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03/30/84 Boroughs of Ellwood City, v. Federal Energy Regulatory

March 30, 1984

BOROUGHS OF ELLWOOD CITY, GROVE CITY, NEW WILMINGTON, WAMPUM, AND ZELIENOPLE, PENNSYLVANIA, PETITIONERS

v.

FEDERAL ENERGY REGULATORY COMMISSION, RESPONDENT, PENNSYLVANIA POWER COMPANY, INTERVENOR; BOROUGHS OF

ZELIENOPLE, PENNSYLVANIA, PETITIONERS

v.

FEDERAL ENERGY REGULATORY COMMISSION, RESPONDENT, PENNSYLVANIA POWER



UNITED STATES COURT OF APPEALS FOR THE DISTRICT OF COLUMBIA CIRCUIT

ELLWOOD CITY, GROVE CITY, NEW WILMINGTON &

COMPANY, INTERVENOR

Nos. 80-2364, 83-1196, 83-1414 1984.CDC.89

Petitions for Review of an Order of the Federal Energy Regulatory Commission.

APPELLATE PANEL:

Wald and Ginsburg, Circuit Judges, and McGowan, Senior Circuit Judge. Opinion for the Court filed by Circuit Judge Wald.

DECISION OF THE COURT DELIVERED BY THE HONORABLE JUDGE WALD

This case marks the latest episode in the ongoing saga of the "price squeeze" doctrine in federal utility ratemaking. Several Pennsylvania municipalities *fn1 ("Boroughs") petition for direct review of decisions by the Federal Energy Regulatory Commission ("FERC" or "the Commission") approving with minor modifications wholesale rates filed by Pennsylvania Power Company ("Penn Power" or "the Company") under sections 205 and 206 of the Federal Power Act. 16 U.S.C. ยงยง 824d, 824e. The proceedings before the Commission were bifurcated into a "cost-of-service" phase and a price discrimination phase. Boroughs appeal from several aspects of the Phase I proceedings, in which the Commission set just and reasonable rates for Penn Power aside from any considerations of unlawful discrimination. In Phase II, the Commission considered allegations of price discrimination. Boroughs' primary claim was that the wholesale rate it was charged by Penn Power was unjustifiably high in comparison with the rate Penn charged certain retail customers for which Boroughs competed, thus creating a "price squeeze." Although the Commission found non-cost-justified price discrimination by Penn Power against its municipal competitors for nearly a year, it refused to issue a price squeeze remedy. It concluded that the discrimination was not "undue" because it was the result of a company decision to take advantage of a change in the state law governing its retail rates. We vacate the Commission's decision not to remedy the price squeeze, but we uphold its decision in all other respects. I. BACKGROUND

Penn Power supplies electrical power to both retail customers, whose rates are under the jurisdiction of the Pennsylvania Public Utility Commission, and wholesale customers, including Boroughs, whose rates are under the jurisdiction of FERC. Penn Power and its municipal customers are both potential suppliers, and thus in competition, for many retail customers.

Penn Power filed with the Commission a rate increase for its wholesale customers in July, 1977. *fn2 The rates were accepted for filing, suspended for two months, and allowed to go into effect subject to refund on September 11, 1977; they remained in effect until January 23, 1982. The Commission scheduled a public hearing on the lawfulness of the proposed rates under sections 205 and 206 of the Federal Power Act, 16 U.S.C. 824d, 824e, which proscribe rates that are unjust, unreasonable or unduly discriminatory. Boroughs intervened in these proceedings, alleging among other things that the new rates were anticompetitive and discriminatory in relation to the retail rates that Penn Power charged industrial customers for whom Boroughs competed.

The Commission bifurcated the proceedings. In Phase I, the Commission determined the just and reasonable rate, based on Penn Power's cost of service to the wholesale customers, apart from any price discrimination issues. *fn3 During the November, 1978, Phase I hearings, Boroughs unsuccessfully contested several elements of Penn Power's rate filing that are now before us on appeal. They argue here (1) that the Commission erred in permitting Penn to include a forty-five-day working capital allowance that was much greater than Penn's actual needs; (2) that the test period estimate of revenues from sales of excess reserves had proved to be inaccurate by $2 million and should have been adjusted accordingly; and (3) that the Commission allowed an excessive rate of return on equity of 13.25%.

In the second phase of the ratemaking proceedings, the Commission considered Boroughs' allegations that the large wholesale rate increase, unmatched by a retail rate increase, resulted in a price squeeze. Boroughs, which are totally dependent on power supplied by Penn, claimed that they had to pay such a high wholesale rate that they could not compete with Penn's lower retail rates for many large customers, especially the industrial customers within the Boroughs' boundaries. Although the Commission agreed with the ALJ that a price squeeze had existed for nearly a year -- from September 11, 1977, when the wholesale rate increase went into effect, to August 31, 1978, when the retail increase took effect -- it found on the basis of additional filings by Penn *fn4 that no price squeeze existed after August 31, 1978. The Commission also overruled the ALJ's decision to issue a remedy. It held that the price discrimination was not "undue" and was thus excused because it was the result of Penn's decision to delay its retail filing until the effective date of a new state law that imposed a definite suspension period. *fn5

Boroughs contend on appeal, first, that the Commission unfairly applied a test of price discrimination that was not developed until after the record was closed, thus precluding them from demonstrating a longer period of price discrimination than the year-long period ultimately found. They contend further that as to the period for which the Commission did find an actual price squeeze, it unjustifiably denied them a remedy. II. COST-OF-SERVICE ISSUES

A. Working Capital Allowance

An electric utility may include in its ratebase a cash allowance to permit it to meet current obligations as they arise. As we explained in City of Cleveland v. FPC, 525 F.2d 845, 850 n.38 (D.C. Cir. 1976) (quoting Alabama-Tennessee Natural Gas Co. v. FPC, 203 F.2d 494, 498 (3d Cir. 1953), "the need for working capital arises largely from the time lag between payment by the company of its expenses and receipt by the company of payment for service in respect of which expenses were incurred."

A utility's actual need for working capital can be most accurately determined by performing a "lead-lag" study of the average number of days that passes between payment of expenses and receipt of revenues for a given service. One part of this calculation is the "revenue lag," which is in turn made up primarily of the "service lag" -- the number of days between the time expenses are incurred for services and the date of billing for those services -- and the "payment lag" -- the number of days between billing and payment. A utility also experiences "lead time" when it receives payment for services before it pays the expenses associated with those services. The number of lag days minus the number of lead days yields a net lag which represents the utility's actual need for working capital. *fn6

A reliable lead-lag study, however, is a burdensome undertaking. The Commission therefore long ago established the standard practice of permitting a utility in the absence of a lead-lag study to include in its ratebase an amount equal to forty-five days of operating expenses. See, e.g., Interstate Power Co., 2 F.P.C. 71, 85 (1939); Union Electric Co., 47 F.P.C. 144, 175 (1972). *fn7 The Commission found that the use of this estimate yielded reasonable results while avoiding the costs of regularly performing a reliable "lead-lag" study and of litigating the issue. Carolina Power & Light Co., 6 FERC P61,154, p. 61,295 (1979). The Commission's rule of thumb has been approved by at least one court. See Union Electric Co. v. FERC, 668 F.2d 389, 397 (8th Cir. 1982).

In 1979 the Commission initiated a rulemaking to revise the formula, recognizing that it may have become outdated in light of current billing practices. *fn8 Pending that revision, the Commission provided that "where a fully developed and reliable lead lag study is available in the record, we will utilize that study to determine the working capital allowance. When a study meeting these criteria is not available we will continue to apply the forty-five-day convention." Carolina Power & Light Co., 6 FERC at p. 61,296.

1. The Commission's Decision

In this case Boroughs offered a lead-lag study which they claimed demonstrated a need for a working capital allowance of only thirteen days. The study was one which Penn had prepared for its last retail filing and which Boroughs had "adjusted" in various ways that the ALJ found were "troubling, and taint[ed] the use of that study." *fn9 The ALJ therefore rejected the study. He nevertheless reduced the allowance from forty-five to forty days in recognition of the Commission's proposed revision of the standard formula. ALJ I, 9 FERC at p. 65,160.

The Commission concurred in the ALJ's rejection of Boroughs' lead-lag study, but on a different basis. The Commission pointed to an apparent inconsistency between the study's estimated revenue lag of forty-five days experienced in paying operating and maintenance expenses and Boroughs' estimate of thirty days for paying interest on long-term debt, dividends, and federal taxes. Neither estimate, it stated, was supported by a study of actual billpaying practices. For example, the study assumed that the revenue lag was forty-five days for wholesale customers; a Penn Power witness testified, however, that, according to another study of the actual billpaying practices of one of these customers, the revenue lag was sixty-six days. *fn10 The Commission thus agreed with the ALJ that Boroughs had not presented the kind of reliable study that could be used in place of the forty-five-day convention. FERC I, 12 FERC at p. 61,080.

Unlike the ALJ, however, the Commission adhered to that convention. It rejected the ALJ's use of the forty-day figure appearing in the notice of proposed rulemaking because that proposed figure represented an estimate of the lag between the rendition of services and the receipt of revenue rather than the lag between payment of expenses for services and receipt of revenue represented by the forty-five-day figure. Id. Boroughs now challenge both the decision to reject its lead-lag study and the use of the forty-five-day rule.

2. Discussion

(a) The Study. In Cities of Aitkin v. FERC, 704 F.2d 1254 (D.C. Cir. 1982), we reversed the Commission's decision to reject a "lead-lag" study and to apply instead the forty-five-day convention. In that case we found that "the Commission [had] point[ed] to no evidence tending to undermine the study's validity," id. at 1258, but had relied upon "a formalistic argument that flies in the face of logic." Id. It had rejected the study simply because it was in part based not on a study of actual payment dates but on the assumption that payment due dates were representative of actual payment dates, an assumption that had been verified by evidence of actual payment practices.

In the case before us, the Commission relied in part on the same flaw -- the failure to study actual payment dates. It also noted, however, that the study's assumption as to the "revenue lag" was expressly contradicted rather than confirmed by Penn's experience and by the single-customer study, which had yielded a sixty-six-day rather than a forty-five-day revenue lag. On the other hand, the Commission acknowledged that the single-customer study from which the sixty-six-day revenue lag was derived had incorrectly used a thirty-day instead of a fifteen-day "service lag." 12 FERC at n.18. Although these two inaccuracies appear in part to cancel each other out, they do tend to undermine confidence in the study's reliability. We cannot say that the Commission acted arbitrarily in concluding that Boroughs had not presented "a fully developed and reliable lead-lag study."

(b) The Forty-Five-Day Convention. The Commission's discussion of Boroughs' lead-lag study reveals not only the weakness of the study but also the desirability of a standard formula that can be applied, at least in most cases, without burdensome investigations and lengthy administrative proceedings on the details of a given utility's actual "service lags," "payment lags," etc. The forty-five-day convention thus appears still to fulfill an important function.

Another important rationale behind the rule, however, was that it yielded reasonably accurate results. The Commission's discussion of the lead-lag study here raises serious doubts over the continuing validity of the forty-five-day convention. For example, the single-customer study that the Commission used to support its rejection of Boroughs' study had, according to FERC, incorrectly used a thirty-day rather than a fifteen-day "service lag." If the corrected figure of fifty-one days -- sixty-six minus fifteen -- were plugged into Boroughs' calculations, it would appear to yield a net lag, and thus a working capital requirement, of about nineteen days. If the bill-paying practices of the single customer are remotely representative, the forty-five-day figure used by the Commission may be seriously defective.

As we have noted, the Commission has recognized this possibility and in 1979 initiated rulemaking proceedings to revise the formula for calculating working capital requirements. Any revision of the formula would seem to require the broader perspective and participation inherent in rulemaking proceedings. In light of this ongoing proceeding, we decline to disturb the Commission's interim decision to continue to use the forty-five-day convention in the absence of a "fully developed and reliable lead-lag study." The temporary -- and we emphasize temporary -- sacrifice of accuracy is outweighed by valid administrative concerns over the implications of permitting ad hoc adjustments based on incomplete data in every individual ratemaking proceeding. We therefore approve the Commission's decision to apply the forty-five-day convention in this case. *fn11

B. Sale of Excess Reserves

The ratebase is derived from actual cost-of-service and revenue data from the previous twelve-month period and estimated costs and revenues for a subsequent twelve-month period -- the "test year." Even when the actual data become available during the proceedings, the Commission will not generally adjust the estimates. It inquires first whether those estimates were reasonable when made; if the utility demonstrates that this is so, the Commission will use them unless the party contesting the estimates shows that they are "substantially in error" and would yield "unreasonable results." Southern California Edison Co., 8 FERC P61,099, p. 61,375 (1979). We have approved this approach to ratemaking. Cities of Batavia v. FERC, 672 F.2d 64, 74 (D.C. Cir. 1981) [hereinafter " Batavia "]; Villages of Chatham v. FERC, 662 F.2d 23, 29-30 (D.C. Cir. 1981); American Public Power Association v. FPC, 173 U.S. App. D.C. 36, 522 F.2d 142 (D.C. Cir. 1975).

1. The Commission's Decision

In this case, Penn Power estimated that it would earn about $7 million in 1977, the test year, from the sale of excess reserve capacity -- i.e., the reserve generating capacity beyond that required to guarantee reliable service to its own customers. In fact it received about $9 million from such sales. The additional $2 million was largely attributable to the addition of new generating units during the latter part of 1977. Boroughs argued that since Penn anticipated the addition of these units and included costs for the additional capacity in its cost estimates, it should have similarly anticipated the resulting increase in reserve capacity sales. They argue that, "given excess capacity from generating units, it is per se unreasonable not to have projected sale of the same." Penn pointed out that this assumes a willing buyer.

The ALJ approved the estimate, pointing to additional factors in support of the estimate's reasonableness. First, Penn did plan more sales and less purchases of firm power during 1977 than in the preceding years, offsetting somewhat the increase in excess capacity. In addition, the ALJ recognized "the inherent limitations in the forecasting process and . . . the special problem in accurately predicting sales of excess power in a year when two new generating units are placed in service." ALJ I, 9 FERC at p. 65,161. Furthermore, he found the $2 million underestimate, only a small fraction of which was allocable to wholesale service, to be not so excessive as to require adjustment of the test year data. *fn12 Finally, he noted that Boroughs "failed to demonstrate that no ...


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