Will FERC Surprise Pipelines Tomorrow by Ruling on its ITA and ADIT Guidance?

Tomorrow at its open meeting, FERC is set to rule on two cases that present its first chance to clarify the policies and guidance it adopted last July regarding Income Tax Allowance (ITA) and Accumulated Deferred Income Taxes (ADIT). When the Commission adopted these policies last summer, it knew that at some later time it would have an opportunity to “establish a binding rule” to apply its guidance. This opportunity is now presented in cases involving Kinder Morgan’s SFPP pipeline and Tallgrass’s Trailblazer pipeline. And, since this past summer, the Commission has abandoned its sole reliance on the Discounted Cash Flow (DCF) methodology for computing the ROE for electric transmission providers in response to a D.C. Circuit case, Emera Maine v. FERC, and has been asked to extend that revised process to pipelines.

The parties in these two cases have asked FERC to make rulings across a very broad spectrum. If FERC were to adopt some of the positions put forward by the parties, tomorrow’s decisions could be as important to the markets as its March and July decisions were last year. While there are many possible outcomes for how FERC rules tomorrow, we focus on the four described below. The first two outcomes are those that we view as the most likely, and we view the next two outcomes as the most impactful: (1) FERC essentially reaffirms its prior decisions, but adopts the Emera Maine method for fixing the ROE for pipelines; (2) it allows a partial ITA for non-MLPs, like Trailblazer, but requires the passback of a portion of the ADIT; (3) it applies the Emera Maine methodology to pipelines and reinstates the ITA for MLPs and other pass-through entities; or (4) it retracts its position on the elimination of ADIT for pipelines that have been denied an ITA.

If you are interested in the MLP or pipeline market as a whole, or specific pipelines with pending rate cases, or own a pipeline facing a possible rate proceeding, or are a shipper on any pipelines, you will want to pay attention to FERC’s open meeting tomorrow. Following the March decisions, Chairman Chatterjee stated that FERC should be more aware of how its decisions can move markets, so if the Commission views the Thursday decision as significant, then it may vote at the meeting but not release decisions until after 4:00 p.m. EST. Depending upon the complexity and gravity of the decision, we will either release a follow-up analysis or host a customer call.

Don’t We Already Know Everything?

In July 2018, FERC affirmed its policy that denies an ITA to “MLP pipelines like SFPP.” FERC also announced that if an MLP or other pass-through pipeline eliminates its ITA from its cost of service under this policy, that the Commission “anticipates that ADIT will similarly be removed from the cost of service.” This second announcement was viewed as positive for the industry because the elimination of the ADIT balance causes an increase in the pipeline’s rate base. Also, under FERC’s announced guidance, the ADIT balance would not have to be passed back to shippers unlike the excess ADIT for a C corporation.

FERC’s announcement made it clear neither of the policies “establish a binding rule,” and that FERC “will have to fully support and justify the application of this guidance in individual cases.” The cases on the docket for Thursday will be one of FERC’s first opportunities to apply its guidance in a precedent setting case that could limit its flexibility in all future cases, so these decisions will impact every other pending or future case regarding the rates of oil and gas pipelines.

The key areas that are poised for decision in tomorrow’s cases include:

Whether FERC will announce a new method for fixing the ROE for pipelines as it did for electric transmission providers in the Emera Maine decision issued last October?
If FERC adopts the Emera Maine methodology for pipelines, does that mean MLPs are once again entitled to an ITA?
Are pass-through entities ever entitled to an ITA, and, if so, how much?
Does the ADIT of an entity no longer entitled to an ITA just disappear, or must it be passed back to shippers?

Emera Maine, What’s That?

Of all the issues that FERC may address in tomorrow’s decisions, the most novel may be the one presented by Trailblazer following FERC’s decision in Emera Maine. As stated by Trailblazer:

Pursuant to the findings of the Emera Maine Remand Order, the Commission can no longer rely solely on the [discounted cash flow] DCF methodology to set Trailblazer’s ROE. Because a double-recovery can only result from the use of the DCF methodology to compute ROE, under the Emera Maine Remand Order, the Commission cannot reasonably find that granting Trailblazer an income tax allowance would result in a double-recovery of income taxes. Trailblazer is therefore entitled to an income tax allowance.

In Emera Maine, FERC abandoned its sole reliance on the DCF methodology for computing the ROE for electric transmission providers and instead adopted the average of the result from the DCF methodology combined with the results from a risk premium analysis, a capital-asset pricing model analysis, and an expected earnings analysis. While FERC has not yet indicated whether it will abandon the DCF methodology for pipelines, it did note that the primary reason it was doing so in Emera Maine was because “investors use those models, in addition to the DCF methodology, to inform their investment decisions.” It seems unlikely that FERC would find pipeline investors to be very different from electric transmission investors.

However, the next step that Trailblazer advocates, that adoption of the Emera Maine methodology for calculating ROE means that the pipeline is entitled to an ITA, seems a bit of a stretch. As explained by Trailblazer’s shippers, each of the methodologies endorsed in Emera Maine are designed to calculate the return an investor expects on its investment as a means of determining the just and reasonable ROE, and that, therefore, no matter how that ROE is calculated, if the entity paying the investor is not paying a tax, there should be no ITA. FERC could choose to continue using only DCF for pipelines, adopt the Emera Maine methodology but still deny an ITA, or adopt Emera Maine and restore the ITA for all entities.

ITA for Pass-through Entities

The Trailblazer case is an important case study for how FERC’s ITA policy applies to corporate structures that don’t include MLPs. As explained in that case, Trailblazer is 100% owned by Tallgrass Equity, which has two sets of owners; Tallgrass Energy owns a 54.79% interest in Tallgrass Equity, and private equity owners hold the other 45.21% interest in Tallgrass Equity. Tallgrass Energy and its predecessor, while a partnership, have been taxed as a C corporation since 2015.

According to Tallgrass, because Tallgrass Energy is taxed as a C corporation, Trailblazer should be entitled to a full ITA because the other owners do not own their interest through an MLP. The shippers argue that Trailblazer is not entitled to any ITA or, at most, should be entitled to an ITA for the 54.79% share of the interest held by Tallgrass Energy. A key reason offered for denying an ITA entirely focuses on the chain of ownership interests. Under this argument, if the first non-wholly owned entity is a pass-through entity not owned entirely by C corporations, then there should be no ITA. FERC could choose among three options -- full ITA for non-MLPs, partial ITA equal to the affiliated interests held by C corporations, or no ITA for pass through entities.

Does ADIT Really Just Disappear?

Perhaps the issue that has received the most briefing in the cases set for decision tomorrow is the determination of the proper amount of ADIT that should be reflected on the books of SFPP and the amount that needs to be passed back to customers as a credit against operating costs. According to SFPP, the answer to both questions is zero. On this issue, the shippers seem to be having difficulty distinguishing the particular facts of the case from the “guidance” issued by FERC last July. The shippers repeatedly note that Commissioners LaFleur and Glick signaled in their concurrence last July that, as a matter of equity, they “believe that the arguments for applying previously accrued ADIT balances to reduce future rate base where a tax allowance is eliminated are compelling,” but the shippers struggle to identify a legal basis for that position.

Because of the tangled history of the SFPP case, it is possible that there are three votes on the Commission for finding that requiring the passback of the ADIT is appropriate. However, there does not appear to be any compelling argument that would have a broader applicability. In fact, SFPP does a very good job of further supporting the FERC guidance that would completely eliminate ADIT for any pipeline that is not granted an ITA. FERC may require the passback of ADIT but limit it to cases like SFPP, may retract its previous guidance about the elimination of ADIT, or confirm that even in cases like SFPP, ADIT simply disappears.

Where Does This All Go?

There is certainly plenty of room in these proceedings for a surprise decision. However, the most likely result would seem to be that FERC adopts the Emera Maine methodology for pipelines but otherwise reaffirms its policy and guidance on ITA and ADIT.

Adoption of the Emera Maine methodology would result in a lower ROE for some pipelines and perhaps an increase in the ROE for others. The following chart compares the Two Step DCF result with the Emera Maine result for five cases which filed such information in the last year.

Insights Coming Soon

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Petitions for Declaratory Orders