pioneer-natural-resources-usa-inc-cap-rock-energy-corporation-v-public ( 2009 )

TEXAS COURT OF APPEALS, THIRD DISTRICT, AT AUSTIN
NO. 03-07-00730-CV
Appellant, Pioneer Natural Resources USA, Inc. // Cross-Appellant,
Cap Rock Energy Corporation
v.
Appellees, Public Utility Commission of Texas and Cap Rock Energy Corporation
// Cross-Appellees, Public Utility Commission of Texas and
Pioneer Natural Resources USA, Inc.
FROM THE DISTRICT COURT OF TRAVIS COUNTY, 250TH JUDICIAL DISTRICT
NO. D-1-GN-06-000282, HONORABLE STEPHEN YELENOSKY, JUDGE PRESIDING
OPINION
This case is an administrative appeal of a rate order of the Public Utility Commission
of Texas that set the rates of Cap Rock Energy Corporation, an electric utility. The district court
affirmed the final order of the Commission. Pioneer Natural Resources USA, Inc., an intervenor in
the administrative case before the Commission, appeals the judgment, asserting that the Commission
erred by including 35% of the cost of a computer system in Cap Rock’s rates, by approving a
capital structure of 75% debt and 25% equity, by adopting a rate of return on equity of 11.75%,
and by approving the reimbursement of certain rate case expenses. Cap Rock also argues that the
Commission erred by imposing a per-kilowatt discount for a certain sub-class of Cap Rock’s
customers. The district court affirmed the Commission’s final order. We affirm the judgment of the
district court.
Factual and Procedural Background
Cap Rock has provided electric service to consumers in northern and western Texas
for many years. Cap Rock operated as an electric cooperative and as an investor-owned utility. In
2003, due to amendments to the Public Utility Regulatory Act (PURA), Cap Rock became subject
to the rate-setting jurisdiction of the Commission. See Act of May 16, 2003, 78th Leg., R.S.,
ch. 1327, 2003 Tex. Gen. Laws 5010, 5010.
On October 24, 2003, Commission Staff filed a petition inquiring into Cap Rock’s
electric utility rates and services. After the Staff ordered Cap Rock to submit a full rate-filing
package, Cap Rock filed a statement of intent with the Commission seeking to change its
rate schedules such that its rates would increase. Electric utility rates are established through a
regulatory process with a goal of permitting the utility “a reasonable opportunity to earn a reasonable
return.” See Tex. Util. Code Ann. § 36.051 (West 2007). In this process, the Commission must
quantify the utility’s invested capital used and useful in providing service to the public, the
appropriate rate of return on that invested capital, and the utility’s reasonable and necessary
operating expenses:
In establishing an electric utility’s rates, the regulatory authority shall establish the
utility’s overall revenues at an amount that will permit the utility a reasonable
opportunity to earn a reasonable return on the utility’s invested capital used and
useful in providing service to the public in excess of the utility’s reasonable and
necessary operating expenses.
Id.; see also id. § 36.052 (West 2007) (establishing reasonable return), § 36.053 (West 2007)
(components of invested capital), § 36.057(c) (West 2007) (authorizing rulemaking regarding
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allowable expenses). The Commission referred the Cap Rock contested case to the State Office of
Administrative Hearings (SOAH) on February 26, 2004.
Pioneer filed a motion to intervene in the proceeding, asserting that it was an
independent oil and gas producer with production facilities in Cap Rock’s service area, it was a
customer of Cap Rock, and it purchased large quantities of electric power and energy under several
of Cap Rock’s rate classifications. In March 2004, Pioneer was granted leave to intervene. The
SOAH administrative law judges issued their proposal for decision on March 16, 2005. The
Commission then issued its final order on November 10, 2005, adopting the proposal for decision
with some modifications, and approving rates to be charged by Cap Rock.
Both Pioneer and Cap Rock filed suit in district court in January 2006, appealing
portions of the Commission’s order. See id. § 15.001 (West 2007). The cases were consolidated.
On November 16, 2007, the district court affirmed the Commission’s final order in all respects.
Pioneer and Cap Rock separately appeal the judgment of the district court.
Standard of Review
This appeal concerns the propriety of the Commission’s order, including its findings
and conclusions. When reviewing these types of determinations, we employ the substantial-evidence
standard to ascertain whether the Commission’s actions are adequately supported by the
evidence presented. See id. (substantial-evidence standard applies to judicial review of
Commission’s proceedings); Tex. Gov’t Code Ann. § 2001.174 (West 2008) (allowing court to
reverse agency determination if not reasonably supported by substantial evidence).
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Under this standard, we are prohibited from substituting our judgment for the
Commission’s “as to the weight of the evidence on questions committed to agency discretion.”
Cities of Abilene v. Public Util. Comm’n, 146 S.W.3d 742, 748 (Tex. App.—Austin 2004, no pet.).
The Commission “is the sole judge of the weight to be accorded the testimony of each witness,”
Central Power & Light Co. v. Public Util. Comm’n, 36 S.W.3d 547, 561 (Tex. App.—Austin 2000,
pet. denied), and “may accept or reject in whole or in part the testimony of the various witnesses who
testify,” Cities of Corpus Christi v. Public Util. Comm’n, 188 S.W.3d 681, 695 (Tex. App.—Austin
2005, pet. denied). We are not asked to determine whether the agency reached the correct
conclusion, but whether some reasonable basis exists in the record for the agency’s action. See id.
In fact, even if the evidence actually preponderates against the Commission’s finding, that finding
may be upheld as long as there is enough evidence to suggest that the Commission’s determination
was within the bounds of reasonableness. Id. We will sustain the Commission’s order if the
evidence is such that reasonable minds could have reached the conclusion that the Commission must
have reached in order to justify its action. Texas Health Facilities Comm’n v. Charter Med.-Dallas,
Inc., 665 S.W.2d 446, 453 (Tex. 1984).
Pioneer’s Points on Appeal
Pioneer appeals the following components of the Commission’s final order approving
Cap Rock’s rates: (1) inclusion of 35% of the cost of a partially installed computer system in
Cap Rock’s rates; (2) adoption of a capital structure of 75% debt and 25% equity; (3) adoption of
an 11.75% rate of return on equity; and (4) reimbursement of expenses incurred by Cap Rock in
connection with two of its witnesses in the rate case.
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Computer System Costs
Pioneer asserts that the Commission erred by allowing Cap Rock to recover 35%
of the cost of its purchased computer system in its rates. Pioneer contends that none of the system’s
cost should have been included as costs in setting Cap Rock’s rates.
Cap Rock purchased a fully outsourced information technology (IT) system for
accounting and customer billing, consisting of software, hardware, installation, maintenance, and
ongoing operational services. The system was purchased from Delinea Corporation, and the various
IT functions were also outsourced to Delinea. In the administrative proceeding, Cap Rock sought
to include in its rate base and cost of service approximately $3.1 million in payments for the system,
$870,000 in amortization expenses, and $1.6 million in annual operation and maintenance expenses.
In its order, the Commission determined that the IT system was “necessary to system reliability and
the ability to operate in the complex electric marketplace,” that outsourcing was an acceptable
approach for Cap Rock to meet its IT requirements, and that 35% of the system’s cost was
reasonable and necessary.
First, Pioneer argues that the purchase of the IT system was not “reasonable and
necessary” and the purchased system “used and useful” and, therefore, that no portion of the system’s
cost should be included in Cap Rock’s rates. Pioneer contends that the system is “massively
oversized” for Cap Rock’s current ratepayers and was only acquired to support “highly speculative”
future growth. An asset is “used and useful” if it is acquired in good faith and held for use in the
reasonably near future in order to enable the utility to supply and furnish adequate and uninterrupted
service. See Cities for Fair Utility Rates v. Public Util. Comm’n, 924 S.W.2d 933, 935 (Tex. 1996).
5
A Pioneer witness testified that an investment of the magnitude of the IT system
in question was “extreme and excessive” for a utility the size of Cap Rock. A Cap Rock witness
defended the size based on the company’s plans to quadruple in size over the next four years, and
alleged that the IT system would handle both Cap Rock’s current IT needs and its future needs upon
such a rapid expansion. There was also testimony, however, that such growth was speculative, as
well as testimony from a Pioneer witness to the effect that the system would be oversized even if
Cap Rock quadrupled in size.
In response to testimony questioning the reasonableness of the IT system’s cost as
well as the need for the system, a Cap Rock witness testified that a new IT system was required in
connection with Cap Rock becoming an investor-owned utility. Regarding the system’s cost, another
Cap Rock witness testified that the new IT system was obtained for a “very reasonable and very
competitive price,” that when taking the entirety of the IT system into account the cost was
comparable to that paid by similarly sized utilities, and that the annual charges will be less than the
average investor-owned utility spends for in-house IT services. In addition, the Cap Rock witness
testified that the system would not be rendered obsolete over time because Delinea was responsible
to keep software versions current, and that the system would be flexible enough to be modified in the
event Cap Rock entered the Texas deregulated market. According to Cap Rock, the future expansion
contemplated by Cap Rock did not result in an increase in the price Cap Rock paid for the system.
Faced with this conflicting evidence, it was the Commission’s responsibility to evaluate and
determine the weight and credibility to give the evidence. See Texas State Bd. of Med. Exam’rs
v. Scheffey, 949 S.W.2d 431, 437 (Tex. App.—Austin 1997, writ denied).
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Pioneer also argues that the IT system was not prudently investigated because
Cap Rock engaged Delinea to present bids and options for acquiring an IT system and then, after
selecting the system, outsourced its operation to Delinea. We find no evidence in the record that
Cap Rock’s engaging Delinea both to research the types of IT systems that were available and to
install and maintain the selected IT system actually selected amounted to some sort of a conflict of
interest. We conclude that the Commission’s determination that the IT system was “reasonable and
necessary” and “used and useful”—at least in part—is supported by substantial evidence.
Even if Cap Rock’s purchase of the IT system was reasonable and necessary, Pioneer
argues that the 35% multiplier employed by the Commission—representing the portion of the system
that was used and useful as to Cap Rock—is not supported by substantial evidence, and that as a
result zero percent of the system’s cost should instead be included in Cap Rock’s rates.
The 35% multiplier actually is the product of two components: (1) a 70% figure
attributable to the accounting treatment of the computer system cost; and (2) a 50% figure
attributable to the portion of the computer system that was operational during the test year. Pioneer
complains that no single witness or party explicitly proposed a 35% multiplier, or supported both
the 70% figure and the 50% figure. However, even when no evidence suggests a specific figure
explicitly, the Commission may infer the figure if it is supported by the body of evidence as to that
issue. See Public Util. Comm’n v. GTE-SW, 833 S.W.2d 153, 159 (Tex. App.—Austin 1992), aff’d
in part, rev’d in part, 901 S.W.2d 401 (Tex. 1995). Moreover, the Commission may “accept or
reject in whole or in part the testimony of the various witnesses who testify.” Cities of Corpus
Christi, 188 S.W.3d at 695 (emphasis added). Separate witnesses testified regarding the 70% figure
7
and the 50% figure, and the Commission was entitled to accept both figures, regardless of whether
there was any one witness who testified to both.
Pioneer contends that the 70% apportionment figure is not supported by substantial
evidence. We disagree. Cap Rock indicated that both its regulated and non-regulated operations
would be using the IT system. Cap Rock’s accounting records demonstrated that 30% of Cap Rock’s
IT system costs had been allocated during the test year to Cap Rock’s non-regulated transmission
provider, NewCorp Resources Electric Cooperative, Inc. There was no other allocation percentage
in the record. While it is true that a Staff witness indicated his suspicion that NewCorp’s share
might be larger, that witness conceded that the 30% figure could be employed as a “minimum.” As
a result, the Commission determined that only 70% of the cost of the IT system was eligible to be
placed into Cap Rock’s rate base.
Pioneer also disputes the 50% component of the IT system allowance. A Cap Rock
witness testified that two software modules—general ledger and accounts payable—were installed
and running during the test year, but that the other modules were still in the process of being
installed. Both Staff and Cap Rock witnesses indicated that the installation of the two modules
resulted in the system being 50% installed. As a result, the Commission determined that only 50%
of the system was “used and useful.”
Pioneer argues that the Commission’s determination was arbitrary because there
was no evidence that the installed 50% of the system equated to 50% of the system’s cost. However,
there was testimony to the effect that the system was purchased as a suite of applications and
that there was no separate cost as to each module. Moreover, there is no indication in the record
8
that the price of the total system could have been priced in accordance with the separate modules.
We decline to hold that absent evidence of per-module costs, the Commission was barred from
authorizing reimbursement for modules that were found used and useful. The Commission has
the discretion to determine the weight to be attributed to undisputed facts and the inferences to be
drawn from those facts. See Cities of Port Arthur v. Railroad Comm’n, 886 S.W.2d 266, 270
(Tex. App.—Austin 1994, no writ). Our focus is on the reasonableness of the decision. We are not
to set aside the Commission’s chosen inference merely because we might believe another inference
is more reasonable. See id.
Pioneer argues that the dual inference rule applies. The Texas Supreme Court has
held that when circumstances are consistent with either of two facts and nothing shows that one
is more probable than the other, neither fact can be inferred. Litton Indus. Prods., Inc. v. Gammage,
668 S.W.2d 319, 324 (Tex. 1984). However, this rule applies when the evidence giving rise to
two separate facts is “meager circumstantial evidence,” which by itself is no more than a scintilla.
See id. In this case, there was sufficient evidence that the system was purchased as a package and
that 50% of the system had been installed. The Commission, as the fact-finder, was entitled to make
the inference that 50% of the system’s cost could reasonably be included in Cap Rock’s rates.
Pioneer also argues that the Commission cannot rely on its own expertise, citing
Railroad Commission v. Lone Star Gas Co., 611 S.W.2d 911, 913 (Tex. Civ. App.—Austin 1981,
writ ref’d n.r.e.). However, in Lone Star Gas, the Commission admitted that its use of a formula was
“not supported by any evidence” in the record, and therefore its determination was based solely on
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its own expertise. See 611 S.W.2d at 913. In contrast, in this case, there is evidence in the record
that 50% of the system was used and useful, and eligible for inclusion in Cap Rock’s rates.
Pioneer argues that the Commission, in selecting a percentage allowance, is limited
to the range of options established in the record. See Central Power & Light Co., 36 S.W.3d at 559.
According to Pioneer, when the parties present polar recommendations of zero percent and
one hundred percent, the Commission is not free to select any figure in the middle, but must select
one or the other. This might be the case if no evidence in the record supported any figure between
zero percent and one hundred percent. However, in this case, as we have discussed, both the 70%
figure and the 50% figure are supported by substantial evidence. This is not a case, then, in which
the Commission selected a figure that is outside the range of the applicable evidence, or that is
otherwise unsupported by any evidence.
We conclude that the Commission did not err by including 35% of the cost of
Cap Rock’s purchased IT system in Cap Rock’s rates.
Capital Structure
Pioneer asserts that the Commission erred by approving a hypothetical
capital structure based on 75% debt and 25% equity. A utility’s capital structure is used in
determining the utility’s rates. The percentage of debt capital and the percentage of equity
capital—i.e. common stock and preferred stock—are each figures used in the formula that
determines the appropriate rate of return, which percentage is in turn multiplied by the rate base—i.e.
the utility’s total, invested capital used and useful in providing service to the public—in order to
calculate the revenue requirement to be allocated among the customers. See Tex. Util. Code Ann.
10
§ 36.051. In Cap Rock’s case, a larger percentage of equity results in a higher rate of return and,
consequently, higher rates.
According to a Cap Rock witness, Cap Rock started with a 96/4 debt-to-equity ratio,
which existed due to cooperatives generally being financed mainly by debt, and due to Cap Rock’s
return of cash to certain former members. As of September 30, 2003, by having profitable
operations, Cap Rock was able to reach a debt-to-equity ratio of approximately 83/17. Despite its
actual capital structure of 83/17, however, Cap Rock proposed that a 60/40 capital structure be used
in setting its rates, so that it might be able to in fact obtain such a structure.
Commission Staff recommended against using a hypothetical capital structure,
arguing that Cap Rock’s proposed 60/40 capital structure would result in a windfall funded through
excessive rates charged to ratepayers, and that Cap Rock has neither sufficient equity for a 40% level
in its capital structure nor the ability to raise additional equity. According to a Staff witness,
Cap Rock did not adequately prepare its capital structure for its conversion to an investor owned
utility, and its 83/17 debt-to-equity ratio was its own fault. Also, according to another witness, as
a cooperative Cap Rock had experienced operating losses associated with three acquisition attempts
in unrelated fields that failed for various reasons. While agreeing that a 60/40 ratio was an
appropriate goal, the witness argued that the hypothetical ratio would result in higher retail rates
despite Cap Rock’s assertions during its conversion that rates would not increase as a result of
the conversion. These witnesses agreed that the Commission should use Cap Rock’s actual
capital structure of 83/17 in setting Cap Rock’s rates.
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In response, the Cap Rock witness testified that Cap Rock has had to delay activities
associated with restructuring its balance sheet because its regulatory uncertainty has adversely
affected its ability to access additional equity. Cap Rock proposed a capital structure of 60% debt
and 40% equity in order to strengthen its financial position and increase its access to funds.
Cap Rock insisted that by using such a hypothetical capital structure in its rate-setting, it could
achieve such a ratio in reality, because access to the equity market would follow from Cap Rock’s
use of the proceeds—obtained from the increased rates—to pay down its long term debt and to
distribute annual dividends to both new and old shareholders. According to the Cap Rock witness,
the requested rate increase could enable Cap Rock to achieve a 61/39 debt-to-equity ratio after only
three years.
The Commission agreed with Staff that a 60/40 capital structure would give
Cap Rock an excessive rate of return and would likely disproportionately benefit the same
management team that had guided Cap Rock through significant losses due to the conversion process
and failed business ventures. However, the Commission also agreed with Cap Rock that migrating
toward a more balanced capital structure and retiring a portion of the company’s debt would be
prudent, and that applying a higher percentage of equity would help accomplish these goals. The
Commission determined that a capital structure of 75% debt and 25% equity would be appropriate
to allow Cap Rock to proceed in a “stepwise fashion,” but required Cap Rock to apply all additional
return resulting from the use of the hypothetical capital structure to retire debt. According to the
Commission, failure to so apply the additional return would be viewed as “not only a violation of
this Order, but also reflective of the quality of the utility’s management.”
12
Pioneer argues that the Commission is without authority to approve a capital structure
that is hypothetical rather than actual. According to Pioneer, once the Commission is able to
determine the utility’s actual capital structure, it has no discretion to use another capital structure in
the applicable rate-setting formula.
Pioneer cites utilities code section 36.051, which permits the utility the opportunity
to “earn a reasonable return on the utility’s invested capital used and useful in providing service to
the public.” Id. Pioneer contends that the term “invested capital” indicates that the allowable return
must be based on the utility’s actual capitalization, not a hypothetical capitalization. However,
the Commission applied the debt and equity percentages in calculating the rate of return, not the
“invested capital,” which refers to the total amount of capital, both debt and equity. See 16 Tex.
Admin. Code § 25.231(c)(2) (2009). The “rate of return” is multiplied by the “invested capital” to
obtain the “return on invested capital.” See id. § 25.231(c). Consequently, section 36.051’s
language does not prohibit the Commission from employing a hypothetical capital structure in setting
the appropriate rate of return.
Pioneer contends that PUC Substantive Rule 25.231(c)(1)(C) requires the
Commission to use the utility’s actual cost of capital because it defines “cost of capital” as “the
weighted average of the costs of the various classes of capital used by the electric utility.” Id.
§ 25.231(c)(1)(C); see also Railroad Comm’n v. Entex, Inc., 599 S.W.2d 292, 295 (Tex. 1980) (cost
of capital is ratio of the two types of financing—debt and equity). However, the rule requires only
that the Commission “shall consider the electric utility’s cost of capital.” 16 Tex. Admin. Code
§ 25.231(c)(1)(C) (emphasis added). The rule does not prohibit the Commission’s departure from
13
the actual cost of capital. Pioneer does not dispute that the Commission did consider Cap Rock’s
actual capital structure.
Pioneer also relies on Railroad Commission v. Entex, Inc., in which the supreme court
stated, while addressing the Railroad Commission of Texas’s rate-making, “The Public Utility
Commission has adopted substantive rules which weight the type of debt based on a utility’s actual
capital structure.” 599 S.W.2d at 295. We decline to hold that such an observation in dicta requires
the Commission to use an electric utility’s “actual capital structure,” particularly given the absence
of any statute or regulation expressly requiring the Commission to use the utility’s actual
capital structure in setting rates. We note that elsewhere in Entex the supreme court recognized that
when an entity’s rate base is inflated due to inflation or deflated due to recession, the administrative
agency has the discretion to manipulate the rate of return in order to counteract those circumstances.
See id. at 294.
Indeed, this Court has affirmed the Commission’s use of figures other than those
actually computed from a utility’s current balance sheet to determine the cost of capital. In Public
Utility Commission v. GTE-SW, although the record contained the actual costs of debt and equity,
the Commission had applied a weighted cost so as to estimate a rate that would be sufficient for
the utility to attract new capital. See GTE-SW, 833 S.W.2d at 157. The hypothetical cost of capital
was employed because the actual cost of capital would not obtain the “reasonable return” required
by statute. See id. at 158. This Court held that such a method was neither required nor prohibited
by statute or regulation, and that the Commission did not abuse its discretion. See id. We again
conclude that the Commission is not prohibited by statute or regulation from employing a
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hypothetical capital structure when the use of such a hypothetical structure is supported by
substantial evidence.
Pioneer next argues that the Commission’s selected capital structure of 75% debt and
25% equity is not supported by substantial evidence. Pioneer contends that the Commission cannot
apply a capital structure that no single witness or party explicitly proposed. Again, however, even
when no evidence suggests a specific figure explicitly, the Commission may infer the figure if it is
supported by some evidence in the record. See id. at 159. There was evidence that the actual 83/17
capital structure would be damaging to Cap Rock without increasing the percentage of equity, and
that the proposed 60/40 capital structure would be damaging to ratepayers without decreasing
the percentage of equity. Therefore, the evidence established a range within which an appropriate
capital structure could be selected. Contrary to Pioneer’s contention, we do not require that the
record contain an explicit recognition by a particular witness or exhibit that a range of reasonable
options exists in order for such a range to exist. While the parties may have argued for specific
endpoints, the evidence presented in favor of and against each endpoint was such as would allow for
a hypothetical capital structure to be selected between those endpoints. See City of El Paso v. Public
Util. Comm’n, 883 S.W.2d 179, 185-86 (Tex. 1994) (for admittedly complex matter, where one
expert testifies to zero percent, and another to 50%, Commission could “select an amount within the
range of figures”); GTE-SW, 833 S.W.2d at 158 (not abuse of discretion for Commission to make
finding of 11.99% when expert witnesses separately testified to percentages of 10.54, 10.85, 12.1,
15
and 15). We conclude that the Commission’s selecting a 75/25 capital structure was supported by
substantial evidence.1
Pioneer argues that, having found that the use of a 60/40 capital structure artificially
skewed in favor of equity allowed Cap Rock to earn an inflated return, the Commission was thereby
barred from using a 75/25 structure that would produce the same effect. Pioneer also argues that the
75/25 structure unreasonably rewarded Cap Rock for its mismanagement. In fact, the Commission
in its Order recognized it typically refuses to increase a utility’s rates to protect the utility’s financial
integrity when such adjustment could reward inefficiency and imprudence, and the Commission
noted that Cap Rock’s ratepayers should not be required to reward Cap Rock for its pursuit of its
“unreasonable expansion dreams.”
However, in setting rates that are not excessive, the Commission is entitled to take
into consideration the financial integrity of the utility. See Entex, 599 S.W.2d at 296; 16 Tex.
Admin. Code § 25.231(c)(1)(A). There was evidence that while a 60/40 structure resulted in an
inflated return, the actual 83/17 structure would not assure Cap Rock’s financial integrity and access
to capital. There was, therefore, evidence by which the Commission could conclude that the
appropriate course was to balance the competing considerations and select percentages between the
two proffered endpoints. In this regard, we note that the selected 75/25 structure is closer to the
1
Pioneer asserts that there was no evidence that established that “a 75/25 structure was
more correct than a 77/23 structure, a 79/21 structure, or an 81/19 structure.” However, our inquiry
is not whether the evidence establishes that the capital structure selected was the best option
available. To the contrary, the record evidence may preponderate against the agency’s decision
and yet still provide a reasonable basis for the decision and, therefore, satisfy the substantial evidence
standard. See Cities of Corpus Christi v. Public Util. Comm’n, 188 S.W.3d 681, 695
(Tex. App.—Austin 2005, pet. denied).
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actual structure than to Cap Rock’s requested structure. Moreover, along with setting a 75/25
structure between the endpoints, the Commission expressly required Cap Rock to use the
entire amount of additional return afforded by the hypothetical 75/25 structure to retire debt. The
Commission stated that without such requirement, it would not have approved a hypothetical
structure in this case. Given, then, that the increased rates resulting from using a hypothetical
structure between Cap Rock’s actual structure and its desired structure are not to be paid to
Cap Rock’s management team, but must be applied toward making Cap Rock more financially
sound, we find the Commission’s determination that the 75/25 capital structure would not allow
Cap Rock to earn an inflated return or reward Cap Rock’s mismanagement to be supported by
substantial evidence.
We conclude that the Commission did not err by approving a hypothetical
capital structure consisting of 75% debt and 25% equity for Cap Rock. The Commission’s selection
of a 75/25 capital structure was based on substantial evidence, was not arbitrary and capricious, and
was not an abuse of discretion.
Rate of Return on Equity
Pioneer asserts that the Commission erred by approving an 11.75% rate of return on
equity. The use of a rate of return on equity greater than the 9.5% rate recommended by Pioneer2
2
Pioneer’s recommendation consisted of a 10% rate of return reduced by one-half percent
to penalize Cap Rock for its imprudent management. Pioneer argues on appeal that its proposed rate
of return was supported by the evidence and should have been approved by the Commission.
However, our inquiry is not whether any rejected rate of return could have been reasonably selected,
but whether the approved rate of return was reasonably selected. See Tex. Gov’t Code Ann.
§ 2001.174 (West 2008); Cities of Corpus Christi, 188 S.W.3d at 695 (test is whether reasonable
basis for agency’s action exists in record, not whether correct conclusion reached).
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resulted in a higher overall rate of return and, consequently, higher rates assessed to Cap Rock’s
ratepayers.
The Commission in its Order determined that the return on equity should include
“a risk adjustment, because of Cap Rock’s more tenuous financial situation, to approximate
what comparable equity investments would earn.” A Staff witness had recommended a “credit-risk
premium,” alleging that it was necessary to reflect the higher return that investors would require to
make an investment in Cap Rock. According to the witness, his methods for calculating Cap Rock’s
return on equity were well-established methods on which the Commission has often relied, and his
use of a premium was also well-established and had been previously relied on by the Commission,
although less frequently. After describing in detail his analysis, the witness recommended a
premium in the range of 2.0% to 2.4%, and ultimately a return on equity of 11.75%.3 Elsewhere
in his testimony, the Staff witness described some of the mismanagement that contributed to
Cap Rock’s financial condition and, as a result, greater difficulty in attracting investors. The
Commission recognized in its findings of fact that Cap Rock’s quality of management had been
“poor,” listing as evidence significant financial losses due to failed business ventures and
aggressively pursued acquisitions with little relationship to Cap Rock’s core business, and large
bonuses paid to Cap Rock’s executives during years in which its financial condition was
deteriorating.
3
Cap Rock also recommended a return on equity of 11.75%, to enable it to “attract capital
on reasonable terms.”
18
Pioneer contends that because the need for a risk adjustment in calculating the
appropriate return on equity was a result of Cap Rock’s mismanagement, the Commission was
prohibited from approving the risk adjustment. Pioneer contends that, in Cap Rock’s case, a risk
adjustment would be nothing more than a reward for Cap Rock’s past mismanagement.
Pioneer relies on the following language from the supreme court’s opinion in Entex:
The return should be reasonably sufficient to assure confidence in the financial
soundness of the utility, and should be adequate, under efficient and economical
management, to maintain and support its credit and enable it to raise the money
necessary for the proper discharge of its public duties.
Entex, 599 S.W.2d at 295-96 (quoting Bluefield Waterworks & Improvement Co. v. Public Serv.
Comm’n, 262 U.S. 679, 693 (1923)) (emphasis added). Pioneer contends that this language prohibits
the Commission from increasing the return on equity when such an increase ultimately results from
the utility’s inefficient or uneconomical management, because such a return would be unreasonable.
We disagree. The above language refers to management subsequent to the rate-setting procedure,
during the period in which the rates apply. It provides no guidance for a situation in which
inefficient or uneconomical management occurred in the past.
Pioneer also relies on utilities code section 36.052, which provides as follows:
In establishing a reasonable return on invested capital, the regulatory authority shall
consider applicable factors, including:
(1) the efforts and achievements of the utility in conserving resources;
(2) the quality of the utility’s services;
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(3) the efficiency of the utility’s operations; and
(4) the quality of the utility’s management.
Tex. Util. Code Ann. § 36.052. Pioneer contends that the Commission’s failure to reduce the rate
of return on equity demonstrates that the Commission failed to consider the factors required by
section 36.052. However, this Court has already considered the Commission’s responsibility when
faced with managerial imprudence, and held as follows:
While the statute instructs the Commission to consider the quality of the utility’s
management, it does not require that the Commission lower the return on
common equity if it finds any imprudence. We understand the statute to leave to the
Commission’s discretion the decision whether the utility’s management warrants a
reduction in the overall rate of return.
Texas Utils. Elec. Co. v. Public Util. Comm’n, 881 S.W.2d 387, 417 (Tex. App.—Austin 1994),
aff’d in part, rev’d in part, 935 S.W.2d 109 (Tex. 1997).
The Commission had discretion regarding how to adjust the rates in response to
Cap Rock’s mismanagement, and whether such adjustment would impact the rate-of-return-on-
equity component of the rate-setting. See id. In fact, the Commission did adjust Cap Rock’s rates in
response to the evidence of mismanagement in the record. As previously discussed, the Commission
rejected Cap Rock’s proposed capital structure of 60/40 so as not to reward Cap Rock for its
mismanagement. In addition, the Commission rejected Cap Rock’s attempt to include various
expenses in its rates based on their unreasonableness, limited the amount of reimbursable costs for
Cap Rock’s executive officers, and provided that an independent “management audit” be undertaken
by Cap Rock. As for the credit risk premium applied to the rate of return on equity, according to
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the record its purpose was to ensure that the final rate of return was comparable to rates of return
for companies with below-investment-grade ratings similar to Cap Rock’s and, in turn, to increase
Cap Rock’s ability to attract investors. See Entex, 599 S.W.2d at 296 (“return to the equity owner
should be commensurate with returns on investments in other enterprises having corresponding
risks” (quoting Federal Power Comm’n v. Hope Natural Gas Co., 320 U.S. 591, 603 (1944))).
We conclude that the Commission did not err by approving a rate of return on equity
of 11.75%. The Commission did not act unreasonably by approving a rate of return on equity that
included a credit risk premium and that excluded any penalty for past mismanagement.
Rate Case Expenses
The Commission allowed Cap Rock to recover approximately $2.5 million in
rate case expenses incurred in preparing and presenting its rate case. Pioneer asserts that the
Commission erred by approving those rate case expenses incurred for the work of two of Cap Rock’s
rate consultants—Larry Crowley and Dr. Stephen Gaske.
The utilities code provides that the Commission include in a utility’s rates its
reasonable and necessary operating expenses, which may include reasonable costs of the utility’s
participating in the rate-making proceeding. See Tex. Util. Code Ann. §§ 36.051, .061(b)(2)
(West 2007). If, then, the Commission determines that a utility failed to prove the reasonableness
of certain expenses incurred during the rate-making proceeding, the Commission may deny
reimbursement of those rate case expenses. See, e.g., City of Port Neches v. Railroad Comm’n,
212 S.W.3d 565, 581 & n.15 (Tex. App.—Austin 2006, no pet.); City of Amarillo v. Railroad
Comm’n, 894 S.W.2d 491, 496-97 (Tex. App.—Austin 1995, writ denied). According to Pioneer,
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the errors made by Crowley and Gaske were so unacceptably poor and prevalent that it was arbitrary
and capricious and an abuse of discretion for the Commission to have charged the ratepayers for
those consultants’ expenses.
The Commission approved inclusion of $215,857 in fees and expenses related to
Cap Rock witness Crowley’s work, along with subsequent costs incurred by other witnesses to
correct his work. Crowley was Cap Rock’s initial revenue-requirements witness, and he prepared
a significant portion of the rate-filing package. After withdrawing as a witness for family reasons,
Crowley was replaced by two other witnesses who made numerous corrections to Crowley’s work.
As a result of those corrections, Cap Rock’s request for a rate increase was reduced approximately
from $10 million to $5 million. According to Pioneer, a significant portion of the replacement
witnesses’ work and testimony was dedicated to revising and correcting Crowley’s work and
explaining the reasons for such corrections.
While Pioneer is correct that the two witnesses who replaced Crowley made several
corrections to his work, one of those witnesses, Gerald Tucker, testified to the value of Crowley’s
work. According to Tucker, although he had to make some “number changes” within the model
created by Crowley, such “cost service model” was a “big part” of Crowley’s work, was made by
Crowley “from scratch,” was not modified by Tucker or the other replacement witness, and worked
very well as to Cap Rock’s rate-filing package. Moreover, according to Tucker, his changes made
to the numbers within the model were “not a major redo” and did not result in Crowley’s earlier time
spent on the model being a waste. Tucker testified that Crowley’s work allowed him to prepare his
rebuttal testimony more quickly, and stated that he was “impressed” Crowley had been able to
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perform his work within the time frame he had been given. The Commission has broad discretion
to determine recovery of expenses in a rate-making proceeding. See City of El Paso v. Public Util.
Comm’n, 916 S.W.2d 515, 522 (Tex. App.—Austin 1995), appeal dism’d by agr., 1996 Tex. App.
LEXIS 1010 (Tex. App.—Austin Mar. 13, 1996). As to evidence presented about the reasonableness
and necessity of rate case expenses, the agency is the sole judge of the weight of the evidence and
the credibility of the witnesses. See City of Port Neches, 212 S.W.3d at 579-80. Tucker’s testimony
regarding the value of Crowley’s work was sufficient to support the Commission’s determination
that the expenses incurred during the rate-making proceeding in connection with Crowley’s work
were reasonable.
The Commission also approved inclusion of $689,374 in rate case expenses
associated with the work of Cap Rock’s rate-design consultant Gaske. The SOAH administrative
law judges had concluded in their proposal for decision that Gaske’s work was “so flawed and
unreliable as to be useless for structuring rates in this case.” According to the administrative law
judges, Gaske’s initial presentation required numerous, significant changes, such that the intervenors
had to spend significant, additional resources to address the revisions. In its final order, the
Commission also rejected the rate design offered by Cap Rock based on Gaske’s work. However,
while acknowledging that there were “major problems” with Cap Rock’s rate design, the
Commission in its final order recognized the “many difficulties” arising from Cap Rock’s producing
the rate design in its first rate case “essentially from scratch,” and reversed the administrative law
judges’ recommendation to disallow Gaske’s rate-design expenses.
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The Commission has broad discretion to determine recovery of expenses in a rate-
making proceeding, see City of El Paso, 916 S.W.2d at 522, and may reverse the recommendation
of administrative law judges on an issue, see Tex. Gov’t Code Ann. § 2003.049(g) (West 2008). The
Commission was entitled to take into consideration the facts that Cap Rock’s rates had not been
regulated by the Commission for a substantial period of time and, therefore, that Cap Rock had
to create much of its rate-filing package from scratch. See City of El Paso, 916 S.W.2d at 522
(acknowledging that nature and complexity of case may be factor to be considered as to
reasonableness of expenses). Therefore, even though Gaske’s recommendation was not adopted, it
was within the Commission’s discretion to determine that his work was not useless and that
Cap Rock did not act unreasonably in incurring expenses in connection with his work.
We conclude that the Commission did not err by approving those rate case expenses
incurred by Cap Rock in connection with the work performed by its rate consultants Crowley and
Gaske as “reasonable costs of participating in a [rate-making] proceeding.” See Tex. Util. Code
Ann. § 36.061(b)(2).
Cap Rock’s Point on Appeal
We turn to Cap Rock’s appeal. The Commission imposed a discount of $2.44
per kilowatt for commercial customers who receive service at primary voltage. In its sole point on
appeal, Cap Rock argues that the imposition of a discount was error.
The Commission allocated $1,711,714 of Cap Rock’s total annual revenue
requirement to the demand component of Cap Rock’s commercial-customer class. Also, the
Commission determined that 366,661 kilowatts was the amount of annual billed demand attributable
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to the commercial class. The Commission then assigned to each commercial class a demand charge
rate of $4.67 per kilowatt (which equals $1,711,714 divided by 366,661). Cap Rock does not dispute
these figures. However, the Commission also found it reasonable for “commercial service customers
who receive service at primary voltage” to receive a discount of $2.44 per kilowatt. Cap Rock
contends that this discount violates section 36.051 of the utilities code, which provides that a utility’s
overall revenues be set at “an amount that will permit the utility a reasonable opportunity to earn a
reasonable return.” See id. § 36.051. According to Cap Rock, in order to earn a reasonable return,
it must receive on average the full $4.67 per kilowatt from each commercial customer. Thus,
Cap Rock argues, either the discount must be eliminated, or the losses resulting from the discount
must be offset by increased rates charged to the commercial-customer class.
The discount of $2.44 per kilowatt adopted by the Commission in its final order for
commercial service customers receiving service at primary voltage was recommended by Pioneer.
During the administrative proceeding, Pioneer proposed an adjustment to Cap Rock’s rate schedules
to account for the lower costs associated with serving customers in the commercial class who owned
their own transformers and, therefore, received power at the higher transmission-grade voltage.
According to Pioneer, typically when a rate is applicable to customers receiving service at different
voltage levels, the rate is discounted for service at higher voltage levels because fewer utility-owned
facilities are needed to provide the service. Cap Rock points to nothing in the record to contradict
Pioneer’s proposal. Imposition of a $2.44-per-kilowatt discount, therefore, was supported by
substantial evidence.
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Cap Rock is correct that utilities code section 36.051 requires that the utility be given
a “reasonable opportunity to earn a reasonable return.” See id. However, we do not agree that the
imposition of the $2.44-per-kilowatt discount eliminates Cap Rock’s reasonable opportunity to earn
a reasonable return.
[T]he determination of just and reasonable utility rates is far from a precise process;
instead, ratemaking relies substantially upon informed judgment and expertise and
utilizes projections and estimates in virtually all areas. The ratemaking process is not
capable of being neatly characterized as “actual” or “hypothetical.”
Public Util. Comm’n v. GTE-Southwest, Inc., 901 S.W.2d 401, 411 (Tex. 1995). The Commission
exercised its informed judgment and expertise in determining that a $2.44-per-kilowatt discount for
a certain subclass of customers would not interfere with Cap Rock’s receiving a reasonable
opportunity to earn a reasonable return. Cap Rock has not shown that in order to receive such a
reasonable opportunity, the entire $1,711,714 assigned to the demand component of Cap Rock’s
commercial-customer class had to be received in rates. Section 36.051 addresses a utility’s overall
return, not its return from a particular class of customers. See Tex. Util. Code Ann. § 36.051. As
previously discussed, in determining the appropriate rate of return, the Commission approved a
capital structure based on 75% debt and 25% equity, which involved an artificial increase in the
equity percentage, and an 11.75% rate of return on equity, which incorporated a risk adjustment.
Each of these selected percentages resulted in a higher overall rate of return and, consequently,
higher rates assessed to Cap Rock’s ratepayers. Cap Rock fails to demonstrate that any potential loss
from the $2.44 discount would exceed the potential gains from such “hypothetical” increases to the
rate of return or from other portions of the Commission’s order not addressed in this opinion.
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In Suburban Utility Corp. v. Public Utility Commission, the Texas Supreme Court
found, on review of the record in a rate-making proceeding, that the Commission had calculated
certain expenses at $200 less than the total amount to which the utility was entitled. 652 S.W.2d
358, 364 (Tex. 1983). Nonetheless, the court held that the utility failed to show substantial prejudice
from the shortfall, and therefore, the court did not consider the error reversible. Id.; see Tex. Gov’t
Code Ann. § 2001.174(2) (administrative decision reversible if substantial rights prejudiced). In the
same way, even if we were to determine that the $2.44 discount could result in a shortfall, Cap Rock
has failed to show any prejudice from the discount. We do not read utilities code section 36.051 to
mean that the mere fact—by itself—that the individual rates assigned to customer classifications
result in a total that is less than—by some amount—the utility’s revenue requirement established by
the Commission in its discretion during the rate-making proceeding inevitably results in rates that
fail to provide the utility a “reasonable opportunity to earn a reasonable return.”
The Commission, taking the $2.44 discount into account, determined that Cap Rock
had a reasonable opportunity to earn a reasonable return. We conclude that the Commission’s
determination is supported by substantial evidence and did not violate section 36.051 of the
utilities code.
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Conclusion
Having overruled the points on appeal asserted by Pioneer and by Cap Rock, we
affirm the judgment of the district court.
__________________________________________
G. Alan Waldrop, Justice
Before Justices Patterson, Pemberton and Waldrop
Affirmed
Filed: December 31, 2009
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