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Zone of Reasonableness

Coping with rising profitability, a decade after restructuring.

Fortnightly Magazine - July 2011

investigations all exceeded 20 percent—averaging 26 percent, almost double the FERC’s largest recent granted ROE.

As Figure 2 indicates, a limited number of pipelines have achieved very low levels of return—in some cases negative. This phenomenon is partly the result of negotiated rates that levelize pricing for shippers, and back-load the return to equity investors. FERC’s 1996 policy statement on pipeline pricing encouraged the use of negotiated rates, and levelized ratemaking has been accepted by FERC for a number of pipelines.

It’s only fair to judge any such presentation of ROEs against the underlying risk to which such equity is applied, which is how the capital markets evaluate the adequacy of returns. Equity investments are by nature contingent claims; equity investors receive returns from their investments only after debt holders have received their contractual interest payments. Capital structures employing high levels of debt subject equity investors to more financial risk than capital structures with less debt. All other things being equal, high levels of financial risk increase the required rate of return for equity investors. The FERC recognizes this fact when exercising its ratemaking authority. For example, the FERC has repeatedly granted a 14 percent rate of return on equity for “greenfield” pipelines whose equity investors not only face development risk, but also significant financial risk— e.g., with debt comprising 70 percent of committed capital—while granting lower rates of return for pipelines with less debt leverage. To evaluate whether a given return on equity is excessive, one must consider not only the business risks that equity investors confront, but also the financial risk. Capital structure is therefore a pivotal variable in assessing whether the current profits accruing to equity investors lie within a zone of reasonableness.

The FERC’s policy on capital structure is to try to rely on actual verifiable data: that is, on a pipeline’s actual capital structure when the pipeline raises its capital directly or otherwise on the parent company’s capital structure. The FERC will only turn to a hypothetical capital structure if it deems that the level of equity is unreasonably high, particularly with reference to observed capital structures in a group of stand-alone pipelines that it concludes are comparable to the pipeline in question. 12 Thus on numerous occasions the commission rejected high equity ratios proposed by a pipeline and assumed a reasonable use of debt capital. 13

Why Returns Increase

Although declining rate base goes far in explaining many pipelines’ steadily increased returns, natural gas market dynamics have also helped their financial results to remain strong. In 2010, domestic natural gas production and consumption reached record levels. These records reflect a long-term trend of strong growth in natural gas demand that began in the mid-1980s. Since then, natural gas has become the fuel of choice for much of the nation’s new electricity generation. Further, natural gas demand for residential, commercial and industrial uses has also grown. In the United States, gas-on-gas competition—that is, competition among different sources of gas including traditional gas sources, shale gas and LNG—has kept prices down, while prices for other hydrocarbons have