Energy infrastructure’s critical path

The Federal Power Act (FPA) and the Natural Gas Act (NGA) have long mandated just and reasonable wholesale gas and electric commodity and transmission rates. In 2005, Congress added a number of important new provisions to the FPA to ensure just and reasonable rates. One of those new provisions gave the Federal Energy Regulatory Commission (FERC) authority over the reliability of the interstate bulk transmission system. Another new provision gave FERC the authority to grant incentive rate treatment to encourage investment in electrical infrastructure.

Under the FPA and NGA, FERC has sought to establish wholesale competitive markets for natural gas and electricity. Robust transmission systems are essential both for reliability for wholesale (and ultimately retail) customers as well as just and reasonable wholesale and retail rates. Natural gas transmission and supply are inextricably linked to properly functioning electricity markets, both in organized and bilateral electricity markets.

The Energy Information Administration (EIA) predicts that natural gas demand will grow from 22 trillion cubic feet (Tcf) to 26.2Tcf in 2030. Likewise, EIA predicts that worldwide electricity consumption levels will double from 2004 to 2030. Moreover, natural gas fired generating units are expected to continue to proliferate and their usage increase through 2020. Additional electric transmission and natural gas transportation facilities are needed to accommodate these increased needs. I believe that infrastructure development in both sectors is critical.

Development of electric transmission

In 1996, the FERC issued Order No. 888, in which the Commission sought to remedy undue discrimination by vertically integrated utilities over interstate transmission facilities by requiring such utilities to functionally unbundle wholesale electric power services and to file open access transmission tariffs. As a result of the open access brought about by Order No. 888 (as well as other FERC initiatives), the nation’s electric utility grid experienced an increase in usage that was unanticipated when the grid was originally constructed. The result has been a severe strain on the nation’s utility grid, which hinders both competition and reliability. Notwithstanding this strain on the grid and that consumers place a high value on the reliable delivery of electricity, net investment in transmission has declined in real terms over the past 20 years. One reason for the decline was investors’ belief that they could have either earned a higher return or invested with greater safety in other endeavors.

Recognizing the harm resulting from a lack of adequate transmission infrastructure, Congress included certain provisions in the Energy Policy Act of 2005 (EPAct 2005) to provide incentives to investors in transmission infrastructure. Specifically, section 1241 of EPAct 2005 added new section 219 to the FPA, directing the FERC to establish incentive-based (including performance-based) rate treatments for new transmission investment. The FERC issued Order No. 679, which set forth processes by which a public utility could seek transmission rate incentives pursuant to section 219.

Order No. 679 provided that a public utility may file a petition for declaratory order or a section 205 rate filing to obtain incentive rate treatment for transmission infrastructure investment that satisfies the requirements of section 219. Order No. 679 established a rebuttable presumption that an investment meets the requirements of section 219 if the applicant demonstrates either that: (i) the transmission project results from a fair and open regional planning process that considers and evaluates projects for reliability and/or congestion and is found to be acceptable to the Commission; or (ii) a project has received construction approval from an appropriate state commission or state siting authority. Order No. 679 also required applicants to show a nexus between the incentive sought and the investment being made to ensure that the incentives are provided to truly worthy projects.
I applaud the Congress’ recognition that transmission underinvestment is a national problem. I continue to advocate that one means to ensure a robust competitive wholesale market is to have adequate infrastructure to accommodate transactions. Nonetheless, the FERC will not issue incentives without an applicant demonstrating that the facilities for which it seeks incentives either ensure reliability or reduce the cost of delivered power by reducing transmission congestion and otherwise meet the requirements in Order No. 679.

Adequate return on natural gas infrastructure

FERC issued Order No. 636, which restructured the natural gas pipeline industry to maximize the benefits flowing from Congressional decontrol of natural gas pricing at the wellhead. Consequently, US natural gas has become a competitive market where gas prices reflect the intersection of supply and demand. Pricing differentials between regions represent the opportunity costs to move gas between market centers. As new supply sources emerge from the Rockies, Barnett Shale, Bossier Sands, Fayetteville Shale and other resources, new infrastructure to move these supplies from the source to the demand center must be built.

During the past year, the Commission has certificated and issued preliminary determinations on several natural gas infrastructure projects that are moving these new supplies. For example, the Rockies Express-West project is transporting gas supply eastward. Similarly, the Commission issued a preliminary determination that Gulf South Pipeline’s infrastructure project moving gas from East Texas to Mississippi should be approved.

Effective regulation of FERC-jurisdictional industries requires a balancing of all competing interests to ensure just and reasonable rates. How does the Commission conduct this balancing act, protect shippers and encourage needed infrastructure? I believe that a recent United States Court of Appeals for the District of Columbia (court) decision may inform my consideration of two contentious issues – the income tax allowance and proxy groups containing Master Limited Partnerships (MLPs). In ExxonMobil, the court approved the Commission’s grant of an income tax allowance to SFPP, LP and MLP. In doing so, the court affirmed the Commission’s ruling that pipelines operating as limited partnerships should be eligible for the income tax allowance to the extent its partners incur actual or potential tax liability on the income they recognize from the partnership. The court observed that the Commission had determined that income taxes incurred by partners on their distributive share of the pipeline’s income are “just as much a cost of acquiring and operating the assets of that entity as if the utility assets were owned by a corporation”. In other words, there was no legitimate reason to restrict the income tax allowance to corporations, given that “both partners and Subchapter C corporations pay income taxes on their first tier income”. Indeed, income taxes accrued with respect to partnership interests are properly attributable to the regulated entity because such taxes must be paid regardless of whether the partners actually receive cash distributions.

The court also endorsed the Commission’s concern that the return to the owners of pass-through entities would be reduced below that of a corporation investing in the same asset if such entities were not afforded an income tax allowance on their public utility income. The Commission had concluded that it would be inequitable to grant a full income tax allowance to corporations while denying a similar allowance to limited partnerships. Indeed, as the court observed, a core ratemaking tenet is that “the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks”.

I note the court’s recognition that an MLP can make a showing based on substantial evidence that it would be inequitable for the Commission to grant a full income tax allowance to a corporation while denying an allowance to a similarly situated limited partnership. Moreover, the court properly found that the Commission reasonably concluded that investors in a limited partnership accrue tax liabilities on their distributive shares of the partnership income, even if they do not receive cash distributions. This supported the Commission’s determination that taxes on the income recognized by a limited partnership should be attributed to the MLP pipeline and included in the regulated entity’s cost-of-service.

Just as the Commission determined that pipelines operating as limited partnerships should receive an income tax allowance in order to maintain parity with pipelines that operate as corporations, I believe that pipelines should be able to make a case based on substantial evidence for including MLPs in their proxy groups in calculating a reasonable return.

In 2006, there were 52 publicly traded MLPs. The majority of oil pipelines and a large number of natural gas interstate pipelines are operated as, or have announced their intention to spin off some or all of their pipeline assets into, MLPs. The proliferation of MLPs in the energy sector has resulted in a paucity of historical proxies for natural gas pipelines, namely, those corporations from which pipeline operations constitute a high proportion of their business. Consequently, the determination of the types of entities to be included in natural gas pipeline proxy groups is an issue the Commission must confront.

In essence, under the existing ratemaking rubric, the Commission must evaluate the best way to equalize after-tax returns for FERC-jurisdictional partnerships and corporations. Based on the court’s reasoning in ExxonMobil, entities may ask the Commission to consider whether the denial of the inclusion of MLPs in a pipeline proxy group is inequitable. Similarly, it will be interesting to determine whether any entity will propose a pretax return on income without an income tax allowance.

The MLP form of business is likely to increase. As these tax efficient entities continue to flourish, I look forward to the Commission’s ratemaking policies evolving as fulsome factual records are developed in future cases.

In summary, I believe that infrastructure development resulting from attractive returns on investments in both the electric and natural gas markets is necessary to facilitate the competitive policies the Commission enacted through Order Nos. 888 and 636.