State ex rel. Utilities Commission v. Intervenor Residents of Bent Creek/Mt. Carmel Subdivisions

CLARK, Judge. These two appeals concern the same utility and the same in-tervenors. It appears from the record that the contract approval case arose out of the rate case. The parties agreed to consolidate the cases for hearing. We elect, therefore, to file one opinion settling both appeals. Although the issues are related, for the sake of clarity, we will treat the appeals separately, beginning with the rate case. Intervenors’ first argument is that the Utilities Commission should not have considered the expenses allocated from CWS and WSC in establishing new rates because they reflected charges for services rendered by affiliated corporations pursuant to contracts not filed with an approved by the Commission as required by G.S. 62-153. Intervenors’ position is that failure to file the contracts and seek Commission approval should result in the disallowance of expenses incurred thereunder. We cannot agree. The statute requiring filing and approval was clearly enacted for the purpose of discovering contracts between affiliated corporations which were “unjust or unreasonable, and made for the purpose or with the effect of concealing, transferring or dissipating the earnings of the public utility.” G.S. 62 153(a). Contracts found to be so are to be avoided and we think expenses incurred under such contracts would have to be disregarded in computing a utility’s expenses. The consideration of the Commission under G.S. 62453(a) is whether the contracts are just and reasonable. If they are, and are not efforts to divert or conceal — 229 — profits, they are to be approved. The statutory scheme is directed at prior approval. The testimony at the hearing indicates that the agreements with WSC and CWS were that the affiliates would provide services to the company at costs. The Commission, had it examined the contracts prior to their implementation, could have looked only to the prospective effect of such agreements; the reasonableness and justness of the scheme set up thereby, i.e., whether it was just and reasonable to allocate the affiliates’ expenses to the company and whether the scheme of allocation was just and reasonable under the circumstances. There was competent, material, and substantial evidence to the effect that the affiliates allocated to the company only their expenses, and there was extensive evidence on the various methods of allocation from which the Commission could conclude that the allocation methods were just and reasonable. Intervenors’ real argument in this appeal is with the reasonableness of the expenses incurred by the affiliates; however, the Commission is not charged under G.S. 62-153 with examining the reasonableness of actual expenditures. It could not, under normal conditions, because the contracts would be ex-ecutory and the affiliate would not yet have incurred any expenses or provided any services to the utility. G.S. 62453(b) prohibits payments to affiliates under contracts not approved by the Commission. The record suggests that because of the poor financial. condition of the Company, few payments had been made to the affiliates. Regardless, however, of whether the expenses had been paid, we see no reason to disregard their character as expenses once the Commission found the contracts under which the expenses accrued to be just and reasonable. We hold that G.S. 62-153 does not prohibit the Utilities Commission from considering fees owed to affiliated corporations under unfiled contracts as expenses of the public utility for purposes of ratemaking so long as the Commission does determine in the ratemaking procedure that the agreements between the utility and the affiliated corporations are just and reasonable and it does not appear that their purpose is to conceal or divert profits from the public utility to an affiliate. Intervenors’ second argument is that the order granting the rate increase was based in part on expenses which were unsup — 230 — ported by competent, material, or substantial evidence as to the reasonableness of the expenses. Specifically, intervenors claim that the allocated expenses of WSC and CWS could not properly be included in the Company’s operating expenses absent evidence that the affiliates incurred the expenses in a reasonable manner. While the Commission appears to have considered the reasonableness of the method of allocation, it appears to have accepted without question the operating expenses claimed by WSC and CWS. The Utilities Commission has authority to “make, fix, establish or allow” only those rates which are “just and reasonable.” G.S. 62-130. See also, G.S. 62-131. G.S. 62-133.1(a) provides: “In fixing rates for any water or sewer utility, the Commission may fix such rates on the ratio of the operating expenses to the operating revenues . . . .” G.S. 62433(b) (3) establishes that the operating expenses to be used by the Commission are “reasonable operating expenses.” This logically follows from the requirement of G.S. 62433.1(a). For rates to be reasonable, the figures from which they are derived must be reasonable. To uphold its statutory duty to establish reasonable rates then, the Commission must examine each of the components going to make up a utility’s expenses for reasonableness. Two of the components going to make up the total operating expenses of the company in this case were the $19,471.00 share of the operating expenses of WSC which was allocated to the Company and the $8,190 share similarly allocated from CWS to the Company and counted as part of the Company’s operating expenses. While there was evidence of record that WSC and CWS actually incurred these expenses and that the amount allocated to the Company was a fair proportion of the whole, there appears in the record no evidence whatsoever that the expenses incurred by WSC and CWS in providing these services were just and reasonable. Our Supreme Court has quoted with approval the following language of the Pennsylvania Supreme Court: “ ‘Charges arising out of intercompany relationships between affiliated companies should be scrutinized with care [citations omitted] and if there is an absence of data and information from which the reasonableness and propriety of the services rendered and the reasonable cost of rendering — 231 — such services by the servicing companies can be ascertained by the commission, allowance is properly refused. * * * ‘Moreover, the record in this case is an illustration of the fact that effective and satisfactory State regulation of utilities is made increasingly difficult by the progressive integration of utility services under holding company domination. ‘The desire of public utility management, evidenced by various methods, to secure the highest possible return to the ultimate owners is incompatible with the semi-public nature of the utility business, which the management directs. It therefore follows that the commission should scrutinize carefully charges by affiliates, as inflated charges to operating companies may be a means to improperly increase the allowable revenue and raise the cost to the consumers of utility service as well as an unwarranted source of profit to the ultimate holding company. ’ ” Utilities Comm. v. Telephone Co., 281 N.C. 318, 346, 189 S.E. 2d 705, 723 (1972). (Emphasis added.) The evidence that WSC and CWS charged the Company with a fair proportion of their costs does not establish that those costs were reasonably incurred. There are any number of ways that an unregulated affiliated corporation’s expenses for goods and services could be passed directly on to a regulated utility in such a manner as to result in the diversion of profits away from the regulated utility to an affiliate. For example, the failure of the Commission to look behind the expense figure listed by affiliated corporations would allow a service corporation to purchase goods, materials, or services from a third affiliate at an unreasonably inflated price and then pass that unreasonable price on to the regulated utility as costs. The service company would lose nothing since its costs would be reimbursed. The third affiliate would reap huge profits which presumably would be passed along to a parent holding company. The regulated utility would then show an artificially inflated loss justifying an artificially inflated rate to be borne by in-state consumers. Such a scheme is entirely possible if the Utilities Commission is allowed to base its conclusion of justness and reasonableness on the simple, superficial fact that an affiliated corporation sold goods and services to a regulated utility at its “cost.” — 232 — The burden was on the utility to show that the price it paid to affiliate corporations was reasonable. Id. The utility presented extensive evidence of the method by which the expenses of its affiliates were allocated as expenses of the regulated utility, but no evidence at all that the figure thus allocated represented a reasonable expense for the goods and services so provided. We hold that the Utilities Commission’s finding that “charges paid to the service corporation are reasonable” was an error. The utility presented no evidence of what the services would cost the utility on the open market, but only presented the self-serving statements of an officer (Treasurer of the Company, of WSC, of CWS and the parent holding Company) to the effect that services were provided to the Company at cost and that they woiuld have cost the company more if provided in any other manner. This was not enough. We believe that in the case of affiliated corporations the Utilities Commission is obligated to determine the reasonableness of the charges on the basis of either (1) the cost of the same services on the open market; (2) *he cost similar utilities pay to their service companies, see Utilities Comm. v. Telephone Co., 285 N.C. 671, 685-86, 208 S.E. 2d 681, 690 (1974); or (3) the reasonableness of the expenses incurred by the affiliated corporation in generating its services. This third method of establishing the reasonableness of a service company’s charges is made possible by the provisions of G.S. 62-51 which specifically authorize the Commission to inspect the books and records of corporations affiliated with a regulated utility. The record does not indicate any inquiry by the Commission into what would constitute a reasonable price for the services the Company received, nor does the record reveal any inquiry into whether the expenses incurred by WSC and CWS were in fact reasonable. In light of this failure we conclude that the Commission’s order granting the requested rate increase was based in part on expenses which were unsupported by competent, material, or substantial evidence as to their reasonableness. Intervenors’ third argument is that the Commission erred in failing to examine the financial data of the Company’s parent and affiliated companies. We believe that examination of the records of affiliated companies under G.S. 62-51 would be necessary in this case only if there were no evidence of what the company would have had to pay non-affiliated companies for the same serv — 233 — ices, or in the alternative, of what similar utilities pay their service companies for similar services. If no evidence is offered on either of these issues, the only remaining evidence upon which the Commission could properly base a conclusion that the Company was reasonable in paying the allocated amounts to WSC and CWS would have to come from an examination of the books of WSC and CWS to determine if their expenses in generating the services were reasonable. If upon hearing on remand the Commission hears evidence which would support a finding of reasonableness of the expenses paid to WSC and CWS without resorting to an examination of each company’s records, then that alone will suffice. If, however, no evidence is presented of the fair value of the services on the open market, or of expenses in similar operating company-service company relationships, then the Commission will be faced with a choice between examining the records and denying the rate increase. * * * In a separate but related appeal, No. 8Q10UC1060, in-tervenors assign error to the Commission’s 30 July 1980 Order approving the service contracts of the Company and Sugar Mountain Utility Company (Utilities, Inc.’s other North Carolina subsidiary) with Water Service Corporation. They argue that the contracts were improperly approved because there was a lack of competent, material, and substantial evidence as to their reasonableness and justness. The evidence before the Commission indicated that the Company and Sugar Mountain were receiving the services of WSC at its cost. It would appear that the price of services provided to an affiliated operating company at “the cost (not including profit) thereof” must be just and reasonable. Intervenors argue that there was no evidence of the reasonableness of the costs incurred by WSC in providing the services. We agree, but as we have previously pointed out, the purpose of G.S. 62-153 is merely to assure that executory contracts between affiliates be just and reasonable on their face. There is nothing unjust about passing on to the Company the costs of services it receives. Approval of the contracts is therefore proper. The possibility that the affiliates might perform under the contracts in such a manner as to inflate the costs beyond a just and reasonable figure will be avoided so long as the — 234 — Commission looks past the designation of the figure as “cost” to determine the reasonableness of the figure as we have held it was required to do in case No. 8010UC827. The order granting the rate increase (No. 8010UC827) is reversed and remanded to the Utilities Commission for further hearing. The order approving the utility’s contracts with WSC (No. 8010UC1060) is affirmed. Judges Arnold and Martin (Harry C.) concur.