The U.S. Court of Appeals for the District of Columbia Circuit has overturned a Federal Energy Regulatory Commission (FERC) gas pipeline order, finding that the FERC had failed to support its decision to use a hypothetical capital structure in determining the pipeline's revenue requirement. In setting rates for Transcontinental Gas Pipeline, the FERC found the corporate parent's equity ratio of 16.27 percent abnormally low. Although FERC practice is to use the actual corporate structure of a pipeline's corporate parent in setting rate of return, the FERC said that using the actual figures in this case would require an "anomalously high" return award to compensate for the financial risk associated with such a low level of equity. Using figures based on a proxy group of unregulated parent companies with pipeline subsidiaries would still require a rate of return on equity (ROE) at the high end of the zone of reasonableness (14.45 percent), according to the FERC, because the pipeline's business and financial risk were higher than those of all but one of the other pipelines and its current credit ratings were below investment grade.

According to the circuit court, the FERC never explained why the allegedly high rate of return must be avoided. It rejected claims that the FERC sought to avoid setting a precedent for the use of a high ROE figures in pipeline rate cases. The court added that the FERC's "naked citation" to its 1977 ruling in Communications Satellite Corp. v. FCC, which supported the use of hypothetical capital structures for ratemaking, was improper because that case involved imputing debt to protect ratepayers rather than adding equity to the ratio to protect investors. The court also ruled that the decision to adopt an ROE at the top of the zone of reasonableness was flawed because the FERC failed to adequately consider the effect of its own decision to allow the pipeline to recover ROE through fixed costs under a straight fixed-variable rate design. North Carolina Utilities Commission et al. v. Federal Energy Regulatory Commission, Case Nos. 93-1456, et al., Dec. 23, 1994 (D.C.Cir.).

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