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decided: April 2, 1945.



Stone, Roberts, Black, Reed, Frankfurter, Douglas, Murphy, Jackson, Rutledge

Author: Douglas

[ 324 U.S. Page 584]

 MR. JUSTICE DOUGLAS delivered the opinion of the Court.

The Federal Power Commission after an investigation and hearing entered orders under § 5 of the Natural Gas Act of 1938 (52 Stat. 823, 15 U. S. C. § 717d) finding the interstate wholesale rates of petitioners to be excessive by specified amounts per year and requiring petitioners to reduce the rates accordingly. 43 P. U. R. (N. S.) 205. The Circuit Court of Appeals for the Tenth Circuit affirmed the Commission's orders. 142 F.2d 943. The cases are here on petitions for certiorari which we granted, limited to the few questions to which we will presently advert.

Petitioners (to whom we will refer as Canadian and as Colorado Interstate) had their origin in an agreement made in 1927 between Southwestern Development Co. (Southwestern), Standard Oil Co. (N. J.) (Standard) and Cities Service Co. (Cities Service). It was the purpose of the agreement to bring natural gas from the Panhandle field in Texas to the Colorado markets, including Denver and Pueblo. Southwestern agreed to transfer through a wholly owned subsidiary, Amarillo Oil Co. (Amarillo), certain gas leaseholds and producing properties to a new subsidiary (Canadian) which it would organize for that purpose. Standard agreed to form a new corporation (Colorado Interstate) and to finance its construction of pipeline facilities which would connect with Canadian's facilities and transport gas from those points in the Panhandle field to the Colorado markets. Cities Service agreed to use its best efforts to obtain franchises through its subsidiaries under which the natural gas could be distributed in certain cities in Colorado including Denver and Pueblo. The gas was to be sold to Colorado Interstate by Canadian at cost (as defined in the contract) for at least 20 years from 1928. We will return

[ 324 U.S. Page 585]

     to other details of this tripartite agreement and of the organization and financing of Canadian and Colorado Interstate. It is sufficient here to say that the companies were incorporated, the pipeline was built, and the business put into operation. Although Canadian and Colorado Interstate are separate companies, the Commission found that their properties have been operated as a single enterprise.

Canadian produces from its own properties all the gas which it sells. It has about 300,000 acres of natural gas leaseholds and on December 31, 1939, was operating 94 wells. Its gathering system consists of approximately 144 miles of pipe. It owns and operates a transmission line which connects with its gathering system in the Panhandle field and ends about 85 miles distant at a point near Clayton, New Mexico. Canadian sells some of its gas at the wellhead and along the Texas portion of its transmission line for consumption in Texas. It also sells gas for resale in Clayton, New Mexico. But the chief portion of the gas in its transmission line is sold at that point to Colorado Interstate. The pipeline of Colorado Interstate extends to Denver. It sells the gas to various distributing companies for resale by them in Colorado and in a few points in Wyoming.*fn1 Colorado Interstate also sells gas from this pipeline direct to industrial customers in Colorado for their own use.

It is thus apparent that the pipeline from Texas to Colorado serves three different uses: (a) intrastate transportation and sale in Texas; (b) interstate transportation

[ 324 U.S. Page 586]

     and sale to industrial customers; and (c) interstate transportation to distributing companies for resale. Only some of those activities are subject to the jurisdiction of the Commission. For § 1 (b) of the Act provides:

"The provisions of this chapter shall apply to the transportation of natural gas in interstate commerce, to the sale in interstate commerce of natural gas for resale for ultimate public consumption for domestic, commercial, industrial, or any other use, and to natural-gas companies engaged in such transportation or sale, but shall not apply to any other transportation or sale of natural gas or to the local distribution of natural gas or to the facilities used for such distribution or to the production or gathering of natural gas."

It is around the meaning and implications of that provision that most of the present controversy turns.

Allocation of Cost of Service. The questions raised by Colorado Interstate and some of those raised by Canadian relate to the failure of the Commission (1) to separate the physical property used in common in the intrastate and interstate business; (2) to separate that used in common in the sales of gas to industrial consumers and the sales of gas for resale; and (3) to separate the property used exclusively in intrastate business or exclusively for industrial sales. The Commission thought it unnecessary to make such a separation of the properties. It noted that nowhere in the evidence presented by petitioners was there "a complete presentation of the entire operations of the company broken down between jurisdictional and non-jurisdictional operations." 43 P. U. R. (N. S.), p. 232. And it concluded, "All that can be accomplished by an allocation of physical properties can be attained by allocating costs including the return. The latter method is by far the most practical and businesslike." Id., p. 232. The Commission adopted the so-called "demand and

[ 324 U.S. Page 587]

     commodity" method for allocating costs. Cf. Arkansas Louisiana Gas Co. v. Texarkana, 96 F.2d 179, 185. It took the costs and divided them into three classes -- volumetric, capacity, distribution.*fn2 Costs relating to the production system were treated as volumetric.*fn3 These included rate of return and depreciation and depletion on leases and wells. These volumetric costs were allocated to the customers in proportion to the number of Mcf's delivered to each customer in 1939. The larger share of the transmission costs of the Denver pipeline were classified as capacity costs. Supplies and expenses of compressing systems, maintenance of compressing system equipment and accruals for its depreciation were classed as volumetric. And one-half of the return and income taxes on the Denver pipeline and one-half of operating labor on the compressing system were classed as volumetric, the other half being classed as capacity. Capacity costs were allocated to the customers in the ratio that the Mcf sales to each customer on the system peak day of February 9, 1939, bore to the total sales to all customers on that day. Distribution costs were composed in part of depreciation, taxes, and return on investment in metering and regulating equipment through which gas is delivered at individual stations to each customer. These were allocated to each customer in the ratio which the investment for each customer bore to the total investment in such facilities which were available to serve all customers. Distribution costs also included operating and maintenance expenses incurred in operating the metering and regulating stations. These were allocated on the basis of the number of stations.

[ 324 U.S. Page 588]

     The function which an allocation of costs (including return) is designed to perform in a rate case of this character is clear. The amount of gross revenue from each class of business is known. Some of those revenues are derived from sales at rates which the Commission has no power to fix. The other part of the gross revenues comes from the interstate wholesale rates which are under the Commission's jurisdiction. The problem is to allocate to each class of the business its fair share of the costs. It is of course immaterial that the revenues from the intrastate sales or the direct industrial sales may exceed their costs, since the authority to regulate those phases of the business is lacking. To the extent, however, that the revenues from the interstate wholesale business exceed the costs allocable to that phase of the business, the interstate wholesale rates are excessive. The use of that method in these cases produced the following results:


Excess Revenue

Revenues Costs Over Costs

Regulated $2,151,000 $1,590,000 $561,000

Unregulated 242,000 188,000 54,000

Colorado Interstate

Excess Revenue

Revenues Costs Over Costs

Regulated $4,438,000 $2,373,000 $2,065,000

Unregulated 1,335,000 1,204,000 131,000

The Commission did not include in the rate reductions which it ordered any of the excess revenues over costs from the unregulated business. The reductions ordered were measured solely by the excess revenues over costs in the regulated business, viz., $2,065,000 in case of Colorado Interstate and $561,000 in case of Canadian.

Colorado Interstate and Canadian make several objections to that method. They maintain in the first place that a segregation of the physical property based upon use is necessary so that the payment due for the use of that

[ 324 U.S. Page 589]

     property which is in the public service may be determined. Reliance for that position is rested on the Minnesota Rate Cases, 230 U.S. 352, 435, and Smith v. Illinois Bell Telephone Co., 282 U.S. 133, 146. Those were cases which involved state regulation of intrastate rates of companies doing both an intrastate and interstate business. But the rule fashioned by this Court for use in those situations was not written into the Natural Gas Act. Congress indeed prescribed no formula for determining how the interstate wholesale business, whose rates are regulated, should be segregated from the other phases of the business whose rates are not regulated. Rate-making is essentially a legislative function. Munn v. Illinois, 94 U.S. 113. Congress, to be sure, has provided for judicial review of the Commission's orders. § 19. But that review is limited to keeping the Commission within the bounds which Congress has created. When Congress, as here, fails to provide a formula for the Commission to follow, courts are not warranted in rejecting the one which the Commission employs unless it plainly contravenes the statutory scheme of regulation. If Congress had prescribed a formula it would be the duty of the Commission to follow it. But we cannot say that under the Natural Gas Act the Commission can employ only one allocation formula and that that formula must entail a segregation of property. A separation of properties is merely a step in the determination of costs properly allocable to the various classes of services rendered by a utility. But where, as here, several classes of services have a common use of the same property, difficulties of separation are obvious. Allocation of costs is not a matter for the slide-rule. It involves judgment on a myriad of facts. It has no claim to an exact science. Hamilton, Cost as a Standard for Price, 4 Law & Cont. Prob. 321. But neither does the separation of properties which are not in fact separable because they function as an integrated whole. Mr. Justice Brandeis,

[ 324 U.S. Page 590]

     speaking for the Court in Groesbeck v. Duluth, S. S. & A. R. Co., 250 U.S. 607, 614-615, noted that "it is much easier to reject formulas presented as being misleading than to find one apparently adequate." Under this Act the appropriateness of the formula employed by the Commission in a given case raises questions of fact, not of law.

Colorado Interstate claims that the Commission's formula ignored or at least failed to give full effect to the priority which the wholesale gas has over direct industrial sales -- a priority recognized in the contracts with industrial users and in the municipal franchises. But over the years the interruptions or curtailments in service to direct industrial customers appear to have been slight.*fn4 Moreover, to the extent that the priority accorded wholesale gas was actually exercised during the test year (1939) the allocation of costs made by the Commission gave full effect to it. As we have seen, volumetric costs were allocated to the customers in proportion to the number of Mcf's delivered to each customer during the year; capacity costs were allocated in the ratio that the Mcf sales to each customer on the system peak day bore to the total sales on that day. The formula used reflected all actual curtailments of load to each customer during the year and on the system peak day.

Colorado Interstate objects because the Commission treated the transmission line as a unit. It points out that some laterals and equipment (such as metering stations) are used exclusively for making wholesale sales, some are used exclusively for making intrastate sales or direct industrial sales, and some are used in common in varying degrees by the several classes of business. It is pointed out, for example, that the line north of Pueblo is used almost exclusively by the regulated business but that under the Commission's formula the pipeline was treated as

[ 324 U.S. Page 591]

     if all the gas went into the pipe in Texas and came out at the Denver city gate. These objections are partially met by the manner in which distribution costs, to which we have referred, were allocated. But that is no more than a partial answer since they pertained only to metering and regulating equipment. The laterals were not segregated. They, however, appear to be used more commonly for direct industrial rather than for wholesale sales; and we are not convinced that the direct industrial sales were saddled with greater costs than they would have been had the laterals been segregated. The gravamen of this complaint is that the industrial sales are being burdened with costs of a part of the system which the direct industrial gas never uses. That contention points up our earlier observation that judgment and discretion control both the separation of property and the allocation of costs when it is sought to reduce to its component parts a business which functions as an integrated whole. The Commission found that but for the direct industrial market at Pueblo, Colorado and the wholesale market at Denver, the pipeline would not have been constructed. 43 P. U. R. (N. S.) p. 210. It is therefore obviously fair to determine transmission costs for the pipeline as a whole and not to compute them on a mileage demand basis. In that way the beneficiaries of the entire project share equitably in the cost. To allow the costs to accumulate the closer the gas gets to Denver would be to assume that the extension to Denver was a separate project on which the earlier customers were in no way dependent. These circumstances illustrate that considerations of fairness, not mere mathematics, govern the allocation of costs. Cf. Wabash Valley Electric Co. v. Young, 287 U.S. 488, 499. What we have said also answers Canadian's complaint that the wholesale sales in Texas for consumption in the towns of Dalhart, Hartley, and Texline, Texas, are burdened with too large a share of transmission costs. We can see in

[ 324 U.S. Page 592]

     this situation no difference between those customers and the ones located at more distant points on the pipeline.*fn5

Colorado Interstate objects to that part of the Commission's treatment of transmission costs whereby it assigned 50% of the return to capacity costs and 50% to volumetric costs. The contention is that the entire return on the transmission facilities should be apportioned to capacity costs on the theory that the volumetric costs have no relation to the property required for meeting the maximum demands of the wholesale business and that the method employed departs from the requirements of a fair return on the property devoted to the public service. But, as we have seen, capacity costs were allocated to customers in the ratio that the Mcf sales to each customer on the system peak day bore to the total sales to all customers on that day. It is not apparent why direct industrial sales should carry a lighter share of the costs merely because their use of the pipeline may be less on the system peak day. As the Commission points out, if the method advanced by Colorado Interstate were used, the amount paid by the industrial customer for transportation of the gas through the pipeline would be measured not by the customer's use throughout the year, which might be substantial, but by its use on the system peak day which might be slight. In that event the industrial customer would obtain to an extent free transportation of gas.

Colorado Interstate also makes objection to the selection and use of February 9, 1939, as the system peak day and the allocation of the capacity cost component of the transmission costs on the basis of use on that day. It is argued that the mean temperature for that day was 8 degrees Fahrenheit above zero, that much lower mean temperatures

[ 324 U.S. Page 593]

     are experienced in the Colorado area, that as the temperature drops the load of resale gas rapidly increases, and that if these capacity costs were allocated on the basis of use during the coldest day the resale gas would carry a greater portion of them. We do not stop to develop the point. We have carefully considered Colorado Interstate's contention. As we read the record, if either of the days selected by Colorado Interstate were taken as the system peak days, there would be allocated to the industrial gas a larger portion of these capacity costs than the Commission allocated. On that showing we cannot say that the choice of February 9, 1939, was unfair.

Colorado Interstate and Canadian object to the Commission's use of the return. The Commission included in the total cost of service for these companies a 6 1/2 per cent return on the rate base.*fn6 In other words, the 6 1/2 per cent return was computed on the basis of all the property used by petitioners in their various classes of business -- intrastate sales, direct industrial sales, and interstate wholesale sales.*fn7 Now it is apparent that if the reduction ordered was based on the excess of revenues from all classes of business over the aggregate costs, the result would be to reduce to a common level the profits from each class. In that case, whenever a company was making a higher return on its unregulated business than the rate of return allowed for the regulated business, the excess earnings from the unregulated part would be appropriated to the

[ 324 U.S. Page 594]

     entire business. When the unregulated business was being operated at a loss or at less than the return which was allowed, excess earnings from the regulated business would be appropriated to the unregulated business. A low rate might therefore be concealed by siphoning earnings from the unregulated business; a high rate might be built up by making the regulated business share the losses of the unregulated one.

It is said that that is what happened here. But that is not true. As we have seen, the Commission ordered a rate reduction based solely on the excess of revenues over costs (including return) derived from the regulated business. None of the excess revenues over costs (including return) from the unregulated business was included in that reduction. If the Commission in determining costs of the unregulated business had used a higher rate of return, it would have increased the costs of that business and reduced the excess revenues allocable to it. But since under the Commission's method of allocation the amount of that excess would not be reflected in the reduction ordered, there would be no difference in result.

The cases are presented as if the 6 1/2 per cent allowed by the Commission on the rate base limits the earnings from the whole enterprise to 6 1/2 per cent. That also is not true. The return merely measures the earnings allowed from the regulated business. As we have noted, the excess of earnings which Colorado Interstate makes from direct industrial sales (on the basis of 6 1/2 per cent return) is $131,000 annually. The Commission pointed out (43 P. U. R. (N. S.) p. 230) that if Colorado Interstate "retains these earnings in excess of a 6 1/2 per cent rate of return on its sales to these ...

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