II. Standard of Review

Although the Commission is only considering rate of return for distribution operations in this case, the standards are still those articulated in Bluefield Water Works and Improvement Co. v. Public Service Comm'n, 262 U.S. 679 (1923) and Federal Power Comm'n v. Hope Natural Gas Co., 320 U.S. 591 (1944). In Bluefield Water Works, the Court stated:

"A public utility is entitled to such rates as will permit it to earn a return upon 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... 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." (Bluefield Water Works 262 U.S. at 692.)

In Hope, the Court reiterates the financial soundness and capital attraction principles of Bluefield:

"From the investor or company point of view 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 of the stock. By that standard the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks. The return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and attract capital." (Hope Natural Gas, 320 U.S. at 603.)

The rate of return on rate base authorized by the Commission must be sufficient to satisfy this standard in order to give utility shareholders a return commensurate with the risks of comparable investments. However, in applying that standard, we must not lose sight of our duty to protect the ratepayers from unreasonable rates.

The risk/return standard established by Hope and Bluefield is often met by identifying companies of comparable risk, and estimating the returns expected by shareholders of those companies. Currently, however, there aren't any domestic stand-alone electric utility distribution companies (UDCs). Without any pure UDCs to provide information on returns, the parties in this proceeding have either (1) used natural gas distribution companies as a proxy for electric distribution or (2) used traditional, integrated electric utility companies as a first approximation or (3) created novel theories of comparability. Some parties then adjusted their result (the "distribution risk" adjustment) to arrive at a UDC cost of capital.

The process of selecting a group of comparable companies, estimating the cost of equity capital for that group using different models and inputs, and then determining a distribution risk adjustment, if any, requires judgment at each step of the process, and that judgment invites controversy.

The arguments over financial theory and its application to the cost of capital modeling, the extensive differences of opinion over the merits and drawbacks of different models, and the varied attempts to find a way to assess the difference in risk and required return between the stand-alone UDC and the integrated electric utility present a multitude of alternatives needing resolution. There is, however, one common theme arising from the differences in theory, models, data, and their application which all parties share. That theme is the need and importance for the Commission to exercise judgment in evaluating the evidence and outcomes presented by the parties. Even under the best conditions, financial modeling is an imperfect tool dependent upon input assumptions that are unavoidably subject to varying degrees of error. We must exercise our judgment as to whether the outcome of a given analysis is consistent with or contrary to common sense.