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decided: August 25, 1981.


Appeal from the Order of the Pennsylvania Public Utility Commission in the case of Pennsylvania Public Utility Commission v. Carnegie Natural Gas Company, Docket Nos. R-79100977, R-79100981 and R-79100994.


Maurice A. Frater, McNees, Wallace & Nurick, for petitioner.

Frank B. Wilmarth, Assistant Counsel, with him, Steven A. McClaren, Deputy Chief Counsel, and Joseph J. Malatesta, Jr., Chief Counsel, for respondent.

President Judge Crumlish and Judges Mencer, Blatt, Williams, Jr., and Craig. Judges Rogers, MacPhail and Palladino did not participate. Opinion by Judge Craig. Judge Mencer did not participate in the decision in this case.

Author: Craig

[ 61 Pa. Commw. Page 437]

Carnegie Natural Gas Company (Carnegie), a wholly owned subsidiary of United States Steel (U.S. Steel) involved in the production and distribution of natural gas, has petitioned this court for review of an order of the Pennsylvania Public Utility Commission (commission) adopted on July 17, 1980, disallowing $2,765,889 of a requested $5,836,222 increase in Carnegie's annual revenue from its natural gas service.

Carnegie initiated this proceeding on October 26, 1979 by filing rate increase tariff supplements to apply to Carnegie's various customer classes, effective

[ 61 Pa. Commw. Page 438]

December 26, 1979. However, on December 7, 1979, the commission initiated an investigation of the tariffs and their supplements, and a week later Carnegie filed additional supplements which extended the effective date to July 26, 1980.

At the time Carnegie submitted its proposed rate increases, its capital structure was devoid of long-term debt. However, in November 1979, Carnegie acquired long-term debt which caused its actual capital structure to be composed of 6.61% debt and 93.39% equity.

After holding hearings at which it received evidence for and against Carnegie's proposed rates, the commission assigned Carnegie a hypothetical capital structure composed of 55% debt and 45% equity upon which the commission imputed a cost of capital to Carnegie and determined 10.87% to be a fair and reasonable rate of return for Carnegie to earn on its capital investment. Moreover, by using the debt component of the hypothetical capital structure to calculate a hypothetical interest expense which exceeded Carnegie's actual interest expense by $1,326,000, the commission, for rate-making purposes, disallowed $651,000 of Carnegie's actual federal and state income tax expense.

Here Carnegie contends that the commission has precluded it from earning a fair return on its capital, and raises three issues for our review:*fn1 (1) whether the record contains substantial evidence to support the commission's conclusion that a capital structure composed of 55% debt and 45% common

[ 61 Pa. Commw. Page 439]

    equity is appropriate for a utility such as Carnegie; (2) whether the commission erred at law by utilizing a hypothetical interest expense to disallow $651,000 of Carnegie's claimed income tax expense; and (3) whether the commission erred in its allocation of revenues among Carnegie's rate classes.

1. Capital Structure

An important element of a utility's rates is the utility's cost of capital, which indicates the fair rate of return to be allowed on the fair value of its property used and useful in the public service, after allowance for proper operating expenses, taxes, depreciation and any other legitimate item. Western Pennsylvania Water Co. v. Pennsylvania Public Utility Commission, 54 Pa. Commonwealth Ct. 187, 422 A.2d 906 (1980). Where a utility's actual capital structure is too heavily weighted on either the debt or equity side, the commission, which is responsible for determining a capital structure which allocates the cost of debt and equity in their proper proportions, must make adjustments to the utility's capital structure. Lower Paxton Township v. Pennsylvania Public Utility Commission, 13 Pa. Commonwealth Ct. 135, 317 A.2d 917 (1974); Riverton Consolidated Water Co. v. Pennsylvania Public Utility Commission, 186 Pa. Superior Ct. 1, 140 A.2d 114 (1958). In Lower Paxton, this court gave the following explanation for using a hypothetical capital structure:

The capital structure of a corporation may affect, sometimes drastically, the cost of capital. The capital structure is, in reality, little more than those dollars represented by its common and preferred stock and its debt. In some cases where the public utility is a wholly-owned subsidiary, its capital structure may not be comparable to another public utility which

[ 61 Pa. Commw. Page 440]

    is obliged to obtain its equity and debt financing in the open market. In other words, it may have on balance a too heavily weighted debt or equity. In this case the record discloses that Dauphin has a capital structure wherein 100 percent is equity capital. Under such circumstances the PUC must make adjustments based upon substantial evidence in order to reach a fair result. . . . It is also conceivable that there may be evidence on the record which will permit the PUC to utilize the capital structure and cost of capital statistics of comparable public utilities instead of those of the company or its parent.

The record before us reveals that, from 1974 through the initiation of this action, the proportion of common equity in Carnegie's capital structure has exceeded 90%. This fact alone is sufficient to justify the commission's imposition of a hypothetical capital structure to calculate the cost of Carnegie's capital. We find no basis for Carnegie's contention that the commission must show actual harm before it may impose a hypothetical capital structure; the quoted language in Lower Paxton requires the commission to make an ...

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