If FERC should allow return on equity (ROE) for natural gas pipelines to fall into the single-digit range, a new report by the Interstate Natural Gas Association of America (INGAA) warned that it would likely have a “chilling effect” on investment in new pipeline infrastructure.
The interstate natural gas pipeline group commissioned Chicago-based Navigant Consulting Inc. to do the report following an initial decision in March in which a FERC administrative law judge (ALJ) proposed a significantly lower ROE than was sought by Kern River Gas Transmission. The ALJ recommended an ROE of 9.34% for the Wyoming-to-California Kern River system, considerably below the pipeline’s request of 15.1% and its current ROE of 13.25%.
The decision sent shivers through the gas pipeline industry, with INGAA and energy analysts predicting that a single-digit ROE, if approved by the full Federal Energy Regulatory Commission, could be a harbinger of things to come industrywide. Lower ROEs would make it more difficult for gas pipelines to attract investors to their new projects.
The Kern River decision “has raised concerns throughout the interstate natural gas pipeline industry and the investment community that FERC could authorize a precipitous drop in allowed returns on equity for natural gas pipelines… Even the potential that Commission-approved ROEs could fall to a similar level [as is proposed for Kern River] would likely have a chilling effect on new infrastructure investment,” said the report, which was released Thursday.
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, the report noted. But this certainty would fade in the face of single-digit ROEs.
“Investors would question the earning power of new investment, as well as past investment, of which there has been over $30 billion in the last 10 years alone. The residual effect of such a shock to investor expectations might take years to correct, while capital would flow away from the pipeline industry in the interim,” the INGAA report said.
A central issue in the ALJ decision was the selection of a proxy group of companies to be used as the benchmark to determine Kern River’s ROE. The judge based her ROE decision on a proxy group proposed by BP Energy that included El Paso, Equitable Resources, Kinder Morgan Inc., Natural Fuel Gas, Questar Corp. and The Williams Cos. The ALJ rejected Kern River’s proxy group, which included several master limited partnerships (MLPs), saying the pipeline failed to show that the proxy group would produce just and reasonable rates. She said MLPs would unreasonably inflate ROE.
The ALJ “relied upon a group of proxy companies that is not representative of the natural gas pipeline industry,” the report noted. The three utilities — Questar, Equitable and National Fuel — “do not compare well with the pipeline business… El Paso, although it is the owner of a large pipeline network, is still showing some effects of the collapse of the merchant sector. Only two members of the proxy group are reasonable examples of healthy stock traded companies with a significant focus on the pipeline business (Kinder Morgan and Williams),” it said.
But even Williams and Kinder Morgan pose some problems. “Williams’ recovery from the same merchant sector problems that beset El Paso is so recent that current [financial performance] numbers reflect it, but [the FERC proceeding record of] Kern River’s does not reflect the recovery. The remaining company, Kinder Morgan Inc., has announced that a group of investors, including senior management of the company, has made an offer to purchase the company and take it private…Thus, it is not reasonable to assume that this group will yield an accurate approximation of investors’ expectations for an interstate pipeline company,” the INGAA report noted.
“This evolution in the group alone should be reason for the Commission to take a fresh look at the criteria it applies for determining the composition of the proxy group.”
As evident in Kern River, “the fundamental issue in selecting a proxy group in a natural gas pipeline rate case is whether or not to include representatives of the many pipeline companies that are organized as MLPs,” the report said. “Now, as MLPs have grown in number, scope and importance, they comprise a very representative group of true, publicly-traded pipeline companies to which the Commission can turn for market guidance.”
The report noted that the combined oil and natural gas pipeline industry is “by far the best place” for the Commission to look when determining the returns required by equity markets for investment in an interstate pipeline. But the fact that many companies in this group are organized as MLPs has been a “stumbling block” for FERC.
The report concluded that the Commission’s concern about the use of MLPs in proxy groups for interstate gas pipelines “is misplaced.” FERC “must recognize the increasingly important role that MLPs play in the interstate pipeline industry by including an appropriate mix of MLPs in the proxy group,” it said.
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