Ponderosa Tel. Co. v. Cal. Pub. Utilities Comm'n

36 Cal.App.5th 999

249 Cal.Rptr.3d 200

The PONDEROSA TELEPHONE CO., et al., Petitioners,

v.CALIFORNIA PUBLIC UTILITIES COMMISSION, Respondent.

F076845

Court of Appeal, Fifth District, California.

Filed June 18, 2019

Cooper, White & Cooper, Mark P. Schreiber, Patrick M. Rosvall, Sarah J. Banola, and Priya D. Brandes, San Francisco, for Petitioners.

Arocles Aguilar, San Francisco, Helen W. Yee, South Pasadena, and Eleanor M.W. Youngsmith, San Francisco, for Respondent.

SNAUFFER, J.

In this original proceeding, three rural telephone companies, The Ponderosa Telephone Co., Sierra Telephone Company, Inc., and Volcano Telephone Company (together petitioners), challenge the decision of the California Public Utilities Commission (PUC) establishing petitioners' "cost of capital," which is a financial yardstick used by the PUC as a component in ratemaking.¹ Conceptually, a utility company's cost of capital, also referred to as a rate of return, reflects that company's cost of generating or obtaining capital for investment in assets (e.g., facilities, equipment or infrastructure) that provide utility services to customers.² Petitioners contend the PUC failed to adequately consider certain risks that exist for investing in small, rural telephone companies, and therefore the cost of capital was set at an unreasonably low level, resulting in a confiscatory rate of return. Based on this line of argument, petitioners claim the PUC decision should be annulled as allegedly (i) contrary to constitutional principles that require a reasonable rate of return, and (ii) lacking in substantial evidence or otherwise arbitrary and capricious. The PUC responds that its determination of petitioners' cost of capital was a reasonable decision based on a fair consideration of all the evidence and argument, noting further that it was not required to adopt the methodology urged by petitioners. Also, the PUC points out that some of the purported risks are mitigated through revenue subsidies received by petitioners as small rural telephone companies.

On balance, we conclude petitioners have failed to meet their burden of demonstrating that the PUC's cost of capital determination was arbitrary, capricious, lacking in any evidentiary support, or that it otherwise fell short of constitutional standards regarding a reasonable rate of return. Accordingly, the PUC's decision Nos. 16-12-035 and 17-12-029 are hereby affirmed.

FACTS AND PROCEDURAL HISTORY

The Parties

Petitioners are small, rural, independent, privately-owned telephone companies, also known as Incumbent Local Exchange Carriers (sometimes referred to in the record as LEC's or ILEC's). These companies offer basic local telephone service to customers in rural and remote areas of California, are considered carriers of last resort within their service areas, and are each regulated by the PUC under a traditional "rate of return" regulatory structure. Additionally, pursuant to Public Utilities Code³ section 275.6, petitioners receive supplemental ratepayer funding through the California High-Cost Fund-A Administrative Committee Fund Program (CHCF-A program).

( § 275.6, subds. (a) & (d).) Because the cost of providing service in rural and remote areas is high compared to the rates permitted to be charged to rural customers, eligible telephone companies receive CHCF-A subsidies. The CHCF-A program is funded by surcharges assessed against all California telephone customers. ( Ponderosa, supra , 197 Cal.App.4th at p. 52, 127 Cal.Rptr.3d 844.)

The PUC, respondent herein, is the state agency charged with regulating public utilities pursuant to article XII of the California Constitution and the Public Utilities Act (§ 201 et seq.). ( Clean Energy Fuels Corp. v. Public Utilities Com. (2014) 227 Cal.App.4th 641, 648, 174 Cal.Rptr.3d 297 ( Clean Energy ).) Statutorily, the PUC is authorized to supervise and regulate public utilities and to " ‘do all things ... which are necessary and convenient in the exercise of such power and jurisdiction’ (§ 701); this includes the authority to determine and fix ‘just, reasonable [and] sufficient rates’ (§ 728) to be charged by the utilities." ( Southern California Edison Co. v. Peevey (2003) 31 Cal.4th 781, 792, 3 Cal.Rptr.3d 703, 74 P.3d 795.) Its power to fix rates and establish rules has been liberally construed. ( Ibid. )

In the proceedings below, the PUC's Public Advocate's Office, which was formerly known as the Office of Ratepayer Advocates (ORA), intervened as a party and opposed petitioners' proposals for determining cost of capital. ORA is an independent office within the PUC that participates in proceedings and is charged with representing ratepayer or customer interests in ratemaking proceedings. (§ 309.5.)

Introduction to the Cost of Capital

Before delving into the specifics of the parties' positions relating to the cost of capital determination, and in order to make the financial information and terminology more understandable, we believe further elaboration on the concept of the cost of capital would be helpful.

As noted, a utility company's cost of capital, also known as the rate of return, reflects the cost the company must pay to generate capital used for investment in infrastructure and equipment. (See, Ponderosa , supra , 197 Cal.App.4th at p. 51, 127 Cal.Rptr.3d 844 ; see also, § 275.6, subd. (b)(2), (b)(5) & (c)(2).) The parties' briefing to this court expressly acknowledges this basic understanding of the function of cost of capital. As the PUC states in its respondent's brief, the rate of return should be set "at a level that is adequate to enable the utility to attract investors to finance the replacement and expansion of its facilities so it can fulfill its public utility service obligation," which requires "comparing market returns on investments for other companies with similar levels of risk." Similarly, petitioners state in their opening brief as follows: "The ‘cost of capital’ is a ratemaking component that reflects a utility's costs of generating capital to invest in utility plant. It is also known as the ‘rate of return’ because it defines the target return on the utility's capital that must be used in setting rates. ‘Cost of capital’ is a measurement of the cost of obtaining debt and equity financing, and it reflects the amount investors would demand to compensate them for the risks of investing capital in the company."

The above descriptions of the purpose or function of the cost of capital are consistent with the legislative pronouncements in section 275.6, subdivision (c)(2), which require the PUC in administering the CHCF-A program to accomplish the following objectives: "Employ rate-of-return regulation to determine a small independent telephone corporation's revenue requirement in a manner that provides revenues and earnings sufficient to allow the telephone corporation to deliver safe, reliable, high-quality voice communication service and fulfill its obligations as a carrier of last resort in its service territory, and to afford the telephone corporation a fair opportunity to earn a reasonable return on its investments, attract capital for investment on reasonable terms, and ensure the financial integrity of the telephone corporation." The term "revenue requirement" in the above provision means "the amount that is necessary for a telephone corporation to recover its reasonable expenses and tax liabilities and earn a reasonable rate of return on its rate base." ( § 275.6, subd. (b)(5).) The term "rate base" means "the value of a telephone corporation's plant and equipment that is reasonably necessary to provide regulated voice services and access to advanced services, and upon which the telephone corporation is entitled to a fair opportunity to earn a reasonable rate of return." ( § 275.6, subd. (b)(2).)

Having described the function of the cost of capital, the crucial question is how the cost of capital is reasonably measured or ascertained. The case of Ponderosa , supra , 197 Cal.App.4th at pp. 51-52, 127 Cal.Rptr.3d 844, provides a starting point. We observed in that case there are ordinarily three major components or steps in determining the cost of capital: (1) the cost of debt, (2) the cost of equity (i.e., the necessary return to generate equity investment), and (3) the capital structure. ( Id. at pp. 51-52, 127 Cal.Rptr.3d 844.) The following is our summary in that case of the cost of capital and other closely-related concepts:

"The [PUC] examines several cost components in calculating a utility company's revenue requirement. The [PUC] begins by determining the value of the assets that the company has invested in to provide utility service. Property or portions thereof that are unproductive for public utility purposes are excluded. This figure is known as the ‘rate base.’ [¶] To invest in rate base assets, a utility company raises funds by either issuing debt or selling equity. Costs are associated with each method. The company either has to pay interest to creditors on borrowed funds or pay a portion of profits or dividends to equity investors, i.e., shareholders. This cost is known as the cost of capital. The cost of capital, also known as the rate of return, multiplied by the rate base is one component of the utility company's revenue requirement.

Utility companies usually use a mix of debt financing and equity as a source of funds for their regulated activities. The reason is that, while debt is cheaper to obtain, it increases financial risks to the shareholders. Interest must be paid to creditors regardless of how the company is doing financially. On the other hand, shareholders expect an annual return that is usually greater than the cost of debt. Accordingly, companies attempt to find a middle ground between all-equity financing and all-debt financing.

The [PUC] determines a utility company's cost of capital in a three-step process. The [PUC] first adopts a reasonable capital structure, i.e., the proportion of debt to

...