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decided: February 28, 1983.


Appeals from the Order of the Pennsylvania Public Utility Commission in the cases of Pennsylvania Public Utility Commission v. Pennsylvania Gas and Water Company -- Water Division, No. R-80071265.


D. Mark Thomas, with him Charles E. Thomas and Patricia Armstrong, Thomas & Thomas, for Pennsylvania Gas and Water Company.

Frank B. Wilmarth, with him Steven A. McClaren and Joseph J. Malatesta, Jr., for Pennsylvania Public Utility Commission.

Daniel Clearfield, Assistant Consumer Advocate, with him Norman James Kennard, Assistant Consumer Advocate, and Walter W. Cohen, Consumer Advocate, for Walter W. Cohen, Consumer Advocate.

President Judge Crumlish, Jr. and Judges Rogers, Blatt, Williams, Jr. and MacPhail. Opinion by Judge Rogers.

Author: Rogers

[ 72 Pa. Commw. Page 332]

A number of issues are presented by these consolidated cross appeals from an order of the Pennsylvania Public Utility Commission (Commission), entered April 24, 1981, and authorizing the Pennsylvania Gas and Water Company (PG&W) to file tariffs or tariff supplements designed to produce annual operating revenues, exclusive of revenue to be derived from the State Tax Adjustment Surcharge, not in excess of $22,122,681 -- representing an increase in

[ 72 Pa. Commw. Page 333]

    allowed revenues of $2,307,272. We will begin with the most weighty of these issues: whether the Commission may lawfully embrace depreciated original cost as the sole measure of the value of a regulated utility's property for ratemaking purposes when the proffered justification for such a measure of value lies not in particular evidence adduced in the rate case sub judice but in a statement of general principle, recently adopted, that all measures of value in excess of depreciated original cost are unsuitable and are unreasonably advantageous to the utility's shareholders. Some general remarks are necessary.

I. Rate Base

A. "Fair Value" vs. "Original Cost"

The process of fixing the rates of a regulated utility may be described most generally as the computation by the regulator of the utility's allowed return; an amount (disregarding for the moment the utility's operating expense) of annual revenue arrived at by the application of a "rate of return" to a "rate base." The rate of return is usually expressed as a percentage and is intended to reflect

     a return on the value of the [utility's] property which it employs for the convenience of the public equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties. . . .

Bluefield Waterworks & Improvement Co. v. Public Service Commission of West Virginia, 262 U.S. 679, 692-693 (1923). The rate base, the computation of which by the Commission is here challenged, is the amount of the utility's property used and useful, at

[ 72 Pa. Commw. Page 334]

    the time of the rate inquiry, in rendering the public service. I A. Priest, Principles of Public Utility Regulation 139 (1969).

A dichotomy exists among the American jurisdictions in the fundamental premises employed to ascribe a value to a utility's rate base. A number of states, by statute or by judicial decision where the regulatory enactment is silent on the point, equate the value of a utility's property with the depreciated original cost figure computed for accounting purposes and registered in the company's books of account. No adjustment is made to the historical cost of assets to reflect changes in technology or in the purchasing power of the dollar. Other states, a minority in number*fn1 attempt in a more or less systematic fashion through the use of "trended costs" predicated on accepted inflationary indices, and estimates of cost of plant replacement and reproduction, to recognize

[ 72 Pa. Commw. Page 335]

    changes over time in the value of capital invested in the public enterprise.

This ongoing debate as to the appropriate means of rate base valuation has been described as "the most widely disputed legal issue in the history of American public utility regulation" and reflects a lack of consensus as to the very nature of the inquiry -- Is the fair return to which a utility owner is entitled to be measured with respect to his investment or with respect to the value of his property?

In Smyth v. Ames, 169 U.S. 466 (1898) the Supreme Court rejected the Union Pacific Railroad's contention that it was entitled to exact customer charges sufficient to meet the interest accruing on its securities and held that considerations of constitutional import, including the Due Process clauses of the Fifth and Fourteenth Amendments and the attendant proscription against uncompensated takings of property by the state, required only that a utility be permitted to earn a fair return on the fair value of its property at the time of the rate inquiry. In arriving at the fair value, such factors as original cost of construction, current value, estimated cost of replacement or reproduction, market value of outstanding securities, and the probable earning capacity of the property were to be considered. It should be noted that the inclusion by the Court of measures of current or reproduction value in the formula represented a defeat for the railroad utility which had argued in that era of rapidly falling prices, for the exclusive use of original cost.*fn2 Thus, the Court rejected the

[ 72 Pa. Commw. Page 336]

    contention that utility owners were entitled to a fair return on their investment and concluded that, instead, a fair return on the value of the utility's useful property was required. This operative "first principle" necessitating the recognition of changes in value over time was also stated by Mr. Justice Hughes in the Minnesota Rate Cases, 230 U.S. 352, 454 (1913):

[T]he making of a just return for the use of property involves the recognition of its fair value if it be more than its costs. The property is held in private ownership and it is that property, and not the original cost of it, of which the owner may not be deprived without due process of law.

A different conceptual foundation was proposed by Mr. Justice Brandeis*fn3 in a dissenting opinion in Missouri ex rel. Southwestern Bell Tel. Co. v. Public Service Commission, 262 U.S. 276, 289 (1923):

The thing devoted by the investor to the public use is not specific property, tangible or intangible, but capital embarked in the enterprise.

Id. at 290. The Constitution, by this view, guarantees a fair return not on the changing value of utility property but on the amount of the owner's investment -- an amount equal to and identified with the property's depreciated original or historical cost. Thus, a decline in the value of property resulting from

[ 72 Pa. Commw. Page 337]

    technological innovation as well as an increase in value brought on by, for example, resource scarcity were to be disregarded. However, Mr. Justice Brandeis explicitly recognized that systematic and long-lived changes in prices generally, reflecting persistent inflation in and, therefore, diminution of the value of the dollar would undermine the usefulness of an original cost rate base measure. The possibility of significant persistent inflation was considered to be very unlikely. Id. at 303 n. 16 (dissenting opinion by Brandeis, J.).

In Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591 (1944) the "prudent investment" or "original cost" paradigm carried the day for the purposes of Constitutional analysis. The issue before the Court was whether the Federal Power Commission had properly valued a producing gas field at the cost to the utility of developing the field. Mr. Justice Douglas later described the holding in Hope as follows:

We [there] held . . . that the Commission was not bound to the use of any single formula in determining rates. And in the [ Hope Natural Gas ] case we sustained a rate order based on actual legitimate cost against an insistent claim that the producing properties should be given a valuation which reflected the market price of the gas.

Colorado Interstate Gas Co. v. Federal Power Commission, 324 U.S. 581, 605 (1945). The line is now clearly drawn. The quantity upon which the utility owner is entitled to a fair return is either the prudent initial cost of his investment or the fair value of the property into which that investment has been converted. For the purposes of Constitutional analysis, the former measure is sufficient.

[ 72 Pa. Commw. Page 338]

B. Current State of the Debate

As we have indicated, the response to Hope Natural Gas has been generally favorable but has fallen well short of unanimous acceptance. Proponents of the use of depreciated original cost argue that such a measure has advantages of administrative efficiency and certainty over the inherently more speculative and hypothetical measures of trended cost or reproduction or replacement value. In addition, it is noted that Hope establishes a utility's Constitutional right to no more (and no less) than a fair return on depreciated original cost. Finally, a conceptual or philosophical objection to the use of some measures of current value for ratemaking purposes is frequently expressed. Briefly, it is argued that the use of market value or capitalized earnings as a measure of the value of utility property would be inherently circular inasmuch as such measures are inextricably linked to and even determined by the allowed revenues -- the calculation of which is the object of the inquiry.

[F]air value is the end product of the process of ratemaking not the starting point . . . . the heart of the matter is that rates cannot be made to depend on "fair value" when the value of the going enterprise depends on earnings under whatever rates may be anticipated.

Hope Natural Gas, 320 U.S. at 601.

This objection loses much of its force when, as is the current practice, original cost values trended with reference to standard indices are used to evidence current value and when, as is also largely the rule today in fair value jurisdictions, measures of current value are only partially recognized as but one of many factors including unadjusted measures of historical cost.

[ 72 Pa. Commw. Page 339]

Critics of the prudent investment or original cost conception today argue primarily that nearly forty years of unremitting inflation have undermined the economic assumptions upon which the conception is based. State regulators are clearly free, it is noted, to exceed the Constitutional compensatory minimum and ought now to do so by recognizing systematic changes in the value of property in order to maintain the financial integrity and viability of the public enterprises. Furthermore, it is argued that the concept of fair value as it has developed gives only partial and incomplete recognition to current value and, therefore, provides needed regulatory flexibility to respond to volatile rates of inflation. Professor Priest expresses his considered opinion as to the necessary eventual resolution of the debate in these terms:

The fair value principle will live . . . and either Congress or the Supreme Court will recognize [it], almost perforce, if the inflation spiral continues toward the zenith. That process of recognition will accelerate as it is discovered that an industry whose prices are determined on the basis of original cost accounting cannot attract on reasonable terms the equity capital required for extensions and additions. And prolonged delay could have a seriously adverse effect on the public interest.

[ 72 Pa. Commw. Page 505]

II A. Priest, Principles of Public Utility Regulation, Page 505 (1969).

Another commentator, after establishing the basis for his assertion that "[u]tilities, like other concerns whose capital is chiefly composed of fixed facilities, have experienced [an] increase in construction costs substantially in excess of the increase in price levels

[ 72 Pa. Commw. Page 340]

    for goods in general," makes a case for the use of a fair market ...

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