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Zone of Reasonableness

Coping with rising profitability, a decade after restructuring.

Fortnightly Magazine - July 2011

those criteria. Indeed, the one pipeline that made an attempt to apply for the loosened regulation of rates was shot down by the FERC with such finality—on the subject of the inherent market power of pipelines over captive customers—that no other pipeline has tried again. 8 The FERC thus continues to be the judge of just and reasonable rates when shippers and pipelines are unable to find mutually-agreeable solutions. While many pipelines now have an incentive to delay scrutiny of their rates and cost of service for as long as possible, the declining rate base phenomenon makes it important for shippers and the FERC to monitor pipeline profits judiciously to assure that rates and costs don’t unduly diverge.

How does the FERC decide whether to initiate an investigation to determine whether a given pipeline’s rates fall outside the zone of reasonableness? The screen that the FERC uses is the earned return on common equity (ROE), as indicated by the data submitted by pipelines in Forms 2 and 2-A. Because many variables are at play in a detailed rate case review, however, the earned returns implied by Forms 2 and 2-A can only serve as initial indicators of profitability and a signal as to whether a more detailed review of cost and revenue is necessary.

Earned Returns

To assess the ROE for 2010, the rates and cost of service for 68 interstate gas pipelines with gas plant exceeding $200 million were analyzed in a four-step process: 1) Estimate the pipeline’s revenue requirement using traditional cost-of-service ratemaking techniques, excluding ROE and income taxes. The revenue requirement includes standard expense items such as depreciation, operation and maintenance costs, interest, other taxes and administrative and general costs. The pipelines report these directly on Form 2. 9 They also report on Form 2 the asset account balances needed to determine the pipeline’s rate base. 2) Calculate pre-tax net income by subtracting the estimated revenue requirement from actual revenues. 3) Calculate after-tax net income by subtracting income taxes from pre-tax net income, using the pipeline’s composite tax rate. 4) Calculate ROE by dividing after-tax net income by the amount of common equity in rate base.

Because the ROE is highly sensitive to the level of equity permitted in the capital structure, and further because many pipelines that are as subsidiaries of larger holding companies have unusual capital structures by regulatory standards, the ROEs were calculated using both the reported capital structure and under the assumption that the FERC would require that the pipeline set rates based on a hypothetical capital structure containing 50 percent equity 10(See Figures 1 and 2) .

The largest allowed return on equity given by FERC to any pipeline in the last decade is 14 percent. 11 As a result, this screening of pipelines’ ROE suggests that rates of return for many pipelines not yet investigated by FERC may be well outside the zone of reasonableness. That FERC has initiated investigations of only a handful of pipelines is surprising in light of these data. The returns on equity that triggered the five rate