On March 21, 2019, the Federal Energy Regulatory Commission (“FERC”) initiated an Inquiry Regarding the Commission’s Policy for Determining Return on Equity (“ROE”) that was published in the Federal Register on March 28, 2019. FERC is seeking comments on this Notice of Inquiry (“NOI”) in eight general areas, including the role its base ROE plays in investment decision-making, and whether FERC should reevaluate how it uses the discounted cash flow (“DCF”) methodology to set ROEs for jurisdictional rates. The DCF methodology has guided cost-of-service ratemaking at FERC since the 1980s. It is used to ascertain an investor’s required return for investing in a firm, and is applied using a proxy group of firms that face similar risks to the entity whose ROE is being determined, which defines a “zone of reasonableness” for the ROE. The use of a proxy group is intended to satisfy the “Hope” and “Bluefield” standards (named for a pair of 20th Century U.S. Supreme Court cases) that an ROE is commensurate with returns on investments in other enterprises having corresponding risks to assure confidence in the financial integrity of the enterprise to allow it to maintain its credit and attract capital. Comments on the NOI are due on June 26, 2019 and Reply Comments are due on July 26, 2019.
The NOI follows Emera Maine v. FERC, a 2017 decision by the U.S. Court of Appeals for the District of Columbia Circuit that vacated FERC’s Opinion No. 531, a 2014 decision that set a base ROE of 10.57% for the New England Transmission Owners (“NETO”) after FERC found their existing base ROE of 11.14% to be unjust and unreasonable. The court chided FERC for improperly applying Federal Power Act (“FPA”) section 206 by failing to explain why the 11.14% rate was unjust and unreasonable prior to setting the new rate. However, the court did not question FERC’s decision to adopt the two-stage DCF methodology to set the ROE for electric utilities, a methodology it already used in natural gas and oil pipeline rate proceedings. Instead, it criticized FERC for relying on “anomalous capital market conditions” to justify its departure from its typical practice of setting ROE using the midpoint of the “zone of reasonableness” without sufficient supportive record evidence.
In a remand proceeding initiated in October 2018 (the “Coakley Briefing Order”), FERC proposed to calculate the NETO’s base ROEs using methodologies other than the two-stage discounted cash flow (“DCF”) methodology, including the risk premium analysis (“Risk Premium”), capital-asset pricing model analysis (“CAPM”), and an expected earnings analysis (“Expected Earnings”). FERC proposed to give equal weight to all four financial models on grounds that investors use a multitude of financial models to make their investment decisions. FERC initiated a similar proceeding for transmission owners operating in the Midwest (“MISO TOs”) in November 2018 (“MISO Briefing Orders”). In February 2019, FERC announced that it would consider this methodology for setting Trailblazer Pipeline Company’s ROE in its pending Natural Gas Act (“NGA”) section 4 rate case proceeding.
The NOI “recognizes the potentially significant and widespread effect of [FERC’s] ROE policies upon public utilities.” For this reason, it seeks comments from a wide-swath of jurisdictional electric transmission, natural gas, and oil pipeline market participants that would be impacted by any change in ROE policy. Any change in ROE policy likely would be contentious and controversial given that ROE is one of the most heavily litigated rate elements in a cost-of-service rate case.
The eight categories of comments are summarized as follows:
- The role of base ROE in investment decision-making and what objectives should guide FERC’s approach to its base ROE policy apart from the Hope/Bluefield
- Whether FERC should apply a single ROE policy across electric, interstate natural gas and oil pipeline industries (2-stage DCF methodology vs. something else).
- The robustness of the DCF model over time and under differing investment conditions.
- The appropriate guidelines for proxy group composition, elimination of outliers, and placement of base ROE within the zone of reasonableness.
- Whether FERC should weigh and consider financial models other than DCF that investors to use to evaluate utility equities.
- Whether there is a problematic mismatch between market-based ROE determinations, such as the DCF and CAPM models, and book-value rate base, and if so, how FERC should address the issue.
- Whether the quartile approach that FERC proposed in the Coakley and MISO Briefing Orders to ascertain whether an existing ROE is just and reasonable.
- Comments on general issues that affect multiple models, such as the underlying data that the models rely on, i.e., whether Institutional Brokers Estimate System (“IBES”) data is good proxy for “investor consensus” and whether growth rates should be based on Value Lines, IBES, or alternative estimates; and whether FERC should continue to use a dividend DCF model, or use a different model such as CAPM, Expected Earnings, or Risk premium.
FERC has a history of initiating NOIs or proposing policy statements following D.C. Circuit remands of specific cases, if the case concerns a matter of general import to the regulated community. This was the case in 2008 when FERC last reviewed its ROE policy to ascertain whether it should permit Master Limited Partnerships (“MLP”) to be included in an ROE proxy group. Similarly, FERC initiated an NOI in December 2016 to evaluate its policies for the recovery of income tax allowances in jurisdictional rates after an order it issued on a products pipeline rate case was vacated and remanded by the D.C. Circuit.
It would not be improper for participants in the regulated community to proceed with caution when responding to this NOI. For example, the 2016 NOI on income tax allowances ultimately resulted in a revised income tax allowance policy that caused significant upheaval in the midstream pipeline industry, and remains the subject of litigation. This stakeholder process could have similar disruptive implications across the regulated sectors if FERC decides to revise how it implements a policy that has been in place for approximately 30 years.