Originally published April 23, 2008
As a follow-up to our April 17, 2008, legal alert regarding the Federal Energy Regulatory Commission's ("the Commission") new policy of allowing the inclusion of master limited partnerships ("MLPs") in proxy groups used to decide the return on equity ("ROE") of natural gas and oil pipeline companies (PL07-2), we provide the following additional details.
In addition to announcing a general policy of allowing MLPs to be included in proxy groups, the Commission decided four related issues that it had considered when developing the Policy Statement: (1) distribution levels for MLPs will not be capped; (2) parties should continue to use forecasts published by the Institutional Brokers Estimate System ("IBES") as the basis for short-term growth; (3) MLPs' equity cost of capital should be adjusted downward 50 percent; and (4) there should be no modification to current two-thirds/one-third weightings of short- and long-term growth factors, respectively.
As we noted in our initial alert, nothing in this Policy Statement requires particular corporations and/or MLPs to be included in proxy groups. Instead, the Commission's Policy Statement provides guidance as to how pipelines should go about including MLPs in proxy groups. In separate orders, the Commission applied the Policy Statement to four rate cases currently under consideration at the Commission: Kern River Gas Transmission Company, Duke Energy Guadalupe Pipeline Inc., High Island Offshore System LLC, and Petal Gas Storage.
Inclusion of MLPs
The Commission quoted heavily from Petal Gas Storage LLC v. FERC, in which the U.S. Court of Appeals for the District of Columbia remanded two Commission orders that had excluded MLPs from proxy groups used to calculate ROE. In Petal Gas, the Court had emphasized that proxy groups must be "risk appropriate" and should result in rates that are commensurate with returns on investments in other enterprises having corresponding risks. The Commission concluded that including MLPs in proxy groups will create a better proxy for rates of return commensurate with companies of similar risk and will encourage investment in infrastructure.
Rather than implementing an entirely new formula for developing proxy groups and calculating ROE, the Commission has elected to incorporate MLPs into the currently used Discounted Cash Flow ("DCF") model. The DCF model, according to the Commission, can accommodate the inclusion of MLPs.
Distribution Levels Not Capped
To redress concerns regarding higher distributions by MLPs that result from MLPs distributing a return of capital in addition to a return on capital, the Commission had considered capping MLP distributions to prevent inclusion of distributions above earnings. However, the Commission concluded that "its concern with the distinction between return on capital and return of capital improperly conflates cost-of-service rate-making techniques with the market-driven DCF method used for determining the pipeline's cost of obtaining capital." In short, the Commission concluded that because investors are concerned with return, whether "on" or "of" equity, the distinction is not relevant to establishing a proper ROE that is commensurate with other enterprises.
IBES Basis for Short-Term Growth
Despite concerns that IBES growth estimates may be less reliable for MLPs, the Commission concluded that the IBES five-year growth forecasts should be used for MLPs. According to the Commission, "the record here demonstrates that it remains the best and most reliable source of growth information available."
The Commission agreed that pipelines generally should select MLPs that are (1) well established and (2) have assets that are predominantly gas and oil pipelines, but the Commission stopped short of requiring all MLPs included in proxy groups to meet the criteria. The Commission concluded that "there may be particular MLPs that do not satisfy these criteria, but are still appropriate for inclusion in the proxy group."
50% Adjustment to Long-Term GDP
The Commission historically has used GDP as a proxy for long-term growth. However, because it believes that the collective long-term growth rate for MLPs will be less than that of corporations, the Commission will require pipelines to adjust the GDP down 50% when projecting long-term growth for MLPs. Corporations will continue to have a long-term growth component equal to the full long-term GDP.
Retention of Weightings
The Commission considered suggestions to adjust the weightings for short- and long-term growth to increase the impact of short-term growth projections. However, it concluded that the record supports the continued use of the current ratio in part because investment houses consider the long-term growth component when evaluating MLPs.
© 2008 Sutherland Asbill & Brennan LLP. All Rights Reserved.
This article is for informational purposes and is not intended to constitute legal advice.