Unanimous FERC Adopts New Rule Protecting Oil Pipelines From Index Rate Challenges

Originally published for customers October 26, 2022

What’s the issue?

Interstate liquids pipelines (oil pipelines in FERC parlance) are allowed to increase their rates annually based on an index FERC establishes once every five years.

Why does it matter?

Liquids pipeline customers are limited in their ability to challenge these increases. At last week’s open meeting, a unanimous FERC adopted a new rule that will further limit the ability of customers to challenge those rate increases, to the point that one shipper organization claims FERC has essentially eliminated “all stand-alone challenges to index increases.”

What’s our view?

Given the polarized nature of FERC in other areas, it is somewhat surprising, but certainly welcome news to liquids pipelines, that the three Democrats on the Commission joined with the two Republicans to adopt this new rule. Going forward, a pipeline should be able to avoid any challenge to increasing its rates by the indexed amount by carefully managing the costs reported on an annual basis to FERC.

 


 

Interstate liquids pipelines (oil pipelines in FERC parlance) are allowed to increase their rates annually based on an index FERC establishes once every five years. Liquids pipeline customers are limited in their ability to challenge these increases. At last week’s open meeting, a unanimous FERC adopted a new rule that will further limit the ability of customers to challenge those rate increases, to the point that one shipper organization claims FERC has essentially eliminated “all stand-alone challenges to index increases.”

Given the polarized nature of FERC in other areas, it is somewhat surprising, but certainly welcome news to liquids pipelines, that the three Democrats on the Commission joined with the two Republicans to adopt this new rule. Going forward, a pipeline should be able to avoid any challenge to increasing its rates by the indexed amount by carefully managing the costs reported on an annual basis to FERC.

 

Index Rate Changes

As we explained in FERC to Embark on Task of Setting Oil Pipeline Rates Through 2026, FERC regulates the rates of pipelines transporting crude and other liquids in interstate commerce under the Interstate Commerce Act. In response to the Energy Policy Act of 1992, FERC issued Order 561, which created its current methodology for regulating oil pipeline rates. Under that order, once a rate is set, a pipeline may increase its rate annually by the inflation rate reflected in the Producer Price Index for Finished Goods (PPI-FG) for the prior year plus an index that FERC sets every five years. FERC last set the index for the years 2021 through 2026 in a decision (approved with just the votes of Chairman Danly and Commissioner Chatterjee) issued in December 2020 over the scathing dissent of Commissioner Glick. About one year after becoming chairman of the Commission, Chairman Glick revisited that decision. As we discussed in What a Difference a Year Makes – FERC Set to Revisit Oil Pipeline Index Decision, FERC, under Chairman Glick, in a decision that was decidedly in favor of the shippers and not the pipelines, reduced the index for the years 2021 through 2026 from 0.78% to 0.21%.

 

Shippers Versus Pipelines

When pipelines take advantage of this right to annually raise their rates, FERC has always allowed shippers to file a protest (which is filed before the proposed increase takes effect) or complaint (which is filed after the increase takes effect) against the pipeline. Under FERC’s regulations, a shipper may file a protest or complaint against an index rate increase by providing “reasonable grounds” for determining that the index rate increase is “so substantially in excess of the actual cost increases incurred by the carrier that the rate is unjust and unreasonable.” Traditionally, FERC reviewed such protests and complaints by applying a preliminary screen based on data from page 700 in the pipeline’s annual reports. If the screen was satisfied, then FERC would launch an investigation into the rate increase through a formal hearing.

However, FERC used different screens for protests and complaints. When a proposed index rate increase is protested, FERC applied the Percentage Comparison Test which is satisfied if there is more than a 10 percentage-point difference between (1) the index rate increase and (2) the percentage change in the prior two years’ total cost-of-service data reported on page 700, line 9. By contrast, when a complaint against an index rate increase is filed, the Commission had considered “a wider range of factors,” including the Substantially Exacerbate Test, which first looks at whether the pipeline is currently over-recovering its cost of service (first prong) and whether increasing its rates by the index rate would so exceed the actual increase in the pipeline’s actual costs that the resulting rate increase would substantially exacerbate the pipeline’s over-recovery (second prong). The key distinction between these two screens is that the first one does not take into account at all the extent to which the pipeline’s current rates may already allow it to substantially overearn, whereas that is the key first prong in the second test.

Finally, a shipper is always entitled to file a complaint about the overall rates charged by a pipeline, but these so-called base rate challenges, as opposed to the index rate challenges, can take more than a decade to resolve and so are not really viewed by shippers as a sufficient means for challenging an annual index rate increase.

 

Democrats Versus Republicans

In 2016, when Democrats were last in charge of FERC, the Commission issued an advanced notice of proposed rulemaking (ANOPR) that proposed a series of reforms to improve the Commission’s and shippers’ ability to ensure that oil pipeline rates are just and reasonable. According to the Commission, which at that time consisted of only three Democrats, because the predominant mechanism for adjusting oil pipeline rates was the annual index changes, it was essential to ensure such changes in rates did not cause pipeline revenues to unreasonably depart from oil pipeline costs. In a move that was strongly supported by shippers, FERC proposed changes to the page 700 information in each pipeline’s annual report, but more importantly proposed prohibiting a pipeline from increasing its rates by the allowed index, if its page 700 revenues exceeded its page 700 total cost-of-service by 15 percent for both of the prior two years or if the proposed index increase exceeded by 5 percent the annual cost changes reported on the pipeline’s most recently filed page 700.

FERC took no action on this ANOPR for most of the time period during which Republicans controlled FERC. Then in February 2020, FERC formally withdrew the ANOPR and issued a notice of intent to completely eliminate the use of the Substantially Exacerbate Test and use only the Percentage Comparison Test, with the required difference being fixed at 10% for both protests and complaints.

 

Last Week’s Unanimous Decision

It is against this backdrop of proposals that flipped from a decidedly pro-shipper proposal by a Democratic-led Commission in 2016 to the pro-pipeline proposal by a Republican-led Commission in 2020 that we come to last week’s open meeting where FERC was to act on the pro-pipeline proposal put forth by the Republican-led Commission in 2020. Therefore, it was somewhat surprising that in a unanimous decision, the Commission brushed aside all of the concerns of shippers and voted to adopt in total the 2020 proposal. As explained by five shippers who have actively challenged rates, HollyFrontier Refining & Marketing, Southwest Airlines, Valero Marketing and Supply, Chevron Products, and American Airlines, the adoption of the proposed policy would “essentially eliminate all stand-alone challenges to index increases.” Thus, shippers would be forced to rely solely on “base rate complaints that can take ten or more years, and millions of dollars in shipper litigation costs to resolve, while pipelines can largely pass their litigation costs through to shippers in the form of higher rates. This is neither streamlined regulation nor reasoned decisionmaking.”

The biggest objection these major shippers had to solely relying on the Percentage Comparison Test is that it would allow pipelines in the following four categories to increase their rates by the index even though their cost and revenue structures were very different:

Pipeline A is over-recovering its cost of service and has experienced decreasing costs for multiple years;

Pipeline B is over-recovering its cost of service but has experienced increases in costs over the preceding year;

Pipeline C is under-recovering its cost of service and has experienced decreasing costs for multiple years;

Pipeline D is under-recovering its cost of service but has experienced increases in costs over the preceding year.

According to these shippers, if the Commission treats these pipelines alike, Pipeline A may be able to increase its rates in a manner that will likely result in unjust and unreasonable rates. “Reasoned decisionmaking requires that the Commission consider the facts and circumstances of each case rather than apply a cookie cutter approach that amounts to an automatic approval of all but the potentially most egregious index rate increases.”

 

How Do Pipelines Stack-Up?

Clearly the key factors cited in the above example by shippers is whether a pipeline's costs are increasing or decreasing and whether it is currently over or under earning. Based on the reports filed by all of the pipelines for 2020 and 2021, we have aligned those with 2021 revenue greater than $25 million based on these two factors of cost increase and revenues as a percentage of costs.

 

2021 Pipeline revenue as a percent of cost

 

The pipelines reflected in the upper right hand corner reported income greater than their cost of service for 2021, while at the same time reporting a decrease in their cost of service. As seen above, there are just a handful of pipelines reporting that their revenues exceeded their cost of service by at least 25% while at the same time reporting a decrease in their costs of over 10%. If that pattern were to hold for 2022, those pipelines may not be able to take advantage of the index rate increases next year without risking a challenge.

 

Path Forward

Given the wholesale rejection of the views of shippers in FERC’s final decision, we fully expect that the shippers will not go quietly. They have until November 21 to seek rehearing and then can file an appeal on December 21 if FERC fails to take action by then on the rehearing request. We fully expect that they will do so and that the pipelines cannot yet rest.

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