October 2016, Vol. 243, No. 10


Reasonable Rates of Return Benefits Pipelines and Shippers Alike

By Mark Lewis and Kirk Morgan, Partners, Bracewell LLP, Washington, D.C.

On July 1, 2016, the U.S. Court of Appeals for the District of Columbia Circuit issued United Airlines, et al. v. FERC, et al., a decision with major rate implications for oil and gas pipelines subject to the jurisdiction of the Federal Energy Regulatory Commission (FERC). The Court’s decision calls into question the ability of MLPs, FERC-regulated pipelines – whether oil or gas – to include an income tax allowance in their cost-based rates.

The dust surrounding the decision has yet to settle and is unlikely to do so for months, if not years. Given the prevalence of the MLP structure among oil and gas pipeline companies, the United decision could have a material impact on cost-based rates. Although many pipelines derive significant revenue from non-cost-based rate methodologies, cost-based rates form an important touchstone for ratemaking.

Cost-based rates are particularly important for new or expanding pipelines. The implications of the United decision have important implications on the ability of pipelines to attract the capital needed to maintain and modernize existing systems and build new systems that are able to serve growing demand from producers and end-users alike.

How FERC responds to the United decision has been the source of much discussion, consternation and debate within the pipeline industry. The Court stopped short of ordering FERC to adopt a specific policy modification and instead ordered FERC to (i) demonstrate that the income tax allowance does not permit partnership pipelines to “double recover” taxes, (ii) remove any duplicative tax recovery for partnership pipelines by adjusting the discounted cash flow return on equity, or (iii) eliminate income tax allowances and set rates based on pre-tax returns alone.

It is unclear at this point which of these options – or some other alternative – FERC will adopt.  Nor is it clear when FERC will act to clarify its policy as there is nothing compelling FERC to issue a response within any specified time frame. Until FERC acts, a cloud of uncertainty exists over what comes next. An MLP pipeline filing a rate case today would include a tax allowance in its filed cost of service and protesting parties would surely rely on United to oppose that cost of service element, with neither side knowing how FERC or subsequently a Court of Appeals will ultimately rule.

On the surface, it is easy to read the court’s decision as pertaining to an esoteric ratemaking detail, but the potential implications are significant. Any change by FERC in reaction to the court’s decision that serves to reduce pipeline rates of return will limit a pipeline’s access to capital, which in turn will lead to capacity shortages. Pipelines must be able to access capital markets so they can invest in their existing systems and expand them to meet increased market demands in response to changes in the pipeline network that are projected to remain strong for years to come. It is incumbent upon pipelines and shippers alike to communicate to FERC that it should not use the United decision as a misguided opportunity to implement ratemaking policy changes that will hamper the ability of pipelines to attract new capital.

Reasonable Rates

It is tempting to oversimplify the interests of pipelines as seeking rates of return that are as high as possible and the interests of shippers as seeking pipeline rates as low as possible. The reality, however, is that rates premised on unreasonably high rates of return do not advance a pipeline’s long-term interests, as such rates will likely drive shippers to competitor pipelines, alternative energy sources, or in the case of oil pipelines, to barge, rail, and trucking alternatives.

Similarly, rates premised on unreasonably low rates of return prevent pipelines from accessing capital markets, thereby preventing pipelines from investing in their existing infrastructure and expanding to meet the needs of a dynamic market.

While it is understandable that, all else being equal, shippers would seek lower rates, they must also realize that this desire cannot be without limit. Specifically, inadequate infrastructure is ultimately more harmful to shipper interests than higher rates. For example, producers in basins with inadequate pipeline outlets often must sell their gas or oil at a discount, resulting in far lower netbacks than might result from any pipeline rate.

The task of the ratemaking regulator is to balance pipelines’ interest in higher rates with shippers’ interest in lower rates. Failure to strike a fair and reasonable balance may result in short-term winners and losers, but in the longer term, failure to strike that balance results in inefficiencies that are problematic for pipelines and shippers.

When a pipeline’s rates are based on a rate of return that is too low, shippers may benefit in the short term to the extent they are paying a rate that is lower than what they would otherwise pay. However, the consequences of an unreasonably low pipeline rate of return are often felt by shippers years later, when capacity shortages arise and increased systemic inefficiencies result from the pipeline’s inability to make capital investments in its system.

Unreasonably low rates of return would be particularly problematic for the industry, and society more broadly, in current conditions because pipelines need to invest heavily in their existing infrastructure – driven in part by the advanced age of many pipeline systems and an increased focus by the industry and regulators on pipeline safety and integrity issues. At the same time that companies need to invest in their existing infrastructure, the demand for new pipeline infrastructure remains strong and is unlikely to relent anytime soon.

This demand is driven by a variety of factors, including the growing appeal of natural gas-fired electric generation and production coming from unconventional plays that are underserved by existing pipeline infrastructure. In June, ICF International on behalf of the INGAA Foundation, issued a report entitled North American Midstream Infrastructure through 2035: Leaning into the Headwinds. The report concludes that over the next 20 years, total investments of between $290-376 billion are needed for new natural gas infrastructure, $137-190 billion for new crude oil infrastructure, and $43-55 billion for new NGL infrastructure.

Pipelines will only be able to meet the demand for new infrastructure if they are able to access capital markets. To the extent an investor can obtain higher returns elsewhere, they will invest elsewhere. For pipelines to access the capital markets that are necessary to support the demand for increased oil and natural gas infrastructure, they must be able to offer investors in those markets a rate of return commensurate with what capital markets can obtain in other industries.

FERC as Activist

Unfortunately, there are some indications that the ratemaking pendulum is swinging toward the side of lower rates of return for pipelines, such that FERC could be tempted to use the Court’s recent United decision as a reason to implement policy changes that lower pipeline returns. In 2009, FERC took the then unprecedented step of initiating investigations into the rates of several natural gas pipelines.

Earlier this year, FERC initiated another round of natural gas rate case investigations. While the natural gas industry may now be accustomed to FERC-initiated rate case investigations, the oil pipeline industry is not. There are signs, however, that FERC activism about pipeline rates may no longer be limited to natural gas pipelines.

FERC has statutory authority to initiate an investigation into an oil pipeline’s rates at its own initiative. For years, however, the oil pipeline industry has taken comfort in FERC’s 1994 pronouncement that it would only initiate rate case investigations “in the most unusual circumstances.”

Notwithstanding this pronouncement, there is growing concern within the industry that FERC is contemplating the initiation of oil pipeline rate cases similar to what it has initiated for certain natural gas pipelines.

This concern stems from two sources. First, in response to an inquiry from U.S. Rep. Lois Capps (D–CA) regarding FERC authority related to regulatory issues stemming from the 2015 Plains Pipeline spill incident, FERC Chairman Norman Bay referred to his agency’s authority to initiate, on its own initiative, an investigation to determine whether a rate or practice is unjust or unreasonable, even though the inquiry did not ask about rates.

Of greater concern, however, is the FERC budget request for 2017, which provides a brief summary of the natural gas rate cases that FERC has initiated since 2009, followed by a sentence explaining that “Similarly in [fiscal years] 2016 and 2017, [FERC] will review the information filed by jurisdictional oil and product pipelines in their financial reports to determine whether these pipeline earnings are just and reasonable. If any pipeline’s earnings appear excessive, [FERC] will consider what additional steps may be warranted.” Understandably, many within the oil pipeline industry are taking less comfort in FERC’s previous statements about only initiating rate cases in the “most unusual circumstances.”

If FERC perceives pipeline returns are too high, it may be tempted to use the United decision as a means of adopting ratemaking policies that would lower pipeline returns. FERC should resist this temptation. Any perception that pipeline returns are too high is misplaced. If returns were too high, the industry would see a flood of unsupported projects. The economic literature is clear that when regulated returns are set too high, regulated entities have an incentive to increase rate base by making investments solely to earn the unduly high return. Yet the industry is not seeing overbuilding. Rather, the new pipeline projects that are moving forward make economic and market sense, suggesting that overall returns are set at a relatively efficient level.

There can be many methods by which an appropriate reasonable rate of return is determined and changes to the methodology may or may not result from the United decision, but whatever methodology FERC adopts going forward, it is in the interest of all market participants that pipeline returns are not reduced to a level that would prevent them from attracting capital that is required to meet the needs of the customers they serve.

Authors: Mark Lewis and Kirk Morgan are partners at Bracewell LLP’s Washington, D.C. office where they routinely advise oil and gas pipeline developers, owners, operators and investors on regulatory and transactional matters. The authors would like to thank Michael Webb, director at the Regulatory Economics Group, LLC, for his contributions to this article.

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