Regulated Pipeline Profitability & FERC Tax Policy: A Primer To MLP or Not To Be? And Form 501G

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1 // 1 Regulated Pipeline Profitability & FERC Tax Policy: A Primer To MLP or Not To Be? And Form 501G Why Read this ebook? If you own, seek to own, develop, seek to develop, are a customer of, invest in, or otherwise have a financial stake in natural gas pipelines, then you need to understand the arcane and technical details of the tax policies, regulations and practices that impact their rates and profitability. Things have changed in 2018! Topics Covered ü Overview of Pipeline Economics ü Tax Cuts and Jobs Act of 2018 ü Income Tax Allowance for Pipelines ü Types of Pipeline Entities (MLPs) ü Tariff Rates, Recourse Rates and Negotiated Rates ü Accumulated Deferred Income Taxes ü Form 501G

2 // 2 Introduction Energy infrastructure, such as pipelines, is vital to supporting everyday living and the economy. Over time the U.S. government (USG) has created various incentives for infrastructure development. A big policy lever available to the USG for promoting energy infrastructure investment is favorable tax treatment. These tax laws and policies helped create many of the unique corporate structures and finance practices found in the energy industry, such as Master Limited Partnerships (MLPs), and are in place to support the long term capital intensive investments required to build and maintain the pipelines, power plants, wind farms, solar arrays, etc. that power the nation. What follows, will examine some recent and significant changes to the interplay between the laws, regulations, policies, practices, and markets that govern and participate in the Midstream (aka activities involving the transportation, processing, storing, and marketing) sector of the energy industry.

3 // 3 These changes are causing some disruption and uncertainty in the markets and some restructurings in the industry as companies decide if the MLP structure is the most advantageous for their energy transportation businesses. Interpreting the arcane and technical details of regulatory policy, litigation, and market forces to determine their top and bottom line impacts is not always easy. Market participants needing clarity must often seek expensive legal opinions that are hard to quantify. LawIQ acquires, structures, analyzes, and interprets all of the public filings we refer to herein utilizing our intelligent software platform and energy and legal experts to provide customers insights and answers they need to forecast and analyze regulatory risks and make the best business decisions. We hope this introductory primer helps you by providing general background knowledge and some specifics on the issues currently affecting the industry. Let s start with some pipeline economics and what is known as an Income Tax Allowance or ITA.

4 // 4 Pipeline Economics An interstate 1 natural gas pipeline ( pipelines ) charge a tariff rate to customers that produce gas and to utilities and other end users that consume the commodity ( shippers ). What pipelines can charge is regulated and complicated. These charges or tariff rates are set by the Federal Energy Regulatory Commission ( FERC ), which fixes a maximum rate, but rates are also subject to market forces and may be discounted or negotiated directly with pipeline customers. Part of FERC s mission 2 is to ensure all of the costs included in a pipeline s rates are just and reasonable. The formula for determining a pipeline s tariff rate is based on its costs and allows for a profit margin; in the lexicon of pricing, this is a cost plus methodology. 1 Interstate pipelines are regulated at the federal level as opposed to intrastate pipelines, which are not subject to the same regulations and policies. 2

5 // 5 The Tax Act and Today s ITA A key component of any pipeline s cost is the income taxes it owes to the federal and state governments. However, unlike the other costs recovered in a pipeline s rates, which are actual costs, the amount allowed for income taxes is set under a FERC policy based on the taxes the pipeline expects to pay. This policy Is called the ITA. Between 2005 and March 2018, the FERC allowed pipelines to include an ITA equal to the 35% federal corporate tax rate as part of a pipeline s cost of service for purposes of calculating its tariff rates. At the end of 2017, Congress passed and the President signed the Tax Cuts and Jobs Act ( Tax Act ), which reduced the corporate income tax rate to 21%. This was the first potential ripple in the pond of pipeline profits. On the surface, a tax break seems positive for the profits of any company, including pipelines. But there is a catch for many of these companies subject to regulations aimed at ensuring reasonableness of rates for consumers. The reduction in tax rates means tariff rates charged to pipeline customers may need to be reduced in some cases. In these cases, which we will detail shortly, a reduction in tariff rates can lead to a substantial reduction in a pipeline s revenue.

6 // 6 The Relevant Regulatory Changes What, When, and What s Next? So how specifically - is the tax law change driving regulation changes, and what does it mean? A pipeline can only be required to reduce its rates after a formal proceeding before the FERC under either Section 4 or Section 5 of the Natural Gas Act (NGA). Until any new rates dictated by one of these proceedings take effect, top line revenue will not change except for circumstances in which pipeline contracts expire. In the meantime, the positive impact of tax reductions can begin to accrue decreasing costs and increasing bottom line profits prior to the aforementioned regulatory proceedings. This change in pipeline company economics was not missed by the Shippers. 3 They want their fair share and promptly began asking FERC to pass the tax savings back to customers by requiring a reduction in tariff rates. In March 2018, FERC simultaneously announced three actions that surprised market participants two related 3 Shippers are predominantly local distribution companies (LDCs), and large oil and gas exploration and production (E&P) companies that contract for the transportation of shipping of their product to market. Shippers are also often companies who businesses require large quantities of fuel, such as airlines, and thus actively participate in commodities markets to purchase and hedge. to the Tax Act and one in response to a court challenge to FERC s ITA policy.

7 // 7 Forces Impacting Future Pipeline Rates TAX REFORM REGULATORY MARKET TRANSPORTATION RATES MLP C LLC

8 // 8 The most surprising of these actions concerned the ITA policy in force since FERC revised the policy in response to a court challenge 4 to a FERC order that allowed a pipeline, SFPP, L.P., (structured as an MLP) to include an ITA in its cost of service. This new policy reversed FERC s policy of allowing all pipelines to include an ITA in their costs of service and stated: MLPs like SFPP would no longer be allowed to include an ITA when calculating their costs of service (the main input into the rates it can charge customers). Simultaneously, FERC issued a proposed rule to require pipelines to file a new form, Form 501G, designed to calculate the impact of the Tax Act and FERC s new ITA policy on the rates of all pipelines. Form 501G is essentially a spreadsheet with two purposes in mind: 1. Calculate the rate reducing impact from the changes in the ITA and the Tax Act. 2. Calculate a pipeline s new return on equity (ROE) assuming the only changes to its cost of service result from tax changes. (Most of the data needed to make these calculations is found in the annual financial reports pipelines are required to file at FERC. 5 ) The proposed rule would also allow a pipeline to file a limited Section 4 rate case that would reduce the pipeline s tariff rates to account for only the impact of these two tax issues. In conjunction with the filing of Form 501G, pipelines were instructed to choose from four options: 1. File a voluntary limited Section 4 case to reduce its rates consistent with the rate reduction reflected in their Form 501G. 2. Agree to file either a prepackaged uncontested rate settlement or a full Section 4 rate case by the end of Explain why the pipeline should not adjust its rates. 4. Do nothing and risk that FERC will initiate a Section 5 rate investigation. 4 United Airlines, Inc. v. FERC, 827 F. 3d 122 (2016), The shipper petitioners (the Shippers ) claimed that FERC s tax allowance policy for partnership pipelines, such as SFPP, is arbitrary or capricious and resulted in unjust and unreasonable rates. 5 We have extracted this data for all of the pipelines required to file the new form 501G and can calculate the rate reduction and ROE for a pipeline under various scenarios allowed under the form.

9 // 9 FERCs final action in March 2018 was to issue a notice of inquiry (NOI) 6 seeking input on accumulated deferred income tax (ADIT) balances on a pipeline s regulatory books. It is sufficient to know four things about ADIT: 1. ADIT is created by the difference between how depreciation is calculated for tax purposes and for regulatory accounting and ratemaking purposes. In essence, tax laws allow for faster depreciation than that allowed for regulatory accounting purposes. 7 Therefore, during the period when tax depreciation exceeds book depreciation, the difference becomes the ADIT account balance. When tax depreciation ends and book depreciation continues, the difference is reflected by reducing the ADIT balance. So when the regulatory depreciation ends the ADIT balance will be zero as well. 2. The ADIT balance is subtracted from the capital asset base of a pipeline. This means that a high ADIT balance can result in a reduction of the rates a pipeline can charge by reducing the asset balance on which a pipeline is earning a return. 3. When there is a change in tax rates, the ADIT balance needs to be adjusted to reflect the change and ensure that when an asset is fully depreciated for regulatory book purposes, the ADIT balance is zero. 4. Under a provision in the Tax Act, the change in the ADIT balance that occurs when the tax rate is reduced must be returned to a pipeline s customers over the remaining useful life of the related assets. This requirement is reflected on the books of the pipeline by recording the reduced amount of the ADIT balance in a Regulatory Liability account which is then amortized over the remaining useful life of the pipeline s assets. 6 Federal agencies issue NOIs as a formal way to solicit public comment to inform possible future policy or regulation formulation or rulemaking. 7 Faster depreciation improves pipeline company economics and encourages energy infrastructure development.

10 // 10 FERC s Actions Since March In July 2018, FERC responded to requests for clarification of its new ITA policy by holding firm on its previously announced decision to deny an ITA for MLPs that are like SFPP. immediate increase in the pipeline s asset balance on which it is allowed to earn a return. This mitigates the reduction in the pipeline s cost of service resulting from the elimination of the ITA. Importantly, FERC paired its denial of an ITA for such entities with an industry request to completely eliminate such an entity s ADIT balance. The elimination of the ADIT balance results in an FERC chose not to clarify what like SFPP means and left that to future case-by-case determinations. Later in July, FERC had its first opportunities to address open issues in two rate cases.

11 // 11 In the first case, FERC made clear that any pipeline whose equity is owned entirely by a MLP is considered like SFPP and will not be allowed an ITA, even if the majority of the interests in the MLP are owned by a related parent C-corporation. as well. - Or - the pipeline could choose to be treated as if it were a tax paying entity (i.e., calculate a reduction based on the corporate rate change from 35% to 21%) but retain both an ITA and its ADIT balance, including returning any excess ADIT to its shippers. In the second case, FERC ordered the pipeline and its shippers to submit arguments regarding whether an ITA is appropriate for a pipeline whose majority owner is taxed as a C-corporation but whose minority interest holders are not C-corporations. For all entities choosing to file a voluntary Sec. 4 rate case, FERC decided it would not launch a Sec. 5 rate investigation for three years from the effective date of the rate reduction resulting from the pipeline s limited rate proceeding, provided: In July, FERC also made changes to the rule requiring the filing of new form 501G. FERC allowed pass-through entities that choose to voluntarily file for a limited rate reduction the option to calculate that rate reduction on the 501-G form in one of two ways. The pipeline could choose to be treated like an MLP (i.e., calculate a reduction based on an elimination of its ITA completely), but have its ADIT balance simply eliminated, 1. the Commission accepts the limited rate filing; and, 2. following the rate reduction, the pipeline s estimated return on equity (ROE), as calculated on Form 501G, is 12 percent or less. Finally in July, FERC adopted some tweaks to the Form 501G and its instructions. One of these changes the default capital structure from a 50/50 debt to equity ratio to a 43/57 ratio, which causes an increase in the calculated rate reductions and may adversely affect the pipeline industry in some cases.

12 // 12 What Is the Risk to a Pipeline s Top-Line Revenue? All of the above leads any impacted pipeline to assess risks to its business by asking: To answer these questions, one needs to know the following: 1. What will be the extent of any reduction in its tariff rates? 2. What will be the impact of the reduction to its top-line revenue; and, 3. When will the impacts occur? 1. Will a pipeline s tariff rates be reduced and by how much? 2. How much of the pipeline s revenue is generated from cost-based tariff rate contracts, discounted rate agreements, and negotiated rate agreements? 3. When will these rate changes occur with respect to these three types of revenue?

13 // 13 How FERC s Tax Changes Can Affect the Recourse Rate to Change its Tariff Rate Revenue The goal when determining a pipeline s cost of service is to determine the amount of annual revenue the pipeline must generate to operate profitably and attract capital for future growth. The basic formula for calculating a pipeline s annual cost of service starts with the calculation of the return the pipeline is entitled to earn on its assets. The ADIT balance on a pipeline s books is a reduction of the assets on which the pipeline is entitled to earn a return. To the extent the ADIT balance is eliminated, the assets on which the pipeline earns a return would increase (a good thing for the pipeline). earn a return. This means adjusting the ADIT balance does not increase the asset balance on which the pipeline company earns a return. The amortization of the new regulatory asset over the remaining useful life of the related assets is deducted from the ITA each year of the amortization period. This results in a reduction in the pipeline s cost of service and therefore its rates (a bad thing for the pipeline). However, if the ADIT balance is simply adjusted for a tax rate decrease, the reduction in the balance is moved to a regulatory liability account which, like the ADIT balance, reduces the assets on which the pipeline is entitled to

14 // 14 In addition to the return earned on its assets, a pipeline is entitled to recover its actual costs in the following categories: Operation & Maintenance Expenses Administrative & General Expenses Depreciation Expense Non-Income Taxes Until March of this year all pipelines were entitled to include an ITA for state and federal taxes. If the ITA is reduced because the tax rate is reduced, the pipeline s cost of service will go down which may result in a tariff rate decrease (bad for the pipeline). NO ITA = LOWER TOP LINE REVENUE PIPE ASSETS ADIT = SMALLER BASE ADIT = LARGER RATE BASE

15 // 15 Calculating Rate Risk for Various 501G Filing Scenarios Under FERC s final rule, 126 pipeline companies are required to file the new Form 501G in three waves between now and the end of the year. Wave one of filings is due by October 11, wave two November 8, and wave three by December 6. Some market participants perceive the completion of Form 501G by pipeline companies as merely a ministerial task involving decisions that will only have limited impacts on important pipeline financial metrics, such as ROE. This is decidedly not the case. The best way to understand which pipelines are likely at risk for a rate reduction and revenue impact is to consider and calculate pro forma scenarios for Form 501G filings. Using our robust data acquisition and extraction technologies and industry expertise, LawIQ has prepared a 501G Analysis and Advisory product to perform scenario analysis for all 126 pipelines required to file this year to assess the risk to any individual pipeline of any future tariff rate reductions. Access fully-complete, quality-checked 501G forms for all 126 pipelines, and easily calculate and analyze scenarios such as: Optimal 501G filing options for each pipeline; Calculating pipeline ROEs based on expected capital structures; Calculating total pipeline (or owner company) revenues based on the mix of recourse rate, negotiated rate, and discount rate revenues, and; Analyzing the impact on the aforementioned scenarios on the existing or 501G-driven moratoriums, as well as other combinations of the above scenarios.

16 1. Select primary Form 501G inputs for any filling pipeline // 16 Many companies, investors and other stakeholders are struggling to interpret and quantify the impact of the complex combination of the 2018 Tax Act and updates to FERC s MLP tax allowance policy. ASSUMPTIONS - Form 501G Company Filing Options SELECT ENTITY FILING TYPE SELECT CAPITAL STRUCTURE ADIT AMORITIZATION PERIOD (YRS) Tax Paying Entity Preserve ITA, Passback ADIT 3 - Default 501G (57%) 25 LawIQ has answers. Contact us at or 2. Select Pipeline 3. Analyze resulting rate reductions and pre vs. post filing Return on Equity Pipeline details Income Tax Allowance Capital Structure - % Equity 2018 Federal Tax Rate % ADIT returned to rate payer SELECT PIPELINE(S) Ownership Filling Wave Indicated Rate Reduction Return in Equity Recourse Rate Revenue (% 2017) Discounted Rate Revenue (% 2017) Negotiated Rate Revenue (% 2017) Moratorium End Date Comeback Period End Date Revenue Impact (Rate reduction x % Recourse Rate Rev) 2017 Revenue Indicated Revenue Reduction Full 57% 21% 100% Transcontinental Pipe Line Company, LLC Williams Partners 3 8.6% % 17.6% 65% 2% 34% 8/31/18 5.3% $1,789,231,275 $94,867,017 OCT 11 NOV 8 DEC 6