Pacific Gas & Elec. Co. v. City and County of San Francisco

265 U.S. 403, 44 S. Ct. 537, 68 L. Ed. 1075, 1924 U.S. LEXIS 2621

• Court: Supreme Court of the United States
• Decided: June 2, 1924
• Docket: 34-36
• Status: Published

Opinions

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 first thereafter at not more than seventy-five cents per thousand 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 eighty-five cfents per thousand.

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 seven 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 seven per centum — for 1913-1914, an excess of $21,402.95; for 191T-1915, $89,446.12; and for 1915-1916, $171,464.48.

We think the evidence supports the finding that a net return of seven 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 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 nor 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 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 yalue fhe 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.

“The company contends that its plant capital, as a basis of earnings, should suffer no deduction because of supposed depreciation due to age, but only, if at all, by the amount of ‘ deferred maintenance.’ And where, as here, there have been abandonments of large units due to obsolescence, the loss 'should be reimbursed by amortization over a period of years after, rather than before, the replacement, this amortization being effected by dividing the economies resulting from new machines and processes between owner and consumer, thus allowing a partial reduction in the rate. . . .

“ Until this case it had not occurred to me that, so far as theory is concerned, reimbursement of the owner could take place after abandonment. It would not seem fair if it involved a raise of rates. Physical depreciation, for example, if an accumulation is necessary to provide for replacement, ought to be provided beforehand from the rates of users of the service which caused the machine to wear out. But where replacement is made on account of obsolescence or inadequacy, and economy is effected in costs, that economy can with fairness be devoted to reimbursement for the replacement cost, the rates remaining unchanged. I know of no well-considered method to meet this reimbursement after the fact. The installments would have to include interest on the unpaid principal and capital would thus not be depreciated for purposes of return. An estimate of the period of amortization would not have to be made if all economies of the new machine were devoted to the amortization; it would work itself out. If the economies were shared with the ratepayer, as plaintiff here suggests, the period should not extend beyond the estimated life of the new machine; a plan which is subject to the objection on the grounds of uncertainty common to all such estimates. . . .

“ But where, as here, and as is generally the case, there is nothing to show what, if any, consideration has been given the question of depreciation methods by the state authorities, or anything beyond a bare schedule of rates to be charged, then the court must determine the proper methods by its own independent judgment. I have tried to make it clear that in the usual case the modified sinking fund method would seem most applicable. Notwithstanding. this, in cases where it had not been the practice to accumulate a reserve, and where the cost of replacements has shown itself to be a fairly uniform amount, or a fairly uniform percentage of income or of capital, then there is no objection in sound reasoning, nor, as I believe, in the law as laid down, why the court should not adopt a replacement method in determining proper costs of production; and in such event it would rate at replacement cost new to determine the owner’s reasonable return and include actual average replacement requirements in the yearly costs, without reserves. Or it might figure on a reserve for part of the plant, and a replacement method for the balance apparently adapted to it. Conceivably, also, the court might amortize the loss by obsolescence after abandonment had taken place, as plaintiff urges here. But I imagine that any court will feel the same hesitation in so doing that I feel here, for it involves reimbursement as to structures no longer in the inventory of units in service, and is without precedent except where the rate-fixing body has laid it down as a proper policy. . . .

“Mr. E. C. Jones, chief gas engineer of plaintiff, also testified that the plant was worth cost new less only the deferred maintenance and the amount of abandonments immediately in prospect. He estimates the amount of this deduction at 1828,916.41 (Exhibit 43), or 6.3 per cent.'of his appraisement at $13,066,201.55 (Exhibit 3) . His estimate includes no consideration of approaching obsolescence; it does include replacement reasonably in view, due to physical deterioration, and to ordinary inadequacy. . . .

“ I have referred several times to plaintiff’s contention that obsolescence should be amortized after rather than before abandonment of a unit of plant. Specifically applied, it is urged that when it is seen that Martin station or other obsolete generator has been superseded by new Jones generators, using the improved Jones process for oil-gas, the demonstrated economies thereby effected are justly to be devoted to reimbursing the company for the loss of capital occasioned by the obsolescence, continuing each year until the loss is made good, with interest. On this settled program the new generator would, of course, be rated for return at replacement cost new at all times. To give the consumer a part of the advantages of the improvement, the company proposes that only half of the very considerable economies of operation shall be devoted to its reimbursement. Many advantages are Urged for this plan: That it throws upon the consumer, who has the benefit of the new equipment in the shape of reduced charges, the burden of the loss by supersession of equipment otherwise in good condition; that it avoids the defect that is inherent in a system of setting aside reserves in advance of abandonment, namely, that while the life of a depreciable unit is difficult enough to estimate when physical decay alone is considered, it is practically impossible to forecast when we consider that obsolescence and-inadequacy, which usually account for abandonments in a gas manufacturing plant, follow no rule as to time of their operation; that, finally, progress in service is promoted by giving a gas company an incentive to improvement of its machinery and its processes in the shape of increased profits. It must be admitted that if replacement of an old machine has not been sufficiently provided for by reserves in advance, a company will naturally defer installing a new machine, and so progress is halted. It is, furthermore, true that the application of the usual formula, fair return on fair present value of the plant in service, gives to the consumer all the advantages of economies in operating costs, which plainly is not entire justice. The City’s counsel agrees (Argument 451) that if obsolescence had occurred suddenly, with no opportunity to create reserves for replacement, the loss should be amortized after abandonment; but he denies that the facts here conform to the hypothesis. . . .

“ Mr. E. C. Jones, chief gas engineer of plaintiff, and his son, Mr. Leon B. Jones, assistant gas engineer, on an application filed May 23, 1912, were on March 10, 1914, granted United States Letters Patent for an improved apparatus for manufacturing oil-gas; and on October 19, 1915, on an application also filed May 23, 1912, were granted letters for the process. On November 30, 1915, they granted to plaintiff the exclusive right to use the process, and to make and use, but not to sell, the apparatus, together with future improvements in either process or apparatus made during the lives of the patents; the rights granted being transferable, but restricted as to place to a number of named counties in northern and central California. Despite the late date of the grant, plaintiff’s beneficial right covered the period in suit, for the prior installation of generators embodying the Jones patents at the Metropolitan and the Potrero stations, with the patentees’ consent, conferred an implied license to use them during their life in the San Francisco district; but this license was not exclusive. The contract underlying the grants (Exhibit 61) recited that the Company had permitted the patentees to use its plant and facilities for experimentation and commercial demonstration of their inventions; had expended in alterations in its Metropolitan plant a sum exceeding $100,000, and also had expended in erecting two new gas generators at the Potrero station embodying the inventions a sum exceeding $215,000; that continued operation of all said new or altered apparatus under the patentees’ direction had demonstrated the great utility and value of the inventions and that they could be utilized ‘ to the great pecuniary advantage ’ of the plaintiff Company; that the Company had allowed the patentees to exhibit the apparatus to many persons interested in gas manufacture in this country and Europe as a demonstration of the utility and value of their inventions, and that the patentees regarded the privilege of future such exhibitions as of great value to them. It was then agreed that for the grants first above referred to the Company would pay the patentees the sum of $46,066.67, and would allow full opportunity for future exhibition of the generators, and so forth.

“The question is, at what figures these rights of the Company shall be taken into the rating base? It seems to be agreed that the amount actually paid in 1915 is already represented in the amount hitherto added as additions and betterments.

“The presentation of plaintiff’s case in the form approved by its counsel does not primarily involve the giving of a value to these patent-rights. Counsel in argument stated in substance that the evidence as to their value seemed to involve such enormous sums that he preferred the more conservative course of giving them consideration in his conception of the proper treatment of losses by obsolescence. It will be remembered that his argument was that no new invention would be installed by a man of business unless its savings were available to him to recoup losses of capital abandoned to make way for it; that the patent monopoly would enable him to compel a price adequate for his recoupment; and that in a proceeding like this it was equitable to divide the savings with the consumer and apply the Company’s share to reimbursement of the loss by abandonment, meanwhile rating the new property at value new. I have said that there was strength of reason in this plan, but that it involved a matter of administrative policy that was primarily for the State’s regulatory body. I have not followed this plan for this reason and for the further reason that it appeared obsolescence could have been foreseen and provided for, and apparently had been provided for. This means that the question of value of the rights must be now considered.

“ The evidence is not very full on the part of plaintiff. And due perhaps to plaintiff’s position as to obsolescence, there was little cross-examination by the City and no contrary evidence. With oil at 68% cents a barrel to plaintiff during the years 1912-16, Mr. Bridges estimates the savings under the Jones process at 2% cents a thousand feet of gas manufactured. (Exhibit 62.) In Table X of his supplemental argument, Mr. Bosley estimates the savings shown by the evidence at 2+ cents for the first two years and over 4 cents for the year 1915-16; or, in sum total, $103,530.39 for 1913-14, $132,419.45 for 1914-15 and $258,557.81 for 1915-16. A just criticism of these estimates is that they give no influence to the economies due to larger production. Mr. Britton, general manager of plaintiff, speaking of results attained in 1916-17, testifies that the new Jones generators effected a saving of two gallons of oil per thousand feet of gas and over one cent a thousand in labor costs of manufacture. (Tr., 2248 seq.) Projecting the savings over the sixteen remaining years of the letters patent, he computes the aggregate savings at $7,630,300. (Tr., 2251.) Mr. Vincent computes the present worth on June 30, 1916, of these future savings at $4,203,300. (Exhibit 67.) While apparently the estimates are made on conservative bases, it is, of course, true that forecasts like this are full of uncertainties; for example, oil may rise to a price prohibitive for gas consumption on the present scale, or other inventions or even substitutes for gas may diminish the value of the Jones patent.

“ There is no doubt that these patents are property, and of great value. It is also true, I think, that justice demands that the utility company should profit in some substantial proportion by the economies brought about by its ability in management or its improvements in methods of manufacture. There is no good reason why the consumers should get all the advantages that are the fruit of the genius of these inventors. If by the terms of their employment Mr. Jones and his son had been bound to assign their patents to plaintiff without further compensation, and had done so, the City could not justly claim that the Company should have no part of the savings effected. The patents would have to be valued. But in view of the fact that the Company and the pat-entees, dealing presumably at arms’ length, have reached a figure of about $46,000 as the value of exclusive rights throughout Northern California, I am as much embarrassed as was plaintiff’s counsel in concluding that in San Francisco alone the rights are to be valued for purposes of return at four million dollars or any substantial fraction of that sum. And how are we to compare in value the full rights obtained by express grant in 1915 and the restricted rights arising by implied license in the prior years? In view of the state of the evidence, it seems to me better to pass the whole matter for future consideration in connection with the rates of later years, when the State Commission can pass on it with full evidence before it. On the record before me I do not see my way clear to add any figure to the rating base on account of these patent rights. . . .

“Objections Nos. 8, 9 and 10 have to do with the valuation of, plaintiff’s rights under the Jones patents. Plaintiff is incorrect in stating that the Master failed to find the present value of the patent rights. , These were allowed in capital value as stated, page 85, at $46,066.67, the amount paid the grantors in 1915. If the plaintiff had paid the inventors, say $500,000, or other considerable sum, for these patent rights, there is no reason to doubt that this figure would have been accepted as the valuation for purposes of return. It is not my view that a valuation must follow cost, although it is more apt to do so where the purchase was recently made. I have stated as fully as I could the reasons why I could not find the immensely greater figure which plaintiff claims. Briefly, the evidence was entirely too speculative. There is, after all, in such a policy no particular restriction to enterprise in denying to stockholders the fruits of valuable inventions, because the stockholders do not function in the direction of enterprise. The way to reward enterprise is to pay large sums to inventors, but that is not the question here. In a supplementary argument counsel asks me to apply here the rule which prevails in patent accountings, where, when damages cannot be ascertained by reference to an established royalty, the Master is permitted to determine from all the evidence what would have been a reasonable royalty. The qualification to this rule is, however, that the Master must have some evidence upon which his mind can work and rely, and that is to a large degree lacking here, save in so far as it is given by the amount of the purchase price. The objections named are accordingly overruled.”

Obviously, under the theory accepted below, appellant worsened its situation for rate-making purposes 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 tiiis change.

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 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.