The opinion of the court was delivered by: Graffeo, J.:
This opinion is uncorrected and subject to revision before publication in the New York Reports.
In this appeal, we consider the legal standards that apply when a utility company seeks permission from the Public Service Commission (PSC) to recoup from ratepayers certain environmental remediation costs it has incurred. We hold that when the PSC reviews a management decision of a utility to assess its prudence, the Department of Public Service (DPS) bears the initial burden of showing that the utility may have acted imprudently based on what was known at the time the challenged decision was made. Furthermore, there must be a rational basis in the record evidence to support the grounds cited in a PSC order for a finding of imprudence.
Petitioner National Fuel Gas Distribution Corp. (NFG Distribution) is a natural gas delivery utility that operates in western New York and is regulated by the PSC under article 4 of the Public Service Law. NFG Distribution is a subsidiary of the National Fuel Gas Company (National Fuel) and has a number of corporate affiliates.
In the 1990s, National Fuel (the parent company) began pursuing insurance coverage for potential environmental cleanup costs at its former manufactured natural gas plants. National Fuel had commissioned an environmental report (the "IES report"), issued in 1996, which estimated that site investigation and remediation (SIR) expenses at the former plants would be approximately $300 million. The IES report further attributed 64% of the potential SIR liabilities to NFG Distribution. To determine the extent of its insurance coverage for these estimated remediation expenses, National Fuel filed notices of potential claims with its general liability insurance companies and provided copies of the IES report to its insurers. All of the insurance carriers initially denied coverage.
Eventually, the insurers and National Fuel reached two separate settlements in 1999, totaling approximately $37 million. All but one of the insurers settled with National Fuel for about $16 million. Additionally, Aegis Insurance agreed to issue a replacement policy providing $20.8 million in future SIR coverage. Since the estimated SIR liability of just one of National Fuel's subsidiaries (such as NFG Supply) could have exceeded the total amount of the settlements, it was conceivable at the time the parties entered into the agreements that one environmental remediation claim by a single subsidiary could exhaust the entire settlement fund to the detriment of the other subsidiaries and their ratepayers.*fn1
National Fuel therefore decided to allocate the proceeds of the settlements among its subsidiaries that had been covered by the insurance policies through the use of a "premiums paid" formula of allocation. Under this approach, each subsidiary received an amount from the settlements proportionate to its share of the insurance premiums paid and its contribution to the costs incurred in obtaining the settlements. As a result, NFG Distribution received almost 46% of the settlement proceeds -- approximately $8.3 million (about 52% of the cash settlement) and approximately $8.5 million in future coverage under the Aegis policy (about 41% of the new SIR insurance). A similar percentage of the total recovery was allotted to two other regulated National Fuel subsidiaries (NFG Supply and Pennsylvania NFG Distribution). The unregulated subsidiaries received approximately 7% of the total settlement, but their share apparently did not consist of cash proceeds, just future SIR coverage under the Aegis policy.
Between 1998 and 2006, NFG Distribution incurred actual SIR expenses of almost $27 million -- 85% of National Fuel's aggregate environmental remediation costs during that period --which depleted the company's proceeds of the monetary settlement and its share of coverage under the Aegis policy. As a result, in 2007, NFG Distribution petitioned the PSC for tariff amendments to increase its rates in order to pass its uninsured SIR costs to its customer base. At that time, NFG Distribution was collecting $600,000 per year for SIR expenses from ratepayers. The tariff request sought to increase that amount to $1.7 million.
DPS challenged the requested increase, arguing that it had been unreasonable for National Fuel to use the premiums paid methodology to allocate the settlements because the percentage of premiums paid by each subsidiary bore no relation to the amount of the settlement funds. According to DPS, the settlements should have been distributed to the subsidiaries based on the actual SIR expenses incurred. DPS requested that the PSC impute approximately 85% of the total settlement to NFG Distribution, thereby reducing the proposed tariff request accordingly. NFG Distribution countered that National Fuel chose the premiums paid methodology in 1999 because the IES report provided only preliminary estimates of potential SIR expenses as of 1996; that not all of National Fuel's former manufactured natural gas sites were included in the report; and it would have been too speculative to attempt to determine the actual SIR costs that each subsidiary would ultimately incur. Consequently, NFG Distribution urged that it was reasonable for its corporate parent to utilize the premiums paid formula at the time the settlements were disbursed in 1999.
The administrative law judge ruled in NFG Distribution's favor, concluding that the premiums paid formula was "not unreasonable on its face" since DPS had failed to demonstrate that some other settlement distribution method would have been reasonable at the time the corporate decision was made.*fn2 The recommended decision determined that no additional portion of the settlements beyond the 46% that NFG Distribution actually received should be imputed to the company. The ALJ recommended that NFG Distribution be permitted to increase its rates to collect $1.7 million annually for environmental remediation expenses, the amount requested by NFG Distribution.
Exceptions were filed to the ALJ's decision and the matter was brought before the PSC. DPS continued to assert that it was unreasonable for National Fuel to have employed the premiums paid method and asked the PSC to impute 85% of the settlements to NFG Distribution. In the alternative, DPS argued that the settlements should have been distributed to the subsidiaries based on the percentage of SIR costs that were attributable to them in the IES Report, which method would have resulted in 64% of the settlement proceeds directed to NFG Distribution. During the evidentiary hearing, a DPS employee testified that it had been unreasonable to allocate the settlements based on premiums paid because the claims that were presented to the insurance carriers were premised on costs associated with specific sites and the amount of settlement proceeds "was not related in anyway [sic] to the insurance premiums paid." According to the DPS employee, the settlements were "based on the estimated remediation costs, and presumably other litigation factors, which had no relation to the amount of insurance premiums paid."
The PSC concluded that National Fuel had acted imprudently, finding that "the 46% allocation of the insurance proceeds was unjust and unreasonable at the time it was made" because National Fuel "should have taken into account the estimates that were available at the time of the liabilities that each subsidiary company was facing." The PSC determined that the proper allocation to NFG Distribution in 1999 should have been 64% of the settlements and ordered that the company be imputed with an additional 18% of the settlements in developing the proper rate structure.*fn3
NFG Distribution then commenced this CPLR article 78 proceeding to contest the PSC's determination. The case was transferred to the Appellate Division, which annulled the PSC's imputation of additional settlement proceeds to NFG Distribution (71 AD3d 62 [3d Dept 2009]). The court held that it was reasonable for National Fuel to use the premiums paid formula in 1999, reasoning that the IES report contained only preliminary estimates of SIR costs, it did not address every potential claim of former manufactured gas sites and there was no evidence in the record to demonstrate that the report was intended to reflect all accurate SIR claims when it was drafted in 1996 or when the settlements were allocated in 1999. The Appellate Division also observed that the premiums paid formula allowed National Fuel to reasonably compute each subsidiary's share of the insurance premiums and the methodology assured that each subsidiary and its ratepayers would receive the benefit of the settlements in proportion to what each subsidiary had paid for insurance coverage. Although the court agreed with the PSC that it would have been a reasonable alternative for National Fuel to have allocated the settlements in 1999 using the potential claims that were listed ...