FERC Transmission ROEs: Could the DC Circuit Court Overturning FERC’s New England ROE Decision Result in a More Supportive Transmission Policy and Higher ROEs for Transmission Owners?

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Eric Selmon Hugh Wynne

Office: +1-646-843-7200 Office: +1-917-999-8556

Email: eselmon@ssrllc.com Email: hwynne@ssrllc.com

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

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April 24, 2017

FERC Transmission ROEs: Could the DC Circuit Court Overturning FERC’s New England ROE Decision Result in a More Supportive Transmission Policy and Higher ROEs for Transmission Owners?

The D.C. Circuit Court’s recent decision on FERC’s transmission ROE methodology carries little downside risk for transmission owners and could lead to a more supportive policy by FERC, resulting in higher allowed ROEs in future rate cases.

Portfolio Manager’s Summary

  • On April 14, 2017, D.C. Circuit Court issued its decision in Emera Maine v. FERC, remanding the case to FERC for reconsideration. The Court ordered FERC to correct two deficiencies in its 2011 order (FERC Opinion 531) reducing the base allowed ROE for transmission owners in ISO New England:
    • The first of these was FERC’s failure to meet the threshold requirement of Section 206 of the Federal Power Act: that, before setting a new, lower allowed ROE, FERC first determine the prior allowed ROE to be “unjust and unreasonable.”
    • The second was FERC’s failure to meet the second requirement of Section 206: that FERC demonstrate that its new allowed ROE, set at the midpoint of the upper half of the zone of reasonableness, was “just and reasonable.”
  • We believe that the court’s decision is unlikely to result in a material change in outcome for the transmission owners. The revised order to be issued by FERC in response to the court’s remand will be based upon the same data, will most likely apply the same methodology and thus will likely arrive at a similar allowed ROE. FERC will add analysis and discussion to support the conclusion that the prior allowed ROE is now “unjust and unreasonable” and that the new allowed ROE is “just and reasonable.”
    • To support its contention that the transmission owners’ current allowed ROE is “unjust and unreasonable,” FERC could argue that an allowed ROE of 11.14% is clearly higher than necessary to support new transmission investment, as evidenced by continued investments by many transmission owners, including private equity, at significantly lower ROEs.
    • To support setting its new allowed ROE at the midpoint of the upper half of the zone of reasonableness, FERC could point out that its traditional use of the midpoint of the zone (9.39%) results in an allowed ROE below those set in state regulatory decisions or implied by other relevant analyses: the average allowed ROE set in electric utility rate cases by state regulatory commissions in 2012 and 2013, the years during which data was collected to determine the zone of reasonableness, was 10.17% and 10.03%, respectively and the CAPM analysis in the record results in a midpoint of 10.4% and a median of 10.9%.
  • However, an alternative outcome is that FERC capitalizes on the court’s remand to issue a very different decision, and in particular one that would support higher allowed ROEs in future cases.
    • The Federal Energy Regulatory Commission by statute has five commissioners; currently, due to resignations, it has only two, one short of a quorum. Given the Trump administration’s focus on promoting infrastructure investment, we expect the President to fill the three empty seats with individuals supportive of that policy. These individuals may shape FERC’s response to the court’s remand in a way that is favorable to transmission owners.
  • Specifically, FERC could advance a policy framework for setting base allowed ROEs that is predicated on the need to incent investment in the nation’s critical high voltage transmission grid by offering higher returns than those available on other utility investments. This would eliminate the need for FERC to support high ROEs through the use of seemingly arbitrary formulas such as the midpoint of the upper half of the zone of reasonableness.
    • We believe that legislative authority for such a rate making framework is provided by Section 219 of the Federal Power Act (as amended by the Energy Policy Act of 2005), which requires FERC to “establish, by rule, incentive-based…rate treatments for the transmission of electricity in interstate commerce by public utilities for the purpose of…ensuring reliability and reducing the cost of delivered power by reducing transmission congestion.” FERC could modify its previously established transmission incentive ROE rules and argue it is justified in setting base allowed ROEs for new and existing transmission assets at a premium to those allowed by state regulators in electric utility rate cases.
    • Furthermore, FERC could find that stability of returns is important to encourage investment as well, and establish a policy of not reviewing allowed returns for a minimum specified period of time, such as three years, absent a significant change in the capital markets.
  • A legislatively authorized decision framework of this type could not only support higher allowed ROEs, but reduce the frequency and limit the grounds for challenges in future Section 206 proceedings, materially reducing uncertainty for transmission owners and their investors.
  • The utilities best positioned to benefit from a change in FERC transmission ROE policy are the owners of transmission with FERC determined ROEs. The largest owners, ranked in declining order as a percentage of electric rate base, are PEG, AGR, ES, EIX, FE, AEP, PCG, D, EXC, PPL, WEC and AEE.

Exhibit 1: Heat Map: Preferences Among Utilities, IPP and Clean Technology

Source: SSR analysis

Details

In 2011, the Commonwealth of Massachusetts filed a complaint with FERC arguing that the base return on equity then allowed by FERC to transmission owners in ISO New England had become “unjust and unreasonable.” Brought under Section 206 of the Federal Power Act, the complaint argued that the transmission owners’ base ROE, set by FERC in 2006 at 11.14%, was well above the level justified by capital market conditions in 2011.

FERC’s procedure in assessing the reasonableness of allowed ROEs is first to establish a “zone of reasonableness,” which it does by reviewing prevailing return expectations on regulated electric utility stocks. It does this by adding to the current dividend yields of these stocks the consensus expectations for their dividend growth. Historically, FERC has tended to set allowed base ROEs at the midpoint of the zone of reasonableness. It is permitted by statute and court precedent, however, to select an allowed ROE within the zone of reasonableness that reflects the particular circumstances of the case.

In June of 2014, FERC issued its opinion in response to Massachusetts’ complaint (FERC Opinion 531, Docket EL11-66). In the opinion, FERC modified its calculation of the expected returns on electric utility stocks by introducing a “two step” estimated of expected dividend growth, based upon the average of short term growth estimates (reflecting the consensus estimate of investment analysts) and long-term growth estimates (based upon the average of available forecasts for long term GDP growth). In electric transmission rate cases, FERC had previously relied solely on short term growth estimates. FERC justified this change by noting that it had for the last 20 years used the “two step” methodology in calculating the cost of equity in rate cases involving oil and gas transmission pipelines, and that it would be consistent to apply the same methodology to power transmission assets as well. Calculated on this basis, FERC found that the zone of reasonableness had indeed fallen, to a range of 7.03% to 11.74%, with a midpoint of 9.39%.

Departing from past practice, however, FERC did not set the new allowed base ROE at the midpoint of the zone of reasonableness. Based on other indicators of the cost of equity to regulated utilities, including the capital asset pricing model and a review of recent state regulatory decisions, FERC argued that an allowed ROE of 9.39% was too low and, critically, would limit the ability of the transmission owners to attract necessary capital, an accepted criterion for rate making long supported by court precedent. FERC therefore determined that the allowed base ROE should be selected from the upper half of the zone of reasonableness (9.39% to 11.74%), and decided that an allowed ROE at the midpoint of the upper half of the zone of reasonableness (10.57%) would be “just and reasonable.”

The New England transmission owners appealed FERC’s order to the D.C. Circuit Court of Appeals, arguing that in modifying their allowed ROE FERC had failed to follow the procedure stipulated by Section 206 of the Federal Power Act. Section 206 sets out a two-step process for FERC to modify a utility’s allowed ROE: first, FERC must show that a utility’s allowed ROE is “unjust and unreasonable;” second, it must demonstrate that the new allowed ROE is “just and reasonable.” The New England transmission owners argued that FERC had altogether failed to carry out the first of these two steps. The states of Massachusetts, Connecticut and Rhode Island also appealed, arguing that FERC had not met the second requirement of Section 206 and had failed to demonstrate that its new allowed ROE was just and reasonable. The two challenges were consolidated into a single case, Emera Maine v. FERC.

On April 14, 2017, D.C. Circuit Court issued its decision, remanding the case to FERC for reconsideration.

In its decision, the Appellate Court ordered FERC to correct two deficiencies in its original order. The first of these was FERC’s failure to meet the threshold requirement of Section 206: that, prior to setting a new allowed ROE, FERC first determine that the prior allowed ROE is “unjust and unreasonable.” The second was FERC’s failure to meet the second requirement of Section 206: that FERC demonstrate that its new allowed ROE, set at the midpoint of the upper half of the zone of reasonableness, was “just and reasonable.”

A third but important element of the decision was the court’s rejection of the transmission owners’ argument that FERC could not find their allowed base ROE of 11.14% to be “unjust and unreasonable” as long as it fell within FERC’s new zone of reasonableness. Rather, the court ruled that while the zone of reasonableness must inform FERC’s decision as to a “just and reasonable” allowed ROE, FERC may apply its discretion in selecting an allowed ROE from within this zone based on the circumstances of the case.

Finally, the Court declined to address a further issue raised by the New England transmission owners: whether, as FERC contended in its 2014 opinion, the upper end of its zone of reasonableness sets a limit of the total ROE (base allowed ROE plus incentives) that may be earned by transmission owners. We expect FERC ultimately to prevail on this issue; it is difficult to support the position that an ROE above the zone of reasonableness is just and reasonable.

We believe that the court’s decision is unlikely to result in a material change in outcome for transmission owners. The revised order to be issued by FERC in response to the court’s remand will be based upon the same data, will most likely apply the same methodology and thus will likely arrive at a similar allowed ROE. FERC will add analysis and discussion to support the conclusion that the prior allowed ROE is now “unjust and unreasonable” and that the new allowed ROE is “just and reasonable.”

We would expect FERC again to apply its two step dividend growth methodology for assessing expected returns on electric utility stocks, and to use these expected returns to determine the zone of reasonableness for the allowed return on equity in the case. The same basic methodology has been used by FERC for many years to set rates for pipelines, and unifying gas pipeline and transmission rate setting methodologies makes sense. To support its contention that the transmission owners’ current allowed ROE is “unjust and unreasonable” FERC could argue that an allowed ROE of 11.14% is clearly higher than necessary to support new transmission investment, as evidenced by continued investments by many transmission owners, including private equity, at significantly lower ROEs. To demonstrate that its new allowed ROE is just and reasonable, FERC could point out that its traditional use of the midpoint of the zone of reasonableness (9.39%) results in an allowed ROE well below those set in state regulatory decisions: the average allowed ROEs set in electric utility rate cases by state regulatory commissions in 2012 and 2013, the period during which FERC collected the data for its analysis, were 10.17% and 10.03%, respectively. FERC also reviewed other methodologies for evaluating a fair return on equity, including the capital asset pricing model and a comparison of risk premia, and concluded that these also justify an allowed ROE above the midpoint: the CAPM analysis in the record results in a midpoint of 10.4% and a median of 10.9%.

 

An alternative outcome, however, is that FERC capitalizes on the court’s remand to issue a very different decision, and in particular one that would support higher allowed ROEs in future cases. Important in this context is President’ Trump’s ability to appoint a majority of FERC’s commissioners. FERC, which by statue operates with five commissioners, currently only has two, one fewer than required for a quorum. Given the critical importance of FERC’s decision-making to timely investment decisions by owners of transmission and generation assets, and the Trump administration’s focus on promoting infrastructure investment, we expect the President to fill these posts. If in doing so he appoints individuals that, consistent with his stated policy, are supportive of infrastructure investment, these individuals may shape FERC’s response to the court’s remand in a way that is favorable to transmission owners.

Specifically, in responding to the court’s instruction that it provide a reasoned explanation of its methodology in setting allowed ROEs, FERC could advance a new policy framework for setting base allowed ROEs. This new framework could be predicated on the need to incent investment in the nation’s critical high voltage transmission grid by offering higher returns than those available on other utility investments. This would eliminate the need for FERC to support high ROEs through the use of seemingly arbitrary formulas such as the midpoint of the upper half of the zone of reasonableness.

We believe that legislative authority for such a rate making framework is provided by Section 219 of the Federal Power Act (as amended by the Energy Policy Act of 2005), which requires FERC to “establish, by rule, incentive-based…rate treatments for the transmission of electricity in interstate commerce by public utilities for the purpose of…ensuring reliability and reducing the cost of delivered power by reducing transmission congestion.” Such rules, the Act continues, shall “promote reliable and economically efficient transmission and generation of electricity by promoting capital investment in the enlargement, improvement, maintenance and operation of all facilities for the transmission of electric energy….” FERC could modify its previously established transmission incentive ROE rules and argue that it is justified in setting base allowed ROEs for new and existing transmission assets at a premium to those allowed by state regulators in electric utility rate cases or at a premium to expected returns on competitive generation investments. Furthermore, FERC could find that stability of returns is important to encourage investment as well, and establish a policy of not reviewing allowed returns for a minimum specified period of time, such as three years, absent a significant change in the capital markets.

A legislatively authorized decision framework of this type, we believe, could not only support higher allowed ROEs, but reduce the frequency and limit the grounds for challenges in future Section 206 proceedings, materially reducing uncertainty for transmission owners and their investors.

 

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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