This opinion will be unpublished and
may not be cited except as provided by
Minn. Stat. § 480A.08, subd. 3 (1998).
IN COURT OF APPEALS
Minnesota Public Utilities Commission
Agency File No. E015M99416
Christopher D. Anderson, Minnesota Power, Inc., 30 West Superior Street, Duluth, MN 55802 (for relator Minnesota Power)
Christopher B. Clark, General Attorney, Northern States Power Company, 414 Nicollet Mall, Minneapolis, MN 55401 (for relator NSP)
Samuel L. Hanson, Michael C. Krikava, Briggs and Morgan, 2400 IDS Center, Minneapolis, MN 55402 (for relators Minnesota Power and NSP)
Mike Hatch, Attorney General, Thomas Erik Bailey, Assistant Attorney General, 900 NCL Tower, 445 Minnesota Street, St. Paul, MN 55101 (for respondent Minnesota Public Utilities Commission)
In these consolidated appeals Minnesota Power (MP) and Northern States Power (NSP) challenge the 1999 orders of the Minnesota Public Utilities Commission (PUC) denying each utility’s request for recovery of 1998 lost margins under pre-approved conservation incentive plans. Because denial of the incentives constituted statutorily prohibited retroactive ratemaking and was arbitrary and capricious, we reverse.
By statute, Minnesota public utilities must spend and invest for improvements in energy conservation. Minn. Stat. § 216B.241, subd. 1a (1998). These mandatory energy conservation programs are known as CIPs (Conservation Improvement Programs) and DSMs (Demand-Side Management programs). The statute provides for recovery of out-of-pocket CIP expenses. Minn. Stat. §§ 216B.241, subd. 2b (1998), 216B.16, subd. 6b (1998). To encourage utilities to develop innovative, cost-efficient and successful CIPs, the statute also provides for PUC approval of incentive plans. See Minn. Stat. § 216B.16, subd. 6c (1998).
The PUC approved NSP’s CIP/DSM proposed incentive plan in 1991 and MP’s proposed plan in 1992, as two-year pilot projects. Each plan included compensation for lost margins. “Lost margins” are the profits lost by the utility due to implementation of conservation programs.
In 1994, the PUC formed a “work group” to study the effect of CIP/DSM programs on conservation. The work group recommended continuing lost margin recovery independent of a utility’s ability to meet its return as designated by the last rate case.
Following the work group report, MP applied for an extension of its plan. The PUC extended MP’s plan “without a requirement that MP file a request for extension in two years.”
In early 1996, NSP applied for extension of its plan with modifications to provide for, among other things, an increase in recovery of lost margins from 50% to 75%. The Department of Public Service (DPS) opposed the plan, arguing that the magnitude of NSP’s proposed incentive was “disproportionately large.” Nevertheless, the PUC found that NSP’s proposal of 75% lost-margin recovery was reasonable and approved NSP’s plan “on an ongoing basis, i.e., until modified or revoked by the Commission.” The PUC noted that the plan “can be examined at any time similar to other ratemaking tools.” Plans submitted by other utilities were also approved.
The approved plans determine how incentive recovery is calculated and provide for annual filing of CIP/DSM cost and incentive recovery, which is verified by the DPS. The plans contain a formula rate adjustment to recover verified costs and incentives from the preceding year. CIP costs and incentives, including lost margins, are recovered from customers using an automatic CIP cost-recovery clause in customer service billing. The cost-recovery clause on the customer bill is referred to as the Conservation Program Adjustment (CPA) and is also known as the CIP adjustment rate. MP filed annually in March or April, while NSP filed in April, to recover their costs and incentives from the prior year. Until 1999, recovery was based on the accuracy of each utility’s calculations pursuant to its approved plan. DPS review also assessed whether performance under the approved plans continued to meet the goals for conservation incentives. The PUC permitted MP’s and NSP’s recovery of incentives pursuant to the approved plans in all years until 1999.
In its April 1996 filing for recovery of 1995 incentives, NSP requested an increase in its CIP adjustment rate from 2.45% to 3.49% to reflect expected CIP costs and incentives for 1996. Land O’Lakes opposed the requested rate adjustment arguing that NSP had earned in excess of its target rate in 1995 and was projected to earn in excess of the target rate of return in 1996. The PUC approved NSP’s incentive recovery and the requested upward adjustment in the CIP adjustment rate. In its order, the PUC noted that the legislature did not link recovery of conservation costs to a utility’s earnings. The PUC stated: “The Commission’s Orders, including those approving NSP’s establishment of DSM financial incentives * * * have followed the legislative mandate to allow conservation cost recovery, regardless of utility earnings.” The PUC found there was no evidence to reverse this “longstanding policy of the legislature and Commission” in order to use the cost/incentive recovery as a “true-up” mechanism to adjust utility earnings.
In 1997, the DPS, in comments to the PUC on MP’s and NSP’s annual petitions for approval of CIP/DSM calculations for 1996, recommended approval of both petitions, but also recommended that the PUC open a docket to investigate the future direction of CIP/DSM financial incentives. The PUC approved both petitions but declined to open an investigation into the future of CIP/DSM.
In 1998 the DPS again recommended approval of NSP’s and MP’s petitions for recovery of costs and incentives because each had complied with the PUC-approved plan. But the DPS recommended that the PUC discontinue the CIP/DSM financial incentive mechanism after collection of the 1997 incentives. The DPS noted that it would be in the ratepayers’ best interest for the PUC to deny the 1997 recovery requests for lost margins, but stated: “we realize that the utilities need time to adjust to the elimination of the CIP/DSM financial incentive mechanism.” The PUC approved both petitions and stated: “The [DPS] claim that the Commission should discontinue financial incentives for [CIP/DSM] will be examined in a separate docket.” (The DPS made similar recommendations in comments on the petitions of other utilities with the same result.)
In June 1998, the PUC opened an investigation into the DPS’s recommendation to discontinue CIP/DSM incentives and asked interested parties to respond. Eleven parties filed comments. The matter came before the commission on November 19, 1998. Staff briefing papers for this meeting warned “a decision that is retroactive to January 1, 1998 may be punitive in effect. Utilities have operated during 1998 under the assumption that incentives were in place.”
In findings and conclusions from the November 19, 1998 meeting, the PUC reviewed comments of the responding parties. The Residential and Small Business Utilities Division of the Office of the Attorney General (RUD-OAG) recommended termination of lost margin recovery programs. The utilities and some conservation groups argued that the incentives were a conservation success story and should be continued. The PUC issued an order that “put all utilities on notice that significant changes to current CIP/DSM financial incentive programs and methodologies may occur, possibly as early as January 1, 1999.” The PUC convened a “Chair’s Round Table” to evaluate the issue. The round table was to report its conclusions to the commission by May 1, 1999.
In the spring of 1999, MP and NSP petitioned for approval of their 1998 lost margins. DSP recommended that the PUC allow the recovery sought because each company was in compliance with its existing plan. Some large customers and RUD-OAG recommended that the PUC disallow lost margin recovery, claiming that MP and NSP should not recover because each earned at a higher rate than was authorized in the last rate setting, making their rates unreasonable and unfair. They argued that lost margins should only be allowed to insure that a utility earns the rate of return targeted in the ratemaking process. NSP, MP, and the DPS argued that each utility had met the conditions of its approved incentive plan and that lost margin recovery was intended as an incentive, not as a mechanism to true-up earnings.
In orders issued July 27, 1999, the PUC disallowed lost margin recovery for both NSP and MP. Both utilities filed petitions for reconsideration. The PUC agreed to reconsider. In separate PUC orders issued in February 2000, the PUC affirmed the prior orders denying recovery of lost margins for NSP and MP because each utility had, even without recovery of lost margins, exceeded its targeted rate of earning. Until the denial of these petitions, the PUC had never tied lost margin recovery to earnings. Two PUC commissioners dissented in each case.
In his dissenting opinion, Commissioner Garvey noted that the PUC’s actions led utilities to believe that 1998 lost margins would be recovered, but that 1999 lost margins would likely be disallowed. Commissioner Garvey considered the PUC’s denial of 1998 lost margins, almost a year after the lost margins were incurred, impermissibly retroactive.
In the denial orders, the PUC expressed its belief that NSP’s and MP’s rates were unreasonable. In a subsequent proceeding, however, the PUC examined the rates of both NSP and MP, and found neither utility’s rate to be unreasonable or unfair.
In April 2000, the PUC approved a revised CIP/DSM incentive plan jointly proposed by DPS and eight utilities including NSP and MP, eliminating lost margin recovery. MP and NSP appeal the PUC’s denial of recovery of lost margins incurred in 1998.
The Minnesota Administrative Procedure Act, codified at chapter 14 of the Minnesota statutes, outlines the standard of review for the appeal of an agency decision. The act states that this court may reverse or modify the agency’s decision if:
The substantial rights of the petitioners may have been prejudiced because the administrative finding, inferences, conclusion, or decisions are:
(a) In violation of constitutional provisions; or
(b) In excess of the statutory authority or jurisdiction of the agency; or
(c) Made upon unlawful procedure; or
(d) Affected by other error of law; or
(e) Unsupported by substantial evidence in view of the entire record as submitted; or
(f) Arbitrary or capricious.
Minn. Stat. § 14.69 (1998).
All of the parties agree that ratemaking is implicated. In ratemaking matters, the PUC is exercising its quasi-legislative authority. St. Paul Area Chamber of Commerce v. Minnesota Pub. Serv. Comm’n, 312 Minn. 250, 254, 251 N.W.2d 350, 353 (1977). In In re Request of Interstate Power Co. to Change Rates, 574 N.W.2d 408 (Minn. 1998), the Minnesota Supreme Court held that the PUC was acting in its legislative capacity when it determined a utility could collect environmental clean-up costs of former gas plants through rates. Id. at 413-14. We review the PUC’s ratemaking under the standard established for legislative action: the PUC’s decision must be affirmed unless shown (by clear and convincing evidence) to be in excess of statutory authority or resulting in unjust, unreasonable, or discriminatory rates. Id.at 413.
I. The PUC’s denial of 1998 lost margins constituted impermissible retroactive ratemaking prohibited by Minn. Stat. § 216B.23 and was arbitrary and capricious.
The Public Utilities Act defines “rate” as
every compensation, charge, fare, toll, tariff, rental and classification, or any of them, demanded, observed, charged, or collected by any public utility for any service and any rules, practices, or contracts affecting any such compensation, charge, fare, toll, rental, tariff, or classification.
Minn. Stat. § 216B.02, subd. 5 (1998) (emphasis added). Given the statute’s broad definition of ‘rate’, the PUC’s incentives plan, formula, and surrounding practices fall within the definition of rate/ratemaking. See Northern States Power Co. v. Minnesota Pub. Utils. Comm’n, 344 N.W.2d 374, 382(Minn. 1984) (“[W]e note a formula rate * * * is just as much a rate as any other kind of rate.”). All parties agree that the PUC has authority to modify or discontinue incentive recovery plans and all agree changes must be prospective. NSP and MP argue that denial of recovery of 1998 lost margins was retroactive rate making. The PUC argues it was prospective.
A key feature of ratemaking is that it operates prospectively. See Peoples Natural Gas Co. v. Minnesota Pub. Utils. Comm’n, 369 N.W.2d 530, 533 (Minn. 1985) (noting ratemaking is quasi-legislative function and legislation operates prospectively); see also Public Utils. Comm’n v. United Fuel Gas Co., 317 U.S. 456, 464, 63 S. Ct. 369, 374 (1943). Retroactive ratemaking is expressly forbidden by statute. See Minn. Stat. §§ 216B.23, subd. 1 (1998) (“[T]he commission shall * * * by order fix reasonable rates * * * to be imposed, observed and followed in the future * * * .”) (emphasis added), subd. 5 (1998) (“[R]ates shall thereafter be observed * * * . Rate design changes shall be prospective * * * .” (emphasis added)); Peoples Natural Gas Co., 369 N.W.2d at 533 (“[T]he Public Utility Act expressly prohibits retroactive ratemaking.”). At the time of the denial, the PUC was examining the policy issues surrounding CIP/DSM incentives in another docket and had put utilities on notice that 1999 incentives could be denied.
The PUC argues that because it had authority to vary the CIP adjustment rate to ensure recovery of costs and incentives earned under the approved plans, it had authority to deny recovery of lost margins altogether. The plans, however, specifically approved lost margin recovery and did not provide for denial of correctly calculated lost margin recovery.
The PUC argues that the primary reason it denied incentives to MP and NSP was that the incentives were no longer producing the expected investments in conservation. It did not apply this reasoning to the request of other utilities for 1998 incentive recovery even though this argument was made to the PUC by parties opposing recovery of lost margins by other utilities. Both MP and NSP dispute this point. The issue of the continued need for incentives was being explored in a separate docket. The record leads this court to conclude that the only real reason for the denial was that NSP’s and MP’s base rates resulted in earnings in excess of the targeted amount in 1998. The PUC used the denial of the lost margin recovery as a retroactive rate adjustment to true-up each utility’s 1998 earnings. No other explanation is plausible in light of the PUC’s allowance of Minnegasco’s and Otter Tail Power Company’s 1998 lost-margin recovery. The PUC emphasized in its orders and in its brief to this court that Minnegasco and Otter Tail Power were allowed to recover lost-margin incentives because their actual 1998 earnings were below the level targeted in the base-ratemaking process even though objections were raised to their petitions that the incentives were not achieving conservation objectives. The fact that the denial would affect 1999 rates does not alter the fact that it actually adjusted NSP’s and MP’s 1998 earnings. The PUC used denial of lost margin recovery to true-up 1998 earnings and thereby engaged in impermissible retroactive ratemaking in excess of its statutory authority.
MP and NSP argue that the PUC discriminated against them by awarding Minnegasco its lost margins from 1998, even though the same organizations that objected to MP’s and NSP’s recovery objected to Minnegasco’s recovery on the basis that Minnegasco’s normalized earnings exceeded the rate authorized in its last rate case. The PUC first justified the disparate treatment by asserting that based on language approving Minnegasco’s plan, the PUC had created an expectation of recovery for Minnegasco that it had not created in the approval orders for NSP’s and MP’s plans. This argument, which was patently specious, has been abandoned on appeal.
The PUC agrees that Minnegasco’s 1998 normalized earnings exceed the authorized rate, but the PUC argues that Minnegasco’s actual 1998 earnings, even if lost margin recovery is allowed, did not exceed the authorized rate, whereas both MP’s and NSP’s actual1998 earnings exceeded the rate of return authorized for each even without allowing lost margin recovery. This argument may justify the disparate treatment but it also acknowledges a direct link between recovery of 1998 lost margins and 1998 earnings, in contrast to the PUC’s assertion that denial of 1998 lost margins had only a prospective effect.
The PUC’s decision to deny MP and NSP’s 1998 recovery of lost margins based on earnings, contrary to the PUC’s prior position that recovery of lost margins would not be linked to earnings, is arbitrary and capricious. The action was arbitrary and capricious because it occurred in the context of the annual accounting required under previously approved plans for recovery of lost margins. The approved plans did not tie recovery to earnings. The action was arbitrary and capricious because, while the utilities had every reason to expect a policy change for 1999 as a result of the separate docket examining incentive programs, they had no reason to expect the PUC to deny benefits under currently approved plans and recovery formulas. The PUC offers no explanation (other than impermissibly adjusting 1998 rates) for making this policy change in the context of the annual accounting. See In re Whitehead, 399 N.W.2d 226, 229 (Minn. App. 1987) (noting lack of agency explanation for departure from practice indicative of arbitrary and capricious action). NSP and MP conducted business in 1998 based on CIP/DSM plans approved by the PUC and on the PUC’s representations and past actions demonstrating that incentive recovery would not be linked to earnings. Even the DSP, which for two years had recommended discontinuing the incentives, recognized the unfairness of retroactively changing the recovery policy. To announce a new policy in orders denying recovery of previously approved incentives amounts to unjust, unfair, arbitrary and capricious action.
NSP and MP also assert that the PUC was estopped from denying the 1998 incentives and that such denial constituted an impermissible refund. The factors set out above mandate reversal of the PUC’s orders denying NSP’s and MP’s recovery of 1998 incentives, and therefore we need not reach the issues of estoppel or impermissible refund.
* Retired judge of the Minnesota Court of Appeals, serving by appointment pursuant to Minn. Const. art. VI, § 10.
** Retired judge of the district court, serving as judge of the Minnesota Court of Appeals by appointment pursuant to Minn. Const. art. VI, § 10.
 Electricity is sold in units designated as a kWh of electricity. When a utility conserves a kWh of electricity, it loses a kWh of electricity that it could have sold. This results in a loss of margin.
 A “rate case” is where a utility’s allowed rates are established. A rate case determines “base rates,” i.e., the rate charged per unit of electricity.