On May 31, 1995, the Federal Energy Regulatory Commission (FERC) issued its Statement of Policy in Docket No. PL94-4-000, Pricing Policy for New and Existing Facilities Constructed by Interstate Natural Gas Pipelines.1 In that decision, the FERC sought to provide upfront rate certainty, thereby giving pipelines and shippers a firm basis for making decisions on large-scale investments.
But is that objective realistic?
A comprehensive review of the ratemaking consequences of the new policy (em primarily the consequences for the biggest projects that will result in vintage rates2 (em reveals that the FERC's objective may be impossible. The barrier to providing upfront certainty lies in the fact that cost allocation for the many nonplant-related accounts can only be decided in a rate case, after the certificate has been issued. As for certainty, a barrier arises because cost allocation of these accounts in a vintage environment can call upon little in the way of precedent or established practice, thereby prompting controversy. The future can best be characterized as a mixed bag. On the one hand, there is no quick fix, in terms of process improvements, that would move the necessary cost-allocation decisions up front. On the other hand, more experience with cost-allocation issues in a
vintage environment should lead over time to an established practice. The cost-allocation challenge will come in developing methods that provide an appropriate basis for ratemaking (em that is, methods that enhance economic efficiency, rather than methods that allocate costs simply because they exist.
Background: PL94-4 in Context
The issues associated with vintage rates are new. Prior to FERC Opinions 3673 and 368,4 vintage rate issues were not common because the Battle Creek5 standard was applied. That standard favors roll-in of facility costs, especially in the case of expansions on integrated systems. Starting with Opinions 367 and 368 and continuing with PL94-4, vintage cost allocation is required unless rates for existing customers increase less than 5 percent, allaying concerns that "rolling in the costs could result in dramatic increases in rates faced by existing customers that might be disproportionate to the benefits they receive from the expansion."6 Now, several years after this change in cost allocation, pipelines have just begun to deal with the repercussions of vintage cost allocation on all costs, particularly nonplant costs, in their rate cases. This lagged adjustment is hindering the objectives of PL94-4.
Vintage Cost Allocation: The Timing Issue
Cost allocation for facilities that do not meet the roll-in standard in PL94-4 will change many times over the life of the facilities. The first cost allocation (in the certificate application) will assign plant-related costs by vintage and a small amount of other costs specific to the expansion facilities, such as property insurance. The second cost allocation (in the general rate case) will add an allocation of operations and maintenance (O&M) and other "overhead" types of expenses to the expansion facilities. Cost allocation will then be adjusted in every subsequent rate case, reflecting the decreasing plant-related costs so that the bulk of the costs will become overhead costs. Likewise, costs and hence rates for pre-expansion facilities will also be in continual flux, reflecting the shifting allocation of nonplant costs and the increasing capital additions of new nonexpansion plant as depreciated plant is replaced (see sidebar).
Seen in this context, the upfront certainty sought in PL94-4 amounts to certainty only with respect to cost allocation for plant-related costs. Shippers contracting for expansion facilities with vintage-cost treatment, as well as pre-expansion shippers, will confront both upfront uncertainty (unknown higher O&M and other overhead costs in the first rate case), and long-term uncertainty (changing future rate
levels caused by plant depreciation and additions for each vintage). Little can be done to change this dynamic. It is not feasible to allocate O&M and overhead costs to vintage expansion service in the certificate application; such an allocation changes rates to all customers, a result clearly outside the scope of a certificate proceeding. Therefore, the issue must be resolved in the next general rate case, which may follow several years after initiation of expansion service.
Vintage Cost Allocation: The Certainty Issue
The discussion thus far pertains simply to procedure. Unfortunately, the procedural aspect of vintage cost allocation marks only the tip of the iceberg. The more contentious issue, by far, is what standard to use for allocation of costs. As the chart illustrates, vintage cost allocation leaves a large number of the FERC Accounts with no defined allocation method. The tools brought to bear on this problem are weak indeed. The tool most sorely lacking is precedent. Because the vintage cost-allocation issue is new, no existing allocation methods qualify as "generally accepted."7 The few cases to tackle the issue have exacerbated the situation by favoring settlement, without precedential value. Faced with what is basically a clean slate on this issue, existing and expansion customers are pitted against each other in the general rate case, with little sense of the standards that will apply, and less idea of the outcome.
Vintage Cost Allocation: Substantive Issues
All of which leads to the core issue: Lacking precedent or established practice, what rules should form the basis for vintage cost allocation?
One proposal would employ allocators (such as gross plant ratios or labor ratios) broadly for all FERC Accounts requiring allocation. Such allocators represent borrowed methods that have been applied to the allocation of costs among pipeline functions. The Kansas-Nebraska method, for example, uses labor and plant ratios. The premise behind these allocators, and the reason they were used in the past, is that all functions use or benefit from these expenditures for administration, compressor maintenance, and so forth. Thus, logic dictates that all customers share in the cost allocation.
Despite its intuitive appeal and ease of application, this method, which the economic literature labels "full-cost apportionment" or "fully distributed costs," suffers on several levels. First, a method based on benefits appears incongruous for a pipeline that has received a determination that costs will be allocated on a vintage basis. Put another way, it is difficult to reconcile the vintaging of plant costs while distributing the costs of operating that plant. Second, the method stands contrary to the primary purpose of vintage cost allocation (em namely, that subsidies should be eliminated. As noted by several scholars, a general method like full-cost apportionment that pays no attention to cost responsibility is destined to produce subsidies:
"To make sure that no subsidies are involved, one must look to stand-alone or incremental costs . . . and not fully distributed costs."8
While it is true that PL94-4 intends only to prevent existing customers from subsidizing new customers, there is no justification for condoning subsidies of existing customers while prohibiting subsidies of new customers.
Lastly, full-cost apportionment negates any economic-efficiency benefit that might flow from vintage cost allocation. Vintage allocation of plant costs, premised on eliminating subsidies, can provide the first step toward marginal cost pricing (em the costs caused by adding capacity are segregated and, thus, accurately measure the change in costs caused by that added capacity.9 And since these segregated costs have no depreciation at the time of certification, they represent the true marginal cost of new capacity, not depreciated or embedded costs. As noted by economist Alfred Kahn, the idea of applying full-cost apportionment to the other cost categories in this context has no grounds if economic efficiency is desired:
"Quite simply, the basic defect of fully distributed costs as a basis for ratemaking is that they do not necessarily measure marginal-cost responsibility in a causal sense."10
The other possibility is to allocate costs based on cost causation. That is, costs caused by an expansion should be assigned to the expansion. The cost-causation standard is consistent with vintage allocation for plant costs (and therefore could be accurately termed "incremental-cost allocation"), ensures against subsidies, and provides a basis for marginal-cost pricing of new capacity.
In light of its policy and theoretical advantages, the second possibility can only be challenged on the grounds of practicality. Pipelines and regulators will have to undertake the analysis necessary to determine the costs caused by an expansion. This task should not prove insurmountable in the environment of a general rate case, however.
Such analysis should provide a practical benefit. Ultimately, cost-allocation methods will be developed based on cost incurrence and made applicable to all pipelines. Analysis, then, may well be the only approach that will yield a basis for precedent and a means of reducing controversy and uncertainty.
The result, rational cost allocation, is not insignificant in the circumstances faced today by pipeline customers. Typically, shippers obtaining expansion capacity that receives vintage treatment of plant costs are paying rates two to three times higher than existing system rates. Adding on a variety of other costs simply because no one is willing to do the required analysis, becomes difficult to defend. Mindful of the goal, the additional work is time well spent:
"No approach to utility pricing can be considered truly rational which does not give an important and even a major weight to marginal-cost considerations."11 t
Jeffrey Hitchings is director of regulatory affairs at Pacific Gas Transmission Co. This article is based on PGT's recent experience in FERC Docket No. RP94-149, but does not necessarily represent the views or opinions of Pacific Gas Transmission.
1. 71 FERC (pp 61,241.
2. Vintage rates refer to the rates that result from a vintage allocation of plant-related costs. The term "incremental" is not accurate because none of the other costs are allocated on the basis of incremental or marginal cost principles, as will be discussed more fully.
3. Great Lakes Transmission L.P., Dkt. Nos. RP91-143-000 et al., Oct. 31, 1991, 57 FERC (pp 61,140.
4. Great Lakes Transmission L.P., Dkt. Nos. RP89-186-000 et al., Oct. 31, 1991, 57 FERC (pp 61,141.
5. Battle Creek Gas Co. v. FPC, 281 F.2d 42 (D.C.Cir.1960), affirming Trunkline Gas Co., 21 FPC 704 (1959).
6. 71 FERC (pp 61,241.
7. As an example of the lack of guidance on this issue, some of the allocators that have been proposed (and are discussed in the next section) have been borrowed from methods used to allocate costs among pipeline functions (transmission, gathering, storage, etc.). There are few instances of allocations being developed specifically for the unique circumstances associated with vintage cost allocation on integrated transmission facilities.
8. James C. Bonbright, et al., Principles of Public Utility Rates, 1988, p. 513.
9. It should be noted that the FERC has long held cost incurrance as a necessary standard for cost allocation as shown in the following statement: "Despite the profusion of allocation methods we employ, there is a common thread that ties them together. That thread is the concept of cost responsibility or cost insurance." 23 FERC (pp 61,396.
10 Alfred E. Kahn, The Economics of Regulation: Principles and Institutions, 1970, p. 151.
11. Vickery, William S., "Some Implications of Marginal Cost Pricing for Public Utilities," American Economic Review, Papers and Proceedings, May 1955, Vol. 45, p. 620.
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