In light of the decline in publicly traded companies with substantial pipeline assets and the rise in master limited partnerships (MLP) in the pipe sector, FERC last Thursday issued a draft policy statement that would allow the use of MLPs in proxy groups to determine oil and natural gas pipelines’ returns on equity (ROE) for ratemaking purposes.

However, the Federal Energy Regulatory Commission (FERC) proposes to cap the cash distributions used to determine an MLP’s return under the discounted cash flow (DCF) methodology at the MLP’s reported earnings. This would render MLP cash distributions comparable to corporate dividends for the purpose of a DCF analysis, staff said.

This is a “significant policy change” that responds to the “pretty striking structural changes [that] have occurred in both the oil pipeline and natural gas pipeline sectors,” said Chairman Joseph Kelliher.

“Historically, the Commission has required that each company included in the proxy group for purposes of DCF analysis meet certain standards, including that pipeline operations account for at least 50% of a company’s assets or operating income. As a result of mergers, acquisitions and other changes in the natural gas industry, fewer and fewer interstate natural gas companies have satisfied that requirement,” he noted.

“In recognition of the shrinking proxy group, the Commission relaxed this requirement a few years ago. We now include diversified natural gas companies in the proxy group, without regard to what portion of the company’s business comprises pipeline operations,” Kelliher said.

“In the past, we have rejected natural gas pipeline requests to include MLPs in the proxy group. While it is true MLPs have a much higher portion of their business devoted to pipeline operations, we have been concerned that MLP distributions may not be comparable to corporate dividends the Commission uses in its DCF analysis,” he noted.

The “changes in both the natural gas and oil pipeline sectors have forced the Commission to revise the way it constitutes a proxy group for purposes of calculating returns on equity. The reality is both sectors have increasingly adopted the MLP structure as the framework for the pipeline business.”

This has raised the policy question of “have we reached the point where the natural gas pipeline sector has adopted the MLP to such an extent that it is perverse to exclude MLPs from the proxy group,” Kelliher said. “In my view, we have reached that point. It seems clear we reached that point with respect to oil pipelines some time ago.”

Commissioner Marc Spitzer stressed the need for the cap on MLP cash distributions, saying it prevents a “windfall to pipelines.” He noted that the cap eliminates the potential for double recovery.

FERC’s action is a “correction and perfection” of traditional ratemaking principles, Spitzer said. “Given the shifting financial structure of the industry, [this policy statement] is appropriate,” agreed Commissioner Jon Wellinghoff.

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.

“I think it’s a positive step, but the devil’s in the details” said Joan Dreskin, general counsel for the Interstate Natural Gas Association of America. The Commission showed a “recognition that the industry is increasingly moving toward the MLP structure.”

The issue of MLPs in proxy groups came to the forefront last year in a rate case involving Kern River Gas Transmission. A FERC judge recommended a 9.34% ROE for the Wyoming-to-California gas 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 the recommended ROE for Kern River 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, Kinder Morgan Inc. and Northern Border Partners. But the proxy group ultimately adopted by FERC for Kern River was composed of companies with a relatively low proportion of pipeline businesses and substantial distribution operations.

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