Although primarily focused on the electric transmission industry, a recent Federal Energy Regulatory Commission (FERC) Notice of Inquiry (NOI) announced reconsideration of how the agency determines returns on equity (ROE) and seeks comments on whether it should apply any revamped ROE policies to interstate natural gas and oil pipelines. This NOI creates an additional avenue for gas industry participants seeking changes in how the FERC evaluates and approves the construction of new gas pipeline facilities.

As described in a previous article, almost a year ago, FERC announced another NOI seeking comments on its Certificate Policy Statement. The existing Certificate Policy Statement takes a light-handed regulatory approach to proposals to construct new pipeline facilities. Generally, under the Certificate Policy Statement, as long as a pipeline demonstrates a market need and is prepared to financially support its new project without relying on subsidization from existing customers, FERC is likely to approve the project. Under FERC’s existing Certificate Policy Statement, this demonstration of market need can come through precedent agreements executed with shippers, including shippers either affiliated with the applicant or who have a minority ownership interest in the new project. In recent years, state-regulated utilities, with the ability to flow through these costs to their retail customers, have begun to participate in the ownership of these new projects.

The recent growth in applications for new pipeline facilities has been spurred by the desire to access new production areas first made available by improved fracking technology. The number of applications has also increased because new projects are profitable investments. In approving new pipeline facilities, FERC has repeatedly granted a 14 percent ROE for new “greenfield” facilities. FERC has used this 14 percent ROE approach since 1997, regardless of wider economic indicators such as corporate bond rates, which fluctuate with economic risk and which rarely, if ever, offer a 14 percent of return on investment.

The idea that the 14 percent ROE granted to new pipeline projects does not vary regardless of broader market conditions indicates that FERC today may not be realistically incorporating risk into expansion facility pricing. This allows pipelines to over-recover on their investments and creates an incentive for pipelines to overbuild. Many commenters on the Certificate Policy Statement NOI urged FERC to change this approach. They noted that overbuilding is not only expensive for consumers who ultimately pay the costs in rates, it also leads to increased use of natural gas facilities and increased greenhouse gas emissions. The NOI’s reassessment of FERC’s ROE policies may be a productive forum for raising concerns about excessive ROEs for newly certificated pipeline facilities. Certainly to the extent FERC adopts policies that lead to lower ROEs for new facilities, this will put a damper on pipeline industry overbuilding in the future, even if the Certificate Policy Statement remains unchanged, as recent changes at the FERC Commissioner level suggest is likely.

Another area of opportunity for natural gas pipeline industry reform is FERC’s use of the discounted cash flow (DCF) methodology in ratemaking proceedings. FERC uses the DCF model to calculate a pipeline’s ROE by comparing the pipeline to other gas pipeline companies representing a comparable risk to investors. To find comparable companies, FERC uses a proxy group of regulated companies in accordance with certain parameters it has created over time. In recent years, however, FERC has grappled with a number of difficulties in composing proxy groups: there are an insufficient number of publicly-traded natural gas pipeline companies, potentially comparable companies with publicly traded stock do not have a substantial proportion of their business in gas pipeline operations, and it is challenging to create a proxy group composed of both master limited partnerships and corporations. These practical difficulties highlight shortcomings of the DCF model and open the door to consideration of the other methodologies described in FERC’s NOI, which calculate ROE based on verifiable, market-based factors such as interest rates, book value, and beta.

Natural gas pipelines are already proposing to use new methodologies for calculating ROE in rate cases not only because of the existing difficulties with the DCF model but also in light of the FERC’s recently revised policy on the income tax allowance. FERC’s NOI presents an opportunity for all interested stakeholders to comment on what models FERC should use, and how FERC should reform its ROE policies to more realistically capture investment risk.