FERC Asks for Input on ROEs for Pipelines and the Opinions Roll In
Comments rolled in on Wednesday in response to FERC’s Notice of Inquiry (NOI) issued on March 21, 2019 concerning whether FERC should extend to gas and oil pipelines its recently adopted methodology for calculating the return on equity (ROE) for electric utilities. Today, we provide an overview of those comments. While some of the views expressed were to be expected, the comments also included a few surprises.
Somewhat surprisingly, it seems that the major shippers on both gas and oil pipelines have little desire for FERC to change its process for calculating the ROEs. In fact, the Liquid Shippers Group, a consortium of oil pipelines shippers, described the NOI as FERC “considering whether to adopt a solution in search of a problem.” Less surprising is that the pipeline companies seem to be unanimous in their support of many of the proposed changes, provided that FERC keeps the process flexible enough to allow increases in the ROEs above current levels. Conversely, many of the environmental groups appear to want FERC to adopt changes that would lower the ROEs because, in their view, the high ROEs that FERC awards are effectively subsidizing an overbuild of pipelines that are damaging the environment and will have limited useful lives.
Based on our review of the comments, we would be surprised if FERC were to take any action until a replacement for Commissioner LaFleur is in place, namely because Commissioner Glick would likely be sympathetic to the argument that the high ROEs may be encouraging an overbuild of pipelines, which only exacerbates the other issues he has with pipeline projects, such as greenhouse gas impacts and reliance on affiliate contracts. Even when FERC eventually acts, based on the comments filed, it would be surprising if it did anything other than make tweaks to its current practices.
The Pipelines’ Views
The Association of Oil Pipelines (AOPL) and the Interstate Natural Gas Association of America (INGAA) filed comments that were generally reflective of the comments filed by individual pipelines. The key for each type of pipeline was pointing out how different the business risks were for pipelines as compared to the electric utilities. INGAA made the point that interstate pipelines and electric transmission providers are subject to “distinct regulatory policies and market forces that create distinct risks.” Or, as explained by the AOPL, oil pipelines “have no certificated, captive markets or franchise service areas, and face significant risks from competition and changing market dynamics.” AOPL also noted that oil pipelines face risks different from those of natural gas pipelines because they compete not only with other pipelines but even “other modes of transportation such as rail, trucks, barges and tankers.”
Both groups asserted that these different risk profiles mean that investors evaluate each industry differently and that FERC should recognize that it is appropriate to apply different ROE methodologies to each industry and/or implement the ROE methodologies differently.
One particular risk noted by INGAA is that FERC “has actively facilitated pipeline-on-pipeline competition to the benefit of consumers” which has “resulted in shippers seeking shorter term contracts to enhance their ability to take advantage of their competitive options.” While this risk is certainly different for gas pipelines versus utilities, our data shows there is substantial variability for this risk between pipeline companies as well. The chart below shows the percentage by volume of contracts for the named pipelines that are either subject to renewal annually or expire by June 30, 2020.
Both AOPL and INGAA supported FERC moving away from exclusive reliance on the Discounted Cash Flow (DCF) method for computing the ROE for pipelines. However, both groups urged FERC to avoid a mechanical application of the four methodologies that it has adopted for electric utilities. In particular, AOPL urged a number of changes to the four factors proposed and urged FERC to retain a flexible approach for selecting the proxy group. Similarly, INGAA did not oppose the use of factors in the calculation of ROE in addition to the DCF, but urged the Commission to adopt a policy that is “dynamic and flexible” and “avoids a rote application of a formula and should avoid applying a one-size-fits-all approach.”
Shippers’ Perspective
The major shipper organizations agree with the pipeline companies that the pipeline industry is very different from the electric utilities and that adoption of a new process for the electric utilities does not mean that the same method should be used for pipelines. In fact, the shipper groups are strongly against FERC moving away from its current use of the DCF method for calculating the ROE.
The American Public Gas Association (APGA) stated that it did not see a need to deviate from the DCF methodology. However, the APGA did encourage FERC to broaden the scope of companies included in the proxy group for use in the DCF method and include natural gas distribution companies in the proxy group. The clear intent of this suggestion is to reduce the resulting ROE because the APGA notes that the state-regulated distribution companies receive lower ROEs.
The Natural Gas Supply Association (NGSA) stated that its initial comments on whether the Commission should change its policies concerning the determination of ROEs for natural gas pipeline could be answered succinctly: “No, the Commission should not change its policies concerning the determination of the ROE for natural gas pipelines.” While the NGSA acknowledged that the DCF method is not perfect, “the courts and the Commission have repeatedly determined that the DCF methodology provides investors with a return that will attract capital to pipeline companies” and concluded that “[i]n other words, the DCF methodology is not broken, so the Commission should not seek to fix it.”
NGSA’s concerns were primarily practical. Because the Commission has successfully and exclusively relied upon the DCF methodology for the past forty years, continuing its use reduces the “number of issues that are subject to litigation in pipeline rate case proceedings.” Thus, adding more analyses and methodologies to the calculation of ROEs would simply “complicate the litigation process and make achieving settlement of rate proceedings more challenging.”
The Liquid Shippers Group (LSG), whose members include Anadarko Energy Services, Apache Corporation, ConocoPhillips, Devon Gas Services, Encana Marketing, Equinor Marketing & Trading, Marathon Oil, Noble Energy and Pioneer Natural Resources, was even more emphatic in its opposition to a change in FERC’s methodology. The LSG described the proposed replacement as being a “new, unwieldy ROE model that has created needless uncertainty and is unlikely to produce just and reasonable ROEs for oil pipelines.” In fact, the LSG further asserted that the mere issuance of the NOI encouraged the oil pipelines to raise the ROE used on the Page 700 filed by oil pipelines as part of their Form 6 in April of this year.
According to the LSG, the oil pipelines uniformly increased the ROE used to calculate their cost of service from the 12.22% ROE used for calendar year 2017 to a 16.19% ROE for calendar year 2018. The LSG asserted this was possible because, under the DCF methodology, the only true variables are the proxy group companies and the six-month study period. According to the LSG, once a proxy group and six-month study period was agreed to, any party would be able to verify the ROE calculated under the DCF formula. However, the “sheer number of variables, inputs, and assumptions in the 4-Part ROE model means that the parties could use the same proxy group and the same six-month study period and still come up with vastly different ROEs.” (emphasis in original).
The LSG is asking FERC to take immediate action to remedy the problem created by the NOI in the Form 6s filed in April. According to the LSG, the fact that the Page 700 ROEs now lack transparency and validity has the “potential to materially, and permanently, undermine the validity of the Commission’s indexed rates.” If a sufficient number of oil pipelines use the new methodology to calculate anomalously high ROEs on their Page 700s, that could impact the calculation of the index during the next Five-Year Review proceeding, which will commence in 2020. Therefore, the LSG requested FERC to “issue an interim order stating that oil pipelines can only include an ROE that results from the Commission’s standard DCF calculation in their Page 700 cost-of-service calculations.”
Environmental Groups’ Views
Environmental groups’ comments and individual petitions were also filed in response to the NOI, and at least one aspect of those responses pose a potential trap for the natural gas pipelines. The main contention of these environmental groups, led by the Natural Resources Defense Council, is that the ROEs that FERC allows influences the development of interstate gas pipelines and excessive ROEs incentivize “pipeline overbuild at a time when we can ill afford the harmful climate and other environmental impacts, or the unwarranted costs to captive ratepayers and other consumers.”
These groups are pushing FERC to reform its methodology and assign ROEs that are “more in line with the authorized rates of return for other capital-intensive energy investments such as electric transmission.” These groups also point out that this new pipeline development is being incentivized at a time when the risk of stranded assets, due to uncertainties around future technology and fuel prices, energy demand, and environmental policies, should urge regulatory caution. According to these groups, “the stranded asset risk is significant given the long-lived nature of gas pipelines, coupled with uncertainty regarding future energy demand and climate policy and increased use of cleaner energy resources.”
The trap this lays for the industry is exemplified by the comments made by Kinder Morgan in which it essentially agrees on the existence of the risk, but emphatically disagrees on the proper regulatory response. Kinder Morgan noted that interstate pipelines face a number of risks including a “long term risk created by growing support for energy decarbonization.”
Kinder Morgan used the following map to illustrate the extent of this risk.
Kinder Morgan acknowledged that renewables will continue to gain momentum. But it also noted that there are “enthusiastic views of the future of interstate natural gas pipelines.” It is these divergent viewpoints that create uncertainty. As Kinder Morgan sees it, it is this greater risk that requires that pipelines be given a higher ROE.
FERC Action Unlikely
Based on Commissioner Glick’s view that climate change is the existential threat of his generation, we believe he would be receptive to the argument that the environmental groups are making -- that the stranded asset risk should lead to lower not higher ROEs to assure that the pipelines only build projects that are truly needed. This makes it unlikely that he would support a revised policy that is also acceptable to Chairman Chatterjee and Commissioner McNamee. Therefore, we expect that this policy will not move forward until a fourth commissioner to replace Commissioner LaFleur is appointed.
Even when FERC moves forward on the comments it has received, we don’t expect a major change from the current DCF methodology, given the extremely adverse reaction from the shipper community. We think it is more likely that FERC will make some tweaks to that methodology that appear to have broad support, such as allowing the inclusion of Canadian companies (e.g., TC Energy and Enbridge) into the proxy groups used for the DCF methodology.
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