April 15, 2020
From 2005 through 2018, FERC’s tax allowance policy was so boring that no one paid any attention to it. But then in March of 2018, in response to a remand in an oil rate case involving SFPP, L.P. (SFPP), FERC shocked the markets and announced that, going forward, it would no longer allow pipelines owned by master limited partnerships (MLP) to include an income tax allowance in their costs of service. To say that this announcement roiled the markets would be an understatement. Shippers were ecstatic and the MLP market all but evaporated from what it once was.
The second shoe to drop came in August of 2018, when FERC announced that it would cushion the blow of its new policy by allowing MLP-owned pipelines to simply delete all previously accumulated deferred income taxes from their balance sheets and not pass those balances back to the pipeline’s shippers. This was the time for MLPs, at least those that were still left, to celebrate and the shippers to complain, as with this announcement FERC raised the regulatory asset base of every MLP-owned pipeline and denied shippers any right to recover the benefit from the elimination of the income tax allowance in future rates. But the uncertainty continued, as FERC announced that for everyone but SFPP, this would just be a “policy” and that, in any future rate case, the pipeline and its shippers could argue whether that policy is correct.
The only problem with this “policy” is that it had an immediate impact on the regulatory books of the companies. All MLP-owned pipelines deleted the accumulated deferred income taxes from their books, which will make it almost impossible to challenge that decision in future rate cases because the accounts that kept track of that balance just disappeared.
Earlier this month, many of these controversial issues were once again appealed to the U.S. Court of Appeals for the District of Columbia Circuit (DC Circuit) as SFPP challenged the application of the policy in the rate case that had previously been remanded to FERC and caused the uncertainty to begin, and Enable Mississippi River Transmission (Enable MRT) challenged the policy in principle as not being a policy but, rather, a new rule that had not been properly supported by any record at FERC.
Today we look at the arguments in that case and where we see this issue going in the future. Sadly, we do not expect the court will rule in a way that resolves any of the uncertainty created by FERC’s “policy” -- which means uncertainty will continue. If we are right, the uncertainty of the “policy” will lead to real-world results when FERC addresses the oil index this summer, and will lead to uncertainty for any future gas pipelines owned by MLPs.
What is at Stake?
The appeals to the DC Circuit attempted to raise a whole host of issues for the court to decide regarding FERC’s policy and how it has been implemented. The issue with which SFPP is most concerned is the elimination of the tax allowance for MLP-owned pipelines. We set forth below the total annual cost of service and total interstate revenues for the oil pipelines that eliminated a tax allowance from their cost of service for 2017, as required by FERC’s “policy” decision.
As can be seen above, in the aggregate, those pipelines had over $8 billion in revenue in 2017 and went from an under-recovery of their costs in 2016 by over 10% to an over-recovery by over 4% in 2017, when they saw an almost $700 million reduction in their aggregated cost of service. The risk this creates for all of these MLP pipelines is that their rates may be subject to challenge. In addition, as we have discussed before in FERC Decision Impacts Returns of all Liquids Pipelines, Especially MLPs, we expect that FERC may very well give MLP-owned pipelines a lower indexing factor for the next five years as compared to their corporate counterparts.
The Issues Under Review
There are a number of issues at stake before the DC Circuit under a series of appeals that were the subject of oral argument earlier this month. These issues include:
- Whether the “policy” is only a policy and is not subject to court review;
- Whether FERC properly supported its decision to deny MLP-owned pipelines a tax allowance, and, more particularly, did it properly deny SFPP such an allowance for the years when it was owned by an MLP; and
- Whether FERC correctly interpreted the law as requiring it to eliminate the accumulated deferred income tax balances from MLP-owned pipelines when it decided to deny them a tax allowance going forward, and, more particularly, whether SFPP’s refunds should be calculated after such an elimination.
Clarity From the Court is Unlikely
Of these three main issues, the only one that may be resolved by the court’s decision in a manner that will address the issue for all pipelines is whether the FERC’s tax allowance policy is merely a policy that cannot be reviewed by the courts. SFPP and Enable did not give the court much evidence of real-world impact from the “policy” and so we expect the court may decide that it cannot rule on the substance of the policy itself. This will leave uncertainty as the key impact of the decision because the issues that are applicable to SFPP may be decided in a way that apply solely to that case and thus will not have much impact on the policy itself.
SFPP’s case involves its rates from 2008 to the present. The DC Circuit previously remanded that case to FERC to address whether its method for determining the return on equity for a pipeline that didn’t pay taxes allowed for a double recovery of those taxes when a tax allowance was also included in the cost of service. FERC was responding to that prior remand when it issued the new policy. To bolster its position that it was only a policy though, FERC said that pipelines would be allowed to prove there was no double recovery in any particular case. But then FERC refused to allow SFPP to present any evidence and simply denied it a tax allowance. We think this denial of the right to present evidence is what the court is likely to find troubling with the SFPP decision, and will allow it to remand the case back to FERC without addressing the broader question of whether the default position of the policy is correct.
Similarly, when FERC calculated the new rates for SFPP, it also simply wiped away SFPP’s existing accumulated deferred income taxes (ADIT). The shippers challenged this part of the decision to the DC Circuit. The shippers argued to the court that the elimination of the ADIT, which creates an immediate increase in SFPP’s rate base, will result in SFPP earning a market return on capital it did not obtain through the capital markets. Thus, the ADIT balance should remain and be amortized over the almost twelve-year period covered by the rate case so that SFPP only earns a market return on the portion of its rate base as it increases with the amortization of the ADIT balance back to the shippers. The key argument against this amortization requirement is that such amortization is a form of retroactive ratemaking. But because all of SFPP’s rates since 2008 are the subject of the case, the court may rule that the ADIT should be returned in that rate case without addressing the broader issue of whether all other MLP-owned pipelines can simply eliminate their ADIT balances without amortization.
The “Policy” Has Real-World Implications
If, as we suspect, the court does not address the substance of the policy, that will create a great deal of uncertainty in all rate cases going forward. It also will not provide clear guidance to FERC as to whether it is on firm ground in addressing other questions going forward.
The problem this creates is illustrated by the rate case involving one of the parties that filed one of the series of appeals that were argued before the DC Circuit, Enable MRT. Rather than take the risk of having its day in court and argue the fine points of an income tax allowance and the return of ADIT, Enable MRT simply settled its rate case with its shippers. In that settlement, the parties agreed that, because of FERC’s policy, the settlement rates did not include any income tax allowance and the company’s ADIT balance was simply eliminated without an obligation to pass it back to the shippers. The parties reserved the right at the end of the settlement term, after April 30, 2024, to contest these issues.
As we have discussed before in Gas Rate Cases in Next Two Years Could Force Tariff Rates Down, the vast majority of rate cases are settled, and so, while FERC has asserted that an MLP-owned pipeline will be able to assert the right to an income tax allowance, the backdrop for any negotiations, like in the Enable MRT case, will be the assumption that the pipeline is not entitled to an income tax allowance and that the ADIT balance should simply be eliminated. While both parties reserved their rights to revisit these issues in a future rate proceeding, that will be much simpler for the pipeline than it will be for the shippers. The pipeline will be able to make a policy-based argument that it is entitled to an income tax allowance if the open issues we describe above are eventually resolved. Shippers, however, will face a much more daunting challenge with regard to the ADIT balances. Based on the “policy,” MLP-owned companies are no longer reflecting those balances on their books. In future rate cases, shippers will simply not have access to the current level of those balances. A similar problem will exist for shippers in the oil indexing process later this year because the books of MLP-owned pipelines will simply not reflect any ADIT balances and so the shippers will not be able to calculate the current year ADIT balance even if they think it should be amortized over some period.
It is possible that the court will choose to address the substance of the policy and if it does, there may be more clarity than we currently expect. But if the court chooses the more limited path we outline above, the bottom line is that the policy, for all practical purposes, will become the operating environment for both pipelines and shippers.