Natural Gas Deregulation Transition Costs
and the Impact Such Costs
Could Have on
State Utility Rates
By David J. Kreher
Part Four: Stranded Costs
Definition
In Order No. 636, the FERC initially defined stranded costs and has refined the definition since. The basic idea is "the items must no longer be 'used and useful' after restructuring. Restructuring is the unbundling as a result of Order No. 636 and its subsequent clarifications. The definition of stranded cost is further explained by the FERC in its statement:
[S]tranded costs are costs now incurred by pipelines in connection with their bundled sales services that cannot be directly allocated to customers of the unbundled services.2
In addition, the FERC gives specific examples of what it considers as stranded costs:
[F]or example, pipelines may retain unclaimed or unneeded upstream pipeline capacity even after assignments of portions of that capacity to their firm transportation customers. Similarly, the pipelines may have unbooked, open-access, contract storage beyond their needs for balancing and system management.3
The FERC also considers as potential stranded costs:
[T]he costs of capacity on upstream pipelines and upstream storage (Account No 858 and 824), storage facilities, production facilities, products extraction facilities, gathering facilities and transmission facilities. This list is not exhaustive and other costs will be considered on a case-by-case basis.4
The result of the above definitions is that the item must be proved to be no longer used and useful. But, to be no longer used and useful is not sufficient; the restructuring process must have caused the items to be stranded.5 The causal connection should be a key issue upon which the State challenges proposed stranded costs, arguing that an item may now be stranded, but the cause of the stranded cost is only partially a result of the regulatory change. A determination that only part of the cost of an item is stranded would mean that the pipeline would be responsible for at least some costs.
Stranded Cost Recovery
The FERC plans to approach the recovery of stranded costs during a full rate case and will review the validity of each stranded cost by evaluating whether it was a prudently incurred cost.6 However, the FERC will "allow pipelines to make limited section 4 filings to recover . . . the costs of stranded facilities that are currently incrementally priced . . . .7 This sort of review will allow for a case by case determination of legitimate expenses and will also allow the FERC to determine how stranded cost costs allocation should occur between the affected parties. The FERC defends the case by case review on the basis that "there is no way of anticipating the nature and amount of the stranded costs, and thus no way at this time of devising an appropriate billing mechanism on a generic basis."8 The State should take its lead from the FERC and recognize that the unquantifiable nature of stranded costs is a justifiable reason for thorough case by case review.
Upon completion of the rate case where stranded costs are considered, the FERC will generally consider the issue of stranded costs as closed. The FERC specifically states:
[O]nce a pipeline's costs have been determined eligible for recovery as stranded costs, the pipeline may not subsequently seek recovery of those costs as an element of its cost of service in any future rate proceeding without recognition of the costs it has recovered as stranded costs.9
Moreover,
[W]hen a [pipeline] seeks to recover stranded costs for . . . facilities . . . , the Commission will consider all of [a pipeline's] gathering transactions, including the transfer of assets to an affiliate, when assessing the recoverability of such stranded costs.10
The FERC also "emphasize[s] that transition costs (such as stranded costs) cannot be recovered until after the pipeline has fully complied with the requirements of [Order 636]."11
When the FERC considers stranded costs, it will do so en sum, that is:
[T]o the extent that [a pipeline] recognizes gains on sales of stranded facilities and later has losses on sales of facilities that it seeks to recover as stranded costs, [the pipeline] must, if it files for recovery of stranded costs, detail the prior gains and reduce the proposed stranded cost recovery amount by the amount of those gains. This requirement will insure that gains on the sales of stranded facilities are taken into consideration if Northern seeks to recover its stranded investment costs in a subsequent [the subsequent] rate proceeding.12
Company Determination of Stranded Costs
The FERC has given some guidance as to what a pipeline must consider when it tries to determine stranded cost as a result of the unbundling process. First, the unbundling process must take place. The pipeline must identify what to do with its facilities, divide them by function, and identify the remaining costs of each facility. The pipeline must also ask whether it should spin-off or spin-down its facilities as opposed to retaining them:
A pipeline choosing this option would spin-off its facilities and apply for stranded cost treatment for any amounts below the book value of the facilities it received. These amounts would, of course, be offset by any amounts received in excess of book value.
Alternatively, . . . the pipeline [] should explore writing down the value of their . . . plant to an economically viable level, and propose the difference between the net depreciated original cost of the plant and the lower market value, as a stranded cost.13
The FERC has defended the second alternative by arguing:
[T]reating this differential as stranded cost would continue to permit the facilities to be used at a rate reflecting market value, which would avoid the harm of well shut-ins that a high non-market-responsive rate might cause. . . . [P]ipelines that choose to retain these facilities will find it necessary to incorporate some element such as a write down of the value of the facilities to market value level, and a recovery of this written down amount over a reasonable period of time, such as five years, or a spin-off of the facilities.14
Before a pipeline considers adopting the second alternative, some considerations should be taken into account. Along these lines, the FERC has stated:
A pipeline choosing to write down the facilities to market value and recover these costs as stranded costs over a reasonable period of time, would not earn a return on the unamortized portion of the facilities. A rate of return on the amount of written down facilities would be inappropriate since this allows a return on facilities that are not economically viable, and may also result in a competitive advantage for the pipeline. The pipeline would, however, be allowed to recover interest on the unamortized portion of its written-down plant over a reasonable amortization period, as this will keep the pipeline whole for the direct cost of its investment in the facilities. Any facility additions added to gathering systems to a write down of facilities to market value would be recovered only through the gathering rate.15
The result of writing down the cost of a facility means that the facility, which is no longer "used and useful," could no longer be treated as an item in the "rate base" and the pipeline could not receive a rate of return from the cost of the facility. The remaining cost of the facility could only be included in the annual costs — items expended on an annual basis — and profit could not be earned from the stranded costs. Further treatment of whether a pipeline should earn a rate of return on stranded costs will be dealt with later.
If a pipeline tries to recover a portion of a pipeline's capacity as stranded there are additional considerations. In so attempting — because the pipeline no longer has a firm transportation customer for a portion of the pipeline's capacity — the FERC will evaluate whether a stranded cost has been incurred by asking whether the pipeline has actively searched for a new customer to replace the old. Specifically, the FERC has held, "[r]ather than shifting the costs of unsubscribed capacity to the remaining shippers, [the pipeline] has some obligation to attempt to develop new business opportunities to make use of its unused capacity."16 In other words, before a pipeline applies for stranded cost recovery on the basis of a loss of firm capacity users, the pipeline must first evaluate its market and seek other customers to replace those lost.
"Used and Useful" Debate
The traditional rate which a utility is allowed to charge "is the sum of (1) its cost of service, and (2) its rate base multiplied by its rate of return."17 There has also been a long-standing assumption, only those items deemed "used and Useful" will be allowed in the rate base. A problem is then created when stranded costs are included in a utilities rate base. On the one hand, stranded costs are no longer "used and useful" and so should not be included. On the other, the regulatory compact says a utility will be able to receive the costs incurred for providing service and is allowed the potential to receive a reasonable rate of return on its investments. In other words, a utility has incurred a cost, which has been prudently incurred; but, because of deregulation, the cost is no longer prudent. If the utility is not allowed to recoup its costs, the potential for a governmental taking will result.
The DC Circuit addressed this problem in a number of cases, Specifically, in NEPCO Municipal Rate Committee v. FERC,18 the Court held "whether FERC's refusal to include project expenditures in the rate base, while allowing their recovery as costs over time, is a valid approach to allocating the risks of project cancellation." (In 88 F.3d 1105, 1179). In that decision, the DC Circuit states, "[we] found such an approach acceptable because, in that case, the Commission's decision was based on substantial evidence and had adequately balanced the interests of investors and ratepayers. * * * [s]o long as the Commission's decisionmaking in the individual proceedings . . . satisfied that standard, it will survive any subsequent challenge brought on 'used and useful' grounds."19
The response, however, does not answer whether a rate of return should be allowed on the stranded costs.
In considering whether a rate of return should be allowed, the DC Circuit, in United Distribution Companies v. F.E.R.C., considered three options:
The Commission could decide that stranded costs should merely be included in the pipeline's cost of service, recoverable through amortization over time. . . . . The Commission might also allow the pipeline to recover not only the amortization, but also interest, i.e, the "cost" of the unamortized portion of the investment. The Commission could further decide to include stranded investments in the utilities rate base and thereby generate a profit for investors.20
However, the Court did not determine whether any of these options were appropriate, as that question was not before it.
State Application
The State will be affected by stranded costs in many different fashions. First, the State will need to consider, review and challenge federally approved stranded costs. Similar to GSR costs, whether the federal government allows the recovery of some costs should not meant the State should not challenge these costs as the state level. The State may also consider whether groups other than the consumer should incur some of the stranded costs. In addition, the causal connection between the deregulation and incurred stranded cost should be challenged. It may not be appropriate for the consumer to incur the entire stranded cost when only a portion originated from deregulation.
The State will also encounter stranded costs in deregulation at the state level. In this instance, stranded costs should be challenged on the basis of whom should pay for the cost and how should it be divided. Also, a rate of return should not be allowed for stranded costs, as the return would give an unfair advantage to existing pipelines. Finally., a challenge should be raised to insure that the interests of investors and ratepayers are adequately considered and balanced, and the ratepayers are not overburdened by stranded costs.
Coming Next: New Facilities Costs
For more information, contact
David J. Kreher
4455 East 31st Street, #261
Tulsa, Oklahoma 74135
918.747.9849
161 F.E.R.C. ¶ 61,272 at *74.
257 Fed. Reg. 13,267, 13,308 fn. 28 (1992) (to be codified at 18 C.F.R. pt. 284).
3Id.
461 F.E.R.C. ¶ 61,272 at *74.
5Id.
657 Fed. Reg. 13,267, 13,308 fn. 28 (1992) (to be codified at 18 C.F.R. pt. 284).
761 F.E.R.C. ¶ 61,272 at 62,042.
857 Fed. Reg. 13,267, 13,308 fn. 28 (1992) (to be codified at 18 C.F.R. pt. 284).
961 F.E.R.C. ¶ 61,272 at *74.
1070 F.E.R.C. ¶ 61,323 at *1.
1162 F.E.R.C. ¶ 61,192 at *41.
1270 F.E.R.C. ¶ 61,031 at *3.
1371 F.E.R.C. ¶ 61,323 at *3.
14Id.
15Id.
1676 F.E.R.C. ¶ 61,122 AT *23.
17Jersey Central Power & Light Co. v. FERC, 810 F.2d 1168, 1172 (D.C. Cir. 1987).
18668 F.2d 1327 (D.C. Cir. 1981)
19United Distribution Companies v. F.E.R.C., 88 F.3d 1105, 1179 (D.C. Cir. 1996).
20Id.
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