Abrupt reg­u­la­tory changes are crimp­ing pipe­lines

Houston Chronicle - - TEXAS INC - Murchie is co-founder and CEO of En­ergy In­come Part­ners LLC. By Jim Murchie

Amer­ica’s reg­u­lated pipe­lines are a mar­vel not just of en­gi­neer­ing but also fi­nan­cial in­no­va­tion. Their ori­gins date back a cen­tury to a de­bate on how best to fi­nance crit­i­cal in­fra­struc­ture. Power util­i­ties and pipe­lines were built by pri­vate cap­i­tal at­tracted to “just and rea­son­able” in­vest­ment re­turns in ex­change for con­strained com­pe­ti­tion. After all, it makes lit­tle sense to build mul­ti­ple pipe­lines or wires along the ex­act same route. In con­trast, high­ways and wa­ter sys­tems were owned and fi­nanced by gov­ern­ments.

To­day, while crum­bling civil in­fra­struc­ture strug­gles to get des­per­ately needed fund­ing, state-reg­u­lated util­i­ties con­tinue to at­tract cap­i­tal for ex­pan­sion and mod­ern­iza­tion thanks to healthy val­u­a­tions close to all­time highs that make cap­i­tal costs com­pet­i­tive. Yet equally crit­i­cal nat­u­ral gas pipe­lines reg­u­lated by the Fed­eral En­ergy Reg­u­la­tory Com­mis­sion have been left in the cold with val­u­a­tions rem­i­nis­cent of the fi­nan­cial cri­sis de­spite steadily ris­ing earn­ings. Why?

The self-in­flicted hang­over after the boom in master lim­ited part­ner­ships is one rea­son. But so is this year’s re­duc­tion to the cor­po­rate tax rate and FERC’s re­sponse to it. This threat­ens jar­ring changes to the del­i­cate bal­ance of reg­u­la­tion and mar­ket com­pe­ti­tion that has de­fined the pipe­line sec­tor since the early 1990s.

It was then that FERC Or­der 636 ush­ered in the tran­si­tion from a mo­nop­oly “cost-of-ser­vice” ap­proach on price set­ting to one that also re­lies on mar­ket forces. This re­flected the pipe­line in­dus­try’s tran­si­tion from a hand­ful of point-to-point routes to an in­creas­ingly com­pet­i­tive net­work pro­vid­ing ship­pers with greater choice and flex­i­bil­ity. Long-term con­tracts un­der­pinned the stable cash flows in­vestors wanted, sup­port­ing ready ac­cess to af­ford­able cap­i­tal. To­day, we es­ti­mate nearly two-thirds of all U.S. nat­u­ral gas is shipped un­der terms and prices ne­go­ti­ated be­tween pipe­line and ship­per with FERC adopt­ing more of a light-handed reg­u­la­tory stance.

This suc­cess­ful bal­ance of com­pe­ti­tion and reg­u­la­tion is now be­ing upset by an ap­par­ent rush to trans­late the lower cor­po­rate tax rate into re­bates. Be­gin­ning in Oc­to­ber, all gas pipe­lines were com­pelled to file a newly de­vel­oped form that ap­plies a lower tax rate to fi­nan­cial data that the FERC al­ready has on file any­way. This is used to re­cal­cu­late new in­di­cated eq­uity re­turns. Bizarrely, the re­sult is then com­pared to an al­lowed re­turn on eq­uity de­ter­mined in a sin­gle pro­ceed­ing lit­i­gated more than eight years ago.

This process cre­ates a bi­ased ex­pec­ta­tion of au­to­matic rate re­duc­tions, ig­nor­ing all other com­mer­cial con­sid­er­a­tions ne­go­ti­ated in pipe­line set­tle­ments. The re­sult­ing sin­gle is­sue, one-size-fits-all rate re­view threat­ens to tear up the myr­iad arm­slength agree­ments be­tween par­ties who are well-in­formed about costs, re­turns on cap­i­tal and com­pet­i­tive al­ter­na­tives. Be­sides con­tra­ven­ing well-es­tab­lished pro­ce­dure, this fol­lows on the heels of an­other FERC ac­tion in March that sent shock­waves through the sec­tor by end­ing in­come-tax re­cov­ery for part­ner­ship-owned pipe­lines. Nearly $30 bil­lion of mar­ket value was wiped out in the process.

My firm, En­ergy In­come Part­ners, man­ages about $6 bil­lion as of Septem­ber 2018, and has in­vested in pipe­line com­pa­nies and util­i­ties for more than fif­teen years. Since 2003, we have in­vested our clients’ cap­i­tal in these busi­nesses be­cause they of­fer an at­trac­tive to­tal re­turn made of an above-av­er­age div­i­dend yield and mod­est un­der­ly­ing growth. Our in­vestors are con­cerned about these abrupt changes in the reg­u­la­tory land­scape, and some are di­vest­ing their pipe­line hold­ings.

Why would FERC un­der­mine its own well-func­tion­ing mar­ket? There was likely pres­sure to take ac­tion as many state pub­lic util­ity com­mis­sions moved to quickly re­duce rates to pass on the cor­po­rate tax sav­ings to con­sumers. That is an un­der­stand­able re­ac­tion. But statereg­u­lated util­i­ties are true mo­nop­o­lies with no com­pe­ti­tion, sell­ing their ser­vices not to other busi­nesses but to the pub­lic. They there­fore op­er­ate un­der strict cost-of-ser­vice ratemak­ing. Nat­u­ral gas pipe­lines op­er­ate in a much more com­pet­i­tive and nu­anced mar­ket.

To­day, many of the util­i­ties in our port­fo­lio are lead­ing the tran­si­tion away from coal to­ward cleaner nat­u­ral gas and re­new­able en­ergy. Con­tin­ued progress re­quires huge in­vest­ment in util­ity and pipe­line in­fra­struc­ture, ac­cess to low-cost cap­i­tal to fund it, and greater co­or­di­na­tion be­tween elec­tric util­i­ties that pur­chase nat­u­ral gas and the in­ter­state pipe­lines that trans­port it.

Nat­u­ral gas de­mand is be­com­ing more dy­namic as it acts as a shock ab­sorber for in­ter­mit­tent wind and so­lar re­sources, and mar­ket-based ne­go­ti­a­tion of­fers the most ef­fi­cient way to pro­vide real-time flex­i­bil­ity while pre­serv­ing re­li­a­bil­ity. These var­ied needs can’t be cap­tured in the sin­gle met­ric of al­lowed re­turn on eq­uity and are why FERC has en­cour­aged ship­pers and pipe­lines to work these de­tails out through busi­ness-to-busi­ness ne­go­ti­a­tion. Pipe­line com­pe­ti­tion has also en­cour­aged ef­fi­ciency by draw­ing dis­tinc­tions be­tween op­er­a­tors. So while a 50-cent tar­iff may re­sult in a 10 per­cent re­turn on eq­uity for an in­ef­fi­cient, cap­i­tal-heavy pipe­line, a 35-cent tar­iff may pro­duce a 15 per­cent re­turn on eq­uity for an ef­fi­cient op­er­a­tor. Is it right to pun­ish the lat­ter?

In our view, FERC has been a bal­anced and thought­ful reg­u­la­tor, nur­tur­ing dis­ci­pline and per­for­mance in the com­pa­nies it over­sees. Or­der 636 in 1992 was vi­sion­ary, but nat­u­ral gas sup­ply, flow and end-use have be­come more com­plex in the 26 years since then. As in­vestors, we would en­cour­age FERC to re­sist po­lit­i­cal pres­sure and avoid a re­treat to lit­i­gated cost-plus ratemak­ing that re­wards sheer spend­ing over ef­fi­ciency. Oth­er­wise, the cur­rent course seems des­tined to pe­nal­ize not just pipe­lines for their suc­cess, but ul­ti­mately in­vestors and the con­sumers seek­ing af­ford­able and clean en­ergy as well.

Peggy Gar­bus Pho­tog­ra­phy

Jim Murchie is the CEO of En­ergy In­come Part­ners.

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