On October 16, 2018, the Federal Energy Regulatory Commission (FERC) issued an order in the Coakley v. Bangor Hydro-Electric Company proceeding that could have important implications for determinations of FERC-regulated pipelines’ rates of return on equity (ROEs) in pending and future rate proceedings.
Though the order addresses complaints that challenge electric utilities’ ROEs, it announces a significant change in FERC’s ROE methodology that departs dramatically from the FERC’s long-time, exclusive reliance on the Discounted Cash Flow (DCF) model. This change could have implications for pipelines also, since FERC previously adopted for electric utilities the same two-step DCF model that it long has used for pipelines.
Should the new methodology apply to pipelines, the most important part of the order is FERC’s description of how it will establish a new ROE, which FERC potentially could use in rate proceedings under the Natural Gas Act and Interstate Commerce Act. The October 16, 2018 order states that FERC will use three financial models that produce zones of reasonableness—the DCF, a capital-asset pricing model analysis (CAPM), and an expected earnings analysis (Expected Earnings)—to establish “a composite zone of reasonableness” based on equal weighting of the three models. FERC will then determine a new, just and reasonable ROE by dividing the zone of reasonableness into quartiles based on the midpoint/median of the lower half of the zone, the entire range of returns, and the upper half of the zone. Those points will be the default ROE values for an entity of less than average risk (relative to the proxy group entities), of average risk, and of greater than average risk, respectively.
The order further explains that FERC will continue to apply its usual criteria for selection of proxy groups, and those criteria will apply equally to selecting proxy groups for the DCF, CAPM, and Expected Earnings models. Screening for low-end outliers is unchanged; however, FERC announced a new screen for high-end outliers (a high-end screen previously was deemed unnecessary under the two-stage DCF model because the long-term growth factor mitigated all DCF results). The new high-end screen will eliminate any potential proxy company whose estimated cost of equity under any of the three pertinent models exceeds by more than 150% the median cost of equity of the proposed proxy group before application of the low-end and high-end outlier screens. Whether this part of the new framework could feasibly be applied to pipelines seems highly questionable, since there are so few eligible proxies in the pipeline industry.
Because this order substantially revises FERC’s ROE determination methodology, FERC can lawfully apply the new approach to pending cases only after providing the parties an opportunity to submit additional evidence and argument. Accordingly, the order establishes a paper hearing process, under which initial briefs and any new, supporting evidence (in the form of affidavits) must be filed within sixty days, and reply briefs must be submitted within thirty days thereafter.
FERC’s ultimate ruling in the affected dockets may provide more details about its new ROE framework. In the meantime, jurisdictional pipelines will keep an eye on FERC’s orders for any suggestions that it intends to apply the new framework to them. The next FERC order instituting a rate investigation, whether based on FERC Form 2 or a 501-G filing, may provide guidance on whether and how FERC plans to adopt this new approach for pipelines.
A copy of FERC's order is available here.
For more information, please contact Michael Thompson (firstname.lastname@example.org) or Ryan Collins (email@example.com).