UNITED STATES COURT OF APPEALS FOR THE D.C. CIRCUIT


MO PUB SVC CMSN

v.

FERC


99-1169a

D.C. Cir. 2000


*	*	*


Williams, Circuit Judge: In 1993 Williams Natural Gas  Company,1 a
natural gas pipeline company within the jurisdic- tion of the Federal
Energy Regulatory Commission, filed for  a general rate increase under
s 4 of the Natural Gas Act, 15  U.S.C. s 717c. The proceeding closed
in 1999 with the  Commission's third rehearing order. Williams Natural
Gas  Co., 86 FERC p 61,323 (1999) ("Third Rehearing"). That and  the
underlying orders are attacked from two sides. A host of  Kansas
cities, the Missouri Public Service Commission and  others, which we
will collectively call the "Public Service  Commission," attack the
allowed rate of return. They argue  that the Commission wrongly
refused (a) to impute to  Williams the capital structure of its
corporate parent, or  alternatively, (b) to adjust Williams's return
on equity down- ward to reflect its subsidiary status and the
"thickness" of its  equity ratio in comparison to that of firms in the
proxy group  used by the Commission to calculate the return on equity.
 The pipeline itself attacks on an unrelated issue, objecting to 




__________

n 1 In the course of the proceedings Williams Natural Gas Compa- ny
became Williams Gas Pipelines Central, Inc. We use "Williams"  as
shorthand.


the Commission's method of projecting the costs for cleaning  up PCB
(polychlorinated biphenyl).


We cannot say that the Commission's use of Williams's  capital
structure and the median return on equity for the  proxy group was
arbitrary and capricious. As to clean-up  costs, the Commission no
longer defends the $1.4 million  annual cost recovery as a figure
representative of actual cost,  and its decision does not purport to
rely on any procedural  default by Williams; we therefore grant
Williams's petition  and remand for further proceedings.


Capital structure and rate of return on equity


The Public Service Commission's brief offers a non- exhaustive, but
here uncontested, explanation of the role of  capital structure and
equity rate of return. It points out that  a firm's return on equity
must be higher than the return on  debt because (1) any dividends are
paid out of after-tax  earnings, whereas the firm can deduct interest
on debt, and  (2) equity is riskier. Because the overall cost of
equity is the  product of the equity share of capital and the equity
rate of  return, these factors imply that an increase in the
equity-debt  ratio tends to increase a firm's allowable overall rate
of  return. But there is an offset: Because debt service has 
priority, the higher the proportion of equity capital, the lower  the
financial risk for the firm's stock, and thus, in this  respect, the
lower the necessary rate of return. See also  Richard J. Pierce, Jr. &
Ernest Gellhorn, Regulated Indus- tries 136-37 (3d ed. 1994).


Williams is a wholly owned subsidiary of The Williams  Companies
("TWC"). Williams's own capital structure is  35.71% debt and 64.29%
equity, while TWC's is 50% debt, 3%  preferred equity, and 47% common
equity. Assuming use of  the same equity rate of return, FERC's use of
TWC's ratio  would be an advantage for Williams's customers.


In calculating the equity rate of return of a wholly owned  subsidiary,
the Commission has a special problem. Since its  shares are not traded
in the market, they have no market  price from which to infer their
rate of return. So the 


Commission looks instead to a proxy group of supposedly  similar firms
whose stock is traded, calculates their return on  equity with the
"DCF" or "discounted cash flow" method, and  then tacks the resulting
number onto the equity of the  subsidiary. See generally Williston
Basin Inter. Pipeline  Co. v. FERC, 165 F.3d 54, 56-57 (D.C. Cir.
1999); North  Carolina Utilities Comm'n v. FERC, 42 F.3d 659, 661
(D.C.  Cir. 1994).


Here the Commission used Williams's capital structure. It  found the
company's business risk average, and, though not  explicitly so
labelling its financial risk, held that its overall  risk (the amalgam
of the two) was not outside the "broad  middle range of average risk."
Third Rehearing, 86 FERC  p 61,323, at 61,860-61. It thus allowed
Williams the median  rate of return of the proxy group. In doing so,
it made no  adjustment to reflect the fact that Williams's equity
ratio was  a good deal thicker than the average of the proxy group
(and  therefore presumably less risky). Indeed, Williams's ratio  was
higher than the highest equity ratio of the proxy group-- 64%,
compared with 42% and 62% for the average and  highest ratio of the
proxy group, respectively.2


We review the challenge under the arbitrary and capricious  standard of
the Administrative Procedure Act. 5 U.S.C.  s 706(2)(A). The
Commission must consider the relevant  factors and draw "a rational
connection between the facts  found and the choice made." Williston
Basin, 165 F.3d at 60  (citation and quotation marks omitted). On the
technical  aspects of ratemaking FERC's decisions necessarily enjoy 
considerable deference. Public Service Comm'n v. FERC,  813 F.2d 448,
451 (D.C. Cir. 1987).


The attack on the Commission's refusal to use TWC's  capital structure
opens with the "double leveraging" theory.  The theory's basic concept
is that the true cost of a subsid- iary's equity capital is the
overall cost of the parent's capital.  Accordingly, the cost of the
subsidiary's equity should be  computed as the weighted average of the
parent's debt and  equity costs. Otherwise, says the theory,
shareholders of the  


__________

n 2 The proxy companies and their equity ratios were: Sonat, Inc. 
(62%), TWC (47%), Enron Corporation (43%), Panhandle Eastern 
Corporation (45%), Coastal Corporation (39%), and Transcontinen- tal
Energy Corporation (16%).


parent receive not only the higher equity returns associated  with the
parent's equity, but an artificial (doubly leveraged)  return on the
subsidiary's equity.


Although the Commission in the first rehearing order opted  in favor of
using TWC's capital structure, Williams Natural  Gas Co., 80 FERC p
61,158 (1997) ("First Rehearing"), even  then it rejected double
leveraging as a rationale: "The rate of  return to a pipeline should
not depend on who owns the  pipeline, nor on how that owner, whether a
holding company  or individual stockholders, financed its investment."
Id. at  61,682; see also Third Rehearing, 86 FERC p 61,323, at 
61,858-59. The double leveraging theory would in principle  be
applicable to a pipeline owned by a single individual, or by  a group
of investors, requiring the Commission to pursue its  inquiry into
these owners' finances. Further, an expert  quoted by the Commission
makes the point that the pipeline  investment's true opportunity cost
does not depend on the  capital structure of the investor, but rather
on the foregone  risk-adjusted returns of alternative investments. See
James  E. Brown, "Double Leverage: Indisputable Fact or Precari- ous
Theory," Public Utilities Fortnightly 26, 29 (May 9, 1974),  cited at
First Rehearing, 80 FERC p 61,158, at 61,682 n.21.


It is not for us to say whether these arguments have put  the kibosh on
the double leverage theory. We can, however,  say that the Public
Service Commission's quick response-- individual investors would never
directly own a FERC- regulated pipeline, and if they did, they would
not stand for  such high equity ratios--is not a serious intellectual
answer to  them. On this record we have no basis to disturb FERC's 
refusal to apply the double leveraging theory.


The Commission nevertheless briefly flirted with the idea  of using
TWC's capital structure. First Rehearing, 80 FERC  p 61,158, at
61,683. But on the next lap it dropped that  approach, with the
reasoning stated in a chronologically con- nected case:


Traditionally, the Commission has preferred to utilize the  applicant's
own capital structure and will continue to do  so if the applicant
issues its own non-guaranteed debt 


and has its own bond rating. But the Commission will  utilize an
imputed capital structure (most often that of  the corporate parent)
if the record in a particular case  reveals that the pipeline's own
equity ratio is so far  outside the range of other equity ratios
approved by the  Commission and the range of proxy company equity 
ratios that it is unreasonable.


Transcontinental Gas Pipe Line Corp., 84 FERC p 61,084, at  61,413
(1998) ("Order 414-A"), affirmed North Carolina Utili- ties Comm'n v.
FERC, No. 99-1037 (D.C. Cir. Feb. 7, 2000)  (unpublished opinion). The
Commission applied this policy to  Williams on the second rehearing.
Williams Natural Gas  Company, 84 FERC p 61,080, at 61,356 (1998)
("Second Re- hearing"). As Williams issued its own non-guaranteed debt
 and had its own bond rating, the normal pre-conditions for  using
Williams's own capital structure were satisfied.


We now turn to the Public Service Commission's argument  that
Williams's equity ratio is so out of line that the Commis- sion should
either have applied the caveat in the excerpt  quoted above (calling
for use of an imputed capital structure  in cases of anomalous equity
ratios), or should have adjusted  Williams's equity rate of return
down from that of the proxy  group. The common sense of this attack is
clear. Given that  a high equity ratio reduces financial risk
(everything else  being equal), it would make no sense for the
Commission to  use a rate of return inferred from the market
experience of a  proxy group with much thinner equity ratios.


But how thick is "too thick," and how much difference in  thickness is
too much? Here the issue is whether 64% equity  is "anomalous,"
bearing in mind that it is 22% above the  proxy average but only 2%
above the highest in the proxy  group. See supra note 2. Judges are
hardly in a position to  play this numbers game. Such numerical limits
cannot readi- ly be derived by judicial reasoning, Hoctor v. USDA, 82
F.3d  165, 170 (7th Cir. 1996), though to be sure courts are driven 
to it occasionally, as in enforcement of the Administrative  Procedure
Act's mandate to ensure that agency action is not  "unreasonably
delayed." 5 U.S.C. s 706(1). The ultimate 


choice may partake of arbitrariness--not in the sense of being 
"arbitrary and capricious," but in the sense that, while nu- merical
lines sometimes must be drawn, it is impossible to  give a reasoned
distinction between numbers just a hair on  the OK side of the line
and ones just a hair on the not-OK  side.


Here, it seems clear at the outset that the Commission was  on firm
ground in rejecting the idea that an equity ratio  outside the bounds
of the proxy group must automatically  require an adjustment. See
Second Rehearing, 84 FERC  p 61,080, at 61,355. Assume a proxy group
with ratios vary- ing from 40% to 44%. Insisting on an adjustment for
a firm  with one of 45% would surely impute an improbable refine- ment
to the rough inferences derived from capital markets, as  well as
raising the question just how great the adjustment  should be.


The Public Service Commission suggests in its brief that  Commission
precedent can provide some guidance. In  Transcontinental Gas Pipeline
Corp., 60 FERC p 61,246  (1992), reh'g denied 64 FERC p 61,039 (1993),
FERC found  that Transco Energy Corporation's equity ratio (the
pipeline  proposed using its parent's equity ratio) was 22% below the 
proxy average and required a different imputed capital struc- ture to
boost pipeline returns. See North Carolina Utilities  Comm'n, 42 F.3d
at 661, 663. FERC does not really respond  to this argument, although
it did observe in the Second  Rehearing that the proxy group average
here is brought  down by the 16% equity ratio for one of the proxy
firms  (Transco, interestingly). 84 FERC p 61,080, at 61,358 n.31. 
Indeed, Transco's presence lowered the proxy group average  over 5%
(47.4% to 42.2%). But as petitioners point out, if one  outlier is to
be removed, why not another (Sonat, at 62%)?  And the double removal
would put the average at 43.8%,  which would leave Williams still well
above the average and  even more above the new top (48%). Further, the
Commis- sion gives no explanation as to why any outlier should be 
removed, see United States Telephone Assn. v. FCC, 188 F.3d  521, 525
(D.C. Cir. 1999) (agency eliminating outlying data  points must
explain "why the outliers were unreliable or their 


use inappropriate"), much less why a low outlier should be  removed and
a high one retained. Had the Transco prece- dent been properly raised,
FERC's failure to offer a distinc- tion might well have required a
remand. See Greater Boston  Television Corp. v. FCC, 444 F.2d 841, 852
(D.C. Cir. 1970)  ("[I]f an agency glosses over or swerves from prior
prece- dents without discussion it may cross the line from the 
tolerably terse to the intolerably mute."). But petitioners' 
exceptions before the Commission did not cite the North  Carolina
Utilities Comm'n case or make such precedent- based arguments.3


Nor is there much force to petitioners' argument that  creeping stare
decisis will inch equity ratios ever-higher, as  each new peak in
equity ratio will justify another, still higher  peak. The Commission
swears off any such progression, see,  e.g., Second Rehearing, 86 FERC
p 61,232, at 61,858, and  petitioners can identify nothing in the
record to undercut its  commitment. A slippery slope argument is
almost always  available. "Judges and lawyers live on the slippery
slope of  analogies; they are not supposed to ski it to the bottom." 
Robert H. Bork, The Tempting of America: The Political  Seduction of
the Law 169 (1990). Especially with the Com- mission's explicit
pledge, the slope risk provides no basis for  us to upset the


Petitioners also claim that in looking in part to pipeline  companies
outside the proxy group in determining the rea- sonableness of
Williams's equity ratio, the Commission failed  to provide adequate
notice and thus failed to allow them an  opportunity to offer evidence
distinguishing the companies  outside the proxy group. But after the
Commission consid- ered pipelines outside the proxy group in the
Second Rehear- ing, petitioners made no request to supplement the




__________

n 3 Petitioners have not been punctilious in their use of precedent, 
mistaking in their brief the facts of North Carolina Utilities 
Comm'n, 42 F.3d at 663, for those of Public Service Comm'n v.  FERC,
642 F.2d 1335 (D.C. Cir. 1980). See Petitioners' Opening  Br. at 32.


All that said, this case is somewhat puzzling. No one  contests the
Public Service Commission's point that a thick  equity ratio implies
less risk and thus a lower rate of return,  everything else being
equal. Yet the Commission selected a  proxy group with widely
dispersed equity ratios, from 16% to  62%, as opposed to a proxy group
nearer to Williams's capital  structure. Further, it is unclear why
the Commission has  taken such an interest, both in its orders and in
its brief here,  in explaining that Williams's 64% ratio is in the
mainstream of  ratios in the pipeline industry generally. The rate of
return  is inferred from the rate of return of the proxy group, so the
 non-anomalous character of Williams's equity ratio by the  standards
of the industry generally is not self-evidently perti- nent.


But there are also gaps in the petitioners' attacks, which  undermine
any inference that FERC's looking to the industry  generally had any
material effect. Given the supposed rela- tion between equity ratio,
risk, and rate of return, we should  expect to see some effort to show
it at work within the proxy  group, or broadly among publicly traded
companies generally.  Yet petitioners offer no such analysis. We know
the direction  of the effect of equity thickness on equity rate of
return (as  no one contests it), but we have nothing on the degree. 
Accordingly, we have no basis for thinking that relationship  to be so
strong as to make a material difference, business risk  being held
constant. On this record, then, we cannot find  anything arbitrary and
capricious in the Commission's use of  Williams's capital structure
and the proxy group's median  return on equity.


PCB removal cost estimates


Before the administrative law judge Williams presented  evidence of
$4.2 million in past unamortized costs for cleaning  up PCB
(polychlorinated biphenyl), plus projections of future  costs. The ALJ
allowed the company to amortize the $4.2  million over three years,
with a procedure for refunding any  amounts Williams recovered from
third parties responsible  for the PCB. ALJ Opinion, 73 FERC p 63,015,
at 65,074-75.  Because Williams made a new s 4 rate filing in 1995,


issue of PCB cost recovery in the present case became  "locked in" for
the period of November 1, 1993 through July  31, 1995.


For this locked-in period, the Commission rejected amorti- zation in
favor of the "test period" method. Williams Natu- ral Gas Co., 77 FERC
p 61,277, at 62,182 (1996) ("First  Order"); see generally
Southwestern Public Service Co. v.  FERC, 952 F.2d 555 (D.C. Cir.
1992). This method takes  actual costs of the most recent 12-month
period (the "base  period"), subject under some circumstances to
adjustment on  the basis of data from a nine-month period following
the base  period (the "adjustment period"), and absent some anomaly 
projects them into the period covered by the rate filing. See  18 CFR


Without looking to whether Williams had offered such test  period
figures, the Commission declared that "the $1.4 million  annual amount
the participants and the ALJ arrived at using  an amortization method
is a reasonable equivalent of WNG's  actual PCB-related test period
costs." First Order, 77 FERC  p 61,277, at 62,182. It also asserted
that Williams had pro- jected 10-year costs of $20 million; "this
averages to $2  million a year which is reasonably close to the $1.4
million  annual amount the ALJ permitted [Williams] to recover." Id. 


Williams did not object to use of the test period method.  But on
rehearing it did strenuously argue that the Commis- sion was wrong to
convert the amortization figures into test  period figures. Williams
pointed to Exhibit 216 in the record,  which stated "Test Period
Actuals" and a total of  "$3,990,768." The Commission rejected the
$3.9 million fig- ure, however, claiming it inappropriately covered a
22-month  period; but in so doing the Commission cited Exhibit 24 not 
Exhibit 216. First Rehearing, 80 FERC p 61,158, at 61,680 &  n.11. As
for Exhibit 216, the Commission stated it provided  "no distinct
record evidence" of the level of PCB costs  "incurred over any annual
period during the test period." Id.  at 61,680 & n.13. The Commission
offered no explanation as 


to the precise flaw in Exhibit 216's statement of "Test Period 
Actuals."


Sticking by $1.4 million as "representative of annual PCB  cost
figures," the Commission chastised Williams for disput- ing the
figure, saying that this was the figure initially pro- posed by
Williams (albeit as a figure for amortization). Id. at  61,679-80.


At oral argument the Commission abandoned any claim of  equivalence
between the $1.4 million accepted by Williams  under the amortization
theory and imposed by the Commis- sion as a "representative" test
period amount. Clearly a  number that emerges from taking past
aggregate costs and  amortizing them over an arbitrarily chosen future
period is  not necessarily useful for applying past experience to
project  future expenses--the basic principle of the test period meth-
od. It could hardly satisfy the Natural Gas Act's require- ment of
substantial evidence for facts found by the Commis- sion, 15 U.S.C. s
717r(b). See also Public Service Comm'n,  813 F.2d at 451.


Instead, the Commission at oral argument seemed to de- fend the use of
$1.4 million as a response to what it claimed  was Williams's failure
to place correct test period figures into  the record. The
Commission's brief points out that $3.2  million of the total test
period $3.9 million were incurred in  two months, proving (in its
current view) that Williams's test  period figures were
"unrepresentative." And for the very  first time in this seven-year
saga, the Commission at oral  argument claimed that Williams's data
failed to satisfy a  regulatory requirement of monthly cost figures


Williams maintains that Exhibit 216's "Test Period Actuals"  was
sufficient evidence. Nothing said by the Commission up  until oral
argument has supplied a reason to believe that that  was inadequate.
That $3.2 million in costs were incurred  during two months of the
test period may show that PCB  removal costs come in lumps. But it
hardly shows that the  $3.9 million annual aggregate figure was


theory in any event never invoked in the Commission's or- ders.


When the Commission at oral argument asserted a require- ment of
monthly data, Williams questioned the existence of  any such
requirement and said that in fact it had supplied  such data. The new
Commission theory is in any event the  purest form of "appellate
counsel's post hoc rationalization,"  which in the usual case we do
not accept. North Carolina  Utilities Comm'n, 42 F.3d at 663. Since
the Commission no  longer defends the $1.4 million figure as
representative, and  in its orders never sought to justify it as a
solution to some  procedural default by Williams, we grant the
petition and  remand the case for the Commission to address this


* * *


The petitions of Public Service Commission are denied; the  petition of
Williams is granted, that part of the order is  vacated, and the case
is remanded to the Commission.


So ordered.