Tax Act Impact - Can Contracts Insulate a Pipeline's Revenue?
After Congress passed the Tax Cuts and Jobs Act (Tax Act), which reduced the corporate income tax rate from 35% to 21%, the clamoring for the Federal Energy Regulatory Commission (FERC) to take action to reduce the rates charged by interstate natural gas pipelines began. A key factor for assessing the risk of a revenue reduction for a particular pipeline is understanding the types of contracts a pipeline may have with its customers, as well as assessing how the pipeline's revenue under the different types of contracts will be impacted. As Kinder Morgan discussed during its recent earnings call, certain types of contracts will mitigate the risks associated with any rate reduction that FERC may require a pipeline to adopt. This analysis is a good starting point. But evaluating other factors, such as specific settlement provisions and calculated return on equity (ROE), are necessary to obtain a more precise view of the risks.
We're hosting a webinar next Wednesday, Profit or Loss? Financial Risks of Tax Cuts on Pipelines, with energy law firm Wright & Talisman, and energy consultancy Brown Williams, in which we'll dive into how the Tax Act may affect the rates and revenues of the pipelines and the public companies that own. Following the webinar, LawIQ will issue a white paper that details the risks of the tax cut on each individual gas pipeline and public companies.
Ratemaking for pipelines is a complex process, with lots of nebulous terminology, which we'll attempt to briefly cover, so that you can better understand the potential impacts of Tax Act. Years ago, FERC adopted the Straight Fixed Variable (SFV) method of rate design, which is a cost-of-service form of ratemaking. Under cost-of-service ratemaking, rates are designed to cover a pipeline's cost of providing service, including earning a reasonable return on its investment. Under SFV, a pipeline collects all of its fixed costs, including its return on investment, through the reservation charge. While FERC uses the SFV method to establish the tariff reservation rate for a pipeline (referred to as the "recourse rate"), FERC allows pipelines to charge its customers less than this maximum rate, provided such "discounted rates" are offered to its customers in a manner that is not unduly discriminatory. Similarly, a pipeline may offer "negotiated rates" on a "not unduly discriminatory" basis.
What's the difference between a negotiated and discounted rate? To start, the negotiated rate can be either higher or lower than the recourse rate. Another distinction between a discounted rate and a negotiated rate contract is that, typically, the negotiated rate shipper agrees to pay the negotiated rate even if the tariff rate is reduced in the future. This circumstance is not usually true for a discounted rate shipper. Because a discounted rate shipper has not agreed to pay more than the recourse rate, if the tariff rate were to drop below the shipper's discounted rate, the discounted rate would drop to the new lower recourse rate. Also, if the discount rate is expressed as a percentage of the recourse rate, any change in the recourse rate would also reduce the discounted rate.
So, in assessing the risk to a pipeline from any future rate reductions, one variable or initial screening criteria to consider is the percentage of the pipeline's revenue that is generated from negotiated rate agreements. As the graphic below indicates, the percentage of negotiated rate revenue can vary from almost zero for some pipelines to 100% for others. But how much risk can a pipeline truly avoid by relying on negotiated rates? And what other factors (e.g., settlement provisions and ROE calculations) are necessary to gain greater perspective on revenue reduction? Tune in to our webinar, and for a deeper, quantitative dive, take a look at our forthcoming white paper.
Interstate Natural Gas Pipeline Revenue
