Kern River’s rate case is halted by FERC and D.C. Circuit. On Tuesday, June 16th, D.C. Circuit Court of Appeals, Judge Sentelle, published the court’s opinion in Aera Energy LLC v. FERC, concluding that the Federal Energy Regulatory Commission complied with the Natural Gas Act (“NGA”) and court precedent. Petitioners Aera Energy LLC and several other natural gas and transportation companies (collectively “Shippers”, companies that contract with a pipeline for the transportation of natural gas and who retain title to such natural gas while it is being transported) ship natural gas using the Kern River Gas Transmission Company’s (“Kern River”) pipeline. Kern River is an interstate natural gas pipeline company subject to the jurisdiction of FERC under the NGA. Kern River owns and operates a 1,717-mile interstate natural gas pipeline system extending from Opal, Wyoming, through the states of Utah and Nevada to California’s San Joaquin Valley near Bakersfield, California. Kern River is an open-access transporter, and utilizes its transmission system to provide natural gas transportation services to customers in the western United States.
The appeal resulted from the consolidation of petitions filed by Kern River and the Shippers who sought judicial review of an array of issues stemming from seven separate opinions issued by the FERC pursuant to the Kern River rate case. The rate case at issue was originally filed at the FERC in 2004 and eleven years later the smoke from this long and hard fought battle finally cleared. The proceedings preceding the appeal occurred between 2004 and 2013. Seeing as there was such a long period of administrative litigation prior to the court appeal, a solid background regarding the pipeline and a timeline of regulatory events leading up to the appeal are necessary to really put into perspective what was at issue before the D.C. Circuit.
Kern River Pipeline Background
January 24, 1990, FERC issued an order granting optional certificates to Kern River and Mojave Pipeline Company to construct, own and operate interstate natural gas pipeline facilities. The order also granted Kern River a blanket transportation certificate, under which Kern River would perform both firm and interruptible transportation service on a self-implementing, open access basis. Kern River was authorized to transport up to 700 mmcf per day on a firm basis, on behalf of contract shippers. In addition, the January order granted Kern River blanket certificate authority to construct and operate appurtenant facilities as necessary to render the authorized transportation services.
To obtain authorization to construct a new pipeline, a natural gas company first must obtain a certificate of public convenience and necessity from the Commission pursuant to section 7(c) of the Natural Gas Act, 15 U.S.C. § 717f(c). Under the Commission’s regulations in effect when Kern River applied for its certificate, a pipeline could obtain a standard section 7 certificate, which required that the applicant meet rigorous standards, including demonstrating demand for the total capacity of its proposed facilities and adequate gas supply. Alternatively, under the Commission’s optional expedited certificate procedures, applicants did not have to demonstrate markets or gas supplies, but applicants had to assume the economic risks of the project. The FERC created the optional certificate alternative in Order No. 436 on October 9, 1985, and eliminated it in Order No. 615 on July 14, 2000. The regulatory framework for optional certificates is a bit more unique than a typical section 7 certificate, and the resulting ratemaking methodology for the pipeline is also unique.
The rate structure that the FERC approved permitted Kern River to charge levelized rates over the course of three rate periods. Under the traditional method of ratemaking, a pipeline receives higher rates during its early years and lower rates in later years. Levelizing the pipeline’s cost of service over its life provides lower rates at the beginning of service than traditional ratemaking, but those rates gradually become higher than traditionally-designed rates as the rate base declines. Lower initial rates help a new pipeline market its capacity and compete with other established pipelines in the area charging low rates. The Commission authorized Kern River to charge one rate for the fifteen-year term of the original Shipper contracts (hereinafter referred to as “Period One rates”), another rate for years 16 through 25 (hereinafter referred to as “Period Two rates”), and a third rate for service rendered after 25 years (Period Three rates are not the subject of this appeal). FERC intended the levelized rate structure to enable Kern River to recover substantially all of its capital debt during the first 15 years and its equity capital during the next 10 years. The charges for service beyond 25 years are to provide for the recovery of Kern River’s operating expenses, taxes, and a reasonable management fee that is equivalent to no more than 10 percent of Kern River’s average pre-tax return.
August 9, 1991, Kern River filed an application to amend its optional certificate — seeking authority to increase its initial rates (which were based on 1989 cost estimates) to reflect Kern River’s actual costs of constructing its pipeline system.
November 29, 1991, Kern River filed its tariff sheets.
January 30, 1992, the Commission approved Kern River’s request to reflect Kern River’s actual costs of constructing its pipeline system. The initial rates were based on the capital cost estimate which Kern River prepared in the summer of 1989. Kern River estimated that the total cost of the pipeline project would be approximately $917 million, as compared to the 1989 cost estimate of $853 million.
February 9, 2000, the Commission approved a March 31, 1999 settlement in Kern River’s Docket no. RP99-274-003 that, among other things, provided a rate reduction in the maximum rates on Kern River’s system, a rate increase moratorium for three years, levelized depreciation rates and other opportunities for shippers to share in potential benefits.
July 26, 2000, Kern River proposed to lower its shipping rates by refinancing its debt. FERC approved the proposal, allowing levelized rates to continue and permitting Kern River, consistent with its original certificate order, to recover its debt by the end of the new debt repayment period.
November 15, 2000, Kern River initiated the California Action Project seeking to increase the pipeline’s transportation capacity by approximately 10,500 Mcf per day. FERC aproved the request on July 26, 2001.
August 1, 2001, Kern River filed another certificate application to expand the pipeline system, known as the “2003 Expansion”. This expansion included about 634 miles of 36-inch pipeline and 82 miles of 42-inch pipeline.
Prior Proceedings
The Hearing On Period One Rates
On April 30, 2004, Kern River proposed an increase to its Period One rates pursuant to section 4 of the Natural Gas Act, 15 U.S.C. § 717c.
• The hearing before administrative law judge, Charlotte J. Hardnett, on Period One rates began on August 17, 2005.
• Judge Hardnett’s March 2, 2006 Period One Initial Decision, addressed numerous cost of service and rate design issues, including Kern River’s proposal to continue its levelized rate methodology.
• Judge Hardnett found that Kern River had carried its burden under the NGA to prove that its levelized cost of service methodology would produce just and reasonable rates.
Commission Orders Regarding The Period One Rate Hearing
In Opinion No. 486, October 19, 2006, the Commission affirmed the ALJ’s finding that Kern River’s rates should continue to be designed based on the levelized rate methodology.
• However, Opinion No. 486 required Kern River to include in its tariff the Period Two rates that would take effect upon expiration of the Period One contracts.
In Opinion No. 486-A, April 18, 2008, the Commission reopened the record to permit all parties to submit additional evidence regarding Kern River’s Period One return on equity.
In Opinion No. 486-B, January 15, 2009, the Commission held that Kern River’s return on equity should be 11.55 per cent, the median return on equity of a range of reasonableness of 8.8 per cent to 13 per cent.
• FERC required Kern River to submit a compliance filing revising its rates consistent with the Commission’s merits findings in Opinion Nos. 486, 486-A and 486-B.
In Opinion No. 486-C, December 17, 2009, the Commission accepted Kern River’s compliance filings with regard to its Period One Rate, subject to the condition that Kern River change the reservation billing determinants (a billing determinant is a measure of customer demand or entitlement to a pipeline’s services) used to allocate costs to 15-year rolled-in system shippers.
• The Commission directed Kern River to file revised tariff sheets to comply with this determination.
• The Commission further determined that the decrease in the Period One rates below the pre-existing level would be effective prospectively as of the date of issuance of Opinion-No. 486-C, December 17, 2009.
On rehearing, Kern River argued that the Commission erred in declaring the Period One rates effective as of the issuance of Opinion No. 486-C.
• Because the Commission accepted the Period One rates subject to changing the billing determinants used to allocate costs, Kern River contended that the prospective Period One rates were indeterminable as of the date of Opinion No. 486-C, and therefore the Commission did not “fix” the rates as required by section 5 of the Natural Gas Act, 15 U.S.C. § 717d.
Opinion No. 486-D, November 18, 2010, denied rehearing regarding Period One rates, and accepted Kern River’s January 29, 2010 filing setting out Period One rates in compliance with Opinion No. 486-C.
• The Commission also denied rehearing on the effective date for prospective Period One rates.
Period Two Rates
In Opinion No. 486, October 19, 2006, the Commission acted under section 5 of the NGA, 15 U.S.C. § 717d, to require that Kern River include in its tariff the Period Two rates that will take effect when firm shippers’ Period One contracts expire.
• FERC found that the Period Two rates were to be based on the same cost of service as Period One rates.
In a March 2, 2009 compliance filing, Kern River proposed to use a traditional rate design for its Period Two rates, rather than continue the levelized rate method used in Period One.
In Opinion No. 486-C, December 17, 2009, the Commission rejected Kern River’s proposed Period Two tariff filing because it was not based upon a levelized rate methodology, and set for hearing how those levelized rates should be calculated.
In Opinion No. 486-D, November 18, 2010, the Commission reiterated that the starting point for calculating Period Two rates is the cost of service determined for Period One rates based upon the 2004 test year data.
• The only exception to this general approach to developing Kern River’s Period Two rates is where there are circumstances unique to the transition from Period One rates to Period Two rates that justify an adjustment to the cost of service underlying the Period One rates.
• Among the unique circumstances that could be addressed anew in the Period Two rate hearing was the change in Kern River’s capital structure from 70 per cent debt/30 per cent equity in Period One to 100 per cent equity in Period Two.
• Due to this change in capital structure, the Commission permitted the parties to address in the Period Two hearing whether Kern River’s return on equity for Period Two should be adjusted from the median 11.55 percent return on equity underlying its Period One rates.
The hearing before the ALJ on Period Two rates commenced on December 8, 2010.
• With regard to Kern River’s Period Two return on equity, Kern River proposed to increase its return on equity to 13 per cent, the top of the range of reasonableness, and shippers advocated for a reduction to 8.8 per cent, the bottom of the range.
• The ALJ concluded that neither Kern River nor the shippers justified departing from the median 11.55 per cent return on equity.
Opinion Nos. 486-E (July 21, 2011) and 486-F (February 22, 2013) affirmed maintaining Kern River’s return on equity for Period Two at the median value of 11.55 per cent.
• The Commission determined that the starting point for calculating the Period Two rates is the Period One cost of service based on 2004 test year data.
-Thus, any changes to the median 11.55 per cent rate of return for purposes of Period Two rates would require compelling evidence that an investor in 2004 — based on information available in 2004 regarding Kern River’s circumstances between 2011 and 2018 (the time frame during which Period Two contracts would become effective) — would perceive Kern River to be a pipeline of greater or lower than average risk.
-The Commission concluded that neither Kern River or the Shippers presented compelling evidence justifying the adjustment of the 11.55 per cent median return on equity up or down.
• Shippers argued that Kern River’s return on equity should be reduced because its financial risk would greatly diminish in Period Two when Kern River would transition from the Period One 70 per cent debt/30 per cent equity capital structure to a 100 per cent equity capital structure.
The Commission found that investors would recognize that Kern River’s capital structure would gradually evolve to a 100 per cent equity structure beginning in 2011, and that this would gradually reduce its financial risk as its debt was retired.
• This decline in financial risk was sufficiently gradual, however, with 88 per cent of the Period One contracts still in effect in 2015, that investors would likely conclude that Kern River’s risk would hardly be different in the early years of Period Two than during Period One, which tended to support a median return on equity for Period Two.
D.C. Circuit Review
Setting the Effective Date of Period One Rates
The first major issue under review by the court is whether FERC erred in fixing Kern River’s Period One rates effective as of the issuance of Opinion 486-C on December 17, 2009. The court followed the rule in Transwestern Pipeline Co. v. FERC, 897 F.2d 944 (D.C. Cir. 1990) explaining that “[t]he Commission need not confine rates to specific, absolute numbers but may approve a tariff containing a rate [formula, rule or model]; it may not, however, simply announce some formula and later reveal that the formula was to govern from the date of announcement.”
Kern River argued that the Period One rates could not have been fixed until the FERC accepted the provisions in Kern River’s compliance filing, which clarified the unjust and unreasonable aspects of Kern River’s Period One rates. FERC did not accept such compliance filing until November 18, 2010. Kern River argued that FERC could not fix Period One rates because the pipeline’s rates were indeterminable as of the date of the Commission’s Opinion No. 486-C. In support of its argument, Kern River relied on Electrical District No. 1 v. FERC, 774 F.2d 490 (D.C. Cir. 1985), where the court explained, “’that the statute means what it says’ – when fixing a rate, it is not enough for FERC to ‘prescribe the legal and accounting principles which, properly applied, will yield one particular rate’ because the statute ‘requires the rate itself to be specified.”
Here, Judge Sentelle, distinguished Electrical District, from the current case stating that “[e]ven though Electrical District ‘adopted a bright-line insistence that a numerical rate be ‘specified’ before it can be fixed, Transwestern…, permitted FERC to fix rates subject to adjustments. FERC convinced the court that it had done more than set forth the basic principles of Kern River’s rates by the time it issued Opinion No. 486-C, citing to the fact that by the time the Commission had fixed Kern River’s Period One rates the pipeline had participated in a full hearing before Judge Hardnett, received a post-hearing decision regarding such hearing, and three Commission Opinions resulted regarding the same issue of Period One rates (486, 486-A and 486-B). Ultimately, the court denied Kern River’s argument and deferred to FERC’s decision to fix Kern River’s Period One rates on December 17, 2009, the date of Opinion 486-C’s issuance.
Adjusting the Period One Rate Credit
The next issue Judge Sentelle considered is whether FERC erred by refusing to consider Kern River’s proposed cost of service adjustment for Period One rates after the issuance of Opinion 486-D on November 18, 2010. The court upheld the Commission’s basis for refusing to consider Kern River’s proposed cost of service adjustment because “the agency’s path may reasonably be discerned from the record.” Motor Vehicle Mfrs. Ass’n of U.S., Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983).
FERC claims that it did not address Kern River’s proposed cost of service adjustment because the Commission was satisfied with Judge Cianci’s reasoning, in his April 14, 2011 decision, that Period One rates had become effective upon the issuance of Opinion 486-C. Judge Cianci rejected Kern River’s proposed cost of service adjustment because Period One rates were finalized upon the Commission’s issuance of Opinion 486-D.
Here, Judge Sentelle claims that Kern River “misread” Opinion No. 486-D, stating that FERC only considered making adjustments that would affect Period Two rates, and that it did not reopen the Period One evidentiary record to adjudicate Kern River’s proposed cost of service adjustment for Period One rates. The court concluded that “FERC did not abuse its discretion by refusing to reopen the Period One [rate] evidentiary record after it issued Opinion 486-D.
Kern River’s Return on Equity for Period Two Rates
The last issue reviewed by Judge Sentelle and the court is whether the FERC erred when it did not reduce Kern River’s return on equity for its Period Two rates. The court ruled that an informed investor would notice the gradual transition toward less financial risk (transitioning from Period One to Period Two rates) induced by a levelized rate structure. The Shippers made four arguments in support of their request that the court reverse FERC Opinion Nos. 486-E and 486-F and remand with instructions for FERC to reduce Kern River’s return on equity in Period Two: FERC (1) failed to address the reduced financial risk associated with Kern River’s capital structure having 100 per cent equity for its Period Two rates; (2) relied on an irrational composite equity 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 court determined that when FERC set Kern River’s return on equity for Period Two rates, it considered how investors in 2004 would have viewed the transition from a 30 per cent equity structure in Period One to the 100 per cent equity structure in Period Two, and that an informed investor would have noticed that the transition toward less financial risk is not abrupt.
Regarding “composite equity”, the court deferred to FERC’s clarification that the Commission was not in fact referring to Kern River’s capital structure when it discussed composite equity in Opinion No. 486-E, but rather, it was referring to an investor’s perception of Kern River’s risk. As for the notion of an “increased business risk”, the court endorsed FERC’s explanation 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.
A pipeline that has an “optional certificate” has a unique capital structure, “and comparisons to other pipelines’ equity ratios do not render it any more or less anomalous.” Opinion No. 486-F. The court endorsed FERC’s reasoning that in other unique situations involving atypically high equity ratios, FERC has adjusted the rate of return on equity downward. FERC explained how other unique situations are not persuasive in the context of Kern River’s rate proceedings because such proceedings involved pipelines certified under the traditional requirements of section 7 of the NGA. The court rejected all of the Shippers’ arguments, thus the Kern River rate of return on equity for Period Two rates shall remain at 11.55%.
Conclusion
The court gave FERC complete deference, ruling for the agency on all three issues of contention. One cannot be optimistic that the adjudication regarding Kern River’s pipeline rates are over. Period Three rates could be next on the docket.