Special Report - Impact of Tax Changes on Section 5 Rate Investigations
Dominion Energy's Overthrust Pipeline (Overthrust) and ONEOK's Midwestern Gas Transmission (Midwestern) must have felt the earth move under their feet when FERC launched Natural Gas Act section 5 rate investigations against them at the same open meeting at which FERC announced how it intended to address significant tax changes for natural gas pipelines. These rate investigations represent a microcosm of the issues that will surely be addressed in the coming years as the industry and FERC adjust to this new "normal" for tax issues. Considering the methodology proposed in FERC's new Form No. 501-G, it appears that Midwestern and Overthrust may be asked to reduce their recourse rates by approximately 13% and 22%, respectively, assuming that their costs and revenues have not changed substantially since 2016. More broadly, for the industry, these investigations should be closely watched as they may provide a lens into how the tax policy changes FERC announced in March may impact rates.
Rate Investigation Precedent
FERC initiated 15 section 5 rate investigations between 2009 and 2017. Each of those investigations resulted in a settlement between the pipeline and its shippers, but not until after FERC required the pipeline to file a cost and revenue study. Pipelines generally filed these cost and revenue studies within 75 days after the initiation of the investigation, which is the same timeline on which this year's investigations are proceeding.
On average, the parties settled the rate investigations approximately 200 days after FERC announced its decision to initiate the rate investigation. The shortest timeline was 162 days and the longest was 287 days. Using this data as a guide, these investigations should be resolved sometime between late August and early December. A complicating factor could be the tax changes that will need to be incorporated into any settlement. However, if these investigations can be resolved on the shorter end of the range, they may provide an early window into how the tax changes FERC announced in March may impact rates, as we discuss more fully below. This is particularly true because the process FERC announced is not expected to require any filings by the industry until mid-September through late December.
Using FERC's New Form as a Guide
The tax change implementation process that FERC issued for comment at its March meeting includes a new form, No. 501-G, which is designed to fulfill two purposes. The first page of the form is intended to calculate an "appropriate" percentage decrease in the pipeline's rates after taking into account the tax changes. The rest of the form is designed to calculate the pipeline's return on equity (ROE) after accounting for the tax changes.
While the calculation of the rate decrease using the methodology in the form is overly simplistic, it may serve as an anchor for the rate reduction sought by a pipeline's shippers. Therefore, LawIQ has used that form to calculate the rate change that would be expected for Midwestern and Overthrust, while also adjusting the "excessive" ROE that led FERC to launch these rate investigations. As seen below, the result of this analysis is that Midwestern may be asked to reduce its rates by approximately 13%, and Overthrust may be asked to reduce its rates by about 22%. Each of the pipelines derives less than 40% of its revenue from negotiated rate contracts, so the impact of such a rate decrease could affect the remaining 60% their revenue. Any actual rate reduction will be based on the cost and revenue studies the pipelines will file and any decrease proposed or agreed to will be based on that much more detailed data.
The Gritty, but Important, Details and Assumptions
The two investigations and the three primary assumptions LawIQ used to apply the Form No. 501-G are important to discuss, as they highlight some key issues that we expect to be the subject of vigorous debate as part of FERC's request for comments regarding how to implement the tax changes. How these issues are addressed and resolved in these cases may provide insight into these same issues for the broader industry.
Will We Get an Answer About Tax Allowances for MLPs Partially Owned by Corporations
Midwestern was, until July 2017, owned by a Master Limited Partnership (MLP). ONEOK bought all of the interests in the MLP from the public, which means that Midwestern is now a subsidiary of a corporation. Overthrust is still 100% owned by an MLP. However, Dominion Energy, a corporation, owns 50.6% of the common units in the MLP, 37.5% of the preferred units and 100% of the non-economic general partner interests. The first key industry insight these cases may provide is how FERC intends to treat a pipeline that is owned by an MLP that is, in turn, partially owned by a corporation.
When FERC announced that it was reversing its long-held policy that allowed a pipeline owned by an MLP to include a tax allowance in its cost of service, FERC stated that MLP-owned pipelines would no longer be allowed to include such an allowance. As we have discussed before, there is limited clarity about what this directive by FERC means, especially for an entity such as Overthrust. Therefore, for purposes of the calculation set forth above, our first assumption is that FERC will continue to allow pipelines such as Overthrust to include some tax allowance in its rates. We have prorated that allowance by the average percentage of common and preferred units owned by Dominion Energy. While it is unclear whether FERC will adopt such a methodology, we believe that pipelines will advocate for something similar with FERC as part of the policy discussion, and that the pipelines would certainly advocate for something similar with their shippers as part of any negotiation.
Anticipating the Impact from Accumulated Deferred Income Taxes
Our second assumption concerns the treatment of Accumulated Deferred Income Taxes (ADIT), which we recently discussed in more detail. At its meeting in March, FERC announced it had not yet decided how to handle excess ADIT, but Form No. 501-G has a cell for reducing the tax allowance used in the "after" case by the first-year amortization of the excess ADIT amount. While the exact method for calculating this amortization has not yet been determined, we believe that, in general, excess ADIT will be amortized over the average remaining useful life of the assets that gave rise to the ADIT balance. For purposes of calculating our "after" case, we have assumed that the amortization period will be 25 years, which reflects our understanding that most significant ADIT balances will relate to long-lived assets, such as the pipeline itself; rather than shorter-lived ones such as compressor stations.
Our third and final assumption is not the subject of further review by FERC, but is a modification in how we have used the form itself. Because FERC designed Form No. 501-G to isolate the rate change percentage caused by the tax changes, it used the same capital structure for the "before" and "after" cases. To include the impact of reducing the ROE that FERC found excessive in its order launching the two investigations, we use different capital structures for the "before" and "after" cases. To calculate the cost of service in the "before" case, we use the "excessive" ROE and capital structure FERC used in its order. For the "after" case, we use the pipeline's reported debt and equity rates and capital structure, except we limit the equity percentage to a maximum of 60%.
We will continue to watch both these cases and the general policy discussions launched by FERC, and will update our customers with our views on how these issues will play out for these two pipelines and the industry as a whole.