What’s the issue?
The market for pipeline capacity is facing a dramatic change in the coming decade as contracts expire from the great buildout of capacity over the prior decade and yet gas remains a key fuel to buffer the intermittency of renewable power.
Why does it matter?
The days of growth through simply increasing the amount of pipe a company can put in the ground may be waning, but the need for that existing pipe may actually be increasing. As a result, the pipeline industry may want to consider encouraging FERC to adopt a form of incentive-based rates that would better align the interests of the public, shippers and investors for companies that perform better in terms of cost, reliability, safety and environmental impact.
What’s our view?
Incentive-based rates are often viewed negatively because they can upset the “expectations” of the markets. However, a well-crafted system, and one supported by the incumbent companies, could allow for a return to those companies that are already embracing the energy evolution by rewarding them for the actions they intend to take for other reasons.
The market for pipeline capacity is facing a dramatic change in the coming decade as contracts expire from the great buildout of capacity over the prior decade, and yet gas remains a key fuel to buffer the intermittency of renewable power. The days when a pipeline’s revenue could grow through very large greenfield projects appear to be waning, but the need for that existing pipe may actually be increasing. In recent comments filed with FERC, the private investment firm Energy Income Partners, LLC (EIP) strongly recommended that FERC consider revising its current return on equity (ROE) methodology from one that incentivizes new investment to one that incentives better use of the existing infrastructure.
Incentive-based rates are often viewed negatively because they can upset the “expectations” of the markets. However, EIP argues that a well-crafted system could better align the interests of the public, shippers and investors by rewarding those companies that perform better in terms of cost, reliability, safety and environmental impact. As we discuss below, we believe EIP has correctly noted the changing dynamics of the market for gas pipeline capacity. Therefore, incumbent companies may decide to support a change to FERC’s ROE methodology. EIP’s recommendations could especially benefit companies that already intend to improve their performance in these key areas for other reasons.
In 2020, electric production was the number one use for natural gas in the U.S.
As seen above, 38% of the natural gas used in this country is for electric generation. But as we discussed in International Energy Agency Lays a Path to Net Zero, the International Energy Agency has called for the retirement by 2040 of all gas-fired power plants that do not include carbon capture and storage. This would result in a substantial decrease in the need for pipeline capacity in the decade beginning in 2030. However, there is also a change coming in this decade driven primarily by the huge buildup of pipeline capacity that occurred between 2010 and 2020. Many of those projects were underwritten by exploration and production companies to ensure an outlet for their production. But a large portion of those contracts will be expiring between now and 2030.
As seen above, the top twelve producers and their affiliates currently hold pipeline contracts totalling over 40 Bcf/day of capacity on pipelines around the country. But over half of those contracts are set to expire by the end of this decade, and over one-third expire by the end of 2024. While many of these contracts will be renewed, the rate charged will almost certainly be lower than that currently being charged, and many of those contracts may switch from being held by the producer to various end-users of gas.
While the Energy Information Administration shows a steady increase in natural gas consumption between now and 2050, the calls for addressing climate change, such as by the IEA, may significantly impact those projections. What seems certain is that under the current environment at FERC, the days of capturing revenue growth by building large greenfield projects are likely over, particularly if a Democrat wins the presidency in 2024.
In The Future of Pipeline Projects at FERC -- Reading Between the Lines, we discussed the range of comments made by parties in response to FERC’s call for comments on its certificate policy statement. One set of comments filed by the Environmental Defense Fund was a bit more interesting than those filed by other environmental groups because it included “testimony” from EIP. It is unusual for private investment firms and environmental groups to work together.
As EIP explains, while the era of large greenfield projects may have waned, “the industry’s need to access capital on favorable economic terms has not.” That statement alone is probably sacrilege to every other environmental group, who generally want there to be no more capital made available to the fossil fuel industry. But as EIP properly explains, ongoing investment is “needed to address safety and reliability and to address issues such as fugitive methane emissions. A regulatory regime that lowers the cost of financing this capital benefits consumers who ultimately bear the cost of these needed investments.”
But the EIP proposal goes further and recommends that FERC adopt a policy that would allow for a higher ROE for pipelines that “perform better in terms of cost, reliability, safety and environmental impact.” Given the new demands being placed on pipelines by state-level initiatives, rapid growth of renewable and natural gas generation (and the attendant need for increased coordination), as well as the growing demand for reduced environmental impact, EIP asks FERC to adopt a “more flexible approach to incentivizing energy delivery solutions other than simply putting more steel in the ground.”
Any changes to the ROE policies by a regulator are often viewed with trepidation by the industry being regulated, as such changes can impact investor expectations and potentially harm overall returns. In addition, regulators often use such flexible policies as a way to punish perceived bad behavior by the regulated entities. The most recent example of this was a decision by the Connecticut Public Utilities Regulatory Authority to impose indefinite “decreases” in the ROE that can be earned by Connecticut Light & Power (dba Eversource Energy) and United Illuminating Company for their perceived poor performance in anticipating and responding to a storm.
While it is understandable that regulated entities would like to avoid such negative ROE decisions, the proposal by EIP is different in that it accepts the concept of there being a base ROE to which every regulated company is entitled, but suggests that the ROE be set at a higher rate to incentivize behaviors that the regulator desires. One key behavior discussed by EIP would address the change in contract capacity that could occur in the coming decade. The suggestion is that the ROE for a pipeline should be higher if it better utilizes existing assets rather than building new pipelines. Increasing utilization could be particularly relevant for ensuring that gas-fired electric generators are provided the type of services they need to counter the intermittency of renewable sources of electricity, which we recently discussed in Will the Texas Outages Lead to Demands for Enhanced Services from Pipelines?
Given how many comments were filed in response to its request for comments on its certificate policy statement, we do not expect the EIP proposal to be adopted as part of that process. However, it may be something the industry needs to consider and raise with FERC in future rate cases as a way to receive compensation for efforts they are already making in such areas as reliability, safety and environmental impact. For instance, Williams has already pledged to achieve a “56% absolute reduction from 2005 levels in company-wide greenhouse gas (GHG) emissions by 2030,” and Tellurian’s Driftwood pipeline recently filed a certificate application for an expansion that would utilize “electric-driven compression in order to reduce the Project’s long term emissions by approximately 99.3 percent as compared to utilizing gas-fired turbines.”
While actions like these were not taken to obtain a higher ROE, allowing a higher ROE for companies taking such measures would, as EIP argues, better align the pipeline’s “financial motivations with delivering value to customers and society.”