-

tical of fair and consistent administration.’ This was largely be-

7

"A “fair value” test does have one area of easy application: where

competition from new technologies (or utility mismanagement) had cre-

ated a situation where a utility could not recover the original costs of

its investment, much less the cost of reproduction, even if its rates were

deregulated altogether. In that circumstance, a fair market value could

be computed by capitalizing future earnings (or determining salvage

value) and setting rates accordingly. The Constitution requires no great-

(Footnote continued on following page)

14

cause any attempt by a regulator to establish a “fair [market]

value” for utility plants is inherently a circular one.* As Justice

Brandeis demonstrated, “‘almost any result may be justified” un-

der the Smyth v. Ames “‘test.’’? In practical effect, the only way

to prevent undercompensating investors was to measure “‘fair val-

ue”’ based on the reproduction cost of the plants or on some proxy

for reproductiori cost that can be readily calculated, such as the

original cost adjusted for inflation (trended original cost). This

Court’s opinions thus increasingly required these valuation meth-

ods during the 1910s and 1920s.'° But with high inflation, this

interpretation of Smyth led to prescriptions of rates that—while

(Footnote continued from previous page)

er return in such instances, for it is market forces, mot the state, that

prevents a greater recovery. See Market Street Railway Co. v. Railroad

Commission of California, 324 U.S. 548, 566-67 (1945). However,

where, as here, the utilities’ services are very valuable, and it is state

regulation alone that would prevent a utility from recovering all its

costs, Smyth proved impractical.

*As Justice Brandeis explained, a “vicious circle” 1s inevitable:

“It is impossible to find an exchange value for a utility, since

utilities, unlike merchandise or land, are not commonly bought

and sold in the market. Nor can the present value of the utility be

determined by capitalizing its net earnings, since the earnings are

determined, in large measure, by the rate which the company will

be permitted to charge; and, thus, the vicious circle would be en-

countered.”

State of Missouri ex rel. Southwestern Bell Telephone Co. v. Public Serv-

ice Commission, 262 U.S. 276, 292 (1923) (Brandeis, J., concurring).

Accord Federai Power Commission v. Hope Natural Gas Co., 320 U.S.

591, 601 (1944).

°State of Missouri ex rel. Southwestern Bell Telephone Co. v. Public

Service Commission, 262 U.S. at 298 (Brandeis, J., concurring).

See, e.g., McCardle vy. Indianapolis Water Co., 272 U.S. 400, 410

(1926); State of Missouri ex rel. Southwestern Bell Telephone Co. v.

Public Service Commission, 262 U.S. at 287-88; id. at 289-312 (Brandeis,

J., concurring); Bluefield Water Works & Improvement Co. v. Public

Service Commission, 262 U.S. 679, 689 (1923); Minnesota Rate Cases,

230 U.S. 352, 434, 454 (1913); Willcox v. Consolidated Gas Co., 212 US.

19, 41, 52 (1909).

15

eminently sound as a matter of economics and preferable as a

matter of policy''—became difficult to defend as constitutional

requirements.

The shortcomings of Smyth v. Ames led Justice Brandeis to

develop an alternative approach, which he advocated as the con-

stitutional minimum. He accepted the Smyth eminent domain

analogy, but concluded that what was “taken” by public utility

regulation is not specific physical assets that are to be individually

valued, but the capital prudently devoted to the public utility

enterprise by the utilities’ owners—investors. State of Missouri ex

rel. Southwestern Bell Telephone Company v. Public Service Com-

mission, 262 U.S. at 290 (Brandeis, J., concurring). “The thing

devoted by the investor to the public use is not specific property,

tangible and intangible, but capital embarked in the enterprise.”

Id. Justice Brandeis urged that “[t]he compensation which the

Constitution guarantees an opportunity to earn is the reasonable

cost of conducting the business,” including the costs of capital

that are recovered by allowing a reasonable return on the utility’s

investment. Jd. at 291.

“Cost includes not only operating expenses, but also capital

charges. Capital charges cover the allowance, by way of in-

terest, for the use of the capital, whatever the nature of the

security issued therefor; the allowance for risk incurred; and

enough more to attract capital. The reasonable rate to be

prescribed by a commission may allow an efficiently man-

aged utility much more. But a rate is constitutionally com-

pensatory, if it allows to the utility the opportunity to earn

the cost of the service as thus defined.” Jd.

Justice Brandeis stated that there is only one limitation that

states may constitutionally impose on a utility’s opportunity to

earn adequate revenues on its actual investment: exclusion of

imprudent investment or expenditures. He stated that ‘the term

[prudence is to be] applied for the purpose of excluding what

'\E.g., A. Kahn, The Economics of Regulation, Vol. 1, 109ff (1970).

16

might be found to be dishonest or obviously wasteful or impru-

dent expenditures.”’ Jd. at 289 n.1.

Under Justice Brandeis’s net prudent investment test, the his-

toric concept of “used and useful” is irrelevant.'? The utility must

be guaranteed the opportunity to recover all prudent expenses,

and earn a return of, and on, all amounts prudently invested in

its utility business, irrespective of whether individual investments

are deemed necessary or beneficial in hindsight. When prudent

investment is the standard, the net result is that utilities have no

opportunities for “rewards” (in the form of above-cost returns),

because all that is returned is the prudent investment, including

capital costs. But the utilities also incur fewer risks. Although a

utility always bears the risk that ratepayers will not be willing to

pay enough for utility service to cover its cost (see pp. 13-14 n.7,

supra), the prudent investment test assures the utility the oppor-

tunity to recover any investment not found imprudent. This test

thus also strikes a constitutional balance.

Justice Brandeis’s opinions formed the foundation for Federal

Power Commission v. Hope Natural Gas Co., 320 U.S. 591 (1944).

Hope Natural Gas both adopted the Brandeis view that “fair

value”’ ratemaking is not constitutionally required and established

that the prudent investment test is constitutionally permissible.

At the same time, Hope held that the Federal Constitution does

not require “the use of any single formula or combination of

formulae in determining rates.” 320 U.S. at 602. This holding

reflects the reality that either the prudent investment test of Jus-

tice Brandeis, the fair value/used and useful test of Smyth, or any

other approach that fairly balances risks and rewards can reason-

ably compensate investors for the duties and risks that they incur,

'2State of Missouri ex rel. Southwestern Bell Telephone Co. v. Public

Service Commission, 262 U.S. at 290-91 (Brandeis, J., concurring); Ac-

cord Jersey Central Power & Light Co. v. FERC, 810 F.2d 1168, 1175

(D.C. Cir. 1987) (en banc) (Bork, J.) (“with the demise of ‘fair value,’

‘used and useful’ ceased to have any constitutional significance”); Wash-

ington Gas & Light Co. v. Baker, 188 F.2d 11, 19 (D.C. Cir. 1950)

(Bazelon, J.), cert. denied, 340 U.S. 952 (1951) (same).

17

and prevent unconstitutional deprivations of property.'? The ju-

dicial role is to assure that the “end result” will be constitutional

under whatever method is employed.

Against this background, the Pennsylvania statutory scheme,

as construed by the Pennsylvania Supreme Court, is invalid both

on its face and as applied to the two appellants. Because Pennsyl-

vania selectively adopts different elements of two distinct meth-

ods, the Pennsylvania scheme is incapable of producing a consti-

tutionally permissible “end result.”

West Ohio Gas Co. v. Public Utilities Commission, 294 U.S. 63

(1935), is controlling. There, the Court, in an opinion written by

Justice Cardozo, held that once a constitutionally permissible

method of ratemaking is adopted, it ‘must be made use of then

consistently, and regardless of the consequences.” Jd. at 71. In

West Ohio Gas, the state commission allocated a utility’s costs on

one basis in one Ohio city and on a different and inconsistent basis

in a second Ohio city served by the same utility. The net result

was that rates were reduced in both cities, and the utility was

blocked from ever recovering 100% of its expenses. Jd. at 69-71.

That was held to be unconstitutional.

Pennsylvania has mandated the same principle of “heads the

utility loses, tails the ratepayer wins.” Pennsylvania applies a

'3Any standard that fairly balances the benefits and burdens of regu-

lation can satisfy constitutional standards. For example, another consti-

tutional approach was suggested in a 1950 opinion for the Court of

Appeals for the District of Columbia Circuit, written by Judge Bazelon.

See Washington Gas Light Co. v. Baker, 188 F.2d 11, 15-22 (D.C. Cir.

1950), cert. denied, 340 U.S. 952 (1951). It stated that a state commis-

sion can constitutionally adopt a “sliding scale” test that retains some

reliance on the historic concept of “used and useful” if the commission

affirmatively compensated the utility for the risk the investment would

be disallowed over the period in which it was made by, for example,

proving it increased the authorized rate of return for this purpose.

There, the court allowed a return of, and on, the investment in an

abandoned plant that was not “used and useful” because the commis-

sion had not affirmatively provided such compensation. /d.

18

strict fair market value test to “unsuccessful” investments. At the

same time, it applies a strict original cost test to successful ones

and adopts no other mechanism to compen: ‘ie utilities for the

risks that prudent and statutorily-required expenditures will be

disallowed. In short, Pennsylvania has assured that the “end re-

sult” of its rate orders can never be fair compensation. This is a

per se violation of the Fourteenth Amendment.

The Pennsylvania utilities have a federal constitutional right to

a recovery of, and on, the over $50 million investment that they

prudently made to discharge a statutory duty to the public. Dur-

ing the period in which the investment was made—and thereafter

—Pennsylvania did not compensate these (or other) Pennsylvania

utilities for the risk that a full recovery of, and on, prudent ex-

penditures would be disallowed even in part. That this order

would unconditionally destroy the constitutionally legitimate ex-

pectations of the utility could not be clezrer.'+

B. There Is No “Consumer Interest” Or Other State Interest

That Could Possibly Justify This Interference With The

Property Rights Of Pennsylvania Utility Investors.

The foregoing establishes that the Penasylvania statutory

scheme is a per se violation of the Fourteenth Amendment. How-

ever, it is apparent, in any event, that there is no “state's interest

in [this] regulation” that could justify this interference with

property rights. Keystone Bituminous Coal Association v. De

‘*However, the Court need not decide whether the appellants are

entitled to a full recovery of, and on, these investments, for appellants

have not challenged the failure to allow a return on the unamortized

portions of their $50 rnillion investment and thereby to return this in-

vestment in real dollars. Appellants are defending a commission rate

order that gives them only a return “of ” their investment by amortizing

$50 million over a ten year period. There is no basis whatsoever for even

a suggestion that Pennsylvania compensated the utilities for the risk that

this prudent $50 million investment would be disallowed in its entirety.

Indeed, as explained below, Pennsylvania’s own actions demonstrate

that there is no state interest that could justify such an extraordinary

result.

19

Benedictis, 107 S. Ct. 1232, 1244 (1987); see Nol.an v. California

Coastal Commission, 107 S. Ct. 3141, 3146-48 (1987).

The Pennsylvania Supreme Court appeared to rest its decision

on the ground that the Federal Constitution allows deprivations

of utility property based on some amorphous “balancing” of a

generalized “consumer interest” in reduced rates against the in-

vestor interest—and that any statute that restrikes this balance is

constitutional. That is not, and cannot be, the law.

To be sure, Hope Natural Gas recognized that there are

“consumer interests” that can constitutionally justify some

interference with full realization of the “investor interests”!> and

that reasonable rates can be produced through a “balancing of the

investor and consumer interests.’ Jd. at 603. However, because

ali investor interests were fully protected in Hope, the Court did

not there define the ‘“‘consumer interests” that are to be balanced.

See id.

Subsequent decisions make it very clear that the only legitimate

“consumer interests” that can be advanced are preventing the

utility from recovering truly imprudent investments or recovering

amounts in excess of those required fairly to compensate utilities

'SHope Natural Gas Co. recognizes constitutionally protected

“investor interests” that are far broader than those that Justice Brandeis

discussed; they include a market return of and oni all capital, with no

stated limitation to prudent investment (320 U.S. at 603):

“[T]he investor interest has a legitimate concern with the financial

integrity of the company whose rates are being regulated. From the

investor or company point of view it is important that there be

enough revenue not only for operating expenses but also for the

capital costs of the business. These include service on the debt and

dividends on the stock. Cf. Chicago & Grand Trunk Ry. Co. v.

Wellman, 143 U.S. 339, 345-346. By that standard the return to

the equity owner should be commensurate with returns on

investments in other enterprises having corresponding risks. That

return, moreover, should be sufficient to assure confidence in the

financial integrity of the enterprise, so as to maintain its credit and

to attract capital.”

20

and their investors for the duties and risks that they incur.'* To

hold that there is a generalized (and boundless) consumer interest

in having lower and more affordable rates and that this interest

justifies reducing rates below the levels that represent the consti-

tutional minimums would sanction unconstitutional deprivations

of property. See Pennell v. City of San Jose, 108 S. Ct. 849, 861-64

(1988) (Scalia, J., concurring in part and dissenting in part on

other grounds).

However, the Court need not address that issue to decide this

case. Pennsylvania’s own actions demonstrate that there is no

consumer interest, or other state interest, that can justify the

interference that occurred. The decisive fact is that Pennsylvania,

by statute, has now authorized the recovery of, but not on, in-

vestment in any plant that is cancelled after 1985. This statute

vitiates any claim that there is a “consumer” or other sufficient

State interest that is served by denying any and all recovery of

prudently-incurred investments in cancelled plants.

As authoritatively construed by the Pennsylvania Supreme

Court, Pennsylvania law is now as follows. A utility that prudent-

ly expended $100 million in planning a plant over the period from

1972 to 1986 is entitled to receive a return of the $100 million in

its rates because it gets the benefit of the 1985 statute. In contrast,

a utility that prudently expended $50 million in planning a plant

'6See, e.g., Federal Power Commission v. Memphis Light, Gus & Water

Division, 411 U.S. 458, 474 (1973) (“under Hope Natural Gas rates are

‘just and reasonable’ only if consumer interests are protected and if the

financial health of the pipeline in our economic system remains strong”’)

(emphasis added); Colurado Interstate Gas Co. v. FPC, 324 U.S. 581, 605

(1945) (“end result” test “is not a standard so vague and devoid of

meaning as to render judicial review a perfunctory process. It is a

standard of finance resting on stubborn facts’); Permian Basin Area

Rate Cases, 390 U.S. 747, 792 (1968) (a court must assure itself that “the

order may reasonably be expected to maintain financial integrity, attract

necessary capital, and fairly compensate investors for the risks they have

assumed, and yet provide appropriate protection to the relevai.. public

interests, both existing and foreseeable”) (emphasis added).

21

over the period from 1972 to 1980 does not receive a nickel of

the $50 million because the 1985 statute is inapplicable. No one

has—or could—identify any basis for this difference in treatment.

The investor interest is identical in each case: to be made whole

for statutorily-required expenditures. If the generalized ““consum-

er interest” in “lower rates” is a valid one, it applies with greater

force in the case of the $100 million investment that is allowed

than in the $50 million investment that is excluded.

This Court’s decisions under the Taking Clause establish that

the “dispensation” that Pennsylvania extends to plants cancelled

after 1985 forecloses any reliance on “consumer interests”’ to jus-

tify the restrictions at issue in this case. In this respect, the case

is controlled by Nollan v. California Coastal Commission, 107 S.

Ct. 3141, 3148 (1987). As in Nol/lan, what Pennsylvania has done

is the “same as if [Pennsylvania] law forbade shouting fire in a

crowded theater, but granted dispensations to those willing to

contribute $100 to the state treasury.”” 107 S. Ct. at 3148. As in

Nollan, the presence in this case of a “dispensation” that is wholly

unrelated to and inconsistent with the purported statutory justifi-

cation forecloses a decision that the state interest is sufficient to

justify what would otherwise be a clearly unconstitutional taking

of property.

II. The Court Should Adopt The Brandeis Prudent Investment

Standard As The Constitutional Benchmark.

The Pennsylvania Supreme Court’s decision in this case is one

of many recent state court decisions that have seriously tested, if

not transgressed, the constitutional prohibition against the taking

of property without just compensation, and these and similar

decisions are imposing increasing burdens on this Court’s dock-

et.'? They all rest on a widespread misinterpretation of the

'"See, e.g., Kansas Gas & Electric Co. v. State Corp. Commission, 239

Kan. 483, 720 P.2d 1063 (1986), probable jurisdiction noted, 107 S. Ct.

1281, appeal dismissed under Rule 53, 107 S. Ct. 3280 (1987); Citizens

(Footnote continued on following page)

22

Court’s prior pronouncements, and, in particular, on the belief

that the Federal Constitution authorizes an amorphous, ad hoc

balancing of a boundless “consumer interest” in lower rates

against the interest of utility investors in having a fair opportunity

to recover all their costs. The confusion has even led the Federal

Energy Regulatory Commission recently to assert that rate orders

—and the criteria on which they are based—are unreviewable. '*

The Court disavowed that view over 40 years ago.'°

The confusion persists precisely because there are several meth-

ods of ratemaking that, at least in theory, would fully protect the

ultimate constitutional interest. See pp. 12-17, supra. The multi-

plicity of possible approaches has produced the same problem

that led to Justice Brandeis’s criticisms of the rule of Smyth v.

Ames. See pp. 13-14, supra. Today, a state legislature, regulatory

commission, Or court can justify “‘almost any result” it wants to

reach by selectively adopting different aspects of different ap-

proaches. That is what the Pennsylvania legislature and court

have done here. Indeed, the problem today is far more serious

than the one that Justice Brandeis faced because, whatever its

(Footnote continued from previous page)

Action Coalition of Indiana, Inc. v. Northern Indiana Public Service Co.,

485 N.E.2d 610 (Ind. 1985), appeal dismissed and cert. denied, 476 U.S.

1137 (1986); Cleveland Electric Illuminating Co. v. Public Utilities

Commission, 4 Ohio St. 3d 107, 447 N.E.2d 746, appeal dismissed, 464

U.S. 802 (1983); Cleveland Electric Illuminating Co. v. Public Utilities

Commission, No. 82-165 (Ohio, July 7, 1982), appeal dismissed, 459 U.S.

1094 (1983); Office of Consumers’ Counsel v. Public Utilities

Commission, 67 Ohio St. 2d 153, 423 N.E.2d 820 (1981), appeai

dismissed, 455 U.S. 914 (1982); see also Petition of Public Service

Commission of New Hampshire, No. 87-311 (N.H. Jan. 26, 1988);

Toledo Edison Co. v. Public Utilities Commission, 12 Ohio St. 3d 143,

465 N.E.2d 886 (1984).

'8See Jersey Central Power & Light Co. v. FERC, 810 F.2d 1168, 1174

(D.C. Cir. 1987) (en banc) (quoting one FERC submission).

'SColorado Interstate Gas Co. v. FPC, 324 U.S. 581, 605 (1945) (“end

result” test “is not a standard so vague and devoid of meaning as to

render judicial review a perfunctory process. It is a standard of finance

resting on stubborn facts."’)

—_—

23

other deficiencies, Smyth v. Ames was generally implemented to

err on the side of protecting constitutional rights. See p. 14 &

n.10, supra.

Against this background, amicus submits that the appropriate

approach, both to secure constitutional values and to protect this

Court’s docket from the burden of reviewing the details of a

plethora of rate decisions, is to adopt the prudent investment test

of Justice Brandeis as the constitutional benchmark. That test

protects investor interests by providing for a return on actual

prudent net investment and recovery of all prudent expenses. It

also protects all legitimate consumer interests by authorizing the

exclusion of wasteful and imprudent expenses.

By making Justice Brandeis’s approach the benchmark, the

Court would not foreclose individual states from adopting differ-

ent approaches. However, the Court would make it clear that a

state cannot disallow all, or some, of a prudent investment, unless

it first affirmatively demonstrates that some other mechanism has

been provided to compensate utility investors for that risk: by

authorizing above-cost return on other investments or otherwise.

See p. 17 n. 13, supra.

At the same time, the Court need not now foreclose the possi-

bility that there are, or could be, other state interests that would,

justify denying utility investors a fair return. However, it should

reject any notion that a generalized “‘consumer interest” in lower,

and more affordable, rates can be such a factor. Consumers have

a legitimate interest in paying rates that exclude truly wasteful

and imprudent expenditures. They also have an interest—which

is the foundation for rate regulation of natural monopolies—in

preventing monopoly pricing and prohibiting discriminatory and

exploitative practices. But when these interests are safeguarded —

as they are under the prudent investment test or any constitution-

al surrogate—further rate reductions in the name of some amor-

phous “consumer interest” is a taking of investor property. See

pp. 19-20, supra.

24

CONCLUSION

For the reasons stated, the judgment of the Pennsylvania Su-

preme Court should be reversed.

May 5, 1988

*Counsel of Record

Respectfully submitted,

Rex E. Lee*

DAVID W. CARPENTER

Sidley & Austin

1722 Eye Street, N.W.

Washington, D.C. 20006

(202) 429-4266

VINCENT BUTLER

RICHARD A. FLATI

DAviD T. EVRARD

Pennsylvania Electric Association

800 N. Third Street

Harrisburg, Pennsylvania 17102

(717) 257-5854

Attorneys for Pennsylvania Electric

Association As Amicus Curiae