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PACIFIC GAS & ELECTRIC CO. v. CITY AND COUNTY OF SAN FRANCISCO, 265 U.S. 403 (1924)

U.S. Supreme Court

PACIFIC GAS & ELECTRIC CO. v. CITY AND COUNTY OF SAN FRANCISCO, 265 U.S. 403 (1924)

265 U.S. 403

PACIFIC GAS & ELECTRIC CO.
v.
CITY AND COUNTY OF SAN FRANCISCO.

SAME
v.
CITY AND COUNTY OF SAN FRANCISCO et al. (two cases).

Nos. 34-36.

Reargued Feb. 19, 1924.
Decided June 2, 1924.

[265 U.S. 403, 404]   Messrs. Louis Titus and Wm. B. Bosley, both of San Francisco, Cal., for appellant.

Mr. R. M. Searls, of San Francisco, Cal., for appellees.

[265 U.S. 403, 405]  

Mr. Justice McREYNOLDS delivered the opinion of the Court.

Since 1905 appellant has been the sole producer and general distributor of heating and illuminating gas in the San Francisco district. By three separate ordinances passed in June of 1913, 1914, and 1915, the board of supervisors directed it to supply such gas during the fiscal year commencing July 1st thereafter at not more than 75 cents per 1,000 feet. Claiming that the rate so prescribed would not yield fair return, appellant brought suits in July, 1913, 1914, and 1915, to prevent enforcement of the respective ordinances. Restraining orders issued upon condition that monthly statements should show each consumer's account, and bond should be given to secure proper repayments, with interest. The maximum rate in the schedule thereafter maintained was 85 cents per 1,000.

December 15, 1916, the causes were consolidated and referred to a master. After taking much testimony he presented an elaborate report, March 2, 1920, which recommended dismissal of the bills and repayment of whatever had been collected above the prescribed rate. The District Court affirmed the report and directed an appropriate decree.

The master found that not less than 7 per centum net upon the value of the property devoted to public use was necessary for a fair return; also that, if observed, the prescribed rate would have yielded more than 7 per centum-for 1913-1914, an excess of $21,402.95; for 1914-1915, $89,446. 12; and for 1915-1916, $171,464.48.

We think the evidence supports the finding that a net return of 7 per centum was necessary in order to avoid confiscation.

The inventory of the many items making up appellant's manufacturing and distributing plant with their reproduction [265 U.S. 403, 406]   cost new was agreed upon by the parties. In order to determine accrued depreciation and ascertain true values during the years 1913-1916, the master applied the 'modified sinking fund method.' Concerning this he said:

It involves 'an estimate of the lives of the different structural units, and an annual allowance set aside from the rates received as a reserve for future replacement on a 5 per cent. compound interest curve, the capital basis of return to the owner being depreciated each year in an amount exactly corresponding with yearly additions to the reserve. It is assumed that loss of plant units by obsolescence and inadequacy, as well as by physical decay, can be forecast with substantial accuracy and provided for in advance of abandonment and replacement.'

Appellant objects to the application of this method and insists that depreciation should have been ascertained upon full consideration of the definite testimony given by competent experts who examined the structural units, spoke concerning observed conditions and made estimates therefrom. As these examinations were made subsequent to the alleged depreciation for the definite purpose of ascertaining existing facts, we think the criticism is not without merit. Facts shown by reliable evidence were preferable to averages based upon assumed probabilities. When a plant has been conducted with unusual skill, the owner may justly claim the consequent benefits. The problem was to ascertain the probable result of the specified rate, if applied under well-known past conditions, not to forecast the probable outcome of a proposed rate under unknown future conditions.

Counsel do not insist that the estimated accrued depreciation is 'grossly excessive,' if confined to the result of physical causes. But they do maintain that the master should have ascertained and stated what depreciation was due to such causes and how much followed obsolescence [265 U.S. 403, 407]   resulting from the introduction of certain patented inventions, and we think such a finding should have been made unless some undisclosed reason prevented. The claim is that, in order to lower cost of production, it became necessary to abandon certain valuable property under conditions not reasonably susceptible of anticipation. The material and relevant facts ought to be disclosed.

The objection to the report most seriously urged is that in his estimate of total value the master failed properly to appraise certain patent rights through which manufacturing costs had been greatly reduced; also that he failed to make proper allowances for the successful use of such rights. This objection is well taken. The following excerpts from the master's long and rather involved report disclose the contested points with the relevant facts and indicate his conclusions:

Obviously, under the theory accepted below, appellant worsened its situation for rate-making puroses when it reduced the cost of manufacturing gas. Introduction of successful patented inventions enabled the public authorities to lower the rate base and gather all the benefits. The operating plant, made capable of producing gas at smaller cost, was declared less valuable than before. The result indicates error somewhere, either in theory or application of principle.

Obsolescence of one or more stations and perhaps other property theretofore of great value (possibly $800,000) followed installation of the patents, but the remaining plant plus the patents gave better results. As an operating unit the new combination had greater value than the old; but the court below disregarded the demonstrated worth of the element which wrought this thange.

The obsolescence in question did not result from ordinary use and wear. Certainly it could not have been long anticipated-the patents were of recent conception; to provide for it out of previous revenues was not imperative, if possible. Former consumers were not beneficiaries; only subsequent ones could be advantaged.

Our concern is with confiscation. Rate making is no function of the courts; their duty is to inquire concerning results and uphold the guaranties which inhibit the taking of private property for public use without just compensation under any guise. We may not, therefore, relegate appellant's claim for past services to the future consideration of the state commission, as the master suggests. After adopting the reduced costs of manufacture for estimating net returns, the court gave no proper [265 U.S. 403, 416]   valuation to the inventions which caused the reduction, and thereby permitted property to be taken without just compensation. The amount of money actually paid to the inventors was not the proper measure of worth. Experience had demonstrated a much higher one; and to obtain the benefit of their use appellant sacrificed much.

Installation of the inventions necessitated new outlay of money and abandonment of property theretofore valuable-both were necessary in order that the cost of manufacture might be reduced. If appellant's permissible profits depend upon the lowered costs and it is denied adequate return upon property which made the reduction possible, or recompense for the obsolescence, successful efforts to improve the service will prove extremely disadvantageous to it.

Whether, under the peculiar circumstances here presented, the rate base should be fixed by adding to the agreed inventory some fair valuation of the patent rights, or whether prompt recoupment should be allowed for the obsolescence caused by their introduction, or whether appellant should be saved from actual ultimate loss by some other feasible method, we will not undertake to determine upon the present record. To the end that the issues may be reconsidered in view of this opinion, the decree below is reversed and the cause remanded for such further proceedings as the circumstances require, including another reference to the master if deemed advisable.

Reversed. [265 U.S. 403, 417]  

Mr. Justice BRANDEIS (dissenting). These cases were tried together. Each challenges as confiscatory an ordinance of the city of San Francisco fixing, for a single year, the price to be charged for gas. The rule of Smyth v. Ames, 169 U.S. 466 , 18 Sup. Ct. 418, was applied. The evidence, in condensed form, comes before us in a record of 943 pages. The master's original and supplemental reports occupy 131 pages. The master and the court found the rates to be compensatory. Three errors are assigned by the company which relate to depreciation. The facts applicable to the several years differ in part; but the same questions are presented in each. It will tend to clarity to discuss these with reference to the facts of No. 34, which involves the rate for the year beginning July 1, 1913

First. The depreciation charge allowed for that year, for the plant as a whole, was $348,853. The company does not complain that this allowance is too small, if treated as an allowance for merely physical observed depreciation. Its claim is that an improved process, which had been introduced at the San Francisco works in 1912, resulted in a saving, during the year 1913-14, of $103,530 in oil and labor; that in 1913 it had become certain that this process would later render obsolete certain parts of the plant (called stations) which were in use throughout that year; and that, for the purpose of meeting this expected loss in capital through later abandonment of stations, the savings effected by the new process should have been charged against the earnings, and credited to a special depreciation reserve. If, as suggested below, the company's contention is that only one-half of the savings should be credited to this special depreciation reserve, the action of the District Court on this ground is obviously free from objection. For, in fact, there was included in the year's depreciation charge, for obsolescence of these stations, $64,962, which is more than one-half of the year's savings. But its claim here is that the whole of the savings of the year 1913-14 should have been so applied; and that, therefore, the balance thereof, namely, $38,568, should [265 U.S. 403, 418]   also have been included in this special depreciation charge. 1  

The sum ($348,853) allowed as the depreciation charge for the year 1913-14 was nearly 3 per cent. of the then reproduction cost new of the whole plant, other than land. The master and the court found, as facts, that none of the plant was abandoned during that year; that the change in the process of manufacture was not revolutionary; that in view of the history of the art, such change or improvements, and resulting obsolescence of parts of the plants, schould have been foreseen; that, in fact, there had been accumulated, during the four years preceding 1912, as a general reserve for depreciation, the sum of $2,116,433.95; that this reserve had been charged off by the company to surplus in November, 1911; and that, but for this fact, it would have been available to meet the loss of capital which occurred later through the abandonment of stations.

This alleged error does not present any question of law. Whether more of the savings of the year 1913-14 due to the introduction of the new process should have been allowed as a special depreciation charge for the obsolescence then known to be accruing, is clearly a question of fact. There is much conflict in the theories on which [265 U.S. 403, 419]   depreciation should be figured. 2 There was doubt when the obsolescence would culminate and what would be its extent. There was conflict in the evidence as to the rate to be deemed a fair return. Whether a return of 7 per cent. is the proper test of a compensatory rate must, obviously, depend in part upon whether the return includes any of the risk of obsolescence. 3 I cannot say that the master and the court erred in their conclusion of fact that, all things considered, the depreciation charge allowed was adequate. The same is true of the depreciation charges allowed for the years 1914 and 1915.4 [265 U.S. 403, 420]   Second. As an alternative to allowing a larger depreciation charge out of the year's savings through the improved process and apparatus, the company urges that the rate base should have been increased, by adding thereto the value of the right to use the new process at the San Francisco works. 5 The court apparently adopted this view of the law. It ruled that the company was entitled to a return upon the then value (as part of the rate base) of the right to use the inventions. It differed from the company only in the estimate of the value. The company's experts declared that the value of this right might be ascertained by capitalizing the average annual savings expected to be effected thereby. So calculated, the value is $4,203,300. The court found specifically that it could not accept estimated savings as a measure of value; among other reasons, because the amount of savings was dependent in large measure upon the price of crude oil, and that this price fluctuates largely from time to time. It included in the rate base for 1913-14 the value of the gas generators (at the Metropolitan plant) which had been reconstructed so as to embody the inventions, and found that there was in [265 U.S. 403, 421]   the record no evidence on which it could give to the right to use the inventions a greater value than was allowed. So far as concerns the year 1913-14, the question is, merely, whether on the evidence in the record the value of the reconstructed generators (including, of course, the right to use them) was too small. 6 It appeared that for the right to use the inventions nothing was paid either during the year 1913-14 or during the year 1914-15; and that for the exclusive right to use them both in San Francisco and throughout a number of counties in Northern California, the company paid to the inventors, in November, 1915, $46,066.68. I cannot say that the master and the District Court erred in the finding of fact by which they valued this item for that year, or in the value assigned to the right in fixing the rate base for either of the two following years. 7 This alternative contention of the company presents, obviously, no question of law.

Third. The reproduction cost new of the manufacturing and distributing plant, other than land, was found to be $12,794,008; the accrued depreciation, $1,518,390 [265 U.S. 403, 422]   (as of June 30, 1914). Thus, the property was found to be worth 88.1 per cent. of its then reproduction cost. The company contends that the accrued depreciation should have been set at $828,916.41; so that the plant was worth 93.7 per cent. of its then reproduction cost. The master employed the 'compound interest' or 'modified sinking fund' method of estimating accrued depreciation. The plant is in part very old. The depreciation found is but a small percentage of the reproduction cost. The evidence bearing upon the amount to be deducted for accrued depreciation occupies 232 pages of the record. The discussion thereof in the master's report occupies 39 pages. There was a conflict of evidence.

No question of law is presented by this assignment of error. 8 The company's objection is not to the particular method selected, but that, in applying it, the master included as depreciation what is called theoretical inadequacy and obsolescence. Whether he did is a question of fact. The city denies that the reduction in value made by the master on account of accrued depreciation includes any sum representing expected loss through future abandonment of the stations. It is clear that, if any deduction was made on account of the probable abandonment of the stations, the obsolescence thus provided for was not theoretical. The new process had been introduced 2 years before the date as of which the valuation was made. On the facts then known, it was expected that the stations would have to be abandoned in the [265 U.S. 403, 423]   near future. Because it was to be expected (and was not theoretical) the company contended that to offset it more of the year's savings should have been charged against the income of that year. I cannot say that the master and the court erred in their findings of fact as to the amount of accrued depreciation.

This litigation has already extended over 11 years. The record discloses that the cases were presented below by competent counsel with the aid of competent experts, and that they received careful consideration by an able master and an able trial judge. Counsel, master, and court have throughout endeavored to apply the rule of Smyth v. Ames, 169 U.S. 466 , 18 Sup. Ct. 418. It was not shown that the rule has, in any respect, been departed from. This court harbors a doubt whether, in applying it, some injustice may not have been done to the company. Is it probable that a nearer approach to justice, as between the parties, will be attained by a continuation of the effort to apply the same rule? To me it seems that the doubt is inherent in the rule itself. It can be overcome only by substituting some other rule for that found to be unworkable. Such other lies near at hand, and it is consistent with the Constitution.

It was settled by Knoxville v. Knoxville Water Co., 212 U.S. 1 , 29 Sup. Ct. 148, that every public utility must, at its peril, provide an adequate amount to cover depreciation. A depreciation charge resembles a life insurance premium. The depreciation reserve, to which it is credited, supplies insurance for the plant against its inevitable decadence, as the life insurance reserve supplies the fund to meet the agreed value of the lost human life. To determine what the amount of the annual life insurance premium should be is a much simpler task than to determine the proper depreciation charge. For life insurance is a co- operative undertaking. The premium to be fixed is not that required by the probable duration of the life of a [265 U.S. 403, 424]   single insured individual, but that required by the average expectancy of life of men or women of the given age. Moreover, for human lives, mortality tables have been constructed which embody the results of large experience and long study. By their use the required premium may be fixed with an approximation to accuracy. But, despite the relative simplicity of the problem, it was found that the variables leave so wide a margin for error that premiums fixed in accordance with mortality tables work serious injustice either to the insurer or to the insured. Although the purpose was to charge only the appropriate premium, the transaction resulted sometimes in bankruptcy of the insurer; sometimes in his securing profits which seemed extortionate; and, rarely, in his receiving only the intended fair compensation for the service rendered. Because every attempt to approximate more nearly the amount of required premium proved futile, justice was sought by another route. Ultimately, strictly mutual insurance was adopted. Under it, the premium charged is made clearly ample, and the part thereof which proves not to have been needed inures in some form to the benefit of him who paid it. Compare Penn Mutual Life Insurance Co. v. Lederer, 252 U.S. 523, 524 , 525 S., 40 Sup. Ct. 397.

Legal science can solve the problem of the just depreciation charge for public utilities in a similar manner. Under the rule which fixes the rate base at the amount prudently invested, the inevitable errors incident to fixing the year's depreciation charge do not result in injustice either to the utility or to the community. If, when plant must be replaced, the amount set aside for depreciation proves to have been inadequate, and investment of new capital is required, the utility is permitted to earn the annual cost of the new capital. If, on the other hand, the amount set aside for depreciation proves to have been excessive, the income from the surplus reserve [265 U.S. 403, 425]   operates as a credit to reduce the current capital charge which the rates must earn. If a new device is adopted which involves additional investment ( to buy a new plant or a patent right) the company's investment, on which the return must be paid, is increased by that amount. If the new device does not involve new investment, but the innovation involves increased current payments (like royalties for use of a process) the additional disbursement is borne by the community as an operating expense. The cost of a scrapped plant is carried as part of the investment on which a return must be paid unless and until it has been retired, that is fully paid for, out of the depreciation reserve. Thus justice both to the owners of the utility and to the public is assured.

Mr. Justice HOLMES. I am of opinion that the decree should be affirmed on the main point for reasons that will be stated by my Brother BRANDEIS.

Footnotes

[ Footnote 1 ] In this connection, the confiscatory character of the rate rests, according to the test applied, upon the allowance or disallowance of a much smaller sum. For master and court have found that the earnings of the year 1913-14 exceeded 7 per cent. upon the rate base by more than $21,000. An additional allowance for depreciation of $17,000 would, therefore (even on the theory contended for by the company), have rendered the rate compensatory on a 7 per cent. basis. Moreover, a 6 per cent. rate was sustained in Stanislaus County v. San Joaquin & Kings River Canal & Irrigation Co., 192 U.S. 201 , 24 Sup. Ct. 241 (1904), Knoxville v. Knoxville Water Co., 212 U.S. 1 , 29 Sup. Ct. 148 (1909), and Cedar Rapids Gaslight Co. v. Cedar Rapids, 223 U.S. 655, 670 , 32 S. Sup. Ct. 389 (1912).

[ Footnote 2 ] The wide differences between engineers as to the proper method to be pursued is well known. See Southwestern Bell Telephone Co. v. Public Service Commission, 262 U.S. 276, 294 , 43 S. Sup. Ct. 544.

[ Footnote 3 ] See Gerard C. Henderson, Railway Valuation and the Courts, 33 Harv. L. Rev. 902, 916, 922, 923; John Bauer, Valuation of Public Utility Properties, 30 Pol. Sci. Q. 254, 275; R. S. Hale, Physical Valuation of Public Utilities, 45 Engineering Mag. 161, 163.

[ Footnote 4 ] Appellant contends here that, due to the new method of manufacture, property of which the reproduction cost was $844,355.74, would become obsolete, that the total depreciation allowance covering this property for the three years was only $275,096, and that the difference-called net loss to the appellant-should be amortized by applying the savings to be effected by the new method of manufacture. But the first abandonment of stations occurred at the end of June, 1915. The estimated loss on the Martin station, then abandoned, was $237,651. No further supersession occurred during the period of litigation. There was merely the prediction made at the trial by the company's experts, that the Independent station would be abandoned in December, 1918, and the Potrero plant in December, 1920. Moreover, for the year 1914-15, the depreciation charge allowed was $ 372,680. Included in this amount is $68,198, directly attributable to loss caused by abandonments. The alleged savings from the new process for that period was $132,419. Thus, the amount allowed exceeded the one-half of the year's saving, which was suggested below as the proper measure of the appropriate charge. The increase in depreciation charge contended for here is $64,221. But the earnings for this year exceeded 7 per cent. on the rate base by more than $89,000, leaving a difference more than sufficient to cover this claim. The year 1915-16 can be similarly disposed of. The depreciation charge allowed was $380,519. The alleged savings from the new process for that year was estimated at $258,557. The increase in depreciation charge contended for here is $208,319. But one-half of the year's savings is $129,279; and the earnings for the year exceeded 7 per cent. on the rate base by $171,464.

[ Footnote 5 ] The process and apparatus had been invented by the company's salaried engineers early in 1912. The cost of experiments were defrayed by it. The utility of the invention was proved in that year, at its expense, by reconstructing, during that year, two of its gas generators and making other changes in plant. In this way the company acquired an implied license to use the inventions. Wade v. Metcalf, 129 U.S. 202 , 9 Sup. Ct. 271; Dable Grain Shovel Co. v. Flint, 137 U.S. 41 , 11 Sup. Ct. 8. It did not acquire an express license until November 30, 1915; that is, shortly after the patent for the apparatus was granted.

[ Footnote 6 ] The question is not one of continuing importance to the parties. Its correctness depends upon the state of the particular record. Any defect in this record can be avoided in proceedings concerning the rates for any year after June 30, 1916; and since October 29, 1917, the gas rates for San Francisco are fixed, not by city officials, but by the state railroad commission.

[ Footnote 7 ] The year 1914-15 presents no change in the situation from the preceding year. For 1915-16 the value of the two new Jones oil gas generators installed in the Potrero plant at a cost of $241,812.59 is included in the rate base, and as the value of the right to use the inventions the $46,066.68 paid. For this period, therefore, the question is merely whether on the evidence in the record the patents should have been valued at a sum in excess of $46,066.68. But for both years only a large undervaluation would affect the result, as the master and the court found that during the year 1914-15 the prescribed rate would yield $89,446 in excess of a seven per cent. return on the rate base, and for 1915-16, an excess of $171,464.

[ Footnote 8 ] We have no occasion to undertake a legal delimitation of the function of a depreciation charge, or to define its legal relations to the depreciation reserves, or to determine whether the loss through the abandonment of a station in 1915 and that expected to result from later abandonments might be set off against the depreciation reserve accumulated shortly before the invention of the new process.

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