Appalachian Power Co. v. Commonwealth

Citations: 216 Va. 617; 221 S.E.2d 872; 1976 Va. LEXIS 175Docket: Record 750603

Court: Supreme Court of Virginia; January 16, 1976; Virginia; State Supreme Court

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The Supreme Court of Virginia, in the case of Appalachian Power Company v. Commonwealth of Virginia, addressed the appeal concerning the State Corporation Commission's order dated May 1, 1975. The Commission determined that a reasonable overall rate of return for Appalachian Power was 8.40% based on its Virginia jurisdictional rate base for the twelve-month period ending December 31, 1974, and allowed the Company to increase rates to generate an additional $19,046,756 in annual gross revenues. 

Appalachian Power had sought a larger increase of $36,196,600 to achieve a 9.65% return, which it argued was necessary for its financial viability and ability to undertake required construction. The Company also requested an interim increase of $25,012,000 to address its critical short-term debt situation. The Court found that, although the Commission's opinion was somewhat lacking in detail, it still provided a sufficient evidentiary basis for the rate of return decision. The Court upheld the Commission's exercise of legislative discretion in setting rates, noting that the established rate of return, while lower than the Company's request, fell within a reasonable range supported by evidence. 

Furthermore, the Court ruled that comparing earnings of other utilities and nonregulated companies was an appropriate method for determining reasonable rates of return. The Company's claims regarding its inability to raise capital were viewed as a reiteration of existing arguments regarding the Commission's discretion over rate setting. Overall, the judgment affirmed the Commission's findings, emphasizing its legislative role in determining fair rates for public service corporations.

The Company asserted that its interest coverage had deteriorated to a point where it could not issue further long-term debt, even with the potential success of a $40 million revenue bond sale for pollution control. It characterized short-term debt as merely interim financing and emphasized that without significant rate relief, its operations would need to be severely restricted to stay within short-term debt limits. The Company claimed it could not allow its short-term debt to exceed $150 million without guarantees for refinancing via long-term capital. It projected a short-term debt requirement of approximately $170 million by June 30, 1975, and over $300 million by the year's end, which it argued could not be fulfilled without a rate increase. The Company indicated that a denial of a substantial rate increase would force it to implement drastic cost-cutting measures, particularly affecting operating and maintenance expenses, including potential employee layoffs. In its application, the Company sought a minimum increase of $36,196,600 to maintain adequate service, acknowledging that even with this increase, interest expense coverage would remain problematic. Opposition to the application primarily came from residential customers, with some industrial users also voicing concerns. The Virginia Attorney General advocated for a reduced rate request of $20.7 million. Following hearings held in January and February 1975, the interim rate increase application was denied on February 28, 1975, with one Commissioner dissenting. The order entered on May 1, 1975, included a Commissioner’s opinion and another's concurrence, while the third Commissioner partially dissented. Appalachian Power Company, a subsidiary of American Electric Power Company, Inc. (AEP), serves 635,000 customers, primarily in Virginia and West Virginia, operates several coal-burning power plants, and is part of an interconnected electric utility system that spans multiple states. AEP’s revenues come from dividends of its subsidiaries, which also manage their preferred stock and long-term debt directly.

Knowledge of the AEP System is crucial for several reasons: it aids in determining the capital structure for rate-making, helps establish the cost of subsidiaries' debt and equity, indicates the relative strength of subsidiaries based on earnings, and clarifies overall system earnings requirements and financial needs. On appeal, there is consensus on jurisdictional separations, the Company's Virginia jurisdictional rate base of $544,825,672, and the operating revenue and expenses for the test year. The Commission determined the Company's adjusted net operating income for that year to be $36,240,378. The Company does not dispute the capital structure proportions or the costs associated with its debt and preferred stock. However, the Company challenges the Commission's determination of rates of return, raising three key questions regarding the support and rationale for these rates, the reliance on comparisons with other subsidiaries' earnings, and the potential unconstitutionality of the rates if they hinder capital attraction necessary for public duties. The court affirmed the Commission's decisions. Testimony from experts, including Herman G. Roseman and Joseph F. Brennan for the Company, and David Parcell for the Commission Staff, highlighted AEP's challenges in raising external common equity capital due to a significant drop in stock price, which was attributed to high equity costs and increased risks. Roseman expressed concern that if AEP continued to attempt to raise capital through common stock at depressed prices, it would lead to dilution of earnings per share and could jeopardize the utility's ability to finance its construction program, ultimately affecting its public service capacity.

AEP and its subsidiaries need to maintain a rate of return on common equity capital that meets or exceeds its cost to avoid significant cuts in their construction program. To achieve a market price at least ten percent above book value, earnings must be sufficiently high. Roseman estimated that AEP requires a 15.42 percent rate of return on common equity based on a statistical model analyzing 93 electric utilities' price-to-book ratios. He recommended a minimum rate of return of 9.65 percent for Appalachian.

Parcell, representing the Commission Staff, argued that regulatory bodies are not obligated to ensure utility stocks sell above book value. He emphasized that rates of return should align with overall economic earnings levels, allowing utilities to compete for capital. Parcell established a fair return range of 12-13 percent for AEP, noting that the lower end of this range reflects historical earnings in the electric utility sector and aligns with averages from comparable manufacturing firms. He determined Appalachian's fair rate of return to be around 8.75 percent, highlighting its highly leveraged capital structure. Parcell explained that while leverage can enhance returns on equity due to lower debt costs and tax-deductible interest payments, excessive leverage may limit the company's future expansion flexibility, especially as rising interest rates increase fixed expenses and hinder new equity financing options.

Parcell argued that the leverage used by Appalachian Electric Power (AEP) was a management decision that had historically benefited stockholders, questioning whether ratepayers should bear the costs of this decision without having previously shared in its benefits. In rebuttal, Brennan criticized Parcell's analysis, labeling it as circular and incomplete, asserting that ratepayers had also benefited from lower rates due to the leveraged capital structure. Brennan emphasized the importance of earnings quality in determining the appropriate rate of return and highlighted the current low investor confidence in utility stocks due to various economic factors.

The Commission's majority opinion deemed Appalachian's rate request excessive, allowing an 8.40% rate of return. A dissenting commissioner argued for a 9% return, which would provide a 13.2% return on common equity. Appalachian contended that the majority opinion did not comply with Code 12.1-39, which requires a statement of reasons for the Commission's decisions, claiming it lacked sufficient rationale. However, the majority opinion was found to have discussed various relevant factors, including AEP's structure, earnings, leverage, and rate design, despite some inadequacies in documentation. The court determined that the majority's opinion, while not detailed, still provided a basis for the Commission's decision, thus complying with the statutory requirement for a statement of reasons.

The legal sufficiency of evidence supporting the Commission's judgment on the rate of return is examined. The Commission operates under a legislative function assigned by the General Assembly to set reasonable rates for public service corporations, specifically regarding heat, light, and power. There is no definitive or scientifically correct rate of return; rather, the Commission's determination must fall within a reasonable zone of discretion. A rate set by the Commission can only be overturned if there is a clear abuse of discretion.

In this case, the Commission determined that Appalachian should earn an 8.40% overall rate of return, which Appalachian argues translates to an 11.24% rate of return on common equity. The Commission's judgment is deemed reasonable based on the evidence presented, particularly the testimony of Staff witness Parcell, whose analysis, although resulting in a lower rate than he recommended, supported the Commission's finding. Parcell indicated that a utility's securities must compete with those of other utilities and unregulated companies, and highlighted the impact of earnings and current market conditions on stock prices.

Parcell's testimony included data from the AEP System, showing that for the first nine months of 1974, the average return on common equity for AEP electric subsidiaries was 11.35%, while excluding Appalachian, it was 10.3%. Historical data from 1966 to 1974 indicated an average return of 11.1% for AEP electric subsidiaries. Other industry comparisons indicated an average return on common equity of 11.4% across the electric utility sector, with similar figures from comparable holding companies and utilities.

Parcell concluded that over the past decade, industrial companies generally outperformed electric utilities in equity returns, reflecting a recognized differential in risk and required earnings between the sectors. This trend illustrates the acknowledgment by regulators and the free enterprise system of the risk-return standard applicable to electric utilities.

The Parcell exhibit indicated that major industrial firms in the AEP service area, excluding Virginia, had an average equity return of 12% from 1969-1974, while firms in western Virginia averaged 9.4%. Parcell noted that prevailing money market conditions were depressed, evidenced by a 12% prime interest rate and a declining stock market. A survey revealed that 75% of leading companies had stock selling below book value. Parcell stated that a lower equity return of 12% aligns with the electric utility industry's performance over the past decade and approximates industrial returns over the last five years. Consequently, the Commission justified setting a return on common equity at 11.24%, considering various factors including Appalachian’s reliance on coal for 97% of its electricity, a high load factor demonstrating effective investment utilization, proximity to coal fields reducing transportation costs, and accounting adjustments to enhance investor attractiveness. The overall rate of return was deemed legally sound within a reasonable legislative discretion range.

Additionally, Appalachian contended that the Commission's reliance on arbitrary comparisons with other AEP companies was prejudicial. The majority opinion cited that AEP earned approximately 14% on equity from 1966 to September 1974, with Appalachian averaging 16.6%, indicating its significant contribution to AEP's earnings. Appalachian argued that this ranking did not reflect an independent assessment of a just and reasonable rate of return for Virginia consumers. However, it was clarified that the Commission had compared investment returns across enterprises with similar risks, not solely among AEP subsidiaries, thus reaffirming the validity of the rate of return determination.

A proper methodology for determining just and reasonable rates of return has been reaffirmed, specifically referencing the Howell Chesapeake and Potomac Telephone Co. case. The Commission's decision to set an overall rate of return at 8.40% and a calculated return of 11.24% has been challenged by Appalachian, which claims this rate inhibits its ability to raise necessary capital to fulfill statutory obligations. However, this argument reiterates previously addressed issues and requires no further discussion. The court affirms the Commission's order, noting that the rate set is lower than recommendations made by expert witnesses and the Attorney General but acknowledges uncertainty in determining a precise correct rate of return. The Commission retains broad authority to regulate public service corporations and is tasked with fact-finding and judgment-making. Despite differing opinions, the court cannot replace the Commission's judgment in these matters. Additional notes highlight considerations of utility long-term debt coverage as a measure of investment safety, the denial of a $35.7 million emergency rate relief application by the Company, the concept of dilution in relation to stock sales below book value, and the acceptance of leverage as a financial tool across industries.