FERC Should Reconsider Its Bias in Favor of Incremental Pricing of Pipeline Expansions

At his first Federal Energy Regulatory Commission (FERC) meeting this past December, Chairman Kevin McIntyre announced the agency will be soliciting comments on whether to revise its 1999 Certificate Policy Statement (CPS), which FERC uses to evaluate applications to build new pipelines or expand existing ones.

Under the CPS, the pipeline must show that the project could proceed without any financial subsidies from its existing customers, causing most pipeline expansions to be priced on an incremental basis. Prior to adoption of the CPS, expansion costs were routinely rolled into existing pipeline rates upon a showing that the project would provide commensurate benefits to both new and existing shippers.

The CPS rejected any preference in favor of rolled-in pricing. Rather, it started from the proposition that to roll-in expansion costs, the pipeline must demonstrate that the project could be built without any subsidies from existing customers. In 2005, FERC clarified that rule by explaining that generally expansion costs can be rolled-in only if expansion revenues exceed costs (and thus permit a future rate decrease for existing shippers). Otherwise, the pipeline must price the expansion on an incremental basis.

This meant that existing shippers would benefit from rate decreases for expansions that lower mainline system costs but not be burdened by rate increases for expansions that could increase such costs. Although beneficial to existing shippers, from the pipeline industry’s point of view, this created a “heads you win, tails I lose” situation.

In response, pipelines turned their focus to expansion projects that could be incrementally priced and to soliciting new entrant partners to co-sponsor increasingly expensive incremental projects.  Newly created utility-affiliated midstream companies began to joint venture on projects with traditional pipeline companies as their utility affiliates separately entering into precedent agreements for project capacity. Since the FERC, under the CPS, looks primarily to precedent agreements as evidence of sufficient need for these projects, this new joint venturing practice by pipelines has led to much public outcry. Environmental groups, affected landowners, and competitors all question the legitimacy of a need showing based on affiliate precedent agreements and urge a broader analysis by FERC of what constitutes project need going forward. But this joint venturing approach is an entirely rational response as pipelines seek to reduce financial risk for incremental projects under the CPS.

The CPS preference for incremental pricing is also fostering an increasing balkanization of pipeline networks -- with new markets and services increasingly made available to only new shippers and with existing customers receiving no benefits from this system growth.

The CPS has also encouraged a marked decline in the transparency of expansion capacity pricing. Under FERC’s negotiated rate policy, the availability of a cost-based recourse rate for a service is intended to mitigate for pipeline market power because shippers can always elect recourse rates in lieu of negotiated rates. In practice, however, most shippers commit to negotiated rates. The negotiated rates are likely to be lower than the projected recourse rates (not surprising since recourse rates typically come with a hefty 14% assumed return on equity). Thus the existence of recourse rate does not mitigate for pipeline market power for these expansions.

Indeed, the negotiation process gives great leverage to the pipeline. Each potential shipper can be kept in the dark as to what rate other shippers are being offered. Negotiated rate precedent agreements are filed with FERC as non-public documents and pipelines have been very successful in keeping the terms of these precedent agreements secret. In most instances, an expansion shipper doesn’t know other shippers’ negotiated rate for the same service until the project is about to go into service and it has entered into a binding service agreement. Then and only then must the pipeline file shipper-specific negotiated rates with the FERC.

It is unclear why this rate secrecy is condoned by FERC and how it is consistent with the agency’s goal of insuring that market participants receive accurate price signals for valuing new gas capacity as compared to other market options.

Another unaddressed issue is how this flight to negotiated rates will impact FERC’s future ability to reset pipeline rates to insure they remain just and reasonable. For example, pipelines are today resisting shipper efforts to have FERC require them to reduce their rates to reflect the recent drop in corporate tax rates effective January 1, 2018 under the Tax Cuts and Jobs Act of 2017. Even if forced by FERC to reduce system recourse rates to account for this change, it is likely that pipelines will maintain that no refunds are due shippers with negotiated rate contracts. One pipeline recently reported that over 95 percent of its capacity is sold under such contracts.

Assuming FERC orders tax-related refunds, with this growing level of negotiated rate contracts, how will FERC insure that now excess pipeline revenues are distributed equitably? More generally, how can FERC exercise its Natural Gas Act Sections 4 and 5  responsibilities to insure just and reasonable and non-discriminatory rates when virtually all capacity is locked up under long-term fixed rate contracts?

These are just a few of the market and regulatory distortions fostered by the current CPS requirement that most expansions be incrementally priced. Reexamining this current requirement – and the resulting biases -- should be an important element for public debate as FERC revisits the CPS later this year.   Stay tuned.