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FERC Wins the Praise of Pipelines For ROR Policy Revisions

August 3, 1998
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FERC Wins the Praise of Pipelines For ROR Policy Revisions

Conceding there were defects in the pipeline rate-of-return policy put in place last summer, FERC made three small but significant changes last week that should give pipelines greater confidence when planning expansion projects.

The changes won the praise of the Interstate Natural Gas Association of America (INGAA). INGAA President Jerald V. Halvorsen said the Commission's action "should help pipelines compete in the increasingly competitive financial markets for the capital to build projects that are necessary to meet projections of a 30 Tcf natural gas economy by 2010."

Keith E. Bailey, CEO of the Williams Cos., who was outspoken about the inadequacies of FERC's rate of return policy at FERC's January conference on the issue, said in an interview with NGI the changes are "obviously positive. I think this moves us back in the right direction."

The changes, which were introduced in four orders affecting Transcontinental Gas Pipeline, Williams Natural Gas, Iroquois Gas Transmission and Williston Basin, include giving more weight to short-term earnings growth rate forecasts than to long-term growth rate forecasts in establishing reasonable returns on equity for pipelines. The draft orders give two-thirds weight to short-term projections because of their greater reliability and one-third weight to long-term projections, rather than weighting them equally as was done previously.

Secondly, in order to provide financial incentives for pipelines to manage their businesses efficiently, the draft orders say the Commission no longer will reduce a low-risk pipeline's equity return if its lower risk is a result of its efficiencies in conducting its business. Thirdly, on the capital structure issue, the draft orders would eliminate the requirement established last year that a pipeline's own capital structure can only be used in rate of return calculations if it is within the range of equity ratios of the proxy companies selected. Rather the draft orders permit use of a pipeline's own capital structure if the pipeline issues its own nonguaranteed debt, has its own bond rating and if the pipeline's equity ratio is reasonably comparable to other equity ratios approved by the Commission and those of the other companies in the selected proxy group.

Based on the revised policies, the draft orders allow Transco a return on equity of 12.49%, and Williams Natural Gas a return on equity of a 13.46%. Both pipelines are permitted to use their own capital structures in calculating their returns.

"While the upward adjustments in allowed returns are not dramatic, in my mind they represent a reasonable response to many of the concerns raised before, at and after the January conference [on financial conditions of pipelines]," said Commissioner Vicky Bailey. "I am satisfied that use of actual capital structures, weighting of growth projections, and flexibility regarding risk and performance issues will go a long way toward achieving reasonable allowed return levels while the Commission continues to explore rate setting in the future, particularly in the context of the [notice of inquiry] we just approved. Additionally I believe the opportunity to achieve higher returns -- if pipelines maximize the opportunities offered by the [notice of proposed rulemaking] -- should go a long way toward insuring that capacity will be able to meet the 30 Tcf demand [projected]."

Chairman James Hoecker said the previous methodology was "far too rigid and didn't allow pipelines to plead their unique circumstances in a rate case." He believes the changes will necessitate little additional litigation, while giving pipelines the greater latitude in arguing the reasonableness of their capital structure as well as their relative risk.

Nevertheless, Hoecker believes rate of return methodologies will be less important in the future as the value of capacity and the quality of pipeline operations become much more important indicators of what return on investment a pipeline ought to be allowed.

In the near term, however, Williams CEO Bailey said the ROR policy changes will be very important in building the confidence of expansion project planners. "We've seen a lot of pipeline projects talked about, and we've seen people get pretty deep in the development cycle [but then turn back]. Few major projects have been committed to. I think the framework that they've laid is one that gives you some confidence that as an opportunity presents itself you are going to be willing to go down that development cycle, spend the resources, spend the time necessary to get the project to a final decision point," he said. "If they continue to be willing, as they appear to be here, to give rates of return that are commensurate with those project risks then the likelihood is capital will be committed.

"Had they locked in where they seemed to be moving., I think it just basically would have shut down the development effort," said Bailey. "There would have been no reason to start the exploration of a project because you would have understood going in that you didn't have a chance to get a compensatory rate of return."

With renewed confidence in the financial regulation of pipelines, Bailey said the next wave of expansions will be focused on the regions with the greatest gas demand growth, such as the Mid-Atlantic, Southeast and Pacific Northwest.

Rocco Canonica

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