New Ways to Calculate ROE as Battles are Fought Over the Old Way

As we discussed in FERC Asks for Input on ROEs for Pipelines and the Opinions Roll In , FERC is currently looking at whether, and if so, how, to revise its methodology for calculating the return on equity (ROE) that a natural gas pipeline is allowed to earn as part of its cost of service. A key issue in that proceeding is whether FERC should apply the methodology it recently adopted for calculating ROE for electric utilities to natural gas pipelines. However, in the meantime, Section 4 and 5 rate cases continue to move forward under the old rules.

Today we look at the current method for selecting the proxy group and how that can be a critical factor in determining the allowed ROE for a pipeline whose rates are being reviewed. We also consider how a proposal put forward by the Environmental Defense Fund (EDF) could alleviate a continuing problem, which is that there are fewer and fewer public companies that meet the qualification for being included in the proxy group. While the industry and shippers all seem intent on keeping the current ROE methodology in place, or only making minor tweaks to it, the methodology suggested by EDF, or something like it, may be needed if the number of companies qualifying for inclusion in the proxy group continues to shrink.

What is a Proxy Group?

In two early cases involving the proper return to be allowed a regulated company, the U.S. Supreme Court held that the allowed ROE should be “reasonably sufficient to assure confidence in the financial soundness” of the regulated company and should be “adequate, under efficient and economical management” to maintain and support its credit and enable it to raise capital. This need to raise capital requires that the revenue be sufficient to pay not only operating expenses but also dividends on stock “commensurate with returns on investments in other enterprises” having similar risks.

Currently, FERC uses a discounted cash flow (DCF) model to determine the rate of return that investors in similar companies expect to receive. This methodology requires FERC to assess the current market demands for investor returns of similar companies. These similar public companies are called a “proxy group” and the determination of the companies included in the proxy group is a key determinant of the appropriate range of ROEs that is produced by the methodology.

Over the years, FERC has developed a number of qualifications that must be met by a company for it to be included in the proxy group. Some of the standards are required because the methodology requires there be publicly available data about the companies. So, for example, to be included in a proxy group, the companies must:

Be publicly traded;
Be followed by Value Line; and
Have Institutional Brokers’ Estimate System (IBES) growth estimates.

Other standards are to insure that the companies have appropriate risk profiles and include:

Having an investment-grade credit rating;
Having had no dividend cuts within the six month data period being examined;
Having sustainable growth rates; and
Having operated for at least five years.

Other criteria are designed to eliminate companies that may not be qualitatively similar. These criteria include:

Not headquartered outside of the United States or regulated by a foreign country;
Not involved in merger and acquisition activity during the most recent six-month period; and
Having at least 50 percent of company assets or operating income in the natural gas pipeline business.

The selection of companies to include in the proxy group can make a difference in the calculation of the allowed ROE, as demonstrated by the different results obtained in Northern Natural’s Section 4 and Section 5 cases.

Relaxing Eligibility Standards

FERC has previously had to relax its standards for proxy group eligibility and it may need to do so again for two key reasons. First, FERC’s elimination of the tax allowance for master limited partnerships (MLP) in March 2018 led a number of companies to merge their MLP into the parent company and often that parent company no longer meets the standard for being included in a proxy group.

Two examples of this are the Boardwalk MLP, which became owned entirely by Loews Corporation, and Dominion Energy’s MLP. Both of these entities became wholly owned by their parent companies and neither of those parent companies meets the standard for having at least 50% of the company’s assets or income invested in or derived from natural gas pipelines. Second, TC Energy and Enbridge are both based in Canada and recently acquired all of the interests of major U.S. pipeline companies. If FERC continues to exclude these companies from participating in the proxy groups, it will be excluding some of the largest U.S. pipeline companies.

Proxy Group Members

Since FERC issued its notice of inquiry seeking comment on whether to revise its methodology for calculating an allowed ROE, there have been a number of cases in which expert testimony was filed either by the pipeline company, FERC staff or other parties. These included seven different proxy groups for either Section 4 or Section 5 cases for Berkshire Hathaway’s Northern Natural Pipeline (as detailed above), National Fuel Gas Supply, Viking Gas and Paiute Pipeline. The table below shows the companies that were included in at least four of the seven proxy groups.

Once a company is included in the proxy group, a key measure derived for that company, which directly impacts the calculation of the allowed ROE, is the pipeline company’s dividend yield. Set forth below, we show the annual year-end dividend yield for these seven companies. As can be seen, there is substantial variation in the yield from company to company and from year to year.

Another key data point for the companies included in the proxy group is their IBES growth rate. For the seven companies in the chart above, this growth rate detailed in a recent case ranged from a low of .9% for TC Energy to a high of 13.5% for Enbridge. FERC prefers that there be at least five companies in the proxy group, but has in the past accepted as few as four. As discussed above, two of these seven companies,TC Energy and Enbridge, do not qualify under FERC’s current standard for proxy group inclusion, because they are headquartered in Canada. Of the remaining five, only two, Kinder Morgan and TC Pipelines, have at least 50% of their assets or income invested in or derived from regulated natural gas pipelines. The other three, Enable, EQT and Williams, have at least 35% of either assets or income from regulated natural gas pipelines. But according to the testimony in one of the rate cases, they do not have the 50% that FERC prefers. This means that, currently, there are not four companies that qualify for inclusion in a FERC proxy group.

A Possible Solution

The comments filed by EDF in response to the FERC NOI may offer a solution to this problem of fewer and fewer companies that qualify for inclusion in a proxy group. EDF supported its comments with an affidavit from James J. Murchie, Co-Founder and CEO of Energy Income Partners LLC (“EIP”). As explained by Mr. Murchie, EIP is a Registered Investment Adviser that oversees about $6 billion of client assets. EIP invests all of its client assets in equity securities of publicly-traded energy infrastructure companies located primarily in the U.S.

Mr. Murchie offered two observations with respect to the determination of ROEs. First, the cost of capital is entirely different than the return those companies earn on that capital (which he defined as “Accounting ROE” and as simply reported earnings divided by book value). According to Mr. Murchie, capital will only be made available to pipeline companies to build new capacity if their allowed returns exceed the cost of capital. Therefore, he believes that the practice of equating the cost of capital to Accounting ROE is fundamentally flawed. He argued that the entire DCF method used by FERC, which uses estimates of the cost of capital to derive an appropriate allowed ROE, is an unnecessary intermediate step that is fraught with shortcomings. A better method, in his view, would be to use an easily observable measure of Accounting ROE, such as the long-term actual ROE of the S&P 500, to reflect an actual competitive market return as a “Base ROE.” In his view, this would completely eliminate the need to establish a proxy group of pipeline companies.

Second, he would then adjust that Base ROE to incentivize companies to perform better in terms of cost, reliability, safety and environmental impact which would align the interests of the public, ratepayers and investors. He argued that the current ROE methodology primarily incentivizes new investment and that the increased complexity of the energy delivery system calls for a more flexible approach. As he sees it, there are different demands being placed on the energy delivery system by state-level initiatives, rapid growth of renewable and natural gas generation (and the attendant need for increased coordination), as well as growing demand for reduced environmental impact and an allowed return methodology needs to be developed that promotes more than “simply putting more steel in the ground.”

In its reply comments, Kinder Morgan picked up some of Mr. Murchie’s criticisms and noted in particular his comments supporting increases to the Base ROE to arrive at a return commensurate with other enterprises having similar risks. For example, a fully regulated electric utility with a state-granted monopoly franchise differs from a natural gas pipeline operating in competitive markets. Investors view an interstate natural gas pipeline, whose upside is capped by a regulated return, but whose downside is unlimited, as a significantly higher risk than a fully regulated utility.

Similarly, according to Mr. Murchie, the pipeline sector faces growing risks and opposition to project siting and development. The resulting delays and cancellations have dramatically changed the way investors handicap future growth versus just five years ago. Pipeline development is a multi-year process requiring a considerable capital commitment even before actual construction commences, and the potential for cancellation during the development process poses a risk that the initial investment becomes stranded. To account for this risk, EIP reduces the expected return that companies will ultimately earn on the entirety of their invested assets. For example, the prospect of a 50% chance of losing 20% of the cost of a new pipeline that is abandoned on cancellation would raise the required ROE by 1.3%, assuming a 13% baseline ROE (50% X 20% X 13% = 1.3%).

Mr. Murchie acknowledges that these assessments of risk are forward-looking and bound to suffer from estimation error, but they are the type of judgments that align with the expertise of FERC, pipeline companies and intervenors, whereas estimates of the nuances and vagaries of capital markets do not.

While Mr. Murchie argues his suggested change is “not radical,” most of the industry and shipper comments seem to be focused on either keeping the current process or making tweaks to it, and not wholly abandoning the proxy group and DCF methodology. However, if market forces continue to shrink the number of companies eligible for inclusion in the proxy groups, FERC may need to change to a process like that suggested by Mr. Murchie at some point in the near future.

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