FERC Opens Door to Changes in Cost of Equity Model

In its October 19, 2006 decision in Kern River Gas Transmission Company (FERC Docket No. RP04-274-000) the Federal Energy Regulatory Commission (“FERC”) signaled its willingness to entertain changes to its traditional method of setting equity returns for natural gas pipelines. According to one Commissioner, the Kern River decision will serve as the “roadmap” for pipeline rate cases for the “foreseeable future.”

FERC’s decision rejects the Presiding Judge’s recommended 9.34% return on equity for Kern River, and instead awards the pipeline an 11.2% equity return. Certain Commissioners publicly noted that the Presiding Judge had “done nothing wrong” in reaching her recommended equity return and, in fact, had followed Commission precedent in reaching her decision. At the same time, in reversing the Initial Decision and increasing Kern River’s return on equity, FERC recognized the increasing difficulty in applying its traditional discounted cash flow (“DCF”) method to determining pipeline equity returns.

Fundamentally, the publicly traded “proxy group” of interstate gas pipelines that underlies the DCF analysis has continued to shrink over time due to industry consolidation. In addition, many pipelines are now owned by multifaceted energy companies that derive a substantial portion of their revenues from non-pipeline assets. In response, litigants have proposed expanded proxy groups that include pipelines structured as Master Limited Partnerships (“MLPs”) or energy companies that derive substantial revenues from regulated monopoly utility assets. Each of these alternative approaches were considered and rejected by the Commission in Kern River.

At the same time, however, FERC did not reject the use of MLPs per se, but rather reasoned only that Kern River had failed to justify their use in this case. In fact, FERC stated that it did not intend to foreclose future proposals to include MLPs in the DCF proxy group. Because FERC’s concern with MLPs stems from perceived differences between MLP cash distributions and more traditional corporate dividends, future cases will now likely feature various proposed “adjustments” intended to make MLP distributions look more like corporate dividends for DCF purposes.

In addition, FERC also signaled a willingness to consider future proxy groups composed of entities that hold significant utility assets. Again, while FERC declined to take this step on the record before it in Kern River, it recognized the potential need to revisit the matter if electric and gas utilities continue to combine, thereby increasing the likelihood that parties in future cases will continue to propose utility-dominated entities as part of their DCF proxy groups.