D.C. Circuit Overturns FERC’s ROE Methodology for Electric Utilities

April 20, 2017

On April 14, 2017, a unanimous panel of the D.C. Circuit Court of Appeals vacated the Federal Energy Regulatory Commission’s (“FERC”) current approach to setting rate of returns on equity (“ROE”).  Setting ROEs is often a major issue in any gas pipeline or electric transmission rate case.  Setting the ROE essentially determines the return investors get on the regulated capital they deploy. The ruling has widespread implications and will give the new FERC Commissioners to be appointed by President Trump broad discretion to establish a new ROE methodology that properly incents the building of new infrastructure.

The current FERC ROE methodology was established in FERC Opinion No. 531.  That order: (a) slashed the ROE received by New England utilities for transmission operations and (b) established a new methodology (often referred to as the “Coakley method”) to be used for calculating electric transmission ROEs going forward.  See Emera Maine v. Federal Energy Regulatory Comm’n, No. 15-1118, ___ F.3d ___, 2017 WL 1364988 (Apr. 14, 2017).

The Court held that FERC’s Opinion No. 531 and its progeny were arbitrary and capricious because the FERC: (1) failed to satisfy its dual-burden under Section 206 of the Federal Power Act (“FPA”) by failing to make an independent finding that the ROE previously granted to the New England transmission owners was unjust and unreasonable and (2) failed to demonstrate that a “rational connection” existed between the record evidence and the new ROE established by the orders.  Id. at *10-11.  As a result, the Court vacated the orders and remanded to the FERC for further proceedings.

This ruling has widespread implications as it impacts all pending and future rate case proceedings where the Coakley methodology would have otherwise been applied.  With three new Commissioners appointed by President Trump soon to take seats at the table in the near future, this ruling opens the door wide open to allow for significant, swift changes to the FERC’s ROE methodology. We expect that the policy goal of any new methodology will be to incentivize new transmission build.

Return on Equity for Transmission Owners under the Federal Power Act

As the Court recognized, under Sections 205 and 206 of the FPA, the FERC “must ensure that all rates charged for the transmission or sale of electric energy are ‘just and reasonable.'”  Id. at *1 (quoting 16 U.S.C. §§ 824d(a), 824e(a)).  This duty also requires that transmission owners receive a ROE on their investment in transmission assets “commensurate with returns on investments in other enterprises having corresponding risks” and “sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital.”  Id. at *4 (quoting FPC v. Hope Nat. Gas Co., 320 U.S. 591, 603 (1944)).  See also Bluefield Waterworks & Improvement Co. v. Pub. Serv. Comm’n of W. Va., 262 U.S. 679, 692-93 (1923).

Historically, the FERC utilized a one-step discounted cash flow analysis to calculate a “just and reasonable” ROE for transmission owners.  Under this approach, FERC constructed a “zone of reasonableness” consisting of ROEs for publicly traded companies similar to the transmission owner at issue.  Id. at *5.  The FERC traditionally assigned an ROE equal to the midpoint or median of the zone of reasonableness, id. at *1, but could make upward adjustments pursuant to Section 219 of the FPA in order to “further encourage the construction of transmission facilities and replacement of aging transmission infrastructure.”  Id. at *2 (quoting S. Cal Edison Co. v. FERC, 717 F.3d 177, 179 (D.C. Cir. 2013)).

Section 206 Challenge to New England Transmission Owners’ Return on Equity

In 2003, a group of New England Transmission Owners (the “NETOs”) submitted a proposal to the FERC pursuant to FPA Section 205 to recover their ROE through transmission rates charged by ISO New England, the regional transmission organization under which the NETOs operated.  Id.  The FERC used a discounted cash flow analysis to construct a zone of reasonableness and ultimately approved a base ROE of 11.14 percent plus an “adder” for certain transmission projects pursuant to Section 219 of the FPA.  Id.  In 2011, certain of the NETOs’ customers filed a Section 206 complaint arguing that the 11.14 percent ROE had become unjust and unreasonable.  Id.

In its order ruling on the complaint against the NETOs, the FERC adopted a new two-step discounted cash flow analysis that, besides data on other transmission utilities, incorporated long-term GDP growth forecasts.  This new “Coakley methodology” yielded a new zone of reasonableness for the NETOs of 7.03 percent to 11.74 percent.  Id.  But FERC chose not to set the NETOs’ ROE at the median or midpoint of the zone.  Rather, because of “anomalous capital market conditions,” the FERC was “less confiden[t]” that the midpoint of this zone of reasonableness was a sufficient ROE and so looked at “additional record evidence,” including risk premium analysis, capital asset pricing model analysis, expected earnings analysis, and comparison of state-commission approved ROEs, to select a just and reasonable ROE from the zone of reasonableness.  Id. at *3 (quoting Opinion No. 531-B, 150 FERC ¶ 61,165 at P 50 (2015)).  The FERC thus set the base ROE for the NETOs at the midpoint of the upper half of the new zone of reasonableness, or 10.57 percent, after considering this additional evidence.  Id. at *3.

The D.C. Circuit’s Opinion Vacating Coakley

On April 14, 2017, the D.C. Circuit vacated the “Coakley orders” on two grounds.

First, the Court held that the FERC failed to satisfy the Section 206 “condition precedent” that an existing ROE be unjust, unreasonable, unduly discriminatory or preferential prior to the imposition of a new ROE.  Id. at *8, 10.  In reaching this holding, the Court rejected the FERC’s argument that “all ROEs other than the one FERC identifies as the utility’s just and reasonable ROE are per se unlawful in a section 206 proceeding.”  Id. at *10 (citing Opinion No. 531-B, 150 FERC ¶ 61,165 at P 33 (2015)).  Rather, the zone of reasonableness “creates a broad range of potentially lawful ROEs” and so a finding that one ROE was just and reasonable did not, standing alone, establish that other ROEs within the range are unjust and unreasonable.  Id.  FERC’s failure to present evidence that the existing 11.14 percent ROE was unjust and unreasonable rendered its orders arbitrary and capricious.

Second, the Court held that there was no “rational connection between the record evidence and [the FERC’s] placement of the base ROE.”  Id. at *10.  The Court noted that the “alternative benchmarks and additional record evidence [the FERC] used . . . merely pointed to a base ROE somewhere above [the midpoint of the zone of reasonableness]” and so did not support the selected rate of 10.57 percent.  Id. at *12.  The FERC’s orders were not “the product of reasoned decision-making” absent this “rational connection.”  Id. at *10, 13.

The D.C. Circuit vacated the orders and remanded the case to the FERC for proceedings consistent with its opinion, presenting the FERC with an opportunity to revisit its policy on calculating just and reasonable ROEs for transmission owners.  The Court repeatedly emphasized that the FERC retains broad discretion to establish a just and reasonable ROE based on the circumstances of the case.[1]

Ramifications of Emera Maine

The D.C. Circuit’s order will have far-reaching impacts well beyond New England.

Consistent with FERC’s dictates in Coakley that the two-stage DCF was to be used going forward, many cases and filings subsequent to Coakley have used the new two-stage DCF methodology.  Thus the impact of Coakley and the D.C. Circuit’s recent decision goes well beyond that specific case.

The fact that the D.C. Circuit vacated Coakley essentially prevents FERC from applying the Coakley methodology until the Commission issues an order on remand.  Thus, companies will need to return to the pre-Coakley one-stage DCF, at least and until FERC takes up the Coakley case on remand.

There will be a great deal of speculation as to what  FERC will do on remand.  But it is clear is that President Trump is set to appoint three Republican Commissioners to the FERC, which will significantly alter the composition of the Commission.  There is no obligation for the “new” Commission to try to re-support or re-adopt the Coakley methodology on remand.  As a result, the new Commission will likely use its broad discretion and the opportunity presented by the remand to implement substantial revisions to its approach to calculating a just and reasonable ROE, including looking to other methods of calculation besides discounted cash flow models.  Indeed, with the Trump Administration promoting the need for infrastructure growth, the new Commission will likely establish an ROE methodology that creates the appropriate incentives to get new transmission built quickly. Additionally, the new Commissioners, once seated, will likely make addressing the order on remand and setting a new method a high priority soon after they are sworn in.

   [1]   Id. at *4 (quoting S. Cal Edison Co., 717 F.3d at 182) (“FERC . . . has discretion regarding the methodology by which it determines whether a rate is just and reasonable.”); id. at *6 (quoting Morgan Stanley Capital Grp., Inc. v. Pub. Util. Dist. No. 1 of Snohomish Cty., 554 U.S. 527, 532 (2008)) (internal quotation marks and alterations omitted) (“[B]ecause the statutory requirement that rates be just and reasonable is obviously incapable of precise judicial definition, we afford great deference to the [FERC] in its rate decisions.”); id. at *7 (“Whether a particular rate within the zone is the just and reasonable rate for the utility at issue depends on a number of factors.”); id. (“Whether a rate, even one within the zone of reasonableness, is unlawful depends on the particular circumstances of the case.”); id. at *10 (“FERC has discretion to make ‘pragmatic adjustments’ to a utility’s ROE based on the ‘particular circumstances’ of a case.”); id. at *11 (“FERC may make adjustments to a utility’s ROE based on the specific circumstances of the case.”).

Gibson Dunn’s Energy, Regulation and Litigation lawyers are available to assist in addressing any questions you may have regarding the developments discussed above.  Please contact the Gibson Dunn lawyer with whom you usually work, or any of the following:

William S. Scherman – Washington, D.C. (+1 202-887-3510, [email protected])
Jeffrey M. Jakubiak – New York (+1 212-351-2498, [email protected])
Jennifer C. Mansh – Washington, D.C. (+1 202-955-8590, [email protected])
Christopher B. Smith – Washington, D.C. (+1 202-887-3764, [email protected])

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