This earnings season, MLPs have been fielding questions around the impact that the lowered corporate income tax rate will have on the rates for their FERC-regulated pipelines. A few MLPs have booked non-cash charges to establish an estimated liability stemming from the new tax law. What does the corporate tax rate have to do with pipelines? Since 2005, FERC has allowed MLPs and corporations to include an income tax allowance in the cost-of- service calculation. (Yes, MLPs don’t pay corporate income tax, but the income tax allowance is still included in the cost-of-service calculation for pipelines owned by MLPs.) There has been some concern that a lower income tax could lead to lower rates (and thus lower revenues for MLPs) going forward. In this post, we’ll discuss FERC’s ratemaking methodologies for interstate pipelines, the potential impact of tax reform on rates, look at what individual companies have said on the topic, and generally set investors’ minds at ease.
How are rates determined for FERC-regulated interstate pipelines?
Natural gas – FERC regulates the transmission of natural gas in interstate commerce under the Natural Gas Act (NGA), which requires rates for interstate pipelines to be “just and reasonable.” Rates are determined based on the pipeline’s cost of service including a reasonable return on equity, which for newbuild natural gas pipelines has been around 14% recently. A pipeline may file to increase its rate under Section 4, and under Section 5, FERC can require prospective rate changes when rates are no longer just and reasonable. A Section 5 proceeding can be initiated by the FERC on its own or in response to a shipper’s complaint (Example of a FERC investigation where returns on equity ranged from 17.7% to 28.5% for a calendar year).
Crude and Products – FERC regulates and establishes reasonable rates for interstate crude and products pipelines. FERC sets the ceiling rate for these pipelines by primarily indexing rates for inflation. As we’ve discussed in the past, rates are adjusted on July 1st of each year. Through July 2021, the index will be based on the Producer Price Index for Finished Goods plus 1.23%. Alternatives to indexation include: 1) settlement-based rates if agreed upon by shippers, 2) cost-based rates if costs exceed the revenues from indexed rates and preclude the carrier from charging a just and reasonable rate (unusual), and 3) market-based rates if the pipeline does not have significant market power and there is adequate competition at the both ends of the pipeline. There are also grandfathered rates for certain pipelines that were in service prior to the Energy Policy Act of 1992.
What impact will tax reform have on the rates charged by FERC-regulated interstate pipelines?
With the corporate income tax rate lowered to 21.0%, there is some concern that pipeline rates will be adjusted lower as well due to the income tax allowance in the cost-of-service ratemaking calculation. The concern is mainly around natural gas pipelines, as very few crude pipelines have rates based on cost of service. That said, not all natural gas pipelines may be impacted. Natural gas pipelines with negotiated rates should not be impacted by tax reform, and those pipelines charging discounted rates (i.e. earning below their maximum allowable rate) should not be materially impacted, since they are already charging less than the maximum. No one can fully predict what FERC will do, but it seems that any impact will take time, as discussed below. Additionally, there are other factors that go into the cost-of-service calculation that may offset the lower tax rate, including operating expenses and maintenance costs.
What can we learn from MLPs that have taken non-cash charges related to the new tax law?
Williams Partners (WPZ) took a $713 million non-cash charge in 4Q17 at Transco and Northwest Pipeline (both interstate natural gas pipelines) related to regulatory liabilities resulting from the new tax law. The liability represents an estimate of the value that will be returned to shippers to account for the deferred portion of the income tax allowance collected on rates in the past. WPZ expects the liability to be amortized over a period of up to 20 years or more, resulting in a more muted impact on an annual basis. Despite the lower tax rate, Transco expects to file for an increased cost-of-service rate in August. Management noted that Transco’s negotiated rates would not be impacted in this rate case. They also noted that most of their major expansions are covered by negotiated rate contracts, and by the time the Atlantic Sunrise pipeline comes online, Transco will be roughly half negotiated rates and half cost-of-service rates.
Spectra Energy Partners (SEP) also took a non-cash charge of $860 million to establish an estimated regulatory liability for its assets under cost of service. There’s no immediate impact on SEP’s rate base, and SEP believes any potential rate refund would be considered with a future rate case.
What are other midstream companies saying about this?
- Buckeye Pipeline Partners (BPL)’s 4Q17 Earnings Call: Asked about any potential impact from tax reform on FERC-regulated pipelines that might flow through over time, BPL management said they did not expect a material impact. They’ve seen a further shift to market-based and negotiated rates. Their FERC index-based pipelines represent about 42% of their revenues.
- Boardwalk Pipeline Partners’ (BWP) 4Q17 Earnings Call: Asked if they anticipate any impact on the Texas Gas system due to tax reform, BWP’s management said, “No, not really.” They expect FERC to continue looking at pipeline over-earning through the Section 5 process. They also noted that a good portion of contracts on Texas Gas are discounted or negotiated rate contracts.
- From Kinder Morgan’s (KMI) 4Q17 Earnings Call: Asked how they assess the impact of lower corporate taxes on their gas pipeline business, KMI said they expect the potential flow-through of tax rate changes to be mitigated and spread out over time. They said the impact is mitigated by negotiated rates, which don’t vary based on changes in cost of service, and discounted rates, because an adjustment would impact the maximum rate. Approximately 70% of their revenues are under those type of arrangements. KMI also believes the impact will be tempered by other changes in the cost of service. Management believes it’s well established that one element of the cost of service cannot be selectively adjusted without considering the overall cost of service. They expect the change from tax reform to play out over time through periodic Section 4 and Section 5 proceedings.
The lowered corporate income tax rate represents a risk for select FERC-regulated pipeline assets that rely on the cost-of-service methodology for ratemaking and represents asset-level risk for some MLPs. That said, the income tax allowance isn’t the only consideration that goes into the cost-of-service calculation, and even having taken a non-cash charge related to the new tax law, Transco still expects to file for increased cost-of-service rates in its initial rate filing later this year. Unless FERC were to implement some broad ruling, which seems unlikely based on commentary from management teams, it will likely take quite some time for the lower income tax rate to flow through to pipeline rates, and even then, it may be offset by other factors. Investors in diversified MLP or energy infrastructure access products will likely be further insulated from this potential risk.