FERC Initiates Sweeping Reform of Ratemaking Treatment for Income Taxes

by King & Spalding
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On March 15, 2018, the Federal Energy Regulatory Commission (FERC) released a series of issuances intended to address the need to reflect the lower maximum corporate income tax rate adopted under the Tax Cuts and Jobs Act of 2017 in the regulated cost-based or indexed rates of interstate natural gas pipelines, oil pipelines and electric utilities.  At the same time, FERC acted, in response to a Court of Appeals remand order, to deny an oil pipeline then owned by a master limited partnership (MLP) the opportunity to include an allowance for income taxes paid by the MLP’s investor owners in calculating the pipeline’s jurisdictional rates.  FERC proposed to modify its policy permitting such income tax allowances for all FERC-regulated entities owned by MLPs and suggested that this new policy is likely to extend to “pass-through” entities other than MLPs (such as limited liability companies).  FERC noted that implementation of the policy changes proposed or announced in these issuances will ultimately lower energy bills paid by consumers.

Late last year Congress passed the Tax Cuts and Jobs Act of 2017 (Act), which the President signed into law on December 22, 2017.[1]  A central feature of the Act is to reduce the maximum corporate income tax rate from 35% to a flat 21% effective January 1, 2018.  FERC came under pressure from pipeline and utility customer groups and state officials to reduce interstate natural gas pipeline, oil pipeline and FERC-jurisdictional electric rates to reflect the new, lower tax rate.  Acknowledging that ratemaking procedures differ by industry, FERC took the following actions:

Electric Public Utilities.  Most electric public utilities employ formula rate mechanisms under which their transmission rates subject to regulation under the Federal Power Act (FPA) are periodically redetermined.  FERC noted that the majority of such rate formulas would incorporate the reduced federal income tax rate as an input to the formula.  No further action is required for these companies as their transmission rates will adjust to reflect the reduced federal income tax rate.  Because some electric public utilities’ formula rates include either a fixed income tax rate or a fixed income tax amount, FERC initiated show cause proceedings under Section 206 of the FPA for the purpose of requiring companies whose rate formulas specify a fixed income tax rate or amount to revise their rate formulas to reflect the reduced income tax rate.[2]  FERC established the date of publication in the Federal Register as the date after which refunds would be due under the Section 206 show cause orders.

Interstate Natural Gas Pipelines.  FERC recognized that interstate natural gas pipeline transportation rates regulated under the Natural Gas Act (NGA) are typically “stated rates” (i.e., numeric rates specified in the company’s tariff), which are generally only subject to adjustment via a general rate case.  Rather than initiating general rate reviews of all interstate natural gas pipelines (under NGA Section 5), FERC issued a Notice of Proposed Rulemaking through which it proposed a streamlined process for effecting reductions to natural gas pipeline rates.[3] 

The primary innovation introduced by the proposed rulemaking is a one-time reporting requirement that each interstate natural gas pipeline is to report certain cost and revenue information.  FERC Proposes a new reporting form, Form No. 501-G, which will be designed to present the effect of the change in the tax rate on each pipeline’s cost recovery and rates.[4]  FERC proposes to use this information to determine whether rate adjustments are appropriate and, if so, the magnitude of such adjustments.  FERC observed that some pipelines may be able to demonstrate that their current rates continue to be just and reasonable even after factoring in the lower income tax rate.[5] 

In addition to filing Form No. 501-G, each interstate natural gas pipeline would elect one of the following options:

·      Voluntarily implement the rate reduction indicated by Form No. 501-G by making a limited NGA Section 4 filing proposing to adjust rates

·       Explain why the rate reduction indicated by Form No. 501-G would be inappropriate (indicating either that no reduction or a different reduction should be implemented; e.g., because the current rates result in an under-recovery of the pipeline’s costs or because a settlement moratorium is in effect)

·       Indicate that the company will voluntarily initiate a Section 4 general rate case by December 31, 2018

·       Do nothing

In addition, a pipeline may voluntarily negotiate a settlement with its customers before the Form No. 501-G filing date, in which case the pipeline would not be required to file the form.  FERC stated that it will consider undertaking Section 5 proceedings against pipelines that do not voluntary take action to reduce their rates.

The Commission’s general policy prohibits pipelines from proposing rate changes due to a change in a single cost component, because there might be offsetting changes in other cost components.  In this case, FERC held that an exception to the general policy is warranted to permit voluntarily rate reductions.  Interested parties may protest a pipeline’s limited Section 4 filing; however, FERC will only consider matters within the scope of such tax rate reduction proceedings.

The FERC NOPR provides interested parties the opportunity to file comments within 30 days following the NOPR’s publication in the Federal Register.  FERC intends to act quickly on the proposed rulemaking so that it can implement a staggered schedule for pipeline Form No. 501-G filings beginning this summer.  Limited NGA Section 4 proceedings to implement voluntary rate reductions could become effective starting in the late summer or early fall.  Rate reductions that are dependent on NGA Section 4 or 5 general rate proceedings probably cannot be implemented until next year.

Intrastate and “Hinshaw” Natural Gas Pipelines.  Intrastate natural gas pipelines  and so-called “Hinshaw pipelines” (gas pipelines that do not cross state lines and are regulated by state utilities commissions) providing interstate transportation services pursuant to Section 311 of the Natural Gas Policy Act (NGPA) and FERC regulations would not be required to make Form No. 501-G filings.  FERC noted that intrastate and Hinshaw pipelines are required to refile their rates generally on a five-year schedule.  FERC will address income tax rate reductions in those proceedings (noting that almost half of these pipelines must file within 24 months).[6]  FERC also proposes to require intrastate and Hinshaw pipelines that reduce their intrastate transportation rates in order to reflect the reduced tax rate to adopt corresponding rate reductions for their interstate services. 

Oil Pipelines.  Most oil pipeline rates subject to regulation under the Interstate Commerce Act are adjusted annually by reference to an index posted by FERC.  The next scheduled update for the index is in 2020; FERC committed to adjust the index at that time to reflect the lower income tax rate.  FERC also indicated that oil pipelines must adjust their indicated income tax allowances when they file Form No. 6, page 700, consistent with the FERC’s revised policies.

Elimination of MLP Income Tax Allowances.  For oil and natural gas pipelines owned by MLPs, FERC announced a policy against inclusion of an income tax allowance in the pipeline’s cost of service.  FERC’s longstanding policy has been to allow tax pass-through entities (generally, partnerships and limited liability companies) to include an allowance for the income taxes paid on the pipeline’s income by the pipeline’s owners and investors (although for income tax purposes MLPs are “pass-through” entities, which are not subject to income taxes, MLP owners and investors are obligated to pay income taxes on MLP distributions).[7]  

In 2016, the DC Circuit Court of Appeals, on judicial review of a FERC oil pipeline rate decision, found inclusion of an income tax allowance in the pipeline’s rates permitted a “double recovery” of tax costs, and remanded the case to FERC for further consideration and justification of the income tax allowance.[8]  On March 15, 2018, FERC issued an Order on Remand in that pipeline rate proceeding[9] as well as Revised Policy Statement[10] in which it agreed with the Court on its “double recovery” concern, holding that a double recovery of tax costs occurs because the discounted cash flow (DCF) methodology used to determine the rate of return for a pipeline owned by a MLP produces a pre-tax return, which takes into account income taxes to be paid by owners and investors.  FERC explained that the DCF methodology, as applied to pipelines organized as corporations, results in an after-tax rate of return, which justifies inclusion of the corporate income taxes paid by such a pipeline in its cost of service. 

FERC states that its Revised Policy Statement only addresses pipelines organized as MLPs and that tax allowances for other types of pass-through entities will be addressed in subsequent proceedings.[11]  Its discussion of proposed Form No. 501-G indicates, however, that non-corporate pipelines will be required to report the effects that eliminating tax allowances will have on their rates.  This suggests that, for interstate natural gas pipelines, the issue of ratemaking tax allowances may be addressed as soon as this summer. 

While some pipelines may wish to challenge FERC’s “double recovery” analysis, rehearing and judicial review of a policy statement are generally not available.  Individual pipelines will therefore not be able to challenge FERC’s double recovery rationale and related policy pronouncement until later proceedings in which FERC applies the Revised Policy Statement to individual pipelines.

Implementation of Other Aspects of Tax Law Change.  At the same time as it acted in the SFPP case and adopted its Revised Policy Statement, FERC issued a Notice of Inquiry seeking comments on how other aspects of the Act should be addressed as a ratemaking matter.[12]  The Act’s lower federal income tax rate affects the calculation of Accumulated Deferred Income Taxes (ADIT) and calls into question the appropriateness of ADIT balances currently carried by many regulated pipeline companies.  ADIT is a balance sheet account which reflects the difference between the amount of income taxes collected by a regulated entity through rates, using straight line depreciation, and the lower taxes actually paid by the entity using accelerated depreciation.  ADIT balances are generally overstated now that the income tax rate has been reduced to 21%.  The Act’s income tax rate change thus creates two problems:  (1) an excess ADIT balance funded by customer payments, which should be returned to customers and (2) a reduction in the ADIT balance, which has the effect of increasing cost-based rates (ADIT is treated as a free source of financing that is used for ratemaking purposes to reduce plant investment).  FERC noted that any approach to changes in ADIT balances it might consider is complicated by provisions of the Act which generally require that excess ADIT be returned to customers over the service life of the underlying plant assets. 

The Act also changes the rules for bonus depreciation.  The Act changed first-year bonus deprecation for certain qualified property to 100%, but provided that bonus depreciation “is not available for assets acquired in the trade or business of the furnishing or sale of electrical energy, water, or sewage disposal services; gas or steam through a local distribution system; or transportation of gas or steam by pipeline.”[13]  The FERC NOI seeks comments regarding the appropriate ratemaking response to incorrect ADIT balances and bonus depreciation, and recommendations as to how the Act’s provisions should be incorporated into other rates subject to FERC’s jurisdiction.  Comments on these subjects are due 60 days after publication of the NOI in the Federal Register.

Conclusion  

Hundreds of regulated entities are affected by FERC’s actions on the reduced corporate income tax rate and denial of income tax allowances for pipelines owned by MLPs.  The market’s reaction was swift; stock prices for holding companies of pipelines organized as pass-through entities dropped sharply on March 15 (although some rebounded later).  Industry analysts have claimed that lower rates which could be the result of reduced or eliminated allowances for income taxes will reduce regulated entities’ cash flows and adversely affect their ability to issue debt.  Some observers, on the other hand, have pointed out that the prevalence of negotiated rate and discounted rate agreements, which will not be affected by any required changes in cost-based rates to reflect a change in income tax allowances, will limit the actual impact of the change, particularly on newer oil and gas pipelines that have been supported by negotiated rate service agreements.  In any event, FERC’s March 15 issuances are likely to spawn a large number of new and contentious proceedings, which will likely take years to resolve.

 

[1] Tax Cuts and Jobs Act, Pub. L. No. 115-97, 131 Stat. 2054 (2017).

[2] Alcoa Plant Generating Inc. – Long Sault Div., 162 FERC ¶ 61,224 (2018) (initiating FPA Section 206 show cause proceedings for 33 entities with stated transmission rates); AEP Appalachian Transmission Co., Inc., 162 FERC ¶ 61,225 (2018) (initiating FPA Section 206 show cause proceedings for 15 entities with a fixed 35% income tax rate in their formula rates).

[3] Interstate and Intrastate Natural Gas Pipelines; Rate Changes Relating to Federal Income Tax Rate, 162 FERC ¶ 61,226 (2018) (“NOPR”).

[4] Form No. 501-G would use the information reported in a pipeline’s Form No. 2 or 2A as inputs to a standardized spreadsheet designed by FERC to require all pipelines to use the same methodology to calculate the effects of the change in tax rate (and tax allowances) and the consequent rate reductions. Natural gas storage companies authorized to charge market-based rates are typically granted waivers from filing Form No. 2 or 2A and would be exempt from filing Form No. 501-G.

[5] NOPR, 162 FERC ¶ 61,226 at P 28 (“For example, a pipeline may argue that it is currently under-recovering its overall cost of service, such that the reduction in its tax costs or elimination of an MLP income tax allowance will not lead to excessive recovery. If that is true, no reduction in the pipeline’s existing stated rates would be justified under NGA section 5.”) (footnote omitted).

[6] Id. at P 58.

[7] Inquiry Regarding Income Tax Allowances, Policy Statement on Income Tax Allowances, 111 FERC ¶ 61,139 (2005).

[8] United Airlines Inc. v. FERC, 827 F.3d 122, 134, 136 (D.C. Cir. 2016).

[9] SFPP, L.P., 162 FERC ¶ 61,228 (2018).

[10] Inquiry Regarding the Commission’s Policy for Recovery of Income Tax Costs, 162 FERC ¶ 61,227 (2018) (Revised Policy Statement on Treatment of Income Taxes).

[11] Id. At P 3 (“In addition, this record does not provide a basis for addressing the United Airlines double-recovery issue for the innumerable partnership and other pass-through business forms that are not MLPs like SFPP. While all partnerships seeking to recover an income tax allowance will need to address the double-recovery concern, the Commission will address the application of United Airlines to non-MLP partnership or other pass-through business forms as those issues arise in subsequent proceedings.”).

[12] Inquiry Regarding the Effect of the Tax Cuts and Jobs Act on Commission-Jurisdictional Rates, 162 FERC ¶ 61,223 (2018)(“NOI”).

[13] Id. at P 77 (citing Section 13301 of the Act).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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