In a major win for interstate pipelines, FERC last Thursday adopted a policy statement that allows the use of master limited partnerships (MLPs) in proxy groups to determine oil and natural gas pipelines’ returns on equity (ROE) for ratemaking purposes. The new policy responds to the decline in publicly traded companies with substantial pipeline assets and the rise in MLPs in the pipe sector.

The Federal Energy Regulatory Commission (FERC) in its proposed policy statement, issued in July 2007, recommended capping cash distributions used to determine an MLP’s return under the discounted cash flow (DCF) methodology at an MLP’s reported earnings. This, FERC argued at the time, would render cash distributions comparable to corporate dividends for the purpose of a DCF analysis (see NGI, July 23, 2007).

Natural gas pipelines were quick to oppose the proposal, which prompted the Commission to eliminate it in the final policy statement [PL07-2]. The exclusion of this alone was a considerable triumph for pipes.

In addition to not capping cash distributions, FERC’s policy statement requires:

Interstate gas pipelines have repeatedly called on FERC to recognize the growing role of MLPs in the pipeline industry, and the need to include them in proxy groups to determine pipe ROEs. The exclusion of MLPs from proxy groups triggers wide shifts in ROEs that can affect the profits pipelines make each year and their ability to attract investors for projects, they said.

A proxy is a group of companies that are used as a benchmark to determine the ROE of a pipeline, which is critical to the calculation of rates. For several years, the debate in the natural gas industry has been over whether MLPs should be allowed to be part of a proxy group, given the number of publicly traded companies with substantial pipeline assets has shrunk considerably.

The vast majority of ROEs authorized by FERC for pipelines over the past 30 years has been between 12% and 14%, which has provided investors with a “high degree” of certainty. But pipelines have been concerned that this certainty would fade in the face of single-digit ROEs.

“Our policy change is born out of a practical recognition that the size of the proxy group used under our prior approach had shrunk dramatically. We made a series of adjustments to compensate for the shrinking proxy group,” but they were to no avail, said Chairman Joseph Kelliher.

“We relaxed our requirements and included diversified natural gas companies in the proxy group, without regard to what portion of the company’s business comprises pipeline operations. We also adjusted returns to account for the relatively lower risks of diversified natural gas companies compared to pipeline companies. These adjustments were challenged in court in a series of cases,” he noted.

“The reality is that the natural gas pipeline sector has increasingly adopted the MLP structure [to determine rates]. The oil pipeline sector adopted that structure some years ago. To insist on excluding MLPs from the natural gas pipeline proxy group in the face of these developments would seem perverse,” Kelliher said.

Furthermore, “shortly after we issued the proposed policy statement last July, the U.S. Court of Appeals for the D.C. Circuit in Petal Gas Storage [v. Federal Energy Regulatory Commission] vacated and remanded our rulings in two earlier decisions where the Commission excluded MLPs from the proxy group [see NGI, Aug. 13, 2007]. The court emphasized that ‘proxy group arrangements must be risk appropriate’ and that changes in the structure of the gas pipeline sector compelled reform in the Commission’s traditional approach toward proxy group composition.”

The policy statement will govern all gas and oil rate proceedings involving the establishment of a ROE that are currently pending before either the Commission or an administrative law judge (ALJ), according to FERC. The Commission has applied the policy statement to four other rate cases in which the proxy group composition is an issue, including Kern River Gas Transmission, Duke Energy Guadalupe Pipeline Inc., High Island Offshore System and Petal Gas Storage.

The issue of MLPs in proxy groups came to the forefront in 2006 in a Kern River Gas rate case. A FERC ALJ recommended a 9.34% ROE for the Wyoming-to-California pipeline, significantly below what it had requested, based largely on the exclusion of MLPs from its proxy group. In October 2006, FERC voted to increase Kern River’s ROE to 11.2%, but it ruled that the pipeline had not met the burden to support its proposal to include MLPs in its proxy group (see NGI, Oct. 23, 2006).

Kern River’s proposed proxy group included Enterprise Products Partners, GulfTerra Energy Partners LP, Kinder Morgan Energy Partners, the former publicly traded Kinder Morgan Inc. and Northern Border Partners. But the proxy group ultimately adopted by FERC was composed of companies with a relatively low proportion of pipeline businesses and substantial distribution operations.

The Commission has granted rehearing on Kern River’s ROE so appropriate MLPs can be included in the composition of the proxy group [RP04-274-006]. The agency set for paper hearing the issue of the makeup of Kern River’s proxy group, the DCF analysis of the proxy group firms and related issue of risk. Initial briefs from participants are due 60 days after this order. FERC said it will require Kern River to file revised tariff sheets and rates within 30 days of a final order being issued in the case.

FERC said it also will reopen the record for a paper hearing in the Duke Energy Guadalupe Pipeline case so parties can submit evidence to determine which specific MLPs and corporations should be included in its proxy group. The paper hearing will help determine the appropriate ROE [PR05-17].

With respect to High Island Offshore and Petal Gas Storage, the Commission said it has referred both cases to a settlement judge for further proceedings [PR03-221, CP01-60-009]. FERC directed Chief ALJ Curtis Wagner Jr. to appoint a settlement judge for each case. A progress report on each case must be filed with the Commission 30 days after each settlement judge is appointed, with status reports filed every 60 days thereafter.

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