Abrupt regulatory changes crimping pipelines
America’s regulated pipelines are a marvel not just of engineering but also financial innovation. Their origins date back a century to a debate on how best to finance critical infrastructure. Power utilities and pipelines were built by private capital attracted to “just and reasonable” investment returns in exchange for constrained competition. After all, it makes little sense to build multiple pipelines or wires along the exact same route. In contrast, highways and water systems were owned and financed by governments.
Today, while crumbling civil infrastructure struggles to get desperately needed funding, state-regulated utilities continue to attract capital for expansion and modernization thanks to healthy valuations close to all-time highs that make capital costs competitive. Yet equally critical natural gas pipelines regulated by the Federal Energy Regulatory Commission have been left in the cold with valuations reminiscent of the financial crisis despite steadily rising earnings. Why?
The self-inflicted hangover after the boom in master limited partnerships is one reason. But so is this year’s reduction to the corporate tax rate and FERC’s response to it. This threatens jarring changes to the delicate balance of regulation and market competition that has defined the pipeline sector since the early 1990s.
It was then that FERC Order 636 ushered in the transition from a monopoly “cost-of-service” approach on price setting to one that also relies on market forces. This reflected the pipeline industry’s transition from a handful of point-to-point routes to an increasingly competitive network providing shippers with greater choice and flexibility. Long-term contracts underpinned the stable cash flows investors wanted, supporting ready access to affordable capital. Today, we estimate nearly two-thirds of all U.S. natural gas is shipped under terms and prices negotiated between pipeline and shipper with FERC adopting more of a light-handed regulatory stance.
This successful balance of competition and regulation is now being upset by an apparent rush to translate the lower corporate tax rate into rebates. Beginning in October, all gas pipelines were compelled to file a newly developed form that applies a lower tax rate to financial data that the FERC already has on file anyway. This is used to recalculate new indicated equity returns. Bizarrely, the result is then compared to an allowed return on equity determined in a single proceeding litigated more than eight years ago.
This process creates a biased expectation of automatic rate reductions, ignoring all other commercial considerations negotiated in pipeline settlements. The resulting single issue, one-size-fits-all rate review threatens to tear up the myriad arms-length agreements between parties who are well-informed about costs, returns on capital and competitive alternatives. Besides contravening well-established procedure, this follows on the heels of another FERC action in March that sent shockwaves through the sector by ending income-tax recovery for partnership-owned pipelines. Nearly $30 billion of market value was wiped out in the process.
My firm, Energy Income Partners, manages about $6 billion as of September 2018, and has invested in pipeline companies and utilities for more than fifteen years. Since 2003, we have invested our clients’ capital in these businesses because they offer an attractive total return made up of an above-average dividend yield and modest underlying growth. Our investors are concerned about these abrupt changes in the regulatory landscape, and some are divesting their pipeline holdings.
Why would FERC undermine its own well-functioning market? There was likely pressure to take action as many state public utility commissions moved to quickly reduce rates to pass on the corporate tax savings to consumers. That is an understandable reaction. But state-regulated utilities are true monopolies with no competition, selling their services not to other businesses but to the public. They therefore operate under strict cost-of-service ratemaking. Natural gas pipelines operate in a much more competitive and nuanced market.
Today, many of the utilities in our portfolio are leading the transition away from coal toward cleaner natural gas and renewable energy. Continued progress requires huge investment in utility and pipeline infrastructure, access to low-cost capital to fund it, and greater coordination between electric utilities that purchase natural gas and the interstate pipelines that transport it.
Natural gas demand is becoming more dynamic as it acts as a shock absorber for intermittent wind and solar resources, and market-based negotiation offers the most efficient way to provide real-time flexibility while preserving reliability. These varied needs can’t be captured in the single metric of allowed return on equity and are why FERC has encouraged shippers and pipelines to work these details out through business-to-business negotiation. Pipeline competition has also encouraged efficiency by drawing distinctions between operators. So while a 50-cent tariff may result in a 10 percent return on equity for an inefficient, capital-heavy pipeline, a 35-cent tariff may produce a 15 percent return on equity for an efficient operator. Is it right to punish the latter?
In our view, FERC has been a balanced and thoughtful regulator, nurturing discipline and performance in the companies it oversees. Order 636 in 1992 was visionary, but natural gas supply, flow and end-use have become more complex in the 26 years since then. As investors, we would encourage FERC to resist political pressure and avoid a retreat to litigated cost-plus ratemaking that rewards sheer spending over efficiency. Otherwise, the current course seems destined to penalize not just pipelines for their success, but ultimately investors and the consumers seeking affordable and clean energy as well.
Jim Murchie is co-founder and CEO of Energy Income Partners.