Opinion ID: 2808691
Heading Depth: 2
Heading Rank: 2

Heading: Shippers’ Petition

Text: Because of the reduced financial risk associated with being debt free in Period Two, the Shippers urged FERC to lower Kern River’s return on equity for Period Two rates. FERC refused. The Shippers argue that FERC failed to engage in reasoned decision making after it: (1) failed to address the reduced financial risk associated with 100 percent equity in Period Two; (2) relied on an irrational composite capital structure; (3) assumed increased business risk would offset decreased financial risk; and (4) failed to follow its precedent, which requires a reduction in the return on equity. The Shippers ask us to reverse Opinion Nos. 486-E and 486-F and remand with instructions for FERC to reduce Kern River’s return on equity in Period Two. We deny the Shippers’ petition under the deferential standard of review we apply to FERC’s ratemaking decisions.
In general, “the higher the proportion of equity capital, the lower the financial risk . . . and thus, in this respect, the lower the necessary rate of return” on equity. Missouri Pub. Serv. Comm’n v. FERC, 215 F.3d 1, 2 (D.C. Cir. 2000). 18 During Period Two rate proceedings, FERC confirmed: “It goes without saying that a 100 percent equity structure would be perceived by informed investors to lessen substantially a company’s financial risk.” Opinion No. 486-F, 142 FERC ¶ 61,132 P 255. That is common sense. See Missouri Pub. Serv. Comm’n, 215 F.3d at 4. Because Kern River has lower financial risk than the members of the 2004 proxy group (based on Kern River’s 100 percent equity structure), the Shippers maintain that FERC should have set Kern River’s return on equity lower than the proxy group’s median 11.55 percent return. FERC reasonably explained why the Shippers’ argument lacks merit. When it set Kern River’s return on equity for Period Two, FERC considered how investors in 2004 would have viewed the transition from a 30 percent equity structure in Period One to the 100 percent equity structure in Period Two. See Opinion No. 486-E, 136 FERC ¶ 61,045 P 204–05. FERC explained how an informed investor would have noticed that the transition toward less financial risk is not abrupt. See id. Instead, the “100 percent equity structure would come on line gradually from 2011 through 2018.” Id. P 205. For example, through the end of 2015 (more than halfway into the transition period), 88 percent of the Period One contracts would still be in effect. See id. Thus, FERC explained that an investor in 2004 would have likely perceived that, during the initial four years of transition to Period Two rates, Kern River’s financial risk would be about the same as Period One. See id. The investor’s perception of the gradual transition, FERC determined, “would trend the required [return on equity] toward the median rather than the lower end of the range in absence of highly persuasive information (evidence) to the contrary.” Id.; see also id. P 206 (noting that the Shippers “have not presented compelling evidence based on the 2004 test period that Kern 19 River’s return on equity should be reduced below the median”). That is not an arbitrary conclusion.
The Shippers contend that FERC unjustifiably abandoned the notion of separate capital structures in Period One and Period Two when it referred to a “composite equity” standard. Shippers Br. 21 (quoting Opinion No. 486-E, 136 FERC ¶ 61,045 P 205). In their view, FERC’s reference to composite equity is inconsistent with the design principles underlying Kern River’s levelized rates—i.e., Kern River must develop “individual rates based upon separately calculated equity rate base amounts for each customer class.” Opinion No. 486, 117 FERC ¶ 61,077 P 119. According to the Shippers, it is irrelevant to the design of Period Two rates that some customers might still be paying Period One rates (based on a 30 percent equity capital structure) through 2018 because FERC must calculate Period Two rates based on a 100 percent capital structure. We reject the Shippers’ arguments because they ignore the context of the Commission’s reference to “composite equity” in Opinion No. 486-E. Considering the reference in context, we conclude that FERC did not abandon the separate capital structures for each period when it referred to composite equity. Rather, FERC explained how an investor in 2004 might perceive Kern River’s “generic business risks” during the gradual transition to Period Two rates from 2011 through 2018. Opinion No. 486-E, 136 FERC ¶ 61,045 P 205; see also Opinion No. 486-F, 142 FERC ¶ 61,132 P 254 (“[T]his language forms part of the Commission’s discussion of what informed investors might have perceived in 2004 about Kern River’s business risk.”). By referring to composite equity, FERC rejected the notion that “the 2004 20 investor would be considering investment in a pipeline that would have exclusively Period Two contracts and a Period Two all-equity capital structure.” Opinion No. 486-F, 142 FERC ¶ 61,132 P 236. This observation is rational and consistent with FERC’s position throughout these proceedings.
The Shippers advance several arguments suggesting that FERC’s analysis of Kern River’s business risk is inconsistent and not supported by the record. None are persuasive. The Shippers urged FERC to set Kern River’s return on equity at the lowest reasonable level because, in their view, Kern River’s business risk is substantially reduced during Period Two by the 100 percent equity structure. FERC explained that a low return on equity would only be appropriate if “Kern River’s business risk would necessarily be so low that investors could be assured that changes in Kern River’s capital structure would offset all of the potential competition from new pipeline capacity or gas supply.” Opinion No. 486-E, 136 FERC ¶ 61,045 P 204 (emphasis added). After considering the Shippers’ arguments, FERC concluded that “the existence of the 100 percent equity capital structure cannot be construed to completely off-set the potential business risks Kern River might face.” Opinion No. 486-F, 142 FERC ¶ 61,132 P 257. That conclusion is neither arbitrary nor capricious. First, FERC determined the record was insufficient to conclude that the change in capital structure over time would completely offset “incentive[s] for entry by competing firms,” which “would be hard to quantify in 2004.” Opinion No. 486-E, 136 FERC ¶ 61,045 P 204. FERC rejected the 21 Shippers’ retrospective analysis of Kern River’s potential competition because it relied on “more detailed information that . . . [became] available some seven years after the close of the 2004 test period.” Id. In doing so, FERC engaged in reasoned decision making because the return on equity analysis “depends upon market perception of future risks” and FERC, as of the 2004 test period, “reasonably factored evidence of potential competition into its [return on equity] calculus.” Canadian Assoc. of Petroleum Producers v. FERC, 308 F.3d 11, 16 (D.C. Cir. 2002). Second, FERC concluded that the record did “not provide compelling evidence that” the gradual transition in capital structure would completely offset Kern River’s re-contracting risk as Period One contracts expired. Opinion No. 486-E, 136 FERC ¶ 61,045 P 204. As of the 2004 test period, no customer had agreed to contract with Kern River for shipping natural gas during Period Two. See Opinion No. 486-D, 133 FERC ¶ 61,162 P 198. Therefore, re-contracting risk was “the primary reason” FERC did not adjust Kern River’s return on equity for Period Two rates. Opinion No. 486-F, 142 FERC ¶ 61,132 P 250. The Shippers challenge FERC’s reliance on re-contracting risk, but their arguments lack merit because they ignore the context of FERC’s purportedly inconsistent statements. According to the Shippers, FERC recognized that recontracting risk is not unique to Kern River. The Shippers, however, misread FERC’s statements. While rejecting Kern River’s argument in favor of a higher “return on equity based on evidence concerning various market changes since the 2004 test period,” FERC explained that re-contracting risk is “not a circumstance unique to the transition from Period One to Period Two.” Id. P 245 (emphasis added). In other words, FERC rejected Kern River’s proposed increase because it was 22 not based on data from the 2004 test period and did not fall within the limited “circumstances unique to the transition from Period One to Period Two rates.” Opinion No. 486-D, 133 FERC ¶ 61,162 P 202. When put into context, FERC reasonably explained how re-contracting risk was not an issue unique to the transition and therefore did “not justify consideration of post-test period market changes.” Opinion No. 486-F, 142 FERC ¶ 61,132 P 245. FERC’s statements about re-contracting risk are not inconsistent. The Shippers suggest that FERC cited lower Period Two rates as a factor that would reduce re-contracting risk. Again, context matters. While addressing the return on equity for Period One rates, FERC noted: “Kern River’s competitive position should be enhanced” as the reduced Period Two rates become effective. Opinion No. 486-B, 126 FERC ¶ 61,034 P 148. Thus, in the context of analyzing Period One risk, FERC concluded that “Kern River exaggerates its financial risk,” while the Shippers “understate Kern River’s contract risk given its relative dependence on the more competitive generating market.” Id. The Shippers also cite language from Opinion No. 486-E where FERC considered adjusting the “load factor” for Period Two rates. 136 FERC ¶ 61,045 P 169. The parties updated the “record with market information for the period of 2004–2009,” id., and FERC acknowledged that Kern River “has been quite effective at competing” for market capacity based on its lower Period Two rates, id. P 171. When put into context, neither this statement nor FERC’s statement about Period One risk is inconsistent with FERC’s analysis of re-contracting risk as perceived by an investor in 2004. The Shippers further contend that re-contracting risk during the transition period “‘would unlikely have been visible even to the most discerning [2004] investor.’” 23 Shippers’ Reply Br. 6 (quoting Opinion No. 486-E, 136 FERC ¶ 61,045 P 200). Once again, the Shippers ignore context because FERC made this statement while referring to “events that actually occurred in 2010 and 2011,” which were “not properly before the Commission.” Opinion No. 486-E, 136 FERC ¶ 61,045 P 200. FERC never concluded that a 2004 investor would be unlikely to perceive re-contracting risk. Instead, FERC reasonably explained that it would be “unlikely” for a 2004 investor to perceive “the specifics underpinning” Kern River’s argument in favor of a “higher risk environment”—i.e., the 2004 investor would not be able to predict circumstances based on updated data from actual events in 2010 and 2011. Id. (emphasis added). When viewed in its proper context, FERC’s statement about the visibility of re-contracting risk is consistent with its analysis of Kern River’s business risk as perceived by a 2004 investor. Because FERC rejected re-contracting risk as a basis for decreasing rate design volumes, the Shippers argue it is inconsistent for FERC to refuse to lower Kern River’s return on equity based on re-contracting risk. Their argument misses the mark because the rate design analysis for volume takes post-2004 test period data into account, whereas the return on equity analysis does not. Simply put, FERC has not advanced inconsistent positions while analyzing how a 2004 investor would view Kern River’s re-contracting risk.
The Shippers contend that FERC departed from its precedent without providing a reasoned explanation. We disagree. FERC acknowledged that Kern River’s 100 percent equity capital structure is “unique” and “anomalous.” See, 24 e.g., Opinion No. 486-F, 142 FERC ¶ 61,132 P 262. In other unique situations involving atypically high equity ratios, FERC has adjusted the rate of return on equity downward. See, e.g., Williams Natural Gas Co., 77 FERC ¶ 61,277, at 62,192 (1996) (adjusting the pipeline’s return on equity “to account for the [reduced] financial risk associated with a high equity ratio”); Gateway Pipeline Co., 55 FERC ¶ 61,488, at 62,677 (1991) (rejecting the pipeline’s “atypical and unduly costly” 100 percent equity capitalization and proposed rate of return in favor of a lower rate); Tarpon Transmission Co., 41 FERC ¶ 61,044, 1987 WL 258004, at  (1987) (rejecting the pipeline’s 100 percent equity structure as “beyond the norm” and reducing the rate of return on equity). FERC reasonably explained how these orders are not persuasive in the context of Kern River’s rate proceedings because they involved pipelines certified under the traditional requirements of Section 7 of the Natural Gas Act. See Opinion No. 486-F, 142 FERC ¶ 61,132 P 262. None of the pipelines had optional certificates similar to Kern River’s certificate. “In this context, Kern River’s capital structure is unique, and comparisons to other pipelines’ equity ratios do not render it any more or less anomalous.” Id. FERC reasonably explained that the cases relied on by the Shippers “show nothing more than the Commission has previously adjusted the return on equity in appropriate circumstances” that do not apply here. FERC Br. 62. The Shippers raise additional arguments, but none warrant relief or compel further discussion. 25