FERC Initiates Review of Return on Equity, Electric Transmission Incentives

On March 21, 2019, the Federal Energy Regulatory Commission issued Notices of Inquiry regarding (1) its method for determining the return on equity for rates charged by public utilities (and whether such ROEs should also be applied to interstate natural gas and oil pipelines) (Inquiry Regarding the Commission’s Policy for Determining Return on Equity,), and (2) the scope and implementation of its electric transmission incentives regulations and policies (Inquiry Regarding the Commission’s Electric Transmission Incentives Policy,). Initial comments are due no later than 90 days after they have been published in the Federal Register.

(1) Rate of Return on Common Equity

Regulated utilities rely heavily on capital from external sources to fund their expansion programs. Therefore, it is essential that such utilities be able to earn an ROE that is both commensurate with the return that investors might realize from other enterprises, and sufficient to maintain investor confidence in the financial integrity of the enterprise.

Many transmission-owning utilities rely on cost-of-service formula rates which established the ROE under economic conditions different from prevailing conditions. In response to concerns raised by consumers, the FERC has begun investigations into whether the ROEs of transmission owners within certain regional transmission organizations/independent system operators should be adjusted to reflect current economic conditions and, if so, what the revised ROE should be.

By way of background, in Emera Maine v. FERC, the D.C. Circuit Court of Appeals vacated and remanded to the FERC its order to revise the ROE used by transmission owners in New England. In response to that decision, the FERC adopted a revised method for determining a just and reasonable ROE for transmission owners based on averaging the results produced by the following economic models:

(a) a two-step discounted cash flow method, which is based on the premise that a stock’s price is equal to the present value of the infinite stream of expected dividends discounted at a market rate commensurate with the stock’s risk.

(b) a capital asset pricing model, which is a measure of the cost of equity to utilities relative to risk.

(c) a forward-looking expected earnings model, which evaluates the return on equity that investors might expect to earn from investments in companies with risks comparable to those faced by the affected transmission owner.

(d) a risk premium model, in which the ROE is based on the premium investors require above the return they expect to earn on a bond investment.

Participants in proceedings pending before the FERC involving challenges to the ROEs used to set rates of transmission owners within ISO New England and within the Midcontinent Independent System Operator, Inc., have been asked to comment on this proposed methodology and on the application of this methodology in those proceedings.

In the new ROE NOI, the FERC expanded its inquiry about use of its revised method for determining the ROE for all transmission owners. In addition, the FERC has asked for advice generally on its approach to determining a proper ROE for public utilities, and is seeking comments on the mechanics of applying each of the models to establish a composite zone of reasonableness for ROEs applicable to public utilities. However, the FERC affirmed that any action taken as a result of this inquiry will not affect the ongoing proceedings involving ISO New England and MISO.

Perhaps most significantly in the ROE NOI, the FERC is also examining whether the policy used to determine ROEs for public utilities should also be used to determine ROEs for interstate natural gas and oil pipeline companies. Among the issues of concern to the FERC are whether comparable data are available for natural gas and oil pipelines to implement the methodology used to establish ROEs for public utilities.

(2) Electric Transmission Incentives

The Energy Policy Act of 2005 requires the FERC to benefit consumers by providing incentives for transmission of electric energy to ensure reliability and reduce the cost of delivered power by reducing transmission congestion. Among the financial incentives adopted by the FERC were adders to the allowable ROE for transmission owners taking certain actions, assurance of the ability to recover costs of certain abandoned transmission development projects, and accelerated recovery of certain other costs. Taken together, these incentives were designed to encourage development of potentially risky transmission expansion projects and to reward transmission owners who took various actions to foster independence between the transmission function and the power marketing function of a utility.

The FERC noted in the Transmission Incentive NOI that since its policy to award such incentives was adopted, there have been numerous changes in the electric utility industry. These changes include “the Commission’s issuance of Order No. 1000 [relating to transmission system expansion], an evolution in the generation mix and the number of new resources seeking transmission service, shifts in load patterns, and an increased emphasis on the reliability of transmission infrastructure.” At the same time, consumer groups have complained that such incentives have resulted in excessive, unjust, and unreasonable charges for transmission service. The FERC is therefore beginning to consider whether revisions of those policies are warranted.

Among the transmission incentive-related topics on which the FERC has sought comments are the following:

• Whether transmission incentives should continue to be based on consideration of risks and challenges associated with a particular project, or, alternatively, whether transmission incentives should be based on potential benefits related to reliability and reductions in the cost of delivered power.
• Whether a cost-benefit analysis should be made (and, if so, how) to determine whether particular transmission incentives should be granted.
• Whether, in lieu of considering the potential benefits of a project, the FERC should focus on the characteristics of the project as a proxy for potential benefits (e.g., located in regions with persistent needs).
• Whether transmission incentives should be tailored to achievement of specified types of benefits, such as reliability, economic efficiency, and enhancements of physical and cyber-security of existing jurisdictional transmission facilities, and/or increased resilience of the transmission system.

The FERC also observed in the Transmission Incentive NOI that most applications for transmission incentives have involved transmission facilities to be developed in regions served by RTOs and ISOs. The FERC therefore asked about the potential use of transmission incentives to encourage desired transmission-based initiatives in non-RTO/ISO regions.

These inquiries into long-standing policies for determining ROEs for regulated entities and for granting electric transmission incentives involve two of the many important reform initiatives that have been discussed by FERC Chairman Neil Chatterjee in recent months. Taken together, these initiatives may have a significant impact on the reliability and cost of electricity throughout the United States, and on the success of market participants in meeting the challenges of the future. We therefore encourage interested stakeholders to make the effort to submit comments on these NOIs for consideration by the FERC, and intend to follow closely the developments relating to these and other industry initiatives coming before the FERC as they unfold.