John Rowe is president, chief executive officer and a director of the

New England Electric System. Prior to joining NEES, MY. Rowe served as president and CEO of Central Maine Power, and as senior vice president of

law for Conrail. He holds a law degree from the University of Wisconsin

Law School. Paige Graening is a senior attorney

for the NEES companies, with primary responsibility for

transmission matters. She is a

graduate of the University of Tulsa

College of Law.

Property Law: / It s Physical-and Logical

The government may require an owner of private property to cede rights to that property in order to serve the greater public good, but it may not do so without ensuring just compensation to the owner. Compensation for forced access to wires that reflects only the owner’s embedded costs is not even facially adequate.

fohn Rowe and Paige Graening

I. What’s Wrong with This Picture?

L et us suppose that some gov-

ernment agency-not, of course, one of the honorable ones that governs us-forces you to grant an easement across your apartment complex and the pri- vate roads you have built. An- other apartment complex devel- oper will receive the easement so that he can build units on an adja- :ent property to compete with

your building. You will have no

:ontrol over who crosses your property, to what extent they will use it or how many will use it at my given time. It is clear, though,

that there will consistently be ac- tivity on the easement. Its pur- pose is to give your competitor an opportunity to attract business away from you in the hope that $enants may pay lower rents. That easement effectively deprives you of your exclusive use of your

property. This pirate government has dra-

matically reduced the overall value of the property which you have painstakingly developed, im-

proved and mortgaged. The pri-

vate road itself is exceedingly valuable as the only access the new’developer has to reach ten- ants. Government assures you

44 The Electricity JoumaZ

that you may charge your com- petitor or your former tenants for

the right to enter and cross your

land, but your toll will be capped at the cost of the road. The govem- ment-set toll ignores the damage by the easement to the rest of

your property You are left to suf- fer the consequences.

The inequities of this situation are striking, indeed shocking. Yet

many proponents of open access to wholesale and retail markets ar-

gue that regulators should treat utility property owners in just this fashion. Under the Jolly Roger of open competition and a level play- ing field, they urge regulators to allow them to use utility wires for

mere embedded costs. They ig- nore the fact that the wires inter- connect generation (including util- ity-owned units and power purchased from others) with fran- chised customers to create an inte- grated property This piracy will, of course, strand utility invest- ments in generation units and pur- chased power contracts. Indeed, that is its intent.

The Takings Clause of the Fifth

Amendment to the U.S. Constitu- tion prevents such destruction of private property rights and values without just compensation to the

property owner. The Constitu- tion’s protections extend to every

property owner, whether a pri- vate citizen, an unregulated or- ganization or a regulated busi- ness. Rules that force utilities to yield their wires to thud parties will result in a taking because

they will destroy the integrated nature of utility property and the value inherent in the enterprise as

a whole. But utilities need not

shrink back in fear while pirates

swarm the decks and loot the ship. Rather, they can fight for their rights with a considerable ar-

senal of legal defenses, including both regulatory and physical tak- ing arguments.

A. Regulatory Takings

Regulatory takings arise in the

context of new government rules which, though intended for the

Under the Jolly Roger of open competition and a level playing field, proponents of open access urge regu- lators to allow them to use utility wires for mere embedded costs.

common good, cause a taking of

private property Those of us who stand on the gangplank of restruc-

turing are protected by U.S. Su- preme Court decisions finding

constitutional guarantees for the

opportunity to earn a fair return and the protection of investment- backed expectations.

Justice Brandeis, never remem- bered as a utility dupe, articulated

the principle that it is the capital invested in utility enterprises which is constitutionally pro- tected:

The thing devoted by the inves- tor to the public use is not spe- cific property, tangible and intan- gible, but capital embarked in the enterprise. Upon the capital so in- vested the Federal constitution guarantees to the utility the op- portunity to earn a fair return.’

Third-party access to utility property which deprives the util-

ity of the opportumty to earn a fair return on the integrated whole of its investment property

by severing it into disconnected parts defies Justice Brandeis’s

logic. Justice Douglas, another ju- rist of skeptical bent, further de- veloped this important theme 20 years later when he wrote:

It is not theory but the impact of the rate order which counts. . . . The return to the equity owner . . . should be sufficient to assure con- fidence in the financial integrity of the enterprise, so as to main- tain its credit and to attract capi- tal.’

Rules for a restructured indus- try which destroy the credit rating or capital-raising ability of a util-

ity by permitting new or different third-party suppliers to use utility wires to skim off customers and

their income-producing accounts force utilities to stand upon consti- tutional protections.

More recently, Chief Justice

Rehnquist reiterated the constitu- tional dimensions of rifling utility coffers through capricious rule- making:

A state’s decision to arbitrarily switch back and forth between methodologies in a way which re- quired investors to bear the risk of bad investments at some times while denying them the benefit of good investments at others

Aypst/September 1996 45

would raise serious constitu- tional questions3

In some quarters, proposed regulations seek to impose new and artificially low market values

on generation resources while holding wires rates below their true market value. The effect will

be to tie investor and utility hands behind their backs and force feed them financial losses.

Cases such as Charles River

Bridge establish that govemment- granted franchises are not im-

mune from competition.4 But we

also know that where govern- ment itself works a taking of pri-

vate property devoted to use by the public, the Fifth Amendment

requires just compensation for the

franchisee deprived of its invest-

ment and its future earnings on that investment.”

B. Physical Takings

Open access to transmission and distribution wires transcends

regulatory takings, however, and invokes the jurisprudence of physical takings. The U.S. Su- preme Court has recognized a physical taking of private prop- erty for public benefit as the most egregious form of interference with private property rights. In Loretto v. Teleprompter Manhattan

CATV Corp.,6 the Court handed down strict language and fully de- veloped safeguards for private property owners forced to yield

their physical property even when deemed for the common good. This bellwether case arose

during the nascent years of the ca- ble television industry and offers

new insight into the thorny prob- lem of stranded cost recovery.

II. What’s at Stake in a Physical Taking of Utility Property?

The typical vertically integrated utility has invested heavily in gen-

eration sources (including gener-

ating units and purchased power contracts), an integrated transmis- sion network and a distribution system for service to retail custom- ers. Indeed, regulators have, di-

The Fifth Amendment protects utilitiesfiom

third parties that would overtake their

wires like Blackbeard S hoards swarming the

decks of a captive ship.

rectly or indirectly, required these

investments. The new and differ-

ent power pricing and supply op- tions that wholesale and retail cus- tomers will obtain under open access will diminish the value of, or strand, much of a utility’s in- vestment in generation sources. The physical implications of open access yield the logical conclusion that the Fifth Amendment pro- tects utilities and their investors from the uninvited presence of third parties that would overtake utility wires, like Blackbeard’s hoards swarming the decks of a

captive ship.

The power transmission grid is, in reality, a network of individu-

ally owned transmission facilities, interconnected at discrete points to enable the efficient and continu- ous flow of energy from generat- ing units to the distribution systems that serve a utility’s com- mercial, industrial and residential customers. Typically, there are many different pathways between any given generator on the trans- mission grid and a distribution system, yet the two normally join at specific points (e.g., distribu- tion substations). The physical characteristics of electricity cause it to follow the path of least im-

pedance and, as load and supply

conditions change around the net- work, the physical flow on the grid may change in size, route and even direction.

S ince electricity is fungible by nature, it has no identifying

characteristics, no color or serial number that identifies it as be- longing to a certain owner once it commingles on the network. Yet property rights attach to specified units of the fungible commodity Through the years utilities have developed-and the law has rec- ognized-settlement mechanisms under which they compensate each other for predictable and per- missible uses of each other’s trans- mission facilities (e.g., through- wheeling). The key fact here is that someone else’s energy is pass- ing along utility wires with the

permission of-and under a mu- tually acceptable contract to-the

wires owner.7 The physical characteristics of a

distribution system differ from

46 The Electricity Journal

those of the interconnected trans-

mission grid and present other is- sues significant in a retail wheel-

ing environment. Like a one-way road, a distribution system is typi- cally radial in nature: it is neither interconnected nor networked. This single, one-way path is a criti-

cal component of the integrated operation that utilities have built

for the sole purpose of serving their retail customers. Utilities own the power flowing over the distribution system until it is me- tered at the ultimate delivery

point and consumed by the ulti-

mate consumer. It-r an open access environment, third parties will gain government permission to use utility distribution wires and they will own defined units of power flowing over them until metered at their customers’ deliv-

ery points. On both transmission and distri-

bution systems, since electricity cannot be stored and therefore constantly occupies and flows over the wires (albeit in varying

amounts, depending on customer demands), third-party electricity will physically invade and perma- nently occupy utility wires. The utility will lose its right to exclude others from its property. In fact, a physical taking of the wires will occur, involving serious constitu-

tional consequences under the

Takings Clause of the Fifth ,

Amendment.

III. What Constitutional Issues Are at Stake in a Taking?

That a private property owner may hold his property to himself and exclude others from entering

upon it or otherwise making use

of it is a fundamental underpin- ning of the American legal sys-

tem. Federal and state courts throughout the nation have up- held this basic precept on count- less occasions when owners have protested third-party invasions

and occupations of their property. Like other owners of private

property, utilities have historically had the legal right to exclude oth-

Being foxed to give access to third parties for the purpose of serving the wires owner’s own custom- ers is constitutionally forbidden without just compensation.

ers from the use of their wires. Un- der open access, however, owners of the transmission and distribu- tion systems would lose these ex- clusive rights as government relegu- lators order them to allow third

parties to use their wires. With the passage of the Energy Policy Act

of 1992, Congress authorized the Federal Energy Regulatory Com-

mission to order certain types of third-party wheeling over trans- mission wires. State regulators contemplating retail wheeling may have-or may obtain from their legislatures-similar author- ity to order third-party use of dis-

AuqpstlSeptember 1996

tribution systems. When exercis-

ing such authority, regulators will deprive utilities of their right to

exclude others from their wires and must provide for appropriate compensation. The result of any wheeling order constitutes a tak- ing of utility property because

government forces the utility to share its wires with a third party.

Utilities that have engaged in some degree of open access, as the NEES companies have for some 15 years, have not yielded exclu- sive control over their wires.

Rather, under the terms, condi-

tions and rates of regulated con-

tracts, they have voluntarily per- mitted third parties to wheel

across their systems so that third parties could serve their own cus- tomers. This differs greatly from being forced to give access to third parties for the purpose of serving the wires owner’s own customers.

T his is precisely the type of action that the U.S. Su-

preme Court has expressly forbid- den on constitutional grounds un- less the owner receives just compensation in return for loss of its exclusive rights over its prop- erty. In Louetto, the Court held that

a property owner subjected to the invasion and occupation of her rooftop by cable TV equipment .

must receive just compensation

under the Takings Clause. The presence of two silver boxes on her rooftop and 34 feet of half- inch cable on the exterior walls of her building certainly did not take up a large portion of Ms. Loretto’s property Nor did the presence of the equipment deprive her of

47

other beneficial uses of her five-

story rental building. The Court nonetheless found that its mere presence-authorized by state regulators4eprived her of exclu- sive control over her property and

constituted a permanent physical occupation of her building. Sig- nificantly, the state had previously

set a nominal fee to be paid by ca- ble companies as compensation for placement of their equipment

on apartment buildings. Even so, the Court held that the Fifth Amendment required regulators to ensure that Ms. Loretto receive

just compensation as the quid pm

quo for the physical invasion and

permanent occupation of her

property The factual circumstances be-

hind Loretto and third-party wheeling over transmission and distribution systems are strikingly

48

similar. As contemplated by regu- lators of the electric industry third-party alternative suppliers would be permitted to reach cus- tomers interconnected with the transmission network or distribu-

tion system by transmitting their units of electricity over utility wires. Because of the continuous entry and presence of this electric- ity on the wires, a physical inva- sion and permanent occupation

of the network and distribution system by third-party power will occur. Some may contend that third-party electricity will fluctu- ate in amount and may not de-

prive the wires owner of the re- maining capacity of its wires.

However, the extent of the occupa-

tion is not determinative of a tak- ing. As Justice Marshall wrote for the majority in Loretto, “[C]onstitu-

tional protection for the rights of

private property cannot be made to depend on the size of the area permanently occupied.“’

A permanent physical occupa- tion is distinguishable from regu-

lation that affects the use of prop- erty It is qualitatively more severe since the owner may have no con- trol over the timing, extent, or na- ture of the invasion and occupa- tion. According to the U.S. Supreme Court,

We think a ‘permanent physical occupation’ has occurred, for pur- poses of that rule, where indi- viduals are given a permanent and continuous right to pass to and fro, so that the real property may continuously be traversed, even though no particular indi- vidual is permitted to station himself permanently upon the premises?

These factors have consistently led the nation’s courts to find a

“They said they just wanted to borrow a cup of sugar.“

The Electricity Journal

taking and to hold that property owners affected by it are guaran-

teed just compensation under the Fifth Amendment.i’ In the context

of open access to wholesale and retail markets, this means that any third party using the system un- der government grant of access will commit a physical taking of

utility wires and will be required to pay just compensation in re-

turn. During the ongoing restructur-

ing of the telecommunications in- dustry, courts have concluded that the constitutional safeguards and applications found in Loretto

prohibit regulatory commissions

from ordering access to local ex- change facilities unless they have the express statutory authority to order a taking and to provide just compensation for such an act. Where regulators required local exchanges to permit competitors to place equipment in their switching rooms (physical co-loca- tion) or serve competitors’ needs with their own equipment (vir-

tual co-location), both the D.C. Circuit and the Supreme Court of

Oregon have invalidated co-loca- tion rules under the physical tak- ings law rooted in the Fifth Amendment and articulated in Loretto. l1 As these cases show, regulators must devise some other, constitutionally sound

means of enhancing competition in telecommunications. To avoid

prolonged litigation over the co- location of third-party electricity on wires, regulators with the authority to order open access would be wise to craft just com- pensation for wires owners now,

as a threshold issue in restructur- ing.

Iv. How Should Just Compensation Be Determined?

A taking is a taking regardless of the compensation paid to the

property owner, but an owner whose property is subject to a tak- ing must be made economically indifferent to the taking. The U.S.

Supreme Court has often stated that an owner is to be put in the

same monetary position that he would have occupied had his property not been taken in the first place.12 Thus, our original cost return on the wires them-

selves is not even facially ade- quate. The presumed or proven benefits of competition enabled

by open access to wholesale and retail customers will not diminish

or supplant the Constitution’s re- quirement of just compensation to

the utility that loses exclusive con- trol over its wires. In cases of physical takings, courts do not employ any impact/benefit bal- ancing test to determine whether a taking has occurred.13 Without

August/September 1996

-

regard to whether the action

achieves an important public benefit or has only minimal eco-

nomic impact on the owner, the Supreme Court has established a per se rule that a taking occurs when there is a permanent physi-

cal occupation of real property The unitary nature of vertically

integrated utility holdings drives

the determination of damages re- sulting from a physical taking.

The integration of distribution, transmission and generation into a tightly woven commodity deliv-

ery system performs as a whole. One part severed from the others can drastically reduce the prop-

erty’s comprehensive value. If the wires are severed from the genera- tion, their loss will destabilize the value of the overall property The result would be akin to a tricycle with only two wheels-broken and going nowhere.

I n determining just compensa- tion, courts will consider the

extent of third-party access and its effect on the remainder of the util-

ity’s integrated, operative pack- age of property (facilities and fran-

chised services). The proper calculation of damages in sever- ance (or partial takings) cases re- lies on a “diminution of value” ap- proach. Under this method of

determining just compensation, courts determine the value of the

entire property before and after the taking. In U.S. V. Virginia Elec-

tric and Power Co., for example, the Supreme Court recognized that a lower court had “adopted an acceptable method of ap- praisal, indeed the conventional method, in valuing what was ac-

49

quired by the Government by tak- ing the difference between the value of the property before and after the Government’s easement was imposed.“14

In cases where open access will sever a utility from its customers, just compensation will be cor- rectly calculated as the invest-

ment stranded by that sever- ance.l” In its Final Rule on Open

Access Transmission and Stranded Cost Recovery, the Fed- eral Energy Regulatory Commis-

sion has developed a fair formula

for capturing this number:

SC0 = (RSE - CMVE) x L,

where

RSE = Revenue Stream Estimate-av- erage annual revenues from the de- parting customer over the past three years, minus average trans- mission revenues that the utility would have recovered from the de- parting customer over the same three years under the new open ac- cess tariff

CMVE = Competitive Market Value Estimate of the generation to be re- leased by the departing customer

L = Length of Obligation or reason- able period utility expected to serve the departing customer.16

In essence, utilities will deduct unbundled transmission revenues

and the new market value of gen- eration from the revenues they would have received from a de- parting customer and collect that amount for the period they other- wise expected to serve that cus- tomer.

Significantly, this does not pre- clude a requirement that utilities

reasonably mitigate their losses. Furthermore, FERC will scruti- nize utilities’ stranded cost claims by subjecting their underlying ob- ligations to verification and pru- dence review.

V The Just Compensation Solution

Private property may be sub-

jected to a taking by government, but the U.S. Constitution requires that the property owner receive

just compensation as the quid pro quo. The Federal Energy Regula-

tory Commission has recently rec- ognized the unfairness of requir- ing utilities to give up their requirements customers without

appropriate cost recovery:

We reaffirm our preliminary de- termination that the recovery of legitimate, prudent and verifiable stranded costs should be al- lowed. . . [Ultilities that entered into contracts to make wholesale

requirements sales under an en- tirely different regulatory regime should have an opportunity to re- cover stranded costs that occur as a result of customers leaving the utilities’ generation systems through Commission-jurisdic- tional 0

Y en access tariffs or

0rders.r

Under open access, electricity owned by third parties would physically invade and perma- nently occupy the transmission and distribution systems devel-

oped and maintained by utilities as private property dedicated to

serving their historic customers.

The utilities’ loss of the power to exclude third parties from their wires would result in a physical

taking, constitutionally compensa- ble under the Fifth Amendment.

The taking would chop through the utility’s bundle of property rights, would cut off the various segments of the utility’s business from each other and would dimin-

“We prefer to think of it as . . sharing.”

50 The Electricity Journal

ish the utility’s ability to use its

property interest as an integrated whole.

The U.S. Constitution, as inter- preted by the nation’s highest court and by other judicial bodies throughout the country, forbids such a taking without just com- pensation. The constitutionally re- quired compensatory monetary award will properly consider the effect of the taking on the utility’s entire bundle of property rights.

The Federal Energy Regulatory Commission has correctly deter- mined the forms of just compensa-

tion by authorizing collection in two alternative forms: (1) an exit fee paid by the departing cus-

tomer, or (2) an access fee paid by the new third-party supplier us- ing the wires to reach that cus- t0mer.l’

Like the property owner whose land and road are subjected to a government-mandated easement, utilities are guaranteed just com- pensation by the U.S. Constitu- tion in return for permitting third- party power to flow over their transmission and distribution wires. Rooted in the concept of fairness, the Takings Clause of the Fifth Amendment forbids the de- struction of private property rights and values unless the prop- erty owner is made whole. Regu-

lators may avoid overwhelming constitutional challenges to the physical taking of utility property and obtain the benefits of competi- tion by crafting just compensation in the form of stranded cost recov- ery for utilities thus deprived of their right to exclude others from

their property. It’s physical-and the response is logical. n

Endnotes:

1. State of Missouri ex rel. Southwest- ern Bell Telephone Co. v. Public Serv- ice Comm’n of Missouri, et al., 262 U.S. 276, 289 (1923).

2. FIX et al. v. Hope Natural Gas Co., 320 U.S. 591, 602-3 (1943).

3. Duquesne Light Co. v. Barasch, 488 U.S. 299, 315 (1989).

4. Proprietors of Charles River Bridge v. Proprietors of Warren Bridge, 36 U.S. 420 (1837).

5. See, e.g., Monongahela Navigation Co. v. U.S., 148 U.S. 463 (1892).

6. Loretto v. Teleprompter Manhattan

CATV Corp., 458 U.S. 419 (1982).

7. Major industry efforts are under- way to address uncompensated uses of the transmission system such as loop flow and parallel path problems. This article does not treat these phe- nomena, which arise from the physical nature of electricity flow but are extra- contractual in nature. Our focus here is on third-party use of wires man- dated by regulators to fulfill the objec- tives of open access. Such use will occur under regulated contracts which must recognize stranded cost recovery to prevent an uncompensated taking of the wires.

8. Supra note 6 at 436

9. Id, at 434-35; subsequently quoted in Nollan v. California Coastal Comm’n, 483 U.S. 825,831-32 (1987).

10. For a summary review of many cases in which the U.S. Supreme Court has found that a permanent physical occupation of real property demands just compensation, see Loretto, supra, 427-35.

11. Bell Atlantic Telephone v. F.C.C., 24 E3d 1441,1445 (D.C. Cir. 1994); GTE Northwest, Inc. v. Public Utility Comm’n of Oregon, 321 Or. 458,468- 74,900 P.2d 495,501-05 (1995). Under virtually reversed circumstances, the Supreme Court of South Dakota invali- dated new rules which forbade a tele- phone company from using its switching and transport property for its own customers and forced it to use new competitors’ facilities. Upon the company’s protest, the court found an unconstitutional regulatory taking of the company’s property. U.S. West Communications, Inc. v. Pub. Util. Comm’n of South Dakota, 505 N.W.2d 115 (1992).

12. See, e.g., US. v. Miller, 317 U.S. 369, 373 (1943); U.S. v. Reynolds, 397 U.S. 14,16 (1970).

13. The per se rule articulated in Loretto supplants the balancing test set forth in Penn Central Transportation Co. v. New York City, 438 U.S. 104 (1978). The Penn Central test is typically ap- plied in cases protesting regulations re- stricting the use of property.

14.365 U.S. 624, 632 (1960).

15. Simply stated, this will include both utility generation units and pur- chased power contracts. Adjustments to stranded cost calculations will also include regulatory assets associated with generation and purchased power obligations.

16. Federal Energy Regulatory Com- mission, Order No. 888, mimeo at 595-7 (1996).

17. Id. at 452.

18. Id.

August/September 1996 51