Conceding there were defects in the pipeline rate-of-returnpolicy put in place last summer, FERC made three small butsignificant changes last week that should give pipelines greaterconfidence when planning expansion projects.

The changes won the praise of the Interstate Natural GasAssociation of America (INGAA). INGAA President Jerald V. Halvorsensaid the Commission’s action “should help pipelines compete in theincreasingly competitive financial markets for the capital to buildprojects that are necessary to meet projections of a 30 Tcf naturalgas economy by 2010.”

Keith E. Bailey, CEO of the Williams Cos., who was outspokenabout the inadequacies of FERC’s rate of return policy at FERC’sJanuary conference on the issue, said in an interview with NGI thechanges are “obviously positive. I think this moves us back in theright direction.”

The changes, which were introduced in four orders affectingTranscontinental Gas Pipeline, Williams Natural Gas, Iroquois GasTransmission and Williston Basin, include giving more weight toshort-term earnings growth rate forecasts than to long-term growthrate forecasts in establishing reasonable returns on equity forpipelines. The draft orders give two-thirds weight to short-termprojections because of their greater reliability and one-thirdweight to long-term projections, rather than weighting them equallyas was done previously.

Secondly, in order to provide financial incentives for pipelinesto manage their businesses efficiently, the draft orders say theCommission no longer will reduce a low-risk pipeline’s equityreturn if its lower risk is a result of its efficiencies inconducting its business. Thirdly, on the capital structure issue,the draft orders would eliminate the requirement established lastyear that a pipeline’s own capital structure can only be used inrate of return calculations if it is within the range of equityratios of the proxy companies selected. Rather the draft orderspermit use of a pipeline’s own capital structure if the pipelineissues its own nonguaranteed debt, has its own bond rating and ifthe pipeline’s equity ratio is reasonably comparable to otherequity ratios approved by the Commission and those of the othercompanies in the selected proxy group.

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

“While the upward adjustments in allowed returns are notdramatic, in my mind they represent a reasonable response to manyof the concerns raised before, at and after the January conference[on financial conditions of pipelines],” said Commissioner VickyBailey. “I am satisfied that use of actual capital structures,weighting of growth projections, and flexibility regarding risk andperformance issues will go a long way toward achieving reasonableallowed return levels while the Commission continues to explorerate setting in the future, particularly in the context of the[notice of inquiry] we just approved. Additionally I believe theopportunity to achieve higher returns — if pipelines maximize theopportunities offered by the [notice of proposed rulemaking] –should go a long way toward insuring that capacity will be able tomeet the 30 Tcf demand [projected].”

Chairman James Hoecker said the previous methodology was “fartoo rigid and didn’t allow pipelines to plead their uniquecircumstances in a rate case.” He believes the changes willnecessitate little additional litigation, while giving pipelinesthe greater latitude in arguing the reasonableness of their capitalstructure as well as their relative risk.

Nevertheless, Hoecker believes rate of return methodologies willbe less important in the future as the value of capacity and thequality of pipeline operations become much more importantindicators of what return on investment a pipeline ought to beallowed.

In the near term, however, Williams CEO Bailey said the RORpolicy changes will be very important in building the confidence ofexpansion project planners. “We’ve seen a lot of pipeline projectstalked about, and we’ve seen people get pretty deep in thedevelopment cycle [but then turn back]. Few major projects havebeen committed to. I think the framework that they’ve laid is onethat gives you some confidence that as an opportunity presentsitself you are going to be willing to go down that developmentcycle, spend the resources, spend the time necessary to get theproject to a final decision point,” he said. “If they continue tobe willing, as they appear to be here, to give rates of return thatare commensurate with those project risks then the likelihood iscapital will be committed.

“Had they locked in where they seemed to be moving., I think itjust basically would have shut down the development effort,” saidBailey. “There would have been no reason to start the explorationof a project because you would have understood going in that youdidn’t have a chance to get a compensatory rate of return.”

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

Rocco Canonica

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