Can a Tennessee city charge customers outside its city limits twice what it charges customers inside?

Subject

Opinion No. 14-46, City's Water and Sewage Rates Outside Corporate Limits, April 14, 2014

Plain-English summary

Representative Timothy Hill asked whether a Tennessee city's water and sewage system could lawfully charge customers outside its corporate limits twice what it charged customers inside. The AG said the doubled rate, standing alone, did not establish invalidity. The rate is presumed valid, and a challenger faces a heavy burden to show that it is not just and equitable.

The statutory backdrop is permissive. Tenn. Code Ann. § 7-35-401(a) authorizes incorporated Tennessee cities and towns to operate water and sewage systems inside or outside their limits and to charge for service. § 7-35-414(a) requires the city's governing body to establish "just and equitable" rates by ordinance, with the rates set to cover operating expenses, debt service, and depreciation. § 7-51-401 specifically addresses extraterritorial utility service and requires that "outside service is self-supporting," meaning the city cannot subsidize out-of-town customers at the expense of inside-the-city ratepayers.

Tennessee courts have endorsed rate differentiation. The Tennessee Supreme Court in CF Indus. v. Tennessee Public Service Commission, 599 S.W.2d 536 (Tenn. 1980), held without hesitation that a utility may impose differing rates among customer classes. The Tennessee Court of Appeals in City of Parsons v. Perryville Utility District, 594 S.W.2d 401 (Tenn. Ct. App. 1979), held that uniform rates across a large service territory are not required, but classifications must rest on actual differences of situation and condition that bear a reasonable and just relation to rates. An arbitrary classification is unjust discrimination.

Tennessee courts have also acknowledged there is no single formula for setting rates (CF Indus., quoting Arkansas Louisiana Gas Co.). Other states have reached opposite conclusions on similar surcharges: an Illinois appellate court called Chicago's 50% out-of-city surcharge unreasonable and discriminatory (Bobrowicz), but the Kansas Supreme Court upheld a 100% surcharge in Usher v. City of Pittsburg, and Mitchell v. City of Wichita endorsed separate classification of out-of-city customers for ratemaking.

The bottom-line rule the AG identified is procedural: ratemaking is essentially a legislative function. Courts give the utility's determination great deference, the rate is presumed correct, and a challenger must make a convincing showing that the rate is invalid (Tennessee American Water Co. v. Tenn. Regulatory Auth.). A 2x rate alone is not enough.

Currency note

This opinion was issued in 2014. Subsequent statutory amendments, court decisions, or later AG opinions may have changed the analysis. Treat this page as historical context, not current legal advice. Verify current law before relying on any specific rule, deadline, or remedy mentioned here.

Common questions

Are out-of-city customers entitled to the same water and sewage rate as in-city customers?

Not as a matter of Tennessee law as it stood in 2014. A municipal utility may set different rates for different customer classes, including a separate class for customers outside the city limits.

What makes a classification legitimate?

City of Parsons v. Perryville Util. Dist. supplied the rule: a classification must rest on "some actual difference of situation and condition, bearing a reasonable and just relation to the matter of rates." If the city can point to actual operational, capital-cost, or service-level differences associated with serving out-of-city customers, the classification has a basis. If the only reason for the higher rate is that those customers cannot vote in city elections, the classification is more vulnerable.

Why must "outside service be self-supporting"?

Tenn. Code Ann. § 7-51-401(a), (b) requires that when a city extends utility service beyond its limits, the rates cover the cost of that outside service so that in-city ratepayers are not subsidizing it. That is a floor, not a ceiling. A city can charge more than cost; it cannot charge less.

What about taxpayer subsidies? Do in-city customers fund the system in ways out-of-city customers do not?

That is a common justification cities offer for higher out-of-city rates: in-city residents have paid for the system through property taxes or general fund contributions, so out-of-city customers should pay a premium to capture the benefit they did not pay for through taxes. Tennessee courts have not adopted a bright-line "tax-equity" rule, but the just-and-equitable framework can accommodate that kind of argument.

What is the standard if a customer wants to challenge a 2x rate?

The customer bears a "heavy burden" of proving the rate is not just and equitable (Tennessee American Water Co., 2011 WL 334678). Courts must accord the agency's determination great deference. The rate is presumed correct. Mere arithmetic comparison to in-city rates does not suffice.

How have other states approached out-of-city surcharges?

The AG acknowledged the split. Bobrowicz v. City of Chicago (50% surcharge struck down). Usher v. City of Pittsburg (100% surcharge upheld). Mitchell v. City of Wichita (separate classification permitted). The outcome turns on the record in each case.

Background and statutory framework

Tennessee organizes municipal water and sewage utilities under Title 7, Chapter 35 of the Tennessee Code. § 7-35-401(a) is the empowerment provision. § 7-35-414(a) is the duty-to-set-just-and-equitable-rates provision and prescribes that rates must produce funds sufficient for operations, debt service (including sinking funds), and depreciation. § 7-51-401 separately governs extraterritorial service and requires self-supporting rates.

Ratemaking doctrine in Tennessee treats the utility's pricing decisions as legislative judgments entitled to substantial deference. The Tennessee Public Service Commission cases (CF Indus.) established that customer classification is permitted, and the Tennessee Court of Appeals (City of Parsons) refined the standard: classifications must be reasonable and tied to actual differences, not arbitrary.

The out-of-state cases the AG cited (Kansas, Illinois) confirm that the question is fact-bound. There is no per-se prohibition on a 2x surcharge, but there is no safe harbor either. The reasonableness inquiry turns on what the record shows about the cost of serving outside customers, the capital structure of the utility, who paid for what historically, and whether the surcharge bears a rational relationship to those differences.

Citations

• Tenn. Code Ann. § 7-35-401(a) (authority to operate water and sewage utilities)
• Tenn. Code Ann. § 7-35-414(a) (duty to set just and equitable rates)
• Tenn. Code Ann. § 7-51-401 (extraterritorial utility service must be self-supporting)
• CF Indus. v. Tenn. Pub. Serv. Comm'n, 599 S.W.2d 536 (Tenn. 1980) (Tennessee Supreme Court; differing rates among customer classes permitted; ratemaking deference)
• City of Parsons v. Perryville Util. Dist., 594 S.W.2d 401 (Tenn. Ct. App. 1979) (Tennessee Court of Appeals; classification must rest on actual difference of situation)
• Mitchell v. City of Wichita, 12 P.3d 402 (Kan. 2000) (Kansas Supreme Court; separate classification of out-of-city customers permitted)
• Bobrowicz v. City of Chicago, 522 N.E.2d 663 (Ill. App. Ct. 1988) (Illinois Appellate Court; 50% out-of-city surcharge struck down)
• Usher v. City of Pittsburg, 410 P.2d 419 (Kan. 1966) (Kansas Supreme Court; 100% out-of-city surcharge upheld)
• Application of Arkansas Louisiana Gas Co., 558 P.2d 376 (Okl. 1976) (Oklahoma Supreme Court; no single ratemaking formula)
• Tenn. Am. Water Co. v. Tenn. Regulatory Auth., No. M2009-00553-COA-R12-CV, 2011 WL 334678 (Tenn. Ct. App. Jan. 28, 2011) (Tennessee Court of Appeals; heavy burden to challenge rate)

Source

• Landing page: https://www.tn.gov/attorneygeneral/opinions.html
• Original PDF: https://www.tn.gov/content/dam/tn/attorneygeneral/documents/ops/2014/op14-046.pdf

Original opinion text

STATE OF TENNESSEE
OFFICE OF THE ATTORNEY GENERAL
April 14, 2014
Opinion No. 14-46
City's Water and Sewage Rates Outside Corporate Limits

QUESTION

Can a city operating a water and sewage system lawfully impose on consumers located outside its corporate limits a rate that is twice the rate charged to consumers located within its corporate limits?

OPINION

The fact that a city imposes a water and sewage rate on customers outside its corporate limits that is twice the rate charged to customers within its corporate limits does not by itself establish that the higher rate is invalid. The rate is presumptively valid, and a party seeking to challenge it bears the heavy burden of proving that the rate is not just and equitable.

ANALYSIS

"Every incorporated city and town in this state is authorized and empowered to own, acquire, construct, extend, equip, operate and maintain within or without the corporate limits of such city or town a waterworks system or a sewage system, to provide water or sewerage service and to charge for such service." Tenn. Code Ann. § 7-35-401(a). Under Tenn. Code Ann. § 7-35-414(a),

[t]he governing body of any city or town acquiring and operating a waterworks or sewerage system under this part has the power, and it is the governing body's duty, by ordinance, to establish and maintain just and equitable rates and charges for the use of and the service rendered by the waterworks or sewerage system, to be paid by the beneficiary of the service. The rates and charges shall be adjusted so as to provide funds sufficient to pay all reasonable expenses of operation, repair, and maintenance, provide for a sinking fund for payment of principal and interest of bonds when due, and maintain an adequate depreciation account, and the rates and charges may be readjusted as necessary from time to time by amendment to the ordinance establishing the rates then in force. . . .

Tenn. Code Ann. § 7-51-401 authorizes a municipality to extend the services of its utilities beyond its corporate limits but provides that in such event the municipality "shall establish proper charges for the services so rendered that any such outside service is self-supporting." Tenn. Code Ann. § 7-51-401(a), (b).

Tennessee courts have held that it is permissible to have different rates among customers. For example, the Tennessee Supreme Court held, "without hesitation or equivocation, that a public utility may impose differing rates among customer classes." CF Indus. v. Tenn. Pub. Serv. Comm'n, 599 S.W.2d 536, 544 (Tenn. 1980). In addition, the Tennessee Court of Appeals has held that "it is not essential that all rates throughout a large territory served from a single water system be the same, and rates in each part of such territory may be fixed at a level which is fair and reasonable in view of the existing conditions." City of Parsons v. Perryville Util. Dist., 594 S.W.2d 401, 406 (Tenn. Ct. App. (1979). See also Mitchell v. City of Wichita, 12 P.3d 402, 408 (Kan. 2000) (stating that municipal water plant serving customers outside city limits may make separate classification of such customers for ratemaking purposes).

Nevertheless, classifications of customers for rate-making purposes cannot be unjustly discriminatory:

A classification must, however, in order to be valid, comport with the rule or principle of sound legislative classification, in that there must be some actual difference of situation and condition, bearing a reasonable and just relation to the matter of rates; and an arbitrary or unreasonable classification amounts to unjust discrimination . . . .

City of Parsons, 594 S.W.2d at 406 (quoting 94 C.J.S. Waters § 297 (1956)).

Tennessee courts have remarked on the absence of a clear test for determining the reasonableness of a utility's rates. In CF Indus., for example, the Supreme Court pointed out that there is no "single formula or a combination of formulas in fixing rates and none is exclusive or more favored than others." 599 S.W.2d at 544 (quoting Application of Arkansas Louisiana Gas Co., 558 P.2d 376, 379 (Okl. 1976)). Rulings from other state courts do not provide additional clarity. For instance, though an Illinois appellate court has held that a 50% surcharge the City of Chicago imposed on unincorporated residents was "unreasonable" and "discriminatory," see Bobrowicz v. City of Chicago, 522 N.E.2d 663, 669 (Ill. App. Ct. 1988), the Kansas Supreme Court has upheld a 100% surcharge to nonresident customers, see Usher v. City of Pittsburg, 410 P.2d 419, 421 (Kan. 1966).

Ratemaking is essentially a legislative and not a judicial function, and a court must accord the agency's determination great deference. CF Indus., 599 S.W.2d at 542. Any challenge to the validity of a particular rate must overcome a presumption that the rate established by the agency is correct, and there is a heavy burden on a party who attacks it to make a convincing showing that the rate is invalid. Tenn. Am. Water Co. v. Tenn. Regulatory Auth., No. M2009-00553-COA-R12-CV, 2011 WL 334678, at *14 (Tenn. Ct. App. Jan. 28, 2011).

Therefore, the mere fact that a city imposes a water and sewage rate on customers outside the corporate limits at twice the rate changed to its customers within the corporate limits does not demonstrate that the higher rate is not just and equitable. The rate is presumed valid. A Tennessee court must accord great deference to the utility's determination. The plaintiff would bear the heavy burden of proving that the rate is not just and equitable.

ROBERT E. COOPER, JR.
Attorney General and Reporter

JOSEPH F. WHALEN
Acting Solicitor General

MATT PULLE
Assistant Attorney General

Requested by:
The Honorable Timothy Hill
State Representative
23 Legislative Plaza
Nashville, Tennessee 37243