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Shale Gas and Pipeline Risk

Earnings erosion in a more competitive world.
April 2012

market value of their assets will become more sensitive to the business cycle. That means they will have a higher cost of capital. It also means they will have a lesser probability of earning it on average, absent appropriate actions by regulators.

Avoiding a Premium

Asymmetric risks pose special challenges to regulators and regulated companies alike.

First, ratemaking flexibility will be vital if investors are to have a fair opportunity to earn a fair return of and on their investments. Longstanding ratemaking practices might need revision. For example, the burden of cost recovery might need to shift, so that the markets facing more competition remain viable and able to contribute to overall cost recovery, even if that means increases in rates for the markets facing less competition.

Second, an increase in the allowed return to compensate for the new risk level will be necessary, but this isn’t a sufficient response by itself, for two reasons. The pipeline’s cost of capital might well depend on how flexible regulators are in responding to the competitive threats. And if regulators aren’t or can’t be sufficiently flexible to eliminate or materially mitigate the asymmetry, calculation of the correct asymmetry risk premium to add to the cost of capital is an extremely difficult task.

One problem in calculating the correct asymmetry risk premium is that each pipeline’s risks will be unique. Just as bond rating agencies consider the specific risks of each bond, an asymmetry risk premium needs to consider the specific risks facing a particular company. The sample-based process used to estimate the cost of equity won’t work for an asymmetry risk premium.

Another, and even harder, problem arises if the odds that the regulated company will have to bear an asymmetric loss depend on the decisions of future regulators. In that case, there’s a danger of circularity: if future regulators are more likely to impose a loss because current regulators awarded an asymmetry risk premium, the size of the asymmetry risk premium that current regulators need to award goes up.

Finally, the size of the fair asymmetry risk premium can be quite large, well above the normal range of debate over the magnitude of the cost of capital in a rate case (See Figure 4) .

These complexities imply that the best solution is cooperation among the parties so that a material asymmetry risk premium is unnecessary.

Endnotes:

1. See “Shale Gas and the Outlook for U.S. Natural Gas Markets and Global Gas Resources,” presentation by Richard Newell, Administrator to the Organization for Economic Cooperation and Development (OECD), p.11, June 21, 2011.

2. See A. Lawrence Kolbe and William B. Tye, “The Duquesne Opinion: How Much ‘ Hope’ Is There for Investors in Regulated Firms?” Yale Journal on Regulation 8:113-157, 1991; “The Fair Allowed Rate of Return with Regulatory Risk,” Research in Law and Economics 15:129-169, 1992; “It Ain’t In There: The Cost of Capital Does Not Compensate for Stranded-Cost Risk,” Public Utilities Fortnightly , May 15, 1995; and “Compensation for the Risk of Stranded Costs,” Energy Policy , 24:1025-1050, 1996; see also A.