Petal Gas Storage , L.l.c. v. Federal Energy Regulatory Commission

United States Court of Appeals
FOR THE DISTRICT OF COLUMBIA CIRCUIT
Argued April 4, 2007 Decided August 7, 2007
No. 04-1166
PETAL GAS STORAGE , L.L.C.,
PETITIONER
v.
FEDERAL ENERGY REGULATORY COMMISSION ,
RESPONDENT
I NTERSTATE NATURAL GAS ASSOCIATION OF AMERICA AND
EXXON M OBIL GAS & POWER M ARKETING ,
I NTERVENORS
Consolidated with
06-1064
On Petitions for Review of Orders of the
Federal Energy Regulatory Commission
Howard L. Nelson argued the cause for petitioners. With
him on the briefs was Kenneth M. Minesinger.
Joan Dreskin and Timm Abendroth were on the briefs for
intervenor Interstate Natural Gas Association of America.

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Lona T. Perry, Senior Attorney, Federal Energy Regulatory
Commission, argued the cause for respondent. With her on the
brief were John S. Moot, General Counsel, and Robert H.
Solomon, Solicitor. Beth G. Pacella, Attorney, entered an
appearance.
Before: SENTELLE , TATEL and BROWN , Circuit Judges.
Opinion for the Court filed by Circuit Judge BROWN .
BROWN , Circuit Judge: This case features two natural gas
pipeline companies, Petal Gas Storage, L.L.C., and High Island
Offshore System, L.L.C., that challenge ratemaking orders from
the Federal Energy Regulatory Commission. The chief
issue—the only one Petal and HIOS share in common, and the
one that brings the Interstate Natural Gas Association of
America (representing most of North America’s natural gas
transportation companies) into this case as intervenor—is
whether the Commission erred in its selection of the “proxy
groups” used to calculate petitioners’ gas transmission rates,
along with its placement of petitioners within those proxy
groups. We hold that the Commission did err, by failing to
explain how its proxy group arrangements were based on the
principle of relative risk. In addition, HIOS presents three
claims of its own, arguing the Commission should have ap-
proved the settlement it presented; selected a faster depreciation
rate for its pipeline system; and awarded it a higher management
fee. We reject all three claims, concluding that the Commission
was well within the considerable deference we show it in
ratemaking cases.
I
We begin with the question of whether the Commission
erred in its selection of proxy groups and placement of petition-

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ers within those proxy groups. The Administrative Procedure
Act’s arbitrary and capricious standard governs our review,
entitling the Commission to substantial deference, particularly
in the ratemaking context, E. Ky. Power Coop. v. FERC, No. 06-
1003, 2007 WL 1713348, at *6 (D.C. Cir. June 15, 2007) (citing
Administrative Procedure Act, 5 U.S.C. § 706(2)(A)), but also
imposing on it a duty of reasoned decisionmaking, Nat’l Fuel
Gas Supply Corp. v. FERC, 468 F.3d 831, 839 (D.C. Cir. 2006),
and requiring that “we . . . reverse a decision that departs from
established precedent without a reasoned explanation,” Exxon
Mobil Corp. v. FERC, 315 F.3d 306, 309 (D.C. Cir. 2003).
The Commission has a duty under § 4 of the Natural Gas
Act to ensure “just and reasonable” rates in the natural gas
industry. 15 U.S.C. § 717c. Proxy groups are a tool the
Commission uses, by policy, to determine just and reasonable
rates. Since the Supreme Court has held that rates “should be
sufficient to assure confidence in the financial integrity of the
enterprise, so as to maintain its credit and to attract capital,”
FPC v. Hope Natural Gas Co., 320 U.S. 591, 603 (1944), rates
are typically based on a pipeline’s costs, including the cost of
capital, Canadian Ass’n of Petroleum Producers v. FERC, 254
F.3d 289, 293 (D.C. Cir. 2001) (CAPP I). As the cost of equity
capital for a private natural gas company cannot be read from
the market, the Commission estimates this figure based on a
proxy group of publicly traded, but otherwise comparable,
natural gas companies. Id. at 293-94.
For natural gas pipelines, the Commission has traditionally
relied on a proxy group of publicly traded companies with a
high proportion of their business in pipeline operations.
Transcon. Gas Pipe Line, 90 F.E.R.C. ¶ 61,279, at 61,933
(2000). But the industry is changing. Acquisitions, financial
mishaps, and other factors have left, by one count, just three
companies that fit the old requirements (too few for a proxy

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group), Williston Basin Interstate Pipeline Co., 104 F.E.R.C.
¶ 61,036, at 61,103 P 35 (2003), and all parties to this case agree
the Commission’s traditional approach must change. See High
Island Offshore Sys., L.L.C., 112 F.E.R.C. ¶ 61,050, at 61,356
P 56 (2005) (“[A]ll the parties agree . . . only one corporation
. . . meets our historical proxy group standards and need not be
excluded for other reasons.”). Controversy about how it should
change has been bubbling up in a number of recent cases, see,
e.g., Kern River Gas Transmission Co., 117 F.E.R.C. ¶ 61,077,
at 61,342–49 PP 123–59 (2006); Williston Basin, 104 F.E.R.C.
¶ 61,036, at 61,103–04 PP 34–43, but this case seems to
represent an arrival point of sorts for the Commission, see Kern
River, 117 F.E.R.C. ¶ 61,077, at 61,345 P 138 (reversing an
administrative law judge for deviating from the HIOS proxy
group). The instant case is also this circuit’s first opportunity to
weigh in on the issue. Cf. Williston Basin Interstate Pipeline
Co. v. FERC, 475 F.3d 330, 333 (D.C. Cir. 2006) (dismissing
without reaching the proxy group issue); Canadian Ass’n of
Petroleum Producers v. FERC, 308 F.3d 11, 14–16 (D.C. Cir.
2002) (CAPP II) (finding no jurisdiction to consider the proxy
group issue).
Petal and HIOS dispute the design and implementation of
the Commission’s proxy groups in their cases on three grounds.
First, they claim the Commission improperly included in their
proxy groups low-risk, diversified natural gas companies with
most of their business in distribution rather than pipe-
lines—essentially LDCs (local gas distribution companies).
Second, they claim the Commission improperly excluded risk-
comparable MLPs (master limited partnerships) with a high
proportion of their business in natural gas pipelines. Finally,
given a proxy group of companies mainly engaged in gas
distribution, Petal and HIOS object to the Commission placing
them in the middle rather than the high end of the range of
returns.

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That proxy group arrangements must be risk-appropriate is
the common theme in each argument. The principle is well-
established. See Hope Natural Gas Co., 320 U.S. at 603 (“[T]he
return to the equity owner should be commensurate with returns
on investments in other enterprises having corresponding
risks.”); CAPP I, 254 F.3d at 293 (“[A] utility must offer a risk-
adjusted expected rate of return sufficient to attract investors.”).
The principle captures what proxy groups do, namely, provide
market-determined stock and dividend figures from public
companies comparable to a target company for which those
figures are unavailable. CAPP I, 254 F.3d at 293–94. Market-
determined stock figures reflect a company’s risk level and,
when combined with dividend values, permit calculation of the
“risk-adjusted expected rate of return sufficient to attract
investors.” Id. at 293; see also Williston Basin Interstate
Pipeline Co. v. FERC, 165 F.3d 54, 57 (D.C. Cir. 1999). The
Commission itself has recognized the principle (and in quite a
pointed way) by excluding, until recently, gas distribution
companies from gas pipeline proxy groups, sometimes expressly
for risk-based reasons. See, e.g., Trailblazer Pipeline Co., 106
F.E.R.C. ¶ 63,005, at 65,037 P 94 (2004) (rejecting inclusion of
LDCs in a proxy group “because they face less risk than a
pipeline”); Wyo. Interstate Co., 96 F.E.R.C. ¶ 63,040, at
65,262–63 (2001) (“The flaw in BP’s position is that the proxy
group advocated by it is heavily influenced by several distribu-
tion companies that are less risky than a transmission company
such as WIC.”); Mountain Fuel Res., Inc., 28 F.E.R.C. ¶ 61,195,
at 61,370 (1984) (“[T]he distribution companies . . . are not
really comparable to the level of risk involved in Resources’
operations.”).
On the record before us, we do not find adequate support for
the contention that the Commission’s proxy group arrangements
were risk-appropriate. In its HIOS ruling, the Commission
states that changes in the gas pipeline industry compel a new

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approach to proxy groups. High Island Offshore Sys., L.L.C.,
110 F.E.R.C. ¶ 61,043, at 61,157–58 PP 131–32 (2005). We
accept this. The Commission rejects the use of MLPs on the
ground that they issue distributions rather than dividends (and
thus might provide returns of equity as well as returns on
equity), and justifies the use of what are primarily gas distribu-
tion companies as “the best [option] available . . . on the current
record.” Id. at 61,157 P 131. While these propositions are not
self-evident, we accept them for the sake of argument. Still,
nothing in the Commission’s explanation tells us why the
companies selected are risk-comparable to HIOS. (Put differ-
ently, when the goal is a proxy group of comparable companies,
it is not clear natural gas companies with highly different risk
profiles should be regarded as comparable.) The Commission
does address the issue of relative risk when it places HIOS in the
middle of the proxy group in terms of return on equity. But in
doing so, the Commission expressly relies on the “assumption
that pipelines generally fall into a broad range of average risk
. . . as compared to other pipelines”—an assumption that is
decisive only given a proxy group composed of other pipelines.
Id. at 61,161 P 154. If gas distribution companies generally face
lower risks than gas pipeline companies (as seems likely), a risk-
appropriate placement would be at the high end of the group.
Finally, as to the Commission’s ruling in Petal’s case (which
involved a somewhat different proxy group from the one later
used with HIOS), the same analysis applies: The Commission
included gas distribution companies without an adequate
analysis of relative risk, and placed Petal in the middle of the
proxy group as if it were comparing Petal’s risk profile to other
gas pipeline companies. See Petal Gas Storage, L.L.C., 106
F.E.R.C. ¶ 61,325, at 62,282–83 PP 26–30 (2004).
We therefore vacate the Commission’s orders with respect
to the proxy group issue. On remand, we do not require any
particular proxy group arrangement. Perhaps it would be best to

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include gas distribution companies and exclude MLPs, but to put
petitioners’ rates of return on equity at the top of the range. Or
perhaps including MLPs and excluding gas distribution
companies, while putting Petal and HIOS in the middle of the
range, would be best. The Commission might even acceptably
return to this court with just the same arrangements it has
chosen, albeit explained and justified in very different terms.
What matters is that the overall proxy group arrangement makes
sense in terms of relative risk and, even more importantly, in
terms of the statutory command to set “just and reasonable”
rates, 15 U.S.C. § 717c, that are “commensurate with returns on
investments in other enterprises having corresponding risks” and
“sufficient to assure confidence in the financial integrity of the
enterprise . . . [and] maintain its credit and . . . attract capital,”
Hope Natural Gas Co., 320 U.S. at 603.
II
We turn now to HIOS’s three individual claims. In 2002,
HIOS sought to raise its shipping rates. An administrative law
judge rejected the rate increase in 2004, and HIOS appealed.
While the appeal was pending, HIOS worked out a settlement
with at least some of its shippers and filed the settlement with
the Commission for approval. The Commission rejected the
settlement and, on the merits, depreciated HIOS’s pipeline
system at a slower rate than HIOS favored, awarded HIOS a
smaller management fee than HIOS requested, and, of course,
used a proxy group to determine HIOS’s rate of return on equity.
Besides the proxy group argument (addressed above), HIOS
claims the Commission should have accepted its settlement
proposal. Failing that, HIOS disputes the Commission’s choice
of depreciation rate and management fee. As before, the
arbitrary and capricious standard governs our review.

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A
The Commission’s stringent, merits-based rejection of its
uncontested settlement, HIOS argues, violated FERC’s settle-
ment regulations and departed without explanation from the
precedent of Stingray Pipeline Co., 101 F.E.R.C. ¶ 61,365
(2002). In the proceedings below, some controversy swirled
over whether to regard the settlement as uncontested (as HIOS
contended it should be). But we need not join the fray: The
opinion under our review for this issue proceeds on the
“assum[ption that] the settlement may be treated as uncon-
tested,” High Island Offshore Sys., 110 F.E.R.C. ¶ 61,043, at
61,140 P 25; FERC’s brief never contends otherwise; and we,
proceeding on the same assumption, affirm.
Under FERC’s regulations for uncontested settlements, the
Commission “may” give a settlement its approval “upon a
finding that the settlement appears to be fair and reasonable and
in the public interest.” 18 C.F.R. § 385.602(g)(3). The
implication—as we have stated in dicta before and affirm
now—is that the Commission may adopt an uncontested
settlement only after finding it “fair and reasonable and in the
public interest”; that is, the Commission has a duty to disap-
prove uncontested settlements that are unfair, unreasonable, or
against the public interest. Mobil Oil Corp. v. FPC, 417 U.S.
283, 314 (1974) (“If a [settlement] proposal enjoys unanimous
support . . . , it could certainly be adopted . . . if approved in the
general interest of the public.” (emphasis added) (internal
quotation marks omitted)); NorAm Gas Transmission Co. v.
FERC, 148 F.3d 1158, 1165 (D.C. Cir. 1998) (“Even if . . .
customers had unanimously supported the proposed settlement,
the Commission would still have the responsibility to make an
independent judgment as to whether the settlement is ‘fair and
reasonable and in the public interest.’”); Tejas Power Corp. v.
FERC, 908 F.2d 998, 1003 (D.C. Cir. 1990) (“Commission may

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approve uncontested settlement only upon a finding that the
settlement appears to be fair and reasonable and in the public
interest.” (internal quotation marks omitted)).
Here, the Commission rejected the settlement for two
reasons. First, it dictated rates half again as high as the adminis-
trative law judge had approved. Second, it awarded a three-
million-dollar payout from HIOS to the active parties to the
settlement—a payout that the Commission concluded would, in
the circumstances of this case, undermine the usual assumption
that a settlement’s active parties will protect the interests of its
inactive parties. HIOS complains this level of scrutiny goes to
the merits in a way properly reserved for contested settlements,
18 C.F.R. § 385.602(h)(1)(i), but we see only the independent
consideration of fairness, reasonableness, and the public interest
the Commission is duty-bound to give. HIOS claims the
Commission approved a very similar settlement proposal in
Stingray. But in Stingray, the rates dictated in the settlement
were lower than those the administrative law judge had ap-
proved. True, Stingray featured a payout provision like the one
here. Faced with the discrepancy, the Commission explains that
“upon further reflection” it is “increasingly concerned about the
unduly discriminatory nature of such arrangements.” High
Island Offshore Sys., 110 F.E.R.C. ¶ 61,043, at 61,142 P 33. In
our view, so slight a change of course, for so ample and well-
established a reason, does not qualify as “depart[ing] from
established precedent without a reasoned explanation.” Exxon
Mobil, 315 F.3d at 309.
B
Determining a gas pipeline’s depreciation rate requires
forecasting “the probable useful life of the specific pipeline
systems in question,” based both on wear and tear and on the
exhaustion of natural resources. Memphis Light, Gas & Water

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Div. v. FPC, 504 F.2d 225, 232 (D.C. Cir. 1974). In this case,
we have a clash of experts. HIOS’s expert, relying on certain
specific reserves in the Gulf of Mexico (where HIOS operates),
gave the pipeline a reserve life of 10 years. FERC’s staff
witness, basing his estimate on a large swathe of the Gulf called
the Western Planning Area, gave a reserve life of 17.5 years.
The issue for the Commission was which of these two estimates
and experts to believe.
That is not, however, the issue facing us. Our question is
whether the Commission’s choice was rational or arbitrary. The
context gives further shape to our arbitrary and capricious
standard of review. First, “[t]he finding of the Commission as
to the facts, if supported by substantial evidence, shall be
conclusive.” Natural Gas Act § 19(b), 15 U.S.C. § 717r(b).
Second, where an agency is “making predictions, within its area
of special expertise, at the frontiers of science . . . as opposed to
simple findings of fact, a reviewing court must generally be at
its most deferential.” Balt. Gas & Elec. Co. v. Natural Res.
Defense Council, Inc., 462 U.S. 87, 103 (1983). Third, where
expert witnesses dispute a factual issue “‘the resolution of which
implicates substantial agency expertise,’” our role is only to
verify that the agency has “relied upon sufficient expert evi-
dence to establish a rational connection between the facts and
the choice made.” Wis. Valley Improvement Co. v. FERC, 236
F.3d 738, 746, 747 (D.C. Cir. 2001) (internal quotation marks
omitted) (quoting Marsh v. Or. Natural Res. Council, 490 U.S.
360, 376 (1989)). Here, the FERC staff expert, relying on data
from multiple sources, cited four facts in support of his conclu-
sion that there is “a significant amount of undiscovered gas
remaining in HIOS’[s] supply area”: an independent source’s
estimates, historical discoveries of new reserves, substantial
exploratory drilling in HIOS’s supply area, and proposed
incentives for further explorations. HIOS makes much of the
expert’s “area-wide approach to determin[ing] the total re-

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serves,” but at no point, on our reading of the testimony, does
the expert actually assume that HIOS can access all the gas in
the Western Planning Area. Rather, he takes “representative”
samples from the whole area to give an indication of what HIOS
can expect from the reserves it can access. The work shows
every sign of care, and the Commission’s reliance on it falls well
within our norms of deference.
C
Typically, a pipeline receives a return on its net investment,
which is measured by the pipeline’s rate base. In the anomalous
situation where a pipeline’s assets have become fully depreci-
ated, FERC policy provides that the pipeline may receive a
“management fee” in lieu of such a return. See Tarpon Trans-
mission Co., 57 F.E.R.C. ¶ 61,371, at 62,240 (1991). Here, both
HIOS and the Commission agree that HIOS should be awarded
a management fee on the Tarpon model, and agree that the
Tarpon formula strictly applied would produce an unreasonably
low result. The issue for the Commission, then, was how to
appropriately modify the Tarpon formula. The issue for
us—again, at the apex of our deference under Baltimore Gas,
462 U.S. at 103—is whether the Commission’s modification
was arbitrary.
HIOS argues its approach to modifying the Tarpon formula
is “more reasonable” and “straightforward” than the Commis-
sion’s, and would “best match[] the return that the fee is
designed to substitute for.” Petitioners’ Reply Br. 31–32. But
FERC is not required to choose the best solution, only a
reasonable one. See Deaf Smith County Grain Processors, Inc.
v. Glickman, 162 F.3d 1206, 1215 (D.C. Cir. 1998) (explaining
the arbitrary and capricious standard). HIOS claims its own
method is better, but provides no evidence that FERC’s ap-

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proach is unreasonable. Therefore, even if true, HIOS’s claims
would not invalidate the Commission’s action.
* * *
For the reasons above, we vacate and remand on the issue
of the proxy groups, and otherwise affirm.
So ordered.

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