Cincinnati Gas & Electric Co. v. Public Utilities Commission

[This opinion has been published in Ohio Official Reports at 

86 Ohio St.3d 53

.]




    THE CINCINNATI GAS AND ELECTRIC COMPANY, APPELLANT, v. PUBLIC
                    UTILITIES COMMISSION OF OHIO, APPELLEE.
    [Cite as Cincinnati Gas & Elec. Co. v. Pub. Util. Comm., 

1999-Ohio-81

.]
Public Utilities Commission—Application to increase rates for natural gas
        service—Commission did not abuse its discretion in excluding a portion of
        the development costs of natural gas company’s customer service system
        from its rate base—Commission acted unlawfully in imputing revenue levels
        for ratemaking purposes that differ significantly from the actual revenue
        collected from customers during the test period pursuant to contracts
        previously approved by the commission.
  (Nos. 97-738 and 97-2199—Submitted September 29, 1998—Decided July 7,
                                           1999.)
  APPEALS from the Public Utilties Commission of Ohio, No. 95-656-GA-AIR.
                                  __________________
        {¶ 1} The Cincinnati Gas and Electric Company (“CG&E”) is a public
utility and a natural gas company as defined in R.C. 4905.02 and 4905.03(A)(6).
As such, it is subject to the jurisdiction of the Public Utilities Commission of Ohio.
On January 8, 1996, pursuant to R.C. 4909.18, CG&E filed with the commission
an application to increase its rates for gas service.            The commission’s staff
investigated the application and filed its report on July 12, 1996. CG&E and a
number of intervenors, including the Office of Consumers’ Counsel (“OCC”), filed
objections to the staff report.
        {¶ 2} In summer 1996, the commission conducted hearings, and on
December 12, 1996, it issued its opinion and order in the rate case. The commission
allowed an increase in gas rates, but not to the level CG&E had sought. CG&E
filed an application for rehearing, which the commission denied on February 12,
                               SUPREME COURT OF OHIO




1997. On April 14, 1997, CG&E filed its notice of appeal in this court in case No.
97-738.
        {¶ 3} On July 2, 1997, the commission issued a supplemental opinion and
order in the rate case. CG&E also appealed after that order, initiating case No. 97-
2199 in this court. Since the appeals in case Nos. 97-738 and 97-2199 are
substantially identical, this court consolidated the two appeals.
        {¶ 4} CG&E’s appeal focuses on two issues, each affecting a different
element in the ratemaking formula set forth in R.C. 4909.15. Briefly, a rate increase
is determined as follows:
        {¶ 5} R.C. 4909.15(A) requires the commission to determine the following:
the valuation of the utility’s property in service as of a date certain, i.e. its rate base;
a fair and reasonable return on that investment; and the expenses incurred in
providing service during the test year. Once these determinations are made, the
commission, pursuant to R.C. 4909.15(B), computes the gross annual revenues to
which the utility is entitled by adding the dollar return on the utility’s investment
to the utility’s test-year expenses. Pursuant to R.C. 4909.15(C), the commission
then determines the utility’s revenues during the test period. If the revenues
received by the utility during the test year are less than the gross annual revenues
to which the utility is entitled, the commission must set new rates that will raise the
necessary revenue. R.C. 4909.15(D); Columbus S. Power Co. v. Pub. Util. Comm.
(1993), 

67 Ohio St.3d 535, 537-538

, 

620 N.E.2d 835, 838-839

. To simplify: The
value of used and useful property (rate base) (1) is multiplied by rate of return (2),
yielding the dollar annual return to which the utility is entitled (3). That amount
(3) is added to test-period expenses (4), yielding gross annual revenues to which
utility is entitled (5). Subtracted from amount (5) is test period revenues (6),
yielding the rate increase (7).
        {¶ 6} The two issues in CG&E’s appeal deal with the rate base, which
CG&E argues was set too low, and test-period revenues, which the company argues




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were set too high. We will set forth the facts relevant to each issue separately,
below.
                                    Rate Base
         {¶ 7} The rate-base issue centers around the cost associated with CG&E’s
development of a new customer service system (“CSS”). CG&E sought to have
the bulk of the development costs of the CSS included in its rate base. The
commission allowed substantially less than CG&E sought.
         {¶ 8} In June 1987, CG&E commenced development of a CSS to replace
its existing customer billing and customer service order systems, which had been
in use for approximately twenty years.        CG&E targeted July 1990 as the
implementation date, with the new CSS to handle customer service operations well
into the future.
         {¶ 9} Because of the extraordinary development costs and expected long-
term usefulness of the new CSS, CG&E chose to capitalize the bulk of development
costs rather than treat them as ordinary operating expenses. To that end, CG&E in
1990 requested and received approval from the commission to capitalize CSS
development expenses in commission case No. 90-277-GE-AAM. At that time,
CG&E’s estimate of the cost of development of CSS was $24 million.
         {¶ 10} The CSS development efforts met trouble from the start. In late
1989, the proposed implementation date was revised from July 1990 to July 1991.
The project experienced further delays, and by July 1991, the CSS was far from
completion and the costs had far exceeded the $24 million estimate; by November
1991, the capitalized expenditures totaled $47.43 million.
         {¶ 11} In mid-1991, CG&E commissioned two outside consultants to
evaluate the viability of completing the project and to provide advice as to
completion procedures.      Both Andersen Consulting and Computer Science
Corporation (“CSC”) concluded that the CSS project was viable. In the fall of
1991, CG&E contracted with CSC to complete the project by July 1993 for a flat




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fee of $14.875 million. In its role of managing the project, CSC was given full
authority with respect to staffing, cost, technical decisions, and schedules. CSC
successfully completed and implemented the CSS by July 1993. At the project’s
completion, the entire capitalized cost was $62.3 million, one hundred sixty percent
above CG&E’s 1990 projection.
       {¶ 12} In the rate case, CG&E sought to recover the portion of CSS costs
allocable to its Ohio gas operations by including such costs, capitalized and
amortized, as an asset in its rate base. The commission’s staff investigated pursuant
to R.C. 4909.19 and recommended a substantial disallowance of capitalized CSS
development costs from the rate base proposed by CG&E.                  The staff’s
recommendation was premised on its conclusion that CG&E had mismanaged the
CSS development project in various respects, thereby causing its costs to be
excessive.
       {¶ 13} The commission staff concluded that CG&E had mismanaged the
CSS project by “unreasonably missing project deadlines and exceeding project
costs, by failing to sign CSS contractors to contracts with identified deliverables
with certain deadlines, by choosing to develop a customized DB2-based CSS
system without adequate identification of software capabilities and resource
availability, by investing in a system where the costs greatly exceeded benefits, and
by failing to maintain an adequate audit trail of CSS system development and
managerial decision-making with regard to costs and deadlines.”
       {¶ 14} Based on those conclusions, the staff recommended that the
commission allow recovery based on the staff’s “best estimate of system costs had
the project been expertly developed and managed.” The staff believed that “the
CSS project was expertly managed from the point where CSC took over project
responsibility” from CG&E, and found that the system was fifty percent complete
at that point. Doubling CSC’s contract fee would yield a figure representing the
total cost had the project been expertly managed from the get-go.




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                                January Term, 1999




        {¶ 15} Thus, the staff recommended that recovery for the CSS “be based on
the amount paid to Computer Science Corporation for completing the remaining
50% of the project — $14.875 million. This calculation would thus become
$29.750 ($14.875 x 2) million for the entire system. For purposes of this rate
proceeding, this option would adjust recovery for CSS to $29,750,000. The Ohio
jurisdictional amount of CSS would then be $25.667 million and the Gas
Company’s portion of Ohio’s jurisdictional amount would be $9.348 million            *
* *.”
        {¶ 16} The commission agreed with the staff, stating that “the staff’s
recommendation reasonably quantifies an appropriate allowance for the costs
incurred for the CSS,” and found that “it was reasonable to use the fixed fee portion
of the CSS contract as the basis for estimating the proper allowance for the entire
project.” Accordingly, the commission adopted the staff’s recommendation “to
allow the Ohio gas jurisdictional portion of the project costs ($9.348 million) in rate
base in this proceeding.”
        {¶ 17} CG&E claims that the commission made an unwarranted deduction
from its rate base, arguing that the commission’s order in that regard was not
supported by the manifest weight of the evidence and constituted an abuse of
discretion.
                               Test-Period Revenues
        {¶ 18} In 1993 and 1994, CG&E entered into contracts for interruptible gas
transportation service with two of its large industrial customers, Armco Steel
Company (“AK Steel”) and Ford Motor Company. The contracts provided for
interruptible gas transportation at rates considerably discounted from the otherwise
applicable tariff rate. The applicable tariff rate for interruptible transportation was
$0.537 per thousand cubic feet (“Mcf”); Ford and AK Steel paid $0.23/Mcf and
$0.24/Mcf, respectively, under their contracts. These discounted rate contracts
were earlier approved by the commission pursuant to R.C. 4905.31 in In re




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Application of Cincinnati Gas & Elec. Co., No. 94-1836-GA-AEC, and In re
Application of Cincinnati Gas & Elec. Co., 93-1436-GA-AEC.
        {¶ 19} During the test period, CG&E provided interruptible gas
transportation services to Ford and AK Steel at the discounted prices established in
its contracts with those two companies.
        {¶ 20} The commission determined the volumes of gas delivered during the
test period under the contracts and multiplied those volumes not by the contract
rates, but instead by the otherwise applicable tariff rate.       The commission’s
calculation resulted in approximately $7 million of what it denominated “delta
revenues,” which represented the additional revenues CG&E would have received
had it delivered the same volumes of gas to Ford and AK Steel at tariff rates instead
of at contract rates.
        {¶ 21} The commission then imputed the delta revenues to CG&E and
included them in its test-period revenues even though CG&E did not actually
generate these revenues under its contracts with Ford and AK Steel. The result of
the delta revenue imputation was that CG&E’s test-period revenues were higher
and concomitantly its rate increase would be lower. As a result, CG&E could not
compensate for its discounted rates to Ford and AK Steel by increasing its other
customers’ rates. The commission’s staff characterized the delta revenues imputed
to CG&E simply as “lost income.”
        {¶ 22} CG&E appealed the commission’s order regarding the test-period
revenues, arguing that the commission abused its discretion by imputing revenues
received pursuant to a contract at a rate that was different from the contractual rate
previously approved by the commission pursuant to R.C. 4905.31.
        {¶ 23} The cause is now before this court upon an appeal as of right.
                               __________________
        G. James Van Heyde and James B. Gainer, for appellant.




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                                January Term, 1999




       Betty D. Montgomery, Attorney General, Duane W. Luckey, William L.
Wright and Paul A. Colbert, Assistant Attorneys General, for appellee.
       Robert S. Tongren, Consumers’ Counsel, Werner L. Margard III and Evelyn
R. Robinson, Assistant Consumers’ Counsel, urging affirmance for amicus curiae
Ohio Consumers’ Counsel.
                               __________________
       PFEIFER, J.
       {¶ 24} We find that the commission did not abuse its discretion in excluding
a portion of the development costs of CG&E’s customer service system from its
rate base. We find, however, that the commission did act unlawfully in imputing
revenue levels for ratemaking purposes that differ significantly from the actual
revenue collected from customers during the test period pursuant to contracts
previously approved by the commission.
                                     Rate Base
       {¶ 25} CG&E argues that the commission abused its discretion by ignoring
evidence and the cross-examination of witnesses, thereby producing an order that
was contrary to the manifest weight of the evidence. It has been long held in
commission matters that “this court will not reverse or modify a [commission]
decision as to questions of fact where the record contains sufficient probative
evidence to show that the [commission’s] determination is not manifestly against
the weight of the evidence and is not so clearly unsupported by the record as to
show misapprehension, mistake, or willful disregard of duty.” Ohio Edison Co. v.
Pub. Util. Comm. (1992), 

63 Ohio St.3d 555, 556

, 

589 N.E.2d 1292, 1294

.
       {¶ 26} Pursuant to R.C. 4909.15(A), the commission in a rate case is to
determine the rate base as being “[t]he valuation as of the date certain of the
property of the public utility used and useful in rendering the public utility service
for which rates are to be fixed and determined.” (Emphasis added.)




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                             SUPREME COURT OF OHIO




       {¶ 27} There is no dispute in this case that the CSS itself is used and useful.
The dispute resides in the development costs of the project, which were capitalized
and treated as property in CG&E’s rate base. Still, those expenses were in the first
instance operating expenses, and, as such, they must meet the prudency test in R.C.
4909.154 before they can gain the status of “used and useful.” R.C. 4909.154
provides:
       “In fixing the just, reasonable, and compensatory rates, joint rates, tolls,
classifications, charges, or rentals to be observed and charged for service by any
public utility, the public utilities commission shall consider the management
policies, practices, and organization of the public utility. * * *
       “***
       “ * * * [T]he public utilities commission shall not allow such operating and
maintenance expenses of a public utility as are incurred by the utility through
management policies or administrative practices that the commission considers
imprudent.”
       {¶ 28} Thus, it follows that operating expenses that the commission
determines under R.C. 4909.154 were imprudently incurred will be disallowed,
when capitalized, as not being used and useful property under R.C. 4909.15(A)(1)
and therefore deducted from capitalized expense included in rate base.
       {¶ 29} This court set forth in Cincinnati v. Pub. Util. Comm. (1993), 

67 Ohio St.3d 523, 530

, 

620 N.E.2d 826

, 830, what constitutes a prudent decision:
       “ ‘[O]ne which reflects what a reasonable person would have done in light
of conditions and circumstances which were known or reasonably should have been
known at the time the decision was made.’ In the Matter of the Investigation into
the Perry Nuclear Power Station (Jan. 12, 1988), PUCO No. 85-521-EL-COI, at
10-11. The standard contemplates a retrospective, factual inquiry, without the use
of hindsight judgment, into the decisionmaking process of the utility’s
management.”




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                                January Term, 1999




       {¶ 30} The commission considered CG&E’s mismanagement of the CSS
project to constitute imprudence, resulting in the disallowance of a substantial
portion of CG&E’s proposed CSS rate-base property. We find that the commission
did not abuse its discretion in making that determination.
       {¶ 31} Institutional hubris is at the heart CG&E’s problems with the
development of the CSS. The stubborn belief that the project could be completed
in-house, despite continued rising costs and missed deadlines, was the source of
much of the project’s expense. By the time the company hired an independent
consultant to complete the CSS on deadline for a fixed fee, the damage had been
done. It is that period before the hiring of the consultant, when the company sought
to develop the project itself, that the commission points to in finding that CG&E
acted imprudently. We find that the record supports that conclusion.
       {¶ 32} We need not slog through the daily history of the development of
this project to determine that it was mismanaged. The big picture tells the tale.
When CG&E commenced development of the system in 1987, it projected that the
project would be completed by July 1990. In 1990, CG&E revised its projected
completion date to June 1991, and projected the capitalized cost to be $24 million.
Prior to 1990, CG&E had already spent $17 million in ordinary operating expenses
on the CSS project, but those expenditures are not at issue in this case. As of April
1991, the CSS project team was reporting in its status reports that the project was
running only two months behind schedule. By fall 1991, the truth was known: since
1990, CG&E had spent $47 million on the CSS, and it was only half complete. All
of these figures reveal that CG&E was an entity in over its head.
       {¶ 33} The evidence showed that at least ten other utilities undertaking
computer projects of similar complexity sought, without exception, independent
professional supervision of project development. From virtually the time project
development began in 1987, CG&E knew, or should have known, that it was
involved in a massive undertaking that far exceeded the expertise of its in-house




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project team. CG&E had already sunk $47 million in capitalized expenditures into
the project when it finally relinquished project development supervision to CSC in
November 1991. Based on its 1990 projection of $24 million to complete the
project, CG&E went one hundred sixty percent over its budget.
       {¶ 34} Evidence     obtained    from    independent     consultant   Andersen
Consulting established that the project was approximately fifty percent completed
when CSC took over supervision in 1991. The CSC contract called for project
completion for a relatively frugal fixed fee of $14.875 million and established July
1993 as the deadline. CSC completed the job on time.
       {¶ 35} The CSC contract amount of $14.875 million and the fifty-percent
completion figure when CSC took over the job are the two most important elements
in the commission’s disallowance of a portion of the CSS costs from the rate base.
First, those figures help establish that the project was mismanaged by CG&E.
CG&E had nearly doubled its budget and had completed only half of the project
when CSC stepped in. For less than $15 million, CSC was then able to complete
in two years as much of the project as CG&E had completed at a cost of $47 million
in four years.
       {¶ 36} Second, the commission used the CSC contract to compute its rate-
base deduction. The commission’s staff used the amount paid to CSC to determine
the reasonable cost of the entire project. Using simple, but not simplistic, logic, the
commission’s staff reasoned that the one-half of the CSS development project
completed before CSC took over would reasonably cost the same as the amount
paid to CSC for the one-half of the project that CSC completed. The commission
thus doubled the fixed contract rate to arrive at its $29.75 million estimate of a
reasonable cost for the project. We find that while the staff’s methodology is
simple, it is justifiable as a means for estimating a reasonable cost for the CSS
development project.




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                                January Term, 1999




       {¶ 37} The figures relied upon by the staff and the commission were not
contrary to the manifest weight of the evidence. The staff presented adequate
evidence supporting the fifty-percent allocation.     The staff report stated that
“CG&E hired Andersen Consulting and CSC to perform a full assessment of the
entire project * * *. Both consultants agreed the CSS project was 50% completed
at the point of their evaluations.” The fifty-percent level of completion is clearly
corroborated by the analytical report of Andersen Consulting entitled “Customer
Service System Review.”
       {¶ 38} In his prepared written testimony, staff witness Francis C. Rack
adopted the fifty-percent level of completion and referred to the Andersen
Consulting conclusion that “the project was 50% complete at the time of their
evaluation.”      Rack testified on cross-examination that a CG&E manager he
interviewed agreed for the most part with the Andersen Consulting review, but that
the manager felt the work completion was closer to sixty-percent complete.
       {¶ 39} Rack further stated on cross-examination that he felt comfortable
relying primarily on Andersen Consultant’s estimation of fifty-percent completion
of the CSS development project in part because of a CG&E manager’s assessment
that Andersen Consulting did an in-depth evaluation of the project that constituted
“the best job.”
       {¶ 40} CG&E cross-examined staff witnesses and elicited from an expert
witness his opinion that the CSS was seventy- to seventy-five-percent complete
when CSC took over the project. CG&E provided other testimony and expert
witnesses that disagreed with or contradicted testimony and opinions of other staff
witnesses.
       {¶ 41} CG&E implies that the commission ignored evidence and cross-
examination of witnesses. Rather, it is probable that the commission merely chose
to rely on evidence and testimony other than that proffered by CG&E.




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       {¶ 42} The commission’s finding that the CSS development project was
fifty-percent complete was based on sufficient record evidence. While CG&E
presented testimony from its witnesses of a greater level of completion, the
commission’s finding of a fifty-percent level of completion is certainly not
manifestly against the weight of the evidence.
       {¶ 43} The commission and its staff also broke down the big picture, and
identified six separate ways by which CG&E was deemed to have mismanaged the
CSS development project. The staff concluded and the commission agreed that
CG&E had unreasonably missed project deadlines and exceeded project costs, had
failed to sign CSS contractors to contracts with identified deliverables with certain
deadlines, had chosen to develop a customized DB2-based CSS system without
adequate identification of software capabilities and resource availability, had
invested in a system in which the costs greatly exceeded benefits, and had failed to
maintain an adequate audit trail of CSS system development and managerial
decision-making with regard to costs and deadlines.
       {¶ 44} Each of those elements is supported by record evidence. CG&E
presented contradictory evidence as to several of the elements, and as to several of
them CG&E challenged whether the evidence presented by the commission’s staff
evinced mismanagement. However, the evidence of elements of mismanagement
was sufficient to support a conclusion that CG&E had mismanaged the CSS
development project.
       {¶ 45} Therefore, the commission’s deduction from the rate base for
CG&E’s imprudent expenditures under R.C. 4909.154 should stand. The $29.75
million figure is nearly twenty-five percent higher than CG&E’s original
capitalized cost estimate of $24 million to complete the project and also
significantly exceeds the tangible benefit of $20 million that the staff found
associated with project completion. We affirm the commission on this issue.
                                  Delta Revenues




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                                 January Term, 1999




        {¶ 46} A utility’s test-period revenues are a key component in determining
whether the commission will grant a rate increase. The test period provides a
snapshot of the utility’s revenues. Those revenues form the basis upon which the
utility will be judged. If the revenues received by the utility during the test year are
less than the gross annual revenues to which the utility is entitled, the commission
is required to fix new rates that will raise the necessary revenue. R.C. 4905.15(D);
Columbus S. Power, 67 Ohio St.3d at 537-538, 

620 N.E.2d at 838-839

.
        {¶ 47} R.C. 4909.15(C) addresses test-period revenues. R.C. 4909.15(C)
provides:
        “The test period, unless otherwise ordered by the public utilities
commission, shall be the twelve-month period beginning six months prior to the
date the application is filed and ending six months subsequent to that date. In no
event shall the test period end more than nine months subsequent to the date the
application is filed. The revenues and expenses of the utility shall be determined
during the test period. The date certain shall be not later than the date of filing.”
        {¶ 48} R.C. 4909.15(C) by its terms does not require that the commission
apply actual test-period revenues in the ratemaking formula. Neither party disputes
that estimates and forecasts are permissible. They are necessary for a representative
sampling.
        {¶ 49} But the revenues attributed to CG&E in this case were something
other than forecasts. Their lack of connection to reality is what CG&E disputes. A
forecast would take into account the contract price for the service provided and
multiply that by the volume anticipated to be used by the buyer to determine
revenue. The commission substituted the price it thought CG&E should charge for
the service. Instead of forecasting based on known factors, the commission ignored
reality. Instead of a snapshot of CG&E’s revenues, the commission substituted its
own surreal vision. The law requires Ansel Adams; the commission gives us
Salvador Dali.




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       {¶ 50} This court has determined that the commission has statutory
authority to make adjustments to test-period revenues. R.C. 4909.15(D)(2) allows
the commission to “smooth out anomalies” in test-period data. Columbus S. Power
Co. v. Pub. Util. Comm. (1993), 

67 Ohio St.3d 535, 539

, 

620 N.E.2d 835, 839

. The
reasoning behind that policy was explained in Consumers’ Counsel v. Pub. Util.
Comm. (1981), 

67 Ohio St.2d 153, 166

, 

21 O.O.3d 96, 104

, 

423 N.E.2d 820

, 828:
       “It is our view that R.C. 4909.15(D)(2)(b) is designed to allow the
commission to make minor adjustments to rates ascertained by the statutory
formula when the criteria upon which rates are based are skewed for one reason or
another. Thus, under R.C. 4909.15(D)(2)(b), the commission may smooth out
anomalies in the ratemaking equation that tend to make the test year data
unrepresentative for ratemaking purposes.”
       {¶ 51} The rates paid for gas transport by AK Steel and Ford during the test
period were not unrepresentative of the price they had paid previously or would
continue to pay. The test-period rates were those rates that AK Steel and Ford
would continue to pay in the long term, contract rates that were approved by the
commission pursuant to R.C. 4905.31. Those contracts required CG&E to transport
gas to AK Steel and Ford for $0.24/Mcf and $0.23/Mcf respectively, rather than the
tariff rate of $0.537/Mcf.
       {¶ 52} This court has held that the commission has the power to “smooth
out anomalies” when something occurs out of the ordinary in the test period. But
in Dayton Power & Light Co. v. Pub. Util. Comm. (1983), 

4 Ohio St.3d 91, 95

, 4
OBR 341, 344, 

447 N.E.2d 733, 736

, this court stated that such “exceptions remain
exceptions, and ad hoc tinkering with the statutory formula is not to become the
rule.” For instance, if the volume transported spiked one way or other because of
an unlikely demand shift, the commission could adjust the figures to more
appropriately reflect what they would be in a more normal time period. But in this
case, only the ordinary happened. The rate stayed as it had been and the way it




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would continue to be, and the way the commission had earlier approved. The
contract revenues are representative of normal operations and do not represent
“anomalies in the ratemaking equation that tend to make the test year data
unrepresentative for ratemaking purposes.” Consumers’ Counsel, 

67 Ohio St.2d at 166

, 

21 O.O.3d at 104

, 

423 N.E.2d at 828

.
        {¶ 53} Therefore, it was unlawful for the commission to substitute the
maximum tariff rate of $0.537/Mcf for the contractual rates of $0.24/Mcf and
$0.23/Mcf in calculating CG&E’s test-period revenues.         We reverse the
commission on this issue.
                                                         Order affirmed in part
                                                          and reversed in part.
        RESNICK and F.E. SWEENEY, JJ., concur.
        MOYER, C.J., COOK and LUNDBERG STRATTON, JJ., concur in judgment
only.
        DOUGLAS, J., dissents.
                                 __________________




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