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Zone of Reasonableness

Coping with rising profitability, a decade after restructuring.

Fortnightly Magazine - July 2011

During the past three years, the Federal Energy Regulatory Commission (the FERC) has initiated five investigations into the justness and reasonableness of interstate gas pipeline rates. 1 Under the Natural Gas Act of 1938 (the NGA), the FERC has a statutory obligation to assure that such pipelines rates are just and reasonable. Case precedent makes clear that no single just and reasonable rate exists for a given pipeline at a given time; instead, for rates to meet the just and reasonable standard, they must remain within a zone of reasonableness. In judicial review of its decisions, the courts have held the FERC to an end result within that zone. 2 The FERC initiated the examination of these five pipelines’ rates precisely because their Form 2 financial data appeared to indicate excessive profitability falling outside that zone.

For interstate gas pipelines, the passage of time can lead to rates that exceed the cost of service because traditional ratemaking is front-loaded by the nature of straight-line depreciation of pipeline investments. Such is particularly true for gas pipelines since the FERC invoked the standard of “incremental” pricing for new capacity additions, which effectively segregates the cost of service for new projects from the pipeline property that supports existing shipper capacity entitlements. 3 Without the need to invest in new pipeline equipment to support existing capacity contracts, the passage of time will drive down the rate base supporting existing contracts through depreciation. This in turn lowers the financing charges associated with carrying the rate base, and therefore lowers the cost of service. 4 Traditional ratemaking, however, requires that rates stay constant in dollar terms until the next rate case. In the period before the restructuring of pipeline regulation was completed in about 2000, the FERC required pipelines to file periodic NGA Section 4 rate cases to assure that rates didn’t stray too far from the cost of service. With the implementation of open access, incremental pricing and competitive gas transport culminating in Order Nos. 636 5 and 637, 6 however, FERC eliminated the ongoing requirement for pipelines to file regular Section 4 rate cases.

The elimination of periodic rate cases places a greater burden on shippers to monitor the rates they pay (under their capacity contracts) and on the FERC itself to screen pipeline returns and to identify excessive returns. While the FERC may have hoped that its competition-friendly policies, which include allowing pipelines to adopt alternative ratemaking practices and to negotiate rates with their customers, 7 would allow shippers and the pipeline to find a set of mutually-agreeable rates and limit the need for litigated proceedings, FERC’s oversight responsibilities are as important today as they ever have been. Although FERC’s 1996 policy statement did envision that some pipelines would be able to meet the criteria for market-based rates, no pipeline to date has been able to meet

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