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Kern River Rate Case Sends 'Shivers' through Pipe Industry, Puts Spotlight on ROEs

A FERC administrative law judge's (ALJ) initial decision earlier this month recommending a significantly lower return on equity (ROE) than was sought by Kern River Gas Transmission is a "troubling sign," according to a major gas pipeline group, but it reminded companies that the Kern River ruling isn't final and is subject to review by the full Commission.

FERC ALJ Charlotte J. Hardnett recommended an ROE of 9.34% for Kern River, considerably below the pipeline's request of 15.1% and its current ROE of 13.25%. Hardnett concurred with the ROE proposed by a witness for BP Energy, a shipper on the Kern River system.

"We are concerned about it becoming a trend" for interstate gas pipelines, said Martin Edwards, vice president of legislative affairs for the Interstate Natural Gas Association of America, which represents interstate gas pipes. The ROE proposed for Kern River "is lower in many cases than what LDCs [local distribution companies] get," he noted.

Wide shifts in ROEs can affect the profits that pipelines make each year and their ability to attract investors for projects, according to Edwards.

He said the Federal Energy Regulatory Commission (FERC) over the past five to six years generally has approved higher ROEs for gas pipelines that show they have reinvested a large portion of their profits in new pipeline facilities. He pointed out that the Wyoming-to-California Kern River pipeline has done just that, doubling its capacity in the past couple of years to respond to the energy crisis in California.

While the ALJ's decision on Kern River, a MidAmerican Energy pipeline, "has sent shivers through the industry, we remind investors here that cutting equity returns on energy transmission infrastructure has not been the policy of the Commission," said energy analyst Christine Tezak of the Stanford Washington Research Group in an "Energy Policy Bulletin" published last Monday.

A central issue in the decision was the selection of a proxy group of companies to be used as the benchmark for Kern River's ROE. Kern River's proposed proxy group included Enterprise Products Partners, GulfTerra Energy Partners LP, Kinder Morgan Energy Partners, Kinder Morgan Inc., Northern Border Partners and The Williams Companies.

FERC staff, which proposed an ROE of 9% for Kern River, chose a proxy group of CenterPoint Energy, Dominion Resources, Duke Energy, El Paso Corp., Kinder Morgan Inc., National Fuel Gas, NiSource Inc. and The Williams Companies. BP's proxy group included El Paso, Equitable Resources, Kinder Morgan Inc., National Fuel Gas, Questar Corp. and The Williams Companies.

ALJ Hardnett rejected the proposed proxy groups of Kern River and FERC staff, and accepted the proxy group of BP Energy. "Kern River did not carry its burden of proving that the proxy group it used, which included MLPs [master limited partnerships], would produce just and reasonable rates. Inclusion of MLPs unreasonably inflates ROE. Staff's inclusion of LDCs in it proxy group, on the other hand, understates ROE. The BP proxy group...does produce just and reasonable rates," she said.

In a December 2002 case involving High Island Offshore System (HIOS), an ALJ recommended, and the full Commission endorsed, dropping El Paso and Williams from the proxy group due to their financial turmoil. But the BP Energy proxy group, which Hardnett endorsed, returned El Paso and Williams to the proxy roster, a move that depressed the median ROE to 9.34%, Stanford's Tezak said.

Hardnett "did not address what we think is a pretty fundamental issue: Why it is appropriate to include El Paso and Williams in this case (based on six months ending October 2004) when they were considered too financially weak in the last six months of 2003 to be included in the HIOS case? We believe that the Commission will need to explain this, especially when the inclusion of these firms so dramatically skews the returns into the single digits for this case and possibly subsequent ones," Tezak noted.

When acting on Hardnett's decision, FERC has the option to accept or reject the Kern River ruling in whole or in part. Based on the outcry following the ALJ's action, Tezak said FERC could establish an ROE based on the proxy group of four companies used in HIOS (excluding Williams and El Paso), instead of the six endorsed by Hardnett in Kern River. "That would bring the ROE back into the double digits." Or in the alternative, she said it might be time for FERC to create an entirely different proxy group for dealing with benchmarks for ROE.

The general rate case dates back to May 2004, when FERC accepted and suspended for five months a $40.1 million rate hike on Kern River's system. In addition to the rate hike, the pipeline sought a ROE of 15.1%.

Kern River's system extends about 900 miles from Wyoming through Utah and Nevada to the San Joaquin Valley near Bakersfield, CA. The pipeline, which began service in 1992, had an initial transportation capacity of 700 MMcf/d. A $1.2 billion expansion in 2003 more than doubled Kern River's firm delivery capacity to 1.7 Bcf/d.

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