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Frontlines

Fortnightly Magazine - March 1 1998

Northern Border, Vector, Millennium and others. Some projects,

however, may never actually dig or lay steel in the ground.

The Interstate Natural Gas Association describes this need for capital: "These projects are being bundled with unregulated services, or they have negotiated rate contracts, so that the rates of return are in fact market-driven."

"Pipelines are getting riskier," adds Mike Barbis, from Union Bank of Switzerland, which he claims will be the world's largest money manager after an upcoming merger. "The market is not accepting cost-plus regulation for pipelines anymore. They've only performed in line with the market since 1995, and that reflects premium returns on the unregulated side. It's reverse cross-subsidization.

"My guess is that the FERC would not tolerate this if it was in the other direction."

So what should the FERC do? Should it honor the NGA, treat pipelines like a low-risk monopoly, ignore the S&P and assume that returns between 10 and 12 percent should make widows and orphans happy? Or should the FERC admit that the industry is changing and set rate of return high enough to attract capital for new construction, although the legacy projects (em including some older pipeline routes that face capacity turnback (em may actually carry more risk than some newer construction proposals?

Fantasy Land?

To set a regulated return on equity for natural gas pipelines, the FERC faces a big problem. How can regulators test what investors expect and demand of pipeline-specific assets when the corporations themselves have diversified into so many unregulated businesses?

William A. Wise from El Paso Energy notes that in 1997 about 87 percent of pipeline corporation earnings came from actual pipeline assets, but says that figure will fall to 50 to 60 percent by 2000.

Richard Ansaldo, a staffer from the New York Public Service Commission, put his finger on it: "We don't have a market in the companies we're trying to regulate."

Under current rules, the FERC sets rate of return on common equity through a method that nearly defies explanation. For a given pipeline company, the FERC uses a two-step DCF method whereby ROE equals the sum of (1) the company's current dividend yield, plus (2) a figure that marks the midpoint of a range of reasonableness represented by hypothetical cost of capital rates derived for a group of five integrated gas pipelines (Coastal, Enron, Panhandle Energy, Sonat, and Transco), selected as a proxy for the entire pipeline industry.

In turn, those hypothetical capital cost figures represent for each company in the proxy group the sum of (a) the current dividend yield for the proxy company and (b) an average of (i) an estimated short-term (five years) dividend growth rate for the proxy company, derived from the Institutional Brokers Estimate System, and (ii) an estimated long-term dividend growth rate, which is represented by an average of three different 25-year forecasts of the growth rate for the U.S. Gross Domestic Product, as prepared by DRI/McGraw-Hill, Wharton, and the U.S. Energy Information Administration.

Using this formula, the FERC calculated an ROE of 12.59 percent last year for Northwest