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T. W. PHILLIPS GAS AND OIL CO. v. PENNSYLVANIA PUBLIC UTILITY COMMISSION (03/26/84)

decided: March 26, 1984.

T. W. PHILLIPS GAS AND OIL CO., PETITIONER
v.
PENNSYLVANIA PUBLIC UTILITY COMMISSION, RESPONDENT



Appeals from the Orders of the Pennsylvania Public Utility Commission in cases of Pennsylvania Public Utility Commission v. T. W. Phillips Gas and Oil Co., No. R-811615, dated May 27, 1982 and June 25, 1982.

COUNSEL

Anthony C. DeCusatis, with him, W. Russel Hoerner, Morgan, Lewis & Bockius, for petitioner.

Frank B. Wilmarth, Assistant Counsel, with him, Albert W. Johnson, III, Deputy Chief Counsel, and Charles F. Hoffman, Chief Counsel, for respondent.

Timothy F. Nicholson, Adler, Nicholson, Claraval & Magdule, for Amicus Curiae, Pennsylvania Gas Association.

William H. Kain, Kain, Brown and Roberts, for Amicus Curiae, Association of Water Companies, Pennsylvania Chapter.

President Judge Crumlish, Jr., and Judges Rogers, Williams, Jr., Craig, MacPhail, Doyle and Barry. Opinion by Judge Rogers.

Author: Rogers

[ 81 Pa. Commw. Page 207]

On August 28, 1981, T. W. Phillips Gas and Oil Co. (Phillips) filed with the Pennsylvania Public Utility Commission (Commission) Supplement No. 68 to its Tariff Gas-Pa. P.U.C. No. 1 and Supplement No. 38 to its Tariff Gas-Pa. P.U.C. No. 2 to become effective October 27, 1981. Supplement Nos. 68 and 38 proposed a base rate increase in annual revenues in the amount of $10,318,621 or 24.3%, based on operating results for the test year ending April 30, 1981.

Phillips is a wholly owned subsidiary of TWP INC. producing, gathering and distributing natural gas entirely within Pennsylvania. As of April 30, 1981, the end of the test year, Phillips furnished gas service to 45,264 residential customers, 3,390 commercial customers, 43 industrial customers, and 10 resale customers. Approximately 26% of its gas supply comes from its own producing gas wells.

The Commission entered an order on October 29, 1981 instituting an investigation of Phillips' existing and proposed gas rates, rules and regulations and suspending the effective date of Supplement Nos. 68 and 38 until May 27, 1982. Also complaints against the proposed rate increases were filed.

[ 81 Pa. Commw. Page 208]

From November, 1981 through February, 1982, a total of fourteen evidentiary hearings were held and on April 9, 1982 Administrative Judge Edward R. Casey presented a recommended order allowing $5,776,353 of additional annual revenues. The Commission on May 27, 1982 adopted and entered an order allowing Phillips $6,624,592 of additional annual revenues.

To our docket number 1506 C.D. 1982, Phillips appealed from the Commission's May 27, 1982 order. It states questions concerning many if not most of the major components of gas utility rates.

To our docket number 1521 C.D. 1982, Phillips appealed from an order of the Commission dated June 25, 1982 in which the Commission denied the appellant's petition that the Commission correct mathematical errors in the order of May 27, 1982.

We consolidated the appeals for argument and disposition.

Our scope of review is limited to determining whether or not constitutional rights were violated, an error of law was committed or a finding of fact was unsupported by substantial evidence. Mill v. Pennsylvania Public Utility Commission, 67 Pa. Commonwealth Ct. 597, 447 A.2d 1100 (1982). In Pennsylvania Public Utility Commission v. Pennsylvania Gas and Water Company, 19 Pa. Commonwealth Ct. 214, 220, 341 A.2d 239, 244 (1975), rev'd on other grounds, 492 Pa. 326, 424 A.2d 1213 (1980), cert. denied, 454 U.S. 824 (1981), we stated that:

[T]he appellate courts cannot conceive an independent judgment from the record, and substitute it for the judgment of the PUC. We may not indulge in the process of weighing evidence and resolving conflicts in testimony. The PUC's discretionary finding and conclusions must be accepted unless they are totally without

[ 81 Pa. Commw. Page 209]

    support in the record, are based on error of law, or are unconstitutional.

Number 1506 C.D. 1982

I. Rate of Return

The Commission found that Phillips should be allowed a rate of return of 12.83% on the fair value of its property. In calculating the rate of return, the Commission used a hypothetical capital structure composed of 55% debt and 45% common equity, 10.24% as the cost of debt and 16% as the cost of common equity.

Phillips of course contests the use of a hypothetical capital structure. It does not, however, say what the rate of return should be if the Commission's hypothetical capital structure were to be used.

Phillips contends that the cost of common equity should have been not less than 18%. It does not dispute the Commission's finding of 10.24% as the cost of debt.

A. Hypothetical Capital Structure

Phillips' expert witness, Frank J. Hanley, testified that Phillips' actual capital structure of 39.9% debt and 60.1% common equity is appropriate for a small gas utility like Phillips and should have been used by the Commission for ratemaking purposes. He stated that risks associated with integrated gas operations and the general trend in all types of gas utilities toward higher equity ratios made Phillips' actual capital structure appropriate. To support these conclusions, Hanley used the capital structures from 1976 to 1980 of three barometer groups, Eleven Small Gas Distribution Companies, Moody's Nine Gas Distribution Companies and Moody's Nine Integrated Gas Companies. He testified that although he considered all the data he "placed greatest emphasis on the data for the eleven small gas distribution companies

[ 81 Pa. Commw. Page 210]

    because they are more similar to the Company [Phillips.]" The capital structures of the three barometer groups were as follows:

1976 1977 1978

Type of Capital A B C A B C A B C

Long-Term Debt 54.5 52.2 51.0 53.7 51.0 49.1 53.4 48.5 47.3

Preferred Stock 6.8 9.6 5.1 6.8 9.7 5.2 6.4 10.2 5.3

Common Equity 38.7 38.2 43.9 39.5 39.3 45.7 40.2 41.3 47.4

1979 1980 Average

Type of Capital A B C A B C A B C

Long-Term Debt 52.2 46.2 48.6 50.1 45.4 46.3 52.8 48.6 48.5

Preferred Stock 5.8 10.5 5.0 5.3 10.3 4.9 6.2 10.1 5.1

Common Equity 42.0 43.3 46.3 44.6 44.3 48.8 41.0 41.3 46.4

All the above figures represent percentages.

A -- Eleven Small Gas Distribution Companies

B -- Moody's Nine Gas Distribution Companies

C -- Moody's Nine Integrated Gas Companies

[ 81 Pa. Commw. Page 211]

Hanley also stated that if a hypothetical capital structure were used, it should be 50% debt and 50% common equity. He based this recommendation on the capital structure of Moody's Nine Integrated Gas Companies for 1980. Hanley argued that Phillips "is easily identified as an integrated company because it has its own production facilities" and should have a higher common equity ratio than the members of Moody's Nine Integrated Gas Companies because it is smaller than they and, due to its limited marketability and liquidity, is a riskier investment.

The Trial Staff's expert, Andrew R. O'Donnell, concluded that the three barometer groups supported a hypothetical capital structure of 55% debt, 5% preferred stock, and 40% common equity. He also placed great emphasis on the data concerning the Eleven Small Gas Distribution Companies and did not consider it necessary to consider Moody's Nine Integrated Gas Companies.

Administrative Law Judge Casey found the use of a hypothetical capital structure appropriate because Phillips' actual capital structure was "out of proportion with industry trends and averages." He recommended a hypothetical capital structure "midway between that proposed by the Trial Staff and Phillips of 55 percent debt and 45 percent equity." Judge Casey did not include preferred stock as part of his recommendation because he did not find it to be a practical or realistic method of raising capital for a company the size of Phillips and because it had fallen into disuse during the last five years among the Eleven Small Gas Distribution Companies.

The Commission adopted Judge Casey's recommendation of a hypothetical capital structure composed of 55% debt and 45% common equity. It stated that a hypothetical capital structure was necessary

[ 81 Pa. Commw. Page 212]

    to determine a fair rate of return because Phillips' actual capital structure was "clearly atypical, whether compared to integrated gas companies, or distribution gas companies." The Commission found Phillips to be most comparable to the Eleven Small Gas Distribution Companies because the latter's members were closer in size to Phillips and, like Phillips, were engaged in production operations. Finally, the Commission noted that the hypothetical capital structure that it adopted for Phillips contained almost the identical percentage of common equity as the Eleven Small Gas Distribution Companies had in 1980.

In Carnegie Natural Gas Co. v. Pennsylvania Public Utility Commission, 61 Pa. Commonwealth Ct. 436, 439, 433 A.2d 938, 940 (1981), we held that "[w]here 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."

The Commission's use of a hypothetical capital structure was in accordance with the law. Its finding that Phillips' actual capital structure was "clearly atypical" and its conclusion that a hypothetical capital structure composed of 55% debt and 45% common equity was appropriate for Phillips is supported by the data on the three barometer groups and the testimony of Mr. O'Donnell.

B. Cost of Common Equity

The cost of common equity is the best estimate of what an investor would pay for a current issue of common stock. Phillips' common equity is held entirely by its parent TWP INC. The cost of common

[ 81 Pa. Commw. Page 213]

    equity is not to be found at the market; nor is there a pat formula for use in reviewing a Commission determination of the cost of Phillips' common equity. See Pennsylvania Public Utility Commission v. Pennsylvania Gas and ...


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