The opinion of the Court was delivered by
This сase presents the complex issue of determining the proper method for valuing the property of a regulated industry for purposes of local property taxation.
We are asked to review the municipal tax assessments of segments of pipeline that are used by the taxpayers for the interstate transmission of natural gas, an operation that that is subject to comprehensive federal regulation. We determine that the method of valuation proposed by the taxpayers, which is based essentially on the book value of the property that is
I.
Transcontinental Gas Pipe Line Corporation (Transco) and Algonquin Gas Transmission Company (Algonquin) both operate interstate natural gas pipelines that run through Bernards Township. Prior to the 1983 property tax assessment, the pipelines had been valued according to an interim or provisional method established in Transcontinental Gas Pipeline v. Township of Bernards, 115 N.J. Super. 593 (App.Div.1970) (Transcontinental I), aff’d o.b. 58 N.J. 585 (1971), and Texas Eastern Trans. Corp. v. Borough of Carteret, 116 N.J. Super. 9 (App.Div.1970), aff’d o.b. 58 N.J. 585 (1971). Under this method, interstate natural gas pipelines were valued at their original cost less depreciation, without any recognition of any increase in value over time, up to an upper limit of 48% depreciation. Following this methodology, the Transco pipeline’s assessed value, including its fifty-foot easement, was $675,000, resulting in a property tax of $32,718.60. The Algonquin pipeline was valued at $569,700, resulting in a property tax of $28,371.06.
For the 1983 tax year, as part of an overall reassessment of the Township’s property, Bernards Township abandoned the
Transcontinental I
methodology and assessed the property at its replacement cost less depreciation. As of the October 1, 1982, assessment date, Transco’s pipeline was valued at $1,959,-200, resulting in a tax of $34,677.84 and Algonquin’s pipeline
The pipeline companies challenged these assessments in the Tax Court, alleging that the assessment methodology was incorrect. In addition, they challenged the 48% cap on depreciation established by the Transcontinental I court’s interim methodology, arguing that, as a regulated utility their income was limited by the value of property that is included in their rate base by the Federal Energy Regulatory Commission (FERC). Since the FERC-mandated depreciation of their property-had long ago exceeded 48%, the pipeline companies argued that it was unfair to value their prоperty for ad valorem property tax purposes at a value higher than the FERC-determined value at which it earned income as part of the utility’s rate base. The two cases were tried together by the Tax Court, with evidence of each proceeding applying to both cases.
At trial, the pipeline companies used the unit-valuation method, determining the value of each pipeline company as a whole, then allocating a percentage of this overall figure to the company’s assets within the Township. The rationale for this approach is that a pipeline must operate as an entire unit to produce earnings, and an isolated section of pipeline would have little or no value standing alone. The pipeline company experts presented evidence of comparable sales as well as income and cost figures based on the income, rate of return, and cost
The Township, on the other hand, presented evidence that the original assessment, if anything, was too low. In light of the useful lifetime of the property, which the taxpayers’ own experts testified was indefinite if properly maintained, and the Township’s expert estimated to be at least 100 years, the Township argued that the 45% lump sum depreciation used in the original assessment was too high, and that a 1% annual straight line depreciation for each pipeline would be more appropriate. The Township expert thus opined that the proper replacement cost new less depreciation of the Transco property was $3,428,923, and the proper value of the Algonquin pipeline was $3,440,000. The Township’s expert also testified that he found no reason to reduce the value of the property to reflect functional or economic obsolescence.
The Tax Court upheld the original assessment, rejecting both pipeline companies’ proposed market sales and capitalized income valuations, and in addition rejecting Algonquin’s proffered stock and debt valuation as well as its depreciated replaсement cost method, which in essence equated FERC depreciation with economic obsolescence. In
Transcontinental Gas Pipeline Corp. v. Bernards Township, (Transcontinental II),
7
N.J. Tax
508 (Tax Ct.1985), aff'd 9
N.J. Tax
636 (App.Div.1987)
(per
curiam), the Tax Court rejected Transco’s
1
contention that the pipeline should be valued for property tax purposes in the same manner as it is valued in FERC ratemaking proceedings, and concluded that replacement cost new less
II.
Taxpayers, in challenging the municipality’s original assessment, bear the burden of rebutting the validity of the quantum of this assessment. Riverview Gardens v. Borough of North Arlington, 9 N.J. 167, 175 (1952). As we observed in Pantasote Co. v. City of Passaic, 100 N.J. 408 (1985), this presumption is not simply an evidentiary mechanism allocating the burden of proof, but “a construct that expresses the view that in tax matters it is to be presumed that governmental authority has been exercised correctly and in accordance with law.” Id. at 413. In Aetna Life Ins. Co. v. City of Newark, 10 N.J. 99 (1952), the Court announced what has come to be accepted as the definitive verbal formulation of the burden imposed on a taxpayer challenging an ad valorem property tax assessment: “it is not sufficient for the taxpayer merely to introduce evidence: the presumption stands until sufficient competent evidence is adduced to provide a true valuation different from the assessment. Such evidence must be definite, positive, and certain in quality and quantity to overcome the presumption.” Id. at 105. In Pantasote we interpreted this to mean that the presumption remained in place even if the municipality utilized a flawed valuation methodology, so long as the quantum of the assessment is not so far removed from the true value of the property or the method of assessment itself is so patently defective as to justify removal of the presumption of validity. Pantasote, supra, 100 N.J. at 415.
The Tax Court correctly rejected taxpayers’ market valuation on the grounds that the pipelines are speciality property so uniquely adapted to its current purpose of transporting natural gas that no ready market for such property exists.
See, e.g. Hackensack Water Co. v. Borough of Old Tappan,
77
N.J.
208, 223 n. 1 (1978) (Handler, J., dissenting),
Tenneco, Inc. v. Town of Cazenovia,
Taxpayers, however, argue that this market information is relevant in a secondary sense, since the evidence presented shows that most pipelines sell at or near book value, which is essentially the figure reached by their capitalization of income and cost valuation approaches. Although some courts have found this corroborating evidence relevant to the valuation of utility property, see Montaup Electric Co. v. Board of Assessors of Whitman, 390 Mass. 847, 852-53, 460 N.E.2d 583, 587 (1984) (rejecting any valuation figure significantly above book value (depreciated original cost) in the absence of evidence that a willing buyer would pay more than that amount for the property), we are not persuaded by this approach. It would be contradictory to reject the market approach on the grounds that it is an unreliable and inappropriate measure of an asset’s worth, due to the fact that the asset was constructed for a particular purpose by the owner without any consideration of resale, see CPC International, Inc. v. Borough of Englewood Cliffs, 193 N.J.Super. 261, 269-70 (App.Div.1984), but then give credence to the result of such an approach as support for the correctness of another valuation approach.
In addition, it does not appear that such transactions reflect all of the interests in the property of a regulated utility. Almost all such sales are from one natural gas pipeline company to another, and are subject to the approval of FERC, which prevents the new purchaser from including in the purchasing utility’s rate base any value for the pipeline in excess of the purchased pipeline’s book value. The reason for this is that the cost of an asset owned by a utility is eventually charged to the ratepayers as a cost through depreciation, and to allow a
The Tax Court was also justified in not relying on taxpayers’ attempt to establish the value of their property through the capitalization of income approach. Under this assessment methodology, the value of a property purchased for investment purposes is equated with the present value of the projected net income stream that will be earned by the property over its useful life. American Institute of Real Estate Appraisers, The Appraisal of Real Estate, 71, 315 (7th ed. 1978). To use this valuation approach it is necessary to obtain a reliable determination of the property’s earning potential, as well as an appropriate capitalization rate that reflects the return investors would require on similar investments. In the absence of such information, the capitalization of income approach must be rejected, and another valuation methodology utilized. See, e.g., Pantasote, supra, 100 N.J. аt 412 (rejecting income approach for special purpose property).
We reject this method of valuation, which has been urged, in some form, by the dissent below. Although the approach is attractive in its simplicity, its application as a method of property tax valuation is inappropriate for several reasons. On a theoretical level, for еxample, it defeats the purpose of the income approach of property taxation, which attempts to capitalize the income of the real property separate from the value of the business using the property, see, e.g., Transcontinental II, supra, 7 N.J.Tax at 521. Furthermore, it is contrary to the approach taken by the Tax Court with respect to other locally valued utility property, see, e.g., Hackensack Water Co. v. Haworth, 178 N.J.Super. 251, 261, 2 N.J.Tax 303, 313 (App.Div.), certif. denied, 87 N.J. 378 (1981) (court rejected a valuation process that sought to recognize the cost of improvements located outside the taxing district in the assessment of the utility’s reservoir).
More importantly, however, there appear to be insurmountable practical problems with the unit valuation approach. In particular, the taxpayers’ methodology for allocating a percentage of this income to a particular asset of the utility is problematic. Taxpayers performed this allocation by comparing the book value of the utility’s rate base property as a whole to the
Even if an accurate allocation percentage could be derived, the mеthod still assumes that a utility’s property earns income directly proportionate to its rate base value. This is a disputable assumption, since a utility’s rate base includes not only pipelines, pump stations, and storage tanks, but office buildings, automobiles, as well as other assets, such as construction work in progress, that currently do not contribute to providing service to consumers. While it can be said in a macroeconomic sense that all of these assets contribute directly or indirectly to the transportation of natural gas,
see Public Serv. Elec. & Gas Co. v. Township of Woodbridge,
73
N.J.
474, 479 (1977), it is unreal to believe that diverse assets all contribute to a utility’s income earning potential in a manner exactly proportional to
While this system is a complex system with each part necessarily relying upon other parts, the uniform allocation of earning power based upon original cost is risky, at best. Some parts of the system may very well throw off earnings at a greater percentage of cost than a corresponding and physically equal part.
[Brooklyn Union Gas Co. v. State Board of Equal, and Assessment,65 N.Y.2d 472 , 485,492 N.Y.S.2d 598 , 602,482 N.E.2d 77 , 81 (1985) (quoting lower court opinion), cert. denied, 475 U.S. 1082, 106 S.Ct. 1461,89 L.Ed.2d 718 (1986).]
Taxpayers claim that the unit valuation method is in fact a correct allocation method, since they are only allowed to earn on their rate base, and their assets yield the same rate of return to investors no matter what the particular character of a certain asset may be. While this is a correct characterization of a utility’s property from the perspective of an investor, it glosses over a subtle but pivotal aspect of utility ratemaking. A utility does not in fact earn income on its rate base in the same manner as an investor earns income on capital invested in the rate base; it earns income by using its assets to sell gas at a rate set by FERC at a level which, if FERC has properly anticipated demand and cost of service, will allow it to cover its costs and provide a reasonable return on invested capital. H. Averch & L. Johnson, “Behavior of the Firm Under Regulatory Constraint,” 52
Amer.Econ.Rev.
1052 (1962). It is simply incorreсt to assume that utility property uniformly generates income in direct proportion to its book value.
See New Hampton, supra,
101
N.H.
at 148-49,
It should be noted that even if a proper income could be determined, the difficulties attendant on the determination of income would also taint the derivation of an appropriate capitalization rate. Both taxpayers developed a capitalization rate by, in effect, re-creating the process by which its rate of return was determined for FERC ratemaking purposes. This approach has elements of self-fulfilling prophesy, since FERC determines estimated net income by multiplying the book value of the property by a rate of return, and then setting gas rates at a level that should produce this income, and taxpayers propose determining the value of the property by dividing the resulting net inсome by what is essentially the same rate of return.
The circularity of this valuation approach was recognized by the United States Supreme Court more than fifty years ago in
Missouri Ex Rel. Southwestern Bell Telephone Co. v. Public Service Commission,
262
U.S.
276, 292, 43
S.Ct.
544, 548, 67
L.Ed.
981, 987 (1923) (Brandeis, J., concurring), and was noted by this Court in
Helmsley v. Borough of Fort Lee,
78
N.J.
200, 214 (1978) (“Once income is controlled, however, using capitalization of income to determine value to regulate future income is a circular process.”), appeal dismissed, 440
U.S.
978, 99
S.Ct.
1782,
It is not the theory but the impact of the rate order which counts. If the total effect of the rate order cannot be said to be unjust and unreasonable, judicial inquiry under the Act is at an end. The fact that the method employed to reach that result may contain infirmities is not then important.
[Hope Natural Gas Co., supra, 320 U.S. at 602, 64 S. Ct. at 288, 88 L.Ed. at 345.]
In other words, value for FERC regulatory purposes does not necessarily have to have any relation to the value of such property for other purposes so long as the rate of return or cost of service factors are adjusted to generate sufficient revenues to provide investors with a reasonable return on capital invested. See Permian Basin Area Rate Cases, 390 U.S. 747, 791-92, 88 S.Ct. 1344, 1372-73, 20 L.Ed. 2d 312 (1968) (judicial review of FERC price determination limited to determining whether rate selected is within a zone of reasonableness.).
Therefore, a FERC utility’s book value and rate of return are not only circular with respect to the utility’s income figures, but are mutually dependent upon each other.
4
While this system is
In addressing the plausibility of depreciated original cost as a measure of true value we can recapitulate the three basic approaches to property valuation. These are the market approach, which assumes that a property is worth what purchasers are willing to payfor similar property, the income approach, which assumes a property is worth the present value of its projected net income stream, and the cost approach, which assumes that a property is worth what a prudent person would pay to replace it. As demonstrated, the market and income approaches are of little probative worth with respect to these regulated specialized properties. This is not an uncommon situation in property taxation; courts of this state have long recognized that for certain types of unique property that were constructed for a special purpose and are only suited for that particular purpose, the market and income approaches are not
Property used by utilities to provide service to ratepayers is perhaps the prototypical example of special purpose property. As the New York Court of Appeals observed with respect to a natural gas pipeline:
The pipeline is unique and specially built for the purpose of transporting natural gas and is used for that purpose. There is no market for the type of property and there are no sales of property for such use. It could not be converted without substantial expenditures and it is an appropriate improvement, which if destroyed, would be reasonably expected to be replaced or reproduced. [Brooklyn Union Gas Co., supra,65 N.Y.2d at 487 ,492 N.Y.S.2d at 604, 482 N.E.2d at 83).]
Courts of this state have applied the cost approach to value natural gas pipelines,
Transcontinental I, supra,
115
N.J.Super.
at 597, electrical utility property subject to local taxation,
Public Service Elec. & Gas Co. v. Township of Woodbridge,
139
N.J.Super.
1, 18 (App.Div.1976), rev’d on other grounds, 73
N.J.
474 (1977);
see also Boston Edison Co., supra,
387
Mass.
at 299-301,
The central question to this appeal, however, is whether original cost or replacement cost is the proper measure of the worth of utility property for the purposes of local property taxation. Transco, in its cost estimate, presented evidence of only depreciated original cost, and Algonquin, while presenting some evidence of replacement cost, utilized an unrealistic value
In our opinion, reliance on the depreciated original cost undermines and is inconsistent with the fundamental assumption on which the cost approach is based. The cost approach takes as its upper limit of value what a prudent person would pay
on the assessment date
to construct property of equal desirability and utility, and then incorporates reductions in value for depreciation, functional obsolescence, and economic obsolescence to reflect the actual age, condition, and utility of the property in its present state.
See The Appraisal of Real Estate, supra,
at 67, 264. The proper economic worth of such property is what the market would pay to replace it, not what the owner paid for it at the time of its initial construction. While original cost may represent the true value of an asset at the time of its construction, the assumption that the original cost of utility property is evidential of its current fair market value is one that self-destructs with the passage of time.
Hackensack Water Co., supra,
77
N.J.
at 224 (Handler, J., dissenting) (citing Eiteman, “Approaches to Utility Evaluation For Ad Valorem Taxation,”
Pub. Uil.Fort.,
May 23, 1963, at 19,
as time goes on, the value of original cost [as a measure of true value] ... diminishes, principally because of two factors that immediately start to work on this particular cost item: one is the effect of inflation, the other is the factor of depreciation, and this, over the years, would tend to minimize the validity of original cost in itself as a true measurement of value. [Northern Natural Gas Co. v. Dwyer, 208 Kan. 337, 351,492 P.2d 147 , 159 (1971), appeal dismissed, cert. denied, 406 U.S. 967, 92 S.Ct. 2408,32 L.Ed.2d 665 (1972).]
For this reason, courts in this state have generally refused to consider depreciated original cost as probative of the property tax value of utility property. See, e.g., Transcontinental II, supra, 9 N.J.Tax at 643-44 (citing cases); Haworth, supra, 178 N.J.Super. at 261, 2 N.J.Tax at 313; Public Serv. Elec. & Gas, supra, 139 N.J.Super. at 20.
The handful of cases in our state in which evidence of original cost was considered probative of fair market value are readily distinguishable on the basis of the record before the courts involved. In
Hackensack Water Co., supra,
77
N.J.
at 217-18, for example, the Court, in rejecting a municipality’s attempt to value land at the bottom of a reservoir as residential property, accepted the acquisition cost of the property as its fair market value in place of a lower nominal cost, which had been assigned by the Division of Taxation. It did so, however, in the absence of any evidence concerning replacement cost and indicated that valuing such property according to its trended original cost would be proper. Similarly, in
Texas Eastern, supra,
116
N.J.Super.
at 16-19, and
Transcontinental I, supra,
115
N.J.Super.
at 598-600, although the Appellate Division’s opinions read as if they were establishing a
per se
rule defining the fair market value of a pipeline as its depreciated original cost, they expressed a willingness to reexamine this determination on a different record. The validity of these opinions are thus limited to the particular facts before the courts at the time of decision, and in light of our decision today
Taxpayers present two arguments in support of their contention that the depreciated original cost of their property should control its property tax valuation. The first is that since the use of their property is regulated, it should be valued for property tax purposes in the same manner as it is in FERC regulatory proceedings. This argument is singularly unpersuasive. As
Hope Natural Gas Co., supra,
320
U.S.
at 602-04, 64
S.Ct.
at 287-89, 88
L.Ed.
at 345, points out, the link between the actual value and regulatory value of interstate natural gas pipelines was broken forty-four years ago, and petitioners have failed to provide any persuasive reason again to forge together actual value and regulatory value. Courts in other states have long recognized “a definite distinction between the valuation of public utility property for ratemaking purposes, determined pursuant to statutes applicable thereto, and the valuation of the same property pursuant to different statutes for ad valorem tax purposes.”
Northern Natural Gas Co., supra,
208
Kan.
at 357-58,
Thе value of property for rate-making purposes, related, as it is, to assuring provision for an adequate return on a utility’s investment, may have little to do with what the property would sell for on a free and open market. The original cost of property, reduced by a fixed annual rate of depreciation, hardly is a guaranteed measure of the fair market value of that property. [Boston Edison Co., supra, 387 Mass. at 303-04, 439 N.E.2d at 767.]
It should be noted that, in the context of rent control, this Court has recognized that public utility precedents are of limited usefulness in determining market value and that the meaning of the term “value” must be derived from the purpose for which the valuation is being made.
Troy Hills Village v. Parsippany Troy Hills Tp. Council,
68
N.J.
604, 622-23 (1975). The “position that ‘rate-making’ value and ‘exchange’ value serve different functions and need not coincide [citations omit
The second argument advanced by taxpayers is that since the only realistic use of this property is as a natural gas pipeline serving its current customers, and FERC will not allow a potential purchaser to include in the rate base any sales price exсeeding the depreciated original cost of the property, that figure should predominate in the determination of fair market value. Although some courts have found this reasoning to be persuasive,
see, e.g., Boston Edison Co., supra,
387
Mass.
at 306-08,
The problem with this approach is that it attempts to value the property from the wrong perspective. Under the cost approach as it applies to special purchase property, the costs of a third person in acquiring the property is not the relevant inquiry; the very reason the cost approach is being utilized is that the property is so uniquely suited to its current use and user that a market sale to a third person is not an accurate indication of its value.
See, e.g., CPC International, supra,
193
N.J.Super.
at 269. Rather, the determination made in applying the cost approach is how much would a prudent person pay to replace the property.
See The Appraisal of Real Estate, supra,
at 214-15. Since the people with the greatest interest in replacing special purchase property are the people for whom it was designed and built, and, in addition, are the people who must assume the cost of property taxation, the relevant question to ask in applying the cost approach to utility
The reason why FERC will not allow the rate base to be escalated to reflect a new purchase price is not because the property has no value above its depreciated original cost, but because this is the limit of an investor’s interest in the property. Under FERC regulation, the price of gas is set to produce sufficient revenues to cover the utility’s costs and provide a reasonable return on the value of the property invested in the rate base. T. Morgan, J. Harrison, & P. Verkuil,
Economic Regulation of Business,
223 (2d ed. 1985). The interest of an investor in the utility’s property is thus limited to earning a reasonable return on the undepreciated assets of the utility; the interest in any residual value of the depreciated property belongs to the ratepayers.
See United Gas Pipeline Co.,
25
F.P.C.
26, 64 (1961). One of the factors included in the cost of service element of the ratemaking proceedings is depreciation, reflecting the fact that one of the costs of the gas is the value of the capital assets consumed in providing service to consumers.
South Dakota Pub. Util. Comm’n v. Federal Energy Reg. Comm’n,
If FERC depreciated utility property at the same rate at which it wore out, this residual value would vanish. However, for a variety of reasons, FERC allows natural gas pipeline companies to deprеciate their property over a much shorter span of time than the property’s functional life. Here, for example, FERC allowed taxpayers straightline depreciation of their property at 3% a year, a figure subsequently raised to 3.5%. On this basis, the property would be fully depreciated in approximately thirty years. Based on the testimony of taxpayers’ own experts, however, properly maintained natural gas pipelines have a virtually infinite lifespan; as long as there is a demand for natural gas, taxpayers’ pipeline will have some functional use. In light of this, in the absence of evidence to the contrary, the Township's estimation of a 100 year functional life was not unreasonable.
6
Therefore, taxpayers’ property, when fully depreciated, will still have most of its useful life ahead of it, and taxpayers conceded that along with this useful life comes a substantial residual value.
See also Northern Natural Gas Co., supra,
208
Kan.
at 359-60,
This “lost” residual value is not reflected in the market and income approaches, which value only the investor’s interest in the property. However, it is precisely because these valuation methods fail to reflect unique aspects of a property’s value that the cost approach predominates in the valuation of special purpose property. While an investor would not pay for this residual value, since it is not includable in the rate base upon which its rate of return is estimated, the ratepayers would definitely pay to replicate this capacity if by chance the current pipeline were to be destroyed. In fact, if the pipeline were to be destroyed, FERC would allow its total cost of replacement to be included in the rate base as the replaced pipeline’s book value.
See, e.g., Montana Power Co. v. Federal Energy Reg. Comm’n,
In a similar fashion, the cost approach recognizes other elements of value of the property to the ratepayers- that would be overlooked by the market and income approaches. Both of these valuation methodologies, when applied to property such as taxpayers’ reflect the effects of FERC’s valuation method for regulatory purposes. The purposes of FERC regulation and
ad valorem
property taxation are drastically different: FERC is primarily concerned with ensuring that investors receive an adequate return on the property that has been invested. For such purposes, the original value of the property
III.
Before turning to the validity of the original assessment, we must address some of the taxpayers’ objections to valuing their property for taxation purposes at its depreciated replacement cost.
Taxpayers' first charge that refusing to include a reduction to reflect the fact that their income is subject to regulation amounts to discriminatory treatment since under rent control, a somewhat similar regulatory cap on value is recognized with respect to property tax assessments. Initially, although there are some similarities, rent control is factually distinguishable in that it presupposes a finite number of apartments to be rented, whereas FERC makes no attempt to limit the amount of gas taxpayers can sell at a given rate. In addition, to the extent that taxpayers testified that they probably could not raise their rates without losing business even if FERC regulation was lifted, it does not appear that FERC
Second, taxpayers claim that valuing their property differently for tax and ratemaking purposes will reduce the profitability of their companies and hurt their investors. Under FERC regulatory practice property taxes are considered a cost of service and passed through to the consumers. See Hope Natural Gas Co., supra, 320 U.S. at 614 n. 24, 64 S.Ct. at 293 n. 24, 88 L.Ed. at 351 n. 24. Taxpayers presented no evidence that FERC has ever denied local taxes as a reasonable cost. Therefore, there is no support for taxpayers’ contention that increases in property taxes will have to be paid out of net earnings, let alone their fear, echoed by the dissent in the Appellate Division, that property taxes, if left unchecked, could eventually absorb all of the company’s net earnings.
Finally, in a related argument, taxpayers contend that the increase in cost caused by increases in property taxes could raise the price of gas to the point where some consumers would switch to alternate sources of energy. To this contention, three things need to be said. First, intentionally undervaluing utility property in order to enable the utility to retain its volume of sales would amount to a subsidy to gas consumers by other local taxpayers. This would be inequitable. As the Appellate Division noted with respect to a similar regulatory scheme administered by the Public Utilities Commission:
A utility’s tax liability, by whatever method derived, will ultimately receive consideration by the P.U.C. in its rate determinations, thus passing on to the utility’s consumers the local tax liability imposed. Using a specially derived principle of valuation for local tax purposes would place the impact thereof on the local residents rather than the consumers____[Public Serv. Elec. & Gas Co., supra, 139 N.J.Super. at 20.]
Second, such intentional undervaluation would conflict with the goal of FERC regulation: to have the cost of gas reasonably reflect the cost of providing such service. Third, to the extent that an increase in property taxation resulted in a significant reduction in the volume of gas sold by taxpayers, this reduction would be properly recognizable as economic obsolescence. Economic obsolescence is the adverse effect on value resulting from influences outside the property itself, including factors such as an adverse economic climate.
The Appraisal of Real Estate, supra,
at 252. Applying this principle in the context of the cost approach, the value of the pipeline should reflect the cost of replacing only the size pipeline necessary to carry the reduced volume.
See, e.g., Boston Edison Co. v. Board of Assessors of Boston,
402
Mass.
1, 520
N.E.
2d 483, 491 (1988);
New England Power Co. v. Town of Littleton,
114
N.H.
594, 600-01,
In sum, we see nothing unjust or inequitable in valuing the property of a regulated utility at its depreciatеd replacement cost.
IV.
Since taxpayers presented no credible evidence concerning the true value of their property, the Tax Court was correct in concluding that the presumption of validity that attaches to the
quantum
of the municipality’s original assessment had not been rebutted.
See Transcontinental II, supra,
9
N.J.Tax
at 645-46.
See also, Aetna Life Ins. Co., supra,
10
N.J.
at 105. Normally, this determination would end our inquiry. However, taxpayers allege that the method of assessment utilized by the municipality was so patently defective and
The flaws in the original assessment methodology were exposed during the deposition of the assessor who prepared it. Confronted with the difficulty of applying other valuation approaches to taxpayers’ property, the assessor simply calculated the value of the property necessary to produce approximately the same tax dollars at the Township’s new tax rate as it had the previous year under its old tax rate.
7
The assessor thus made no attempt to determine the rate at which taxpayers’ property appreciated in relation to the increase in value of other kinds of property in the Township. Without evidence that all kinds of property in the Township, whether it be residential,
Furthermore, the assessor perpetuated this erroneous approach in his attempt to couch his valuation estimate in terms of replacement cost. Rather then determining the replacement cost new and then adjusting this value to reflect the remaining useful life of taxpayers’ property the assessor took the value of the property determined to produce the same tax dollars as the previous year and then, аssuming a 45% depreciation factor, determined what replacement cost new would lead to the predetermined assessed value. 8 Finally, although the actual depreciation rate was irrelevant to the assessor’s valuation method, it should be noted that the figure used was not derived from any actual estimate of the property’s remaining functional life but the upper level of depreciation set by the Transcontinental I court as part of its interim valuation method, the same method which was rejected by the assessor in deriving the property’s assessment for the 1983 tax year.
The assessor’s methodology was thus a perversion of proper appraisal techniques at every step of the process. Although in
Glen Wall Assoc, v. Wall Tp.,
99
N.J.
265, 276-77 (1985), we indicated that the Tax Court should recognize practical and realistic limits in establishing the foundation necessary to support an expert’s valuation, this does not compromise the expert’s duty to fully document his determination.
Id.
at 280. While the assessor did compare his artificial cost figures with average estimated cost figures available in commercial hand
Y.
In light of the large number of similar natural gas pipeline property tax valuation cases currently awaiting decision in the Tax Court, we deem it prudent to make a few advisory observations on how such cases should be decided in the absence of legislative action, which has been called for in the past but has not yet been forthcoming. See, e.g., Transcontinental I, supra, 58 N.J. at 586; Transcontinental II, 9 N.J.Tax at 646; Texas Eastern, supra, 116 N.J.Super. at 19, 20. While each case will turn on its own facts, there are certain elements that these cases will have in common.
First, the proper method of valuing such property is
by-determining
its depreciated replacement cost. A natural gas pipeline is a textbook example of special purchase property; it is uniquely suited to its current use and, due to the effects of FERC regulatory conditions, both the market and income approaches are inherently unreliable indicators of the fair market value of such property, as opposed to its worth to investors as an operating business. In
Haworth, supra,
178
N.J.Tax
at 261,
Second, in using the depreciated replacement cost approach, particular care must be taken to make a proper reduction to account for economic obsolescence. Economic obsolescence reflects a reduction in the value of property caused by factors extraneous to the property itself, such as changes in population characteristics and economic trends, excessive taxes, and governmental restrictions. Although the Township’s expert testified to the lack of any economic obsolescence, and the Tax Court properly rejected Algonquin’s attempt to convert economic obsolescence into a surrogate for the unit valuation income approach, determining the existence and extent of economic obsolescence is an integral part of any proper application of the cost approach. In
Brooklyn Union Gas Co., supra,
Here, there was testimony that external economic developments, such as increases in the price of gas and the capability of some consumers to switch from gas to other sources of energy, had the potential to affect the demand for gas. To the extent that over the years such factors have led to what was once a well-designed pipeline now having excess capacity, depreciated replacement cost should be geared only to the pipeline that would be constructed in light of current аnd projected future demand. Similarly, to the extent that any increases in taxes caused a similar reduction in volume of gas demanded,
Finally, care must be taken to determine an equitable manner of calculating replacement costs.
Cf. Haworth, supra,
178
N.J.Super.
at 261, 2
N.J.Tax
at 313 (describing the elements of trended original cost methodology). The approach used by the Township’s expert in this case was to determine the current cost of constructing a length of pipe, multiplying this figure by the length of pipeline to be valued, determining the expected lifetime of such a pipeline and then reducing the replacement cost to reflect the loss in value caused by the pipe in question already having served part of its functional life. This is an acceptable method of determining replacement cost, as long as economic obsolescence is properly reflected, but there are others. In particular, the trended original cost approach, suggested in
Hackensack Water Co., supra,
77
N.J.
at 217-18, and outlined in
Haworth,
in which the original cost is subject to yearly adjustments to reflect depreciation and increased costs of replacement, may in some cases be a more convenient valuation methodology.
See Northern Natural Gas Co., supra,
208
Kan.
at 349-51,
Whatever method of determining replacement cost is utilized, the goal should be to arrive at a value which properly reflects the value of the pipeline that would be required to meet the current demand of consumers of natural gas, since they are in fact the people who would both demand the replacement of the
The decision below is reversed and remanded to the Tax Court for further proceеdings consistent with this opinion.
For reversal and remandment — Chief Justice WILENTZ and Justices CLIFFORD, POLLOCK, HANDLER, O’HERN, GARIBALDI, and STEIN — 7.
Opposed — None.
Notes
Algonquin's challenge to its assessment was rejected in a separate, though substantially similar, unpublished opinion.
Algonquin also offered evidence relating to a stock and debt approach, but Its own expert gave this approach little weight due to the fact that Algonquin stock is not publicly traded. Neither the Tax Court nor the Appellate Division gave any credence to this evidence of value.
In cases where the acquired property will not be used to provide service to its original customers, however, no question of double payment is presented, and FERC will allow the full acquisition cost to be included in the rate base. See, e.g., Black Hills Power & Light Co., 40 F.P.C. 166 (1968); Virginia Electric Power & Light Co., 38 F.P.C. 487, 488 (1967).
In fact, since it is only the total effect of the ratemaking proceeding that is at issue, errors in determining both the value of the property and the rate of return could be offset by overestimation of the cost of service component included in the rate charged to consumers for gas, which in the end determines the actual income earned by the utility. In this context, it should be noted that the share of gross income attributable to cost of service, which for Transco exceeded 53,400,000,000, dwarfs that allocated to provide a rеturn to investors, which for Transco was approximately 5130,000,000. The central issue in this
Algonquin's cost approach involved trending the original cost of the rate base, deducting FERC depreciation, and then, as economic obsolescence, the capitalized difference in income between income that would be expected at its estimated depreciated replacement cost and the income actually generated. The resulting figure was slightly higher than book value due to the fact that, for the years involved, Algonquin earned slightly more than its FERC-projected income. In effect, this approach equates economic obsolescence with FERC's refusal to let Algonquin include depreciated assets in the rate base, and is merely a restatement, after a series of calculations, of petitioners' argument that property not included in the rate base has no value.
The Tax Court rejected this figure as excessive. It appears, however, that there was no evidence in the record that contradicts this figure. While FERC regulations recognize that eventual exhaustion of natural gas resources may cut short a pipeline’s functional life and is thus a relevant factor in determining depreciation for FERC ratemaking purposes, see 18 C.F.R. Part 201-12B (1986), an increase in the rate of depreciation to reflect this factor has never been sustained, despite the deferential standard of review applied to FERC regulatory determinations. See South Dakota Pub. Util. Comm'n, supra, 668 F2d at 334-35 (finding FERC depreciation figure reflecting assumption that pipeline would run out of gas in the year 2000 to be outside of the zone of reasonableness and not supported by substantial evidence); accord Memphis Light, Gas & Water Div. v. Federal Power Comm’n, 504 F.2d 225, 234 (D.C.Cir.1974).
The assessor described the process:
Q And in fact, you simply multiplied the 1981 assessment by the value of three, didn’t you?
A Essentially.
Q Yes. There was no other process in arriving at the value for the 1983 tax bill, was there?
A That was what is available to me, yes.
********
Q But the 1982, October 1, 1982 evaluation for 1983 taxes was arrived at simply by your trending factor of three?
A Well ... I would [sic] subscribe to the adjective simply. The average of three was the result of ... 4,400 other appraisals that were made in town____ So as the three is a simple number, it was certainly not arrived at simply.
This was the assessor's explanation:
Q ... You say you took an aggregate value of $1,698,800, is that correct? A That’s the total assessed value.
Q Yes. You then took 45 percent- depreciation from that?
A No. I am saying that the $1,698,800 is — does represent a depreciated value for assessment purposes. And utilizing a 45 percent depreciation factor, you then arithmetically are asking yourself $1,698,800 is 55 percent of what number.