Potomac Edison Co. v. Public Service Commission

⁵⁷⁵ Levine, J., delivered the opinion of the Court. In this appeal, the Potomac Edison Company (Potomac) seeks reversal of a decision of the Circuit Court for Washington County (Rutledge, J.) upholding an order entered in a rate proceeding by the Public Service Commission of Maryland (the commission). Potomac appealed the circuit court decision to the Court of Special Appeals, but we granted certiorari prior to consideration of the case by that court. The other parties to this appeal, in addition to the commission itself, are the People’s Counsel and Howmet Corporation, which, as a substantial purchaser of electricity from Potomac, was granted leave to intervene at the commission level in opposition to Potomac’s requested rate increase.

We affirm. On October 1, 1974, Potomac filed an application and revised schedules of electric rates designed to produce an additional $11,900,000 in annual gross revenues, an increase of 22 percent over its rates then in effect. Pursuant to Maryland Code (1957, 1969 Repl. Vol., 1974 Cum.

Supp.) Art. 78, § 70, the commission suspended the revised rate schedules for a period not to exceed 120 days (later extended for an additional 30 days) from October 31, 1974, and also instituted proceedings to determine whether the proposed rates were “just and reasonable” within the meaning of Art. 78, § 69 (a). It is from those proceedings that this appeal arises. Prior to a hearing on the application, the commission, acting under Art. 78, § 71, granted Potomac’s emergency application, and authorized Potomac to file revised temporary rates that would produce not more than an additional $5,454,000 in annual gross operating revenues. This action resulted in a surcharge of 10.16 percent on all customer bills.

Potomac is a wholly owned subsidiary of Allegheny Power System, Inc. (APS), a holding company operating two other subsidiaries, West Penn Power Company and Monongahela Power Company. Potomac renders service throughout Garrett, Allegany, Washington and Frederick Counties, and in parts of Montgomery, Carroll and Howard Counties. It ⁵⁷⁶ also provides service in parts of Pennsylvania, Virginia and West Virginia. The application in controversy was the third filed by Potomac within a period of some 41 months.

In April 1972, the commission granted Potomac a rate increase designed to produce over $4,000,000 of additional revenue based upon an allowed rate of return of 7.94 percent. On May 31, 1974, the commission permitted Potomac to increase its rates by $5,645,192 with an allowed rate of return of 8.2 percent. Four months later, Potomac filed the application in dispute here, seeking a 9.9 percent rate of return. In the pre-hearing stages, the parties, in accordance with the established practice of selecting a fixed “test period” for determining revenue requirements, agreed upon the 12-month period ending September 30, 1974.

Although the evidence presented before the commissión’s hearing examiner was voluminous, we shall attempt a relatively brief summary. In common with many other public utilities throughout the nation, Potomac found itself plagued in 1974, as a consequence of inflation and rising interest costs, by an attrition of earnings (a term frequently used in utility rate proceedings and defined succinctly by Potomac as “a disproportionate growth in the [plant] expenses of providing public service which is not matched by a corresponding growth in revenues”). To compound this problem, Potomac’s ability to issue new long-term indebtedness was attenuated by applicable legal requirements. Pursuant to the Public Utility Holding Company Act of 1935, Potomac’s bond indenture restricts it from issuing such debt if pre-tax earnings fall below 2.0 times its outstanding interest costs for any consecutive 12-month period within the latest 15 months.

Wholly apart from this legal impediment to the issuance of long-term indebtedness was Potomac’s concern that its recent earnings experience would impair its bond rating, and thus affect its ability to attract institutional investors. An element in arriving at the “reasonable return” standard set by Art, 78, § 69 (a) is the “fair value” of the utility company’s property, that is, its “rate base.” A key ⁵⁷⁷ issue in this case was whether, as advocated by Potomac, its record of performance during the test period should be calculated by a “terminal” (end of period) rate base, that is, as of. September 30, 1974, the final day of the test period, or whether an “average” rate base (the average of the 12 months) should be applied. Potomac justified adoption of a terminal rate base by pointing to the erosion of its earnings caused by plant replacement at increased costs (attrition).

The commission, moreover, had applied a terminal rate base in the two prior Potomac cases. Evidence presented by the People’s Counsel supported a weighted average rate base on three grounds: First, Potomac earned its net income over the entire 12-month period; secondly, as the intervals between rate cases diminish, each case becomes a review of the immediate past and the resulting rates are geared to the immediate future; finally, a hedge against attrition is developed by factoring into the income statement known increases in expenses of the entire year. Pursuant to the recommendations of its auditor and the hearing examiner, the commission, with one member dissenting, applied the average rate base. Under Potomac’s calculations, the terminal rate base was some $8,000,000 greater than the average rate base.

Because of modifications made by the commission, this difference was reduced by approximately $1,000,000. Use of the terminal rate base, of course, would result in a larger rate increase. Evidence presented by Potomac supported a rate of return related to its own capital structure ratios, long-term debt and preferred stock, rather than those of APS, but recognized that the common equity cost rates of the parent corporation should be employed because of Potomac’s status as a wholly owned subsidiary. Potomac’s witnesses maintained that each subsidiary owned by APS should be judged, as to bonds and preferred stock, on its own individual performance, since Potomac’s bonds are not guaranteed by APS or the other subsidiaries.

The evidence presented by the People’s Counsel, however, favored reliance on the APS cost rate of long-term debt capital in conformity ⁵⁷⁸ with the commission’s decisions in the two prior Potomac cases. The commission, on the recommendation of the hearing examiner, followed the precedent which it had set in the two prior Potomac cases, and considered the capital structure of APS in testing the reasonableness of the proposed rates. In essence, the commission appears to have reasoned that APS, as the sole owner of Potomac's common stock, would exercise significant controls over the subsidiary, and that purchasers of Potomac bonds would expect APS not to remain oblivious to a possible default. In the face of Potomac’s evidence that a fair rate of return would be 9.9 percent, the People’s Counsel countered with equally expert opinion that the fair rate of return should be no greater than 8.50 percent.

The commission adopted the hearing examiner’s finding that the fair rate of return should be 8.60 percent, which, when applied to the average rate base of $199,882,000 for the 12-month period ending September 30, 1974, would yield an increase in gross annual revenues of $4,829,000. 1 The commission order was affirmed on appeal to the circuit court, which ruled that the commission had not erred in considering the capital structure of the parent corporation. The court further found that the commission had not acted capriciously or unreasonably, or without substantial evidence to support its decision. We agree. Potomac presents two broad-brush contentions on this appeal.

First, it urges that the rate of return fixed by the commission is unreasonable and not supported by substantial evidence. Second, it contends that the commission was unreasonable, arbitrary and capricious in failing to allow for the attrition which it had experienced during the test year. ⁵⁷⁹ (1) In rate proceedings, it is the statutory duty of the commission to determine “just and reasonable rates.” Art. 78, § 68. To comply with this standard, as we indicated earlier, the commission is required to fix rates which are designed to yield “a reasonable return upon the fair value of the company’s property used and useful in rendering service to the public,” Art. 78, § 69 (a), that is, upon the company’s “rate base.” See Public Serv. Comm’n v. Balto.

Gas & El., 273 Md. 357, 363 , 329 A. 2d 691 (1974). The statutory test in Maryland, therefore, is the embodiment of the “fair value rule.” Balto. Trans. Co. v. Pub.

Ser. Comm., 206 Md. 533, 542 , 112 A. 2d 687 (1955); C. & P. Phone Co. v. Pub. Serv. Comm., 201 Md. 170, 179-80 , 93 A. 2d 249 (1952).

Accordingly, the ascertainment of a fair rate base and the setting of a reasonable return thereon invariably become the focal points of the typical rate proceeding. There are two facets to Potomac’s attack on the rate of return set by the commission, the first of which appears to be more of a mathematical exercise than a legal argument. The principal expert witness for Potomac testified that the cost rate required to attract new common stock investors to APS had increased progressively from 7.74 percent in 1969 to 12.15 percent in early 1974, and that, in his opinion, the proper cost rate to be applied in this proceeding to Potomac’s common equity, which constitutes about 33 percent of its total capital, was 15.00 percent. This opinion as to common equity cost was linked directly, of course, to the witness’s ultimate recommendation of a 9.9 percent return to Potomac’s overall cost of capital. 2 The principal expert witness for the People’s Counsel, on the other hand, rendered the opinion that the proper cost rate of common equity capital to APS, and thus to Potomac, ⁵⁸⁰ was between 11.75 and 12.25 percent, and that therefore the fair rate of return should be no more than 8.50 percent.

Potomac complains here because the commission, on recommendation of the hearing examiner, settled on 8.60 percent as a fair rate of return, which, when related to the capital structure and other cost rates advocated by the People’s Counsel expert, would allegedly produce a return on common equity of over 12.00 percent. As we perceive Potomac’s argument, it is that the commission, while professing to allow for a 12.00 percent return on common equity, actually provided for only 11.16 percent; hence, its “rate of return decision is internally inconsistent,” and is therefore unreasonable. The short answer to this contention is that the commission’s rate of return determination was based upon adoption of the consolidated APS capital structure and senior embedded costs, whereas the example employed by Potomac to yield the 11.16 percent figure uses its own capital structure and senior embedded costs. In actuality, then, Potomac’s quarrel with the rate of return determination comes down to its dissatisfaction with the commission’s adoption of the APS capital structure and senior embedded costs.

In Potomac’s view, the commission’s reasoning in adopting the APS capital structure for its rate of return determination was defective. The argument that APS will not stand aloof while Potomac defaults is irrelevant, it says, because APS is, in any event, not legally liable for Potomac’s senior capital obligations. Moreover, the result of the commission’s use of the consolidated capital structure is that Potomac’s Maryland customers are being subsidized by the company’s customers in other states and by the customers of