What’s the issue?
Last week at its open meeting, FERC finally issued an order in the rate case involving Panhandle Eastern Pipe Line which had been pending since 2019 and which had been awaiting a Commission decision for eighteen months.
Why does it matter?
While the outcome of the case is clearly important for the pipeline and its shippers, it will also impact the entire industry because FERC uses the ROE from the last fully litigated case for various other purposes.
What’s our view?
The previous fully litigated case was one involving El Paso Natural Gas Pipeline from 2011, which resulted in a 10.55% ROE. Thus, even though the FERC decision reduced the ROE proposed by the administrative law judge to 11.25%, the ruling will be important for the entire industry for perhaps another ten years as it essentially raised the ROE floor by seventy basis points.
Last week at its open meeting, FERC finally issued an order in the rate case involving Panhandle Eastern Pipe Line (Panhandle) which had been pending since 2019 and which had been awaiting a Commission decision for eighteen months. While the outcome of the case is clearly important for the pipeline and its shippers, it will also impact the entire industry because FERC uses the ROE from the last fully litigated case for various other purposes.
The previous fully litigated case, filed in 2011, involved El Paso Natural Gas Pipeline and resulted in a 10.55% ROE. Thus, even though the FERC decision reduced the ROE proposed by the administrative law judge to 11.25%, the ruling will be important for the entire industry for perhaps another ten years as it essentially raised the ROE floor by seventy basis points.
Following passage of the Tax Cuts and Jobs Act at the end of 2017, FERC initiated the Form 501G process that required all pipelines to file a report showing how their return on equity was impacted by the reduction in the corporate tax rate. On October 11, 2018, Panhandle filed its form and, like most pipelines, asserted that no change in its tariff rates were required. FERC apparently disagreed and so on January 16, 2019 it instituted a Section 5 proceeding to investigate Panhandle’s rates. FERC also subsequently commenced a Section 5 proceeding concerning the rates of a Panhandle affiliate, Southwest Gas Storage Company. Relying on the old maxim that the best defense is a good offense, Panhandle responded to the Section 5 investigation by filing a rate case under Section 4 of the Natural Gas Act to increase its rates. FERC suspended the proposed increases for the full five months, but they were put into effect on March 1, 2020, subject to refund.
Panhandle’s use of a Section 4 proceeding in response to the Section 5 proceeding was not the only aggressive tactic it has used in the proceeding. As in most cases, a key component of determining the pipeline’s total cost of service is establishing an appropriate return on equity (ROE) that the pipeline is entitled to earn on its investment in the assets. As we discussed previously in Even Adverse Decision in Panhandle Eastern Rate Case May be Favorable for Industry, the difference between FERC’s expert and Panhandle’s expert has narrowed because FERC staff implemented a revised Commission policy that required the use of both the capital asset pricing model and the traditional discounted cash flow method and averaging the two results. As a result, FERC staff raised its calculation of the allowed ROE from 11.14% to 12.01%. However, Panhandle maintained the appropriate ROE should be its expert-supported 14.67%. But Panhandle did not rest on that assertion and also launched a personal attack against the FERC staff witness -- Panhandle filed to have his entire testimony stricken from the proceeding because it alleged he had made false statements under oath, plagiarized the work of others and claimed that the work of other witnesses was his own.
On March 26, 2021, following a full hearing on all issues, the appointed administrative law judge (ALJ) issued an initial decision in the case, finding that Panhandle’s proposed rates, which it has been collecting from shippers since March 1, 2020, were not justified. With respect to the issue of an appropriate ROE, the ALJ determined that Panhandle’s proposed ROE of 14.67% was excessive and fixed the ROE at only 11.43%. While the ALJ found the FERC staff witness’s calculation to be the most compliant with Commission policy, the ALJ believed that the witness had included two companies in the proxy group that should have been excluded. Excluding those two companies from the analysis reduced the overall ROE from the 12.01% recommended by staff to the 11.43% in the ALJ’s decision.
The movement over the course of the proceeding is perhaps best shown by simply looking at the total cost of service for the pipeline as calculated by FERC staff and Panhandle over the course of the proceeding and as determined by the ALJ in the initial decision.
While the issues presented in a fully litigated rate proceeding can be complex, it was surprising that it took FERC over eighteen months to issue its order in this case. At all times since the ALJ issued the initial decision, FERC had five members and the ultimate decision issued yesterday was not all that surprising, so it is not readily apparent what took FERC so long. FERC’s decision does not provide a final calculation of the pipeline’s total cost of service, but leaves that to a filing to be made by Panhandle, but we expect the costs to go down from the ALJ’s calculation based on some of the key topics we discuss below.
FERC accepted most of the ALJ’s initial decision and discussed a number of significant issues that pipeline companies will need to review in detail, and which are certainly beyond the level of detail we can provide here. But there were some key components of the decision that will have ramifications for the industry as a whole.
First, FERC addressed a key question about accumulated deferred income taxes (ADIT), which is a pretty arcane area of the rate setting process. However, the issue the decision addressed is one that may come up again. At the time the Tax Cuts and Jobs Act was passed in late 2017, Panhandle was owned by a corporate entity. Therefore, the passage of that act required Panhandle to divide its ADIT into two buckets, the part that would continue under the reduced tax rates and the excess ADIT (EDIT) associated with the reduction in the corporate tax rates. This is fairly standard and we know what to do with both portions had Panhandle continued to be owned by a corporation. But on July 1, 2019, Panhandle’s corporate parent contributed the company to a master limited partnership (MLP). Under the ALJ’s initial decision this contribution to an MLP wiped out both Panhandle’s ADIT and EDIT because, as the subsidiary of an MLP, it is no longer entitled to a tax allowance in its rates. FERC disagreed with this decision by the ALJ and determined that the contribution to an MLP only eliminated the ADIT, but not the EDIT and that the EDIT must be passed back to shippers in the form of a credit against the company’s cost of service. Thus, the Commission has seemingly partially eliminated a benefit of dipping a pipeline through an MLP to purge it of all of its ADIT and EDIT. The contribution to an MLP will now only eliminate the ADIT, but not the EDIT. The change on this one issue is expected to reduce the overall cost of service by more than $10 million.
As is typical in most rate cases, the key fight with regard to calculating the appropriate ROE was a battle of the experts over which companies should be included in the proxy group used to calculate the return the market is demanding from companies like the pipeline. As stated in the order, all participants agreed that TC Energy and Williams should be included in the proxy group. But the Commission’s viewpoint on the remaining proposed members of the group, which included TC Pipelines, Kinder Morgan, Dominion, National Fuel, and Enbridge, was slightly different from the ALJ’s decision. FERC determined that the appropriate proxy group would be TC Energy, National Fuel, Williams, Kinder Morgan, and Enbridge. The changes to the proxy group reduced the overall ROE approved from the 11.43% recommended by the ALJ to 11.25%. This will also lead to a reduction in the overall cost of service as proposed by the ALJ.
One significant upside both for Panhandle and the industry as a whole is that FERC overruled the ALJ’s use of a 40-year useful life for Panhandle’s assets and accepted Panhandle’s assertion of a 35-year useful life based on the fact that the Energy Information Administration shows strong demand for gas only through 2050 and therefore any longer useful life was not supported by the record evidence. This will increase the overall cost of service, but other changes that FERC ordered in calculating the rate base to be used makes it difficult to determine the dollar impact of this change, but it may be enough to counteract most or all of the cost decreases discussed previously.
The FERC order does not fix the rates for Panhandle, but requires Panhandle to file, within thirty days, a compliance filing consistent with the findings in the order and, within 60 days, pro forma recalculated rates, including work papers in electronic format. Because Panhandle is subject to FERC regulations, revenues collected during the pendency of a rate proceeding must be refunded to the extent they exceed the final rates. Panhandle’s annual report for 2021 shows that at the end of that year it had a reserve for such potential refunds equal to $57.4 million.
While the FERC order reduced the ROE as calculated by the ALJ, the 11.25% in the order is still higher than the last litigated ROE of 10.55% ROE from the El Paso Natural Gas Pipeline case from 2011. Because FERC uses the last litigated ROE for purposes beyond the particular case in which it was set, this increase of 70 basis points may help others in the industry.
First, it may reduce the risk of future Section 5 proceedings. We have noted before that FERC will typically not launch a Section 5 proceeding unless it determines that the pipeline’s ROE is above about 16%, or approximately 150% of the 10.55% ROE established in El Paso. If that same ratio is applied to the 11.25% in this case, that would mean that the Section 5 threshold may go up to around 17%.
Second, FERC uses the last litigated rate case ROE to fix the rate that a new pipeline can recover on assets that it acquires from an existing pipeline. This may improve the return for transfers of assets from one regulated company to another, such as the transfer of Ruby Pipeline to Tallgrass that was announced just last week.
Third, FERC also applies the most recently litigated ROE to expansions on existing pipelines but typically allows a 14% ROE for new pipelines. The increase in the last litigated rate would reduce the disparity between these rates, perhaps encouraging existing pipelines to undertake expansions rather than forming a new company.
For those of you with a keen interest in rate cases, we’ve recently filmed an in-depth discussion examining the topic with our friends at East Daley Analytics, and expect the video to be available in January.