Crossing the ROE Chasm – Pipelines vs. FERC

Natural Gas Rates
June 13, 2017
A core component of the Federal Energy Regulatory Commission’s (FERC) mandate for the regulation of interstate gas, liquids and transmission lines involves assuring that transportation rates are just and reasonable. Put another way, for gas pipelines, FERC must ensure that the return on investment it provides pipelines is sufficient to attract the capital to build and operate pipelines, while also providing that the return on investment is not excessive. To satisfy this mandate, FERC conducts a painstaking annual review of each natural gas pipeline based principally on the natural gas operators’ Form 2 filings. This process leads to uncertainty regarding FERC’s decision, as pipelines seek to determine whether they are at risk, followed by a contentious battle over the methodology used. Settlements in these cases have led to a reduction in maximum recourse rates by more than 25%. After nearly a decade of investigations, why do large disparities routinely exist between FERC’s and the company’s calculations? 
Earlier this year, the FERC initiated two Natural Gas Act Section 5 rate investigations of Natural Gas Pipeline Company of America (NGPL) and Wyoming Interstate Company (WIC). Both companies are currently in initial settlement talks with their shippers. One key determinant used by FERC in its annual review of these pipelines is a return on equity (ROE) calculation that leverages the industry-specific values provided in the Form 2. The FERC’s methodology allows it to gain insight into the returns a company is seeing in the context of its operations, which is calculated based on about 60 unique values, not all of which are disclosed in the Order Instituting Investigation. And certain values are more significant than others. 
The capitalization structure FERC uses can significantly affect the ultimate ROEcalculation. The FERC generally uses a pipeline’s actual capital structure upon beginning its investigation. In these two cases, FERC used a hypothetical 50/50 debt to equity capitalization structure, even though NGPL and WIC reported a 100% equity capitalization structure on their Form 2s. It is more costly for the rate payer if a pipeline finances its investment entirely with equity, so the FERC has determined that it is only reasonable to use a subsidiary pipeline’s actual capital structure when the subsidiary issues its own debt that is not guaranteed by its parent. Because this wasn’t true for WIC or NGPL, FERC used the hypothetical capital structures to calculate the ROE Interestingly, both companies have been the subject of rate investigations in recent years. NGPL’s 2010 settlement provided that neither NGPL nor any settling parties would file to propose changes to the settlement rates before April 1, 2016, and  WIC’s 2013 settlement imposed a rate case moratorium on the pipeline until July 1, 2016. 
Another driver of disparities between FERC and company calculated ROEs in Section 5 proceedings is the availability of timely data. While the FERC initiated the proceedings in January 2017, at that point the companies under investigation had not yet filed annual data for 2016. As a result, the FERC relied on the financial data that each company provided in 2014 and 2015. In an effort to remedy this issue and acquire more timely data, the FERC often requests more recent data from the company in the form of a cost and revenue study. As a result, the FERC is able to review the most recent, in this case 2016, data in its continued effort to identify any unreasonable returns. 
The cost and revenue study also allows the company under investigation to clarify operating conditions in an effort to prove its rates are, in fact, reasonable or that conditions have recently changed to such an extent that changing its rates is unnecessary. By the time the cost and revenue study has been filed, pipeline companies, as well as their shipper base, have committed significant capital in the form of expert representations from attorneys and accountants. Relatedly, the FERC staff (OEMR, OAL, etc.) have devoted many months of man-hours conducting these reviews. From both perspectives, the process is inefficient, at best, and costly at worse.
In an effort to provide our customers with timely insight into the FERC’s annual review process, we’ve automated the FERC’s ROE calculation methodology, thereby limiting the information gaps that lead to an inefficient process. If you are looking to learn more, please let us know.
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