Constitutional Limitations on the Ability of States to Rehabilitate Their Failed Electric Utility Restructuring Plans

• Publication year: 2008

UNIVERSITY OF PUGET SOUND LAW REVIEWVolume 31, No. 33.SPRING 2008

Constitutional Limitations on the Ability of States to Rehabilitate Their Failed Electric Utility Restructuring Plans

James M. Van Nostrand(fn*)

I. Introduction

In recent years, several states have struggled with the consequences of regulatory regimes they adopted in the late 1990s to restructure the electric utility industry.(fn1) When they were implemented, the general pattern of these restructuring plans included an initial rate reduction for various customer classes, followed by a multiyear rate freeze.(fn2) The expected result was that during the rate freeze period, competition would develop and power costs would decline over time, so that upon expiration of the rate freeze, rates would not change, or would perhaps even decline.(fn3) For the most part, however, the anticipated competition did not develop.(fn4) Moreover, during the same period, the cost of generating power increased significantly, due primarily to increases in the costs of the underlying fuel sources.(fn5) When the anticipated benefits of competition failed to materialize, states considered various options for rehabilitating their programs. These included complete abandonment of the restructuring effort or mid-course corrections to the regulatory regimes, such as extending the term of the rate freeze, or requiring rate increases in reduced amounts to be phased in over a period of years.

These rehabilitation efforts can raise serious constitutional questions under a Takings Clause analysis under the Fifth Amendment, and as a matter of procedural due process. This Article will review the constitutional limitations that come into play when a state seeks to rehabilitate its failed electric utility restructuring plan. Under the Constitution, utilities are entitled to earn a reasonable return on the assets devoted to public service.(fn6) A situation in which retail rates are frozen may result in denial of a compensatory return if the electric utility is incurring higher costs to generate or procure its power supply. This is the traditional "takings" argument based on the Fifth Amendment to the Constitution, as applied to the states under the Fourteenth Amendment.(fn7) Apart from this commonly asserted argument, however, a different constitutional issue arises in the context of proposed rate freezes. As a matter of procedural due process, a regulated utility cannot be deprived of its opportunity to demonstrate a need for rate relief to achieve the level of profitability that satisfies constitutional requirements.(fn8) These procedural due process rights are imperiled when, for example, a state simply extends a rate freeze period and thereby denies the electric utility a hearing in which the utility would have an opportunity to make its case for higher rates.

This Article will review these two separate constitutional issues, but will focus primarily on the procedural due process implications that arise in these restructuring controversies. Several cases have recognized and discussed the distinctions between the common "takings" claims and the far less common procedural due process claims that arise when a utility is denied the ability to demonstrate a need for rate relief. Part II includes a discussion of these leading cases and their applicability to the circumstances when states attempt to rehabilitate electric utility restructuring efforts. Part III continues with a review of illustrative restructuring plans enacted in various states, and how these constitutional issues have, or potentially will, come into play as states struggle with the results of their restructuring regimes.

II. The Constitutional Limitations

There are two main constitutional limitations applicable to rate regulation: (1) Taking Clause limitations; and (2) Due Process Clause limitations. The discussion of constitutional limitations starts in Section A with the Takings Clause claims commonly asserted by utilities in the context of rate regulation. Takings Clause jurisprudence recognizes that regulated utility companies must be allowed to earn a fair rate of return on their investment.(fn9) If a utility regulatory commission fails to grant rate relief in an amount adequate to provide a utility with an opportunity to earn a reasonable return, or denies recovery on a specific utility investment, the utility may have a constitutional claim based on the Takings Clause. Where a utility is denied an opportunity to make a case showing that rate relief is necessary (such as through extension of a rate cap period) a Due Process Clause challenge may be available.(fn10) A statute on its face may violate the Due Process Clause if it does not provide a mechanism by which the utility may seek relief from allegedly confiscatory rates. This is in contrast to a Takings Clause claim that the rates resulting from the implementation of the statute are confiscatory. It is a Due Process Clause challenge that may arise in the context of states' efforts to rehabilitate their failed electric utility restructuring plans. Section B of Part II will discuss Due Process Clause jurisprudence and how it potentially arises in the context of utility rate freeze measures.

A. The "Takings " Claim

The Fifth and Fourteenth amendments to the Constitution prohibit the government from taking private property for public use without just compensation.(fn11) These provisions apply to government regulation of maximum rates, and establish a constitutionally-based floor below which a rate ceiling must be reversed as confiscatory.(fn12) In determining maximum rates, the courts initially attempted to identify the constitutional floor by reference to an agency's determination of the regulated firm's rate base.(fn13) In Bluefield Water Works and Improvement Co. v. Public Service Commission, the Supreme Court enunciated the constitutional standard for determining the adequacy of a utility's allowed rate of return: A public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties; but it has no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures. The return should be reasonably sufficient to assure confidence in the financial soundness of the utility and should be adequate, under efficient and economical management, to maintain and support its credit and enable it to raise the money necessary for the proper discharge of its public duties.(fn14)

Prior to 1944, the courts engaged in a detailed review of each of the three major components used in determining a utility's maximum rates: (1) its rate base; (2) the allowed rate of return; and (3) operating expenses.(fn15) In 1944, in Federal Power Commission v. Hope Natural Gas Co., the Supreme Court enunciated a different approach that would not require a detailed constitutional review of each component of the rate-setting equation.(fn16) Specifically, the Court held that, in setting maximum rates, the utility commission would not be "bound to the use of any single formula or combination of formulae in determining rates."(fn17) Rather, it would be the "result reached[,] not the method employed" that would be controlling.(fn18)

Hope involved the rate-setting statute under sections 4 and 5 of the Natural Gas Act,.(fn19) According to Hope, "[t]he rate-making process under the Act, i.e., the fixing of 'just and reasonable' rates, involves a balancing of the investor and the consumer interests."(fn20) The Court described the investor interest as having "a legitimate concern with the financial integrity of the company whose rates are being regulated,"(fn21) and went on to describe the "company or investor interest" as follows:It is important that there be enough revenue not only for operating expenses but also for the capital costs of the business. These include service on the debt and dividends on the stock. By that standard the return to the equity owner should be commensurate with returns on investment in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital.(fn22)

The three tests established by the Court in Bluefield and Hope are commonly referred to as: (1) the comparable earnings test; (2) the financial integrity test; and (3) the attraction of capital test.(fn23) According to Bluefield, rates that fail to meet these standards "are unjust, unreasonable and confiscatory, and their enforcement deprives the public utility company of its property in violation of the Fourteenth Amendment."(fn24)

The "just and reasonable" standard in utility ratemaking statutes is a term of art, and typically requires a balancing between the interests of the owners of the utility (i.e., the utility investors) and the utility's customers.(fn25) This balancing recognizes that while utility customers should pay rates that are reasonable, the rates must be sufficient to produce a profit level that enables the utility to maintain its financial integrity and...