# Presentation: 681631

## Oil Pipeline Ratemaking Methodologies

- Michele Joy
- Association of Oil Pipe Lines
- May 18, 2004

## Pipeline’s Goal

- To meet competition and to capitalize on business opportunities.

## Regulator’s Goal

- To promote competition and to protect shippers from the exercise of undue market power.

## Our Goal Today

- To understand the content and intent of the law so as to achieve the regulator’s objectives while meeting the pipeline’s goal.

## FERC Mandate

- 1906 Interstate Commerce Act
- Interstate oil pipelines must be common carriers (with a few minor exceptions)
- Rates must be just and reasonable
- Undue discrimination & preferences are prohibited
- Carriers must file and post tariffs
- Politics work against deregulation

## Status of Oil Pipeline Regulation Pre-Energy Policy Act of 1992

- Uncertainty regarding Opinion 154-B
*ARCO* experience
- Some companies earning above Opinion 154-B revenue levels
- Uncertainty regarding market-based option
*Buckeye* experience
- Exposure in the event of complaints

**Notes:**
For the 80 years before Opinion 154-B issued, oil pipelines set their rates using a valuation methodology and then using Opinion 154, which led to very different results and allowed returns than TOC.  Those rates were valid when set.

## The Energy Policy Act of 1992 (EPAct)

- All existing and unchallenged rates are deemed just and reasonable (“grandfathered rates”).
- Those rates can only be challenged upon a demonstration of “substantially changed circumstances.”
- The Commission is told to introduce new procedures.

**Notes:**
Recall that grandfathered rates had already been in effect at least one year without protest or complaint

Some of the procedural changes that were thought to be necessary were the requirement that a protestant have an economic interest in the proceeding – without which no settlement is possible, the need for Alternative Dispute Resolution, and the right of a pipeline to withdraw a tariff and terminate a proceeding.  Similarly, if a complaint is withdrawn, the proceeding terminates.

## The Energy Policy Act of 1992 (EPAct) (cont.)

- Congress orders the Commission to establish a “simplified and generally applicable ratemaking methodology”

## The Result: Four alternativesfor existing rates

- Indexation
- Settlement Rates
- Cost-based Rates
- Market-based Rates
*Plus *Security Cost Recovery Surcharge

**Notes:**
Prior to 1995, pipeline tariffs were often set by business people through negotiations.  Few tariffs were filed with any supporting documentation.  After 1995 is the first time any justification for the rate must be part of the filing.

The cost-based alternative was important to some whose 1994 rates were held below Opinion 154-B permitted levels.  If only permitted to raise rates through an index, they would forever be foreclosed from recovering their costs.

## The Result: At least two ratemaking options for new service

- Negotiated Rates
- Cost-of-Service
*Market-Based Rates*

## Indexation

*The good news:*
- It’s simple
- It’s usually optional
- Challenges are limited
*The bad news:*
- It’s been negative
- Negative is mandatory

**Notes:**
Good news -  Don’t have to raise rates, but are permitted to raise them to the index ceiling.  This is important in many competitive markets.

## Indexation

- Index applies to pipeline’s ceiling rates
- Actual rates may be less than ceiling rate
- Ceiling rate may be re-set if alternatively set rate accepted
- If existing rate above new ceiling rate, it must go down or alternative rate justification must apply

## Index Adjustment

- To be reviewed every five years
- First review left index unchanged
- Court of Appeals found analysis flawed
- FERC revised index from 2001 to PPI
- FERC plans to review index again in 2006
- Court of Appeals affirms revised index

## Settlement Rates

*All *current shippers using that service must agree to the new rates.
- If settlement rate is challenged, the pipeline may defend the rate on either a cost-of-service or competitive basis.

## Cost-of-Service

- This option is not automatically available
- First, the carrier’s costs must “substantially diverge” from revenues the carrier is capable of earning under indexed rates.
- The costs must then be justified using the Opinion No. 154-B model.

## The Opinion No. 154-B Model

- Cost-of-Service showing for oil pipelines differs from other FERC regulated industries in two principal respects
- Starting Rate Base
- Trended Original Cost (TOC)

## Starting Rate Base

**The formula looks like this:  SRB = O(d) + R(e)**
***where:***
**SRB = Starting Rate Base**
**O = book net depreciated original cost as of 12/31/83**
**R = net depreciated cost of reproduction new from 1983 valuation**
**d = debt ratio as of 6/28/85**
**e = equity ratio as of 6/28/85**

**Notes:**
Starting Rate Base is still being recovered as TOC defers recovery. 

## Trended Original Cost

**	****	****	****	****	**** ****DOC****	****	**** ****TOC**
**A  Nominal Rate of Return (ROR)****	****16.00%****	****16.00%**
**B  **_**Inflation Rate**__**	**__**	**__**	**__**  n/a**__**	**__**	**__** 7.00%**_
**C  Real ROR****	****	****	****A-B****	****  n/a****	****	**** 9.00%**
**D  Rate Base****	****	****	****	****$1,000****	****	****$1,000**
**E  Return on Rate Base**
**  ****	****Nominal for DOC****	****A****	****16.00%**
_**	**__**Real for TOC**__**	**__**	**__**C**__**	**__**	**__**	**__** 9.00%**_
**F  Current earnings****	****	****DxE****	****  $160****	****	****    $90**
**G  Inflation Rate****	****	****	****  n/a****	****	**** 7.00%**
**H  Deferred earnings****	****GxD****	****  n/a****	****	****    $70**

**Notes:**
A conversion from TOC to DOC would leave companies under-recovering.  DOC also runs counter to the intent of TOC, which is to encourage new market entry.

## Compare - Security Cost Surcharge

- No substantial divergence test
- Costs must be linked to enhanced security post 9/11/01
- Both capital and operating costs may be recovered
- Confidentiality will be maintained if warranted

**Notes:**
Intended to apply through June 30, 2006, the time of the next index adjustment.

## Market-Based Rates

- Requires a mini-antitrust showing.
- The carrier must demonstrate that there is adequate competition in both the *origin* and the *destination* markets.
- Finding made that individual pipeline lacks market power in each market examined.

## Carrier’s case must at least do the following: 

- Define the relevant geographic (origin and destination) and product market.
- Identify competitive alternatives.
- Compute the market concentration.

## Slide 22

**Notes:**
Majority of pipelines are located within markets reviewed to date.

## Slide 23

## Questions about market-based rates 

- Market-based rates are only permitted in markets where a pipeline is found to lack market power.
- Uncertainty on how to set rates in less competitive markets.
- Only guidance has been to avoid cross subsidization.

## Initial Rates

- Requires agreement of at least one unaffiliated shipper, or
- Rate must be justified using cost-of-service methodology.
- Even if the unaffiliated shipper agrees, the rate may be challenged by anyone with an economic interest.
- Pipeline must then defend using cost-of-service method,  unless Commission approved alternative.

## Alternatives for Initial Rates

- Special contractual agreements (Express)
- Market power showing (Longhorn)

**Notes:**
Discuss rolled in versus incremental pricing?

## Conclusions

- The regulations allow rates to be set using four different methodologies
- This flexibility in rate setting reflects the history and competitiveness of the industry
- Industry players must understand the regulations  to structure business deals appropriately
- The Commission must understand the business drivers in order to foster pipeline growth while protecting shippers