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Zone of Reasonableness

Coping with rising profitability, a decade after restructuring.

Fortnightly Magazine - July 2011

risen considerably. The favorable market dynamics in natural gas have allowed most pipelines to remain fully-subscribed (with capacity contracts) and to maintain high utilization factors. 14 Of course, regional differences in the supply-demand balance, additions of new pipeline capacity, and storage additions naturally lead some pipelines to fare better than others.

Pipeline investors believe the strong growth in natural gas supply and demand will continue. Consequently, they have begun a wave of new pipeline construction across the country. A recent industry report by the Department of Energy’s Energy Information Administration explains the growth trend:

Favorable market and regulatory conditions explain why many pipeline investors are doing so well in spite of the economic downturn and lower overall interest rate environment. In such an investment environment, reliable gas pipeline rate base is a highly attractive asset—particularly if ROEs automatically trend upward over time without attention from the FERC or the groups holding the bulk of capacity contracts (gas utilities or power plants).

FERC Remedies

Under NGA Section 5, the FERC can initiate an investigation of pipeline rates on its own motion or “upon complaint of any State, municipality, State commission, or gas distributing company.” 16 However, there are significant limitations under Section 5 of the Natural Gas Act that significantly limit its effectiveness in remedying unjust and unreasonable pipeline rates.

A Section 5 proceeding is very different than the typical rate increase case that a pipeline files under Section 4. The most critical difference is that any rate reduction under Section 5 will take place prospectively only, either upon the date of a FERC decision of the appropriate rate or a FERC order approving a negotiated settlement rate. A Section 4 proceeding, by contrast, automatically adopts the newly-filed pipeline rates no later than five months after filing, with a refund (one way or the other) once the FERC makes its final determination.

Because of the limitations of Section 5, pipelines have inherent financial incentives to delay resolutions of Section 5 proceedings—and corresponding disincentives to settle cases. While there may be costs the pipeline incurs in litigation, they are typically much more than offset by reduced rates made effective sooner than in a fully-litigated case. A related effect is that any rates agreed on in settlement of a Section 5 investigation generally include a premium to the pipeline as an inducement to allow a reduction in rates to take effect sooner than would otherwise occur.

Other than the existing asymmetry with respect to ratemaking relief, there’s one other important difference between Section 5 and Section 4 proceedings. By regulation and precedent, rates in a Section 4 proceeding are determined based on costs incurred and revenues received during a defined 12-month test period. In contrast, there are no regulations, nor any reliable precedents, defining the specific cost period to be used to determine the appropriate rates in a Section 5 proceeding. The FERC at the outset of a Section 5 proceeding typically requires a pipeline to file a cost and revenue study using the most recent 12-month period for which data is available. However, the