Composition of Proxy Groups for Determining and Oil Pipeline Return on Equity

123 FERC ¶ 61,048

UNITED STATES OF AMERICA

FEDERAL ENERGY REGULATORY COMMISSION

Before Commissioners: Joseph T. Kelliher, Chairman;

Suedeen G. Kelly, Marc Spitzer,

Philip D. Moeller, and Jon Wellinghoff.

Composition of Proxy Groups for Determining Gas

and Oil Pipeline Return on Equity

Docket No. PL07-2-000

POLICY STATEMENT

(Issued April 17, 2008)

1.

On July 19, 2007, the Commission issued a proposed policy statement concerning

the composition of the proxy groups used to determine gas and oil pipelines’ return on

equity (ROE) under the Discounted Cash Flow (DCF) model.1 Historically, in

determining the proxy group, the Commission required that pipeline operations constitute

a high proportion of the business of any firm included in the proxy group. However, in

recent years, there have been fewer gas pipeline corporations that meet that standard, in

part because of the greater trend toward Master Limited Partnerships (MLPs) in the gas

pipeline industry. Additionally, there are no oil corporations available for use in the oil

pipeline proxy group. These trends have made the MLP issue one of particular concern

to the Commission and are the reason that the Commission issued the Proposed Policy

Statement.2

1 Composition of Proxy Groups for Determining Gas and Oil Pipeline Return on

Equity, 120 FERC ¶ 61,068 (2007) (Proposed Policy Statement).

2 After an initial round of comments and reply comments, the Commission

concluded that it required additional comment on the issue of the growth rates of MLPs.

After notice to this effect and the receipt of a round of initial and reply comments, staff

held a technical conference involving an eight member panel on January 23, 2008 that

was transcribed for the record. Comments and reply comments were filed thereafter.

comments and reply comments, the Commission

concluded that it required additional comment on the issue of the growth rates of MLPs.

After notice to this effect and the receipt of a round of initial and reply comments, staff

held a technical conference involving an eight member panel on January 23, 2008 that

was transcribed for the record. Comments and reply comments were filed thereafter.

Docket No. PL07-2-000

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2.

After review of an extensive record developed in this proceeding, the Commission

concludes: (1) MLPs should be included in the ROE proxy group for both oil and gas

pipelines; (2) there should be no cap on the level of distributions included in the

Commission’s current DCF methodology; (3) the Institutional Brokers Estimated System

(IBES) forecasts should remain the basis for the short-term growth forecast used in the

DCF calculation; (4) there should be an adjustment to the long-term growth rate used to

calculate the equity cost of capital for an MLP; and (5) there should be no modification to

the current respective two-thirds and one-third weightings of the short- and long-term

growth factors. Moreover, the Commission will not explore other methods for

determining a pipeline’s equity cost of capital at this time. The Commission also

concludes that this Policy Statement should govern all gas and oil rate proceedings

involving the establishment of ROE that are now pending before the Commission,

whether at hearing or in a decisional phase at the Commission.

I.

Background

A.

The DCF Model

3.

The Supreme Court has stated that “the return to the equity owner should be

commensurate with the return on investments in other enterprises having corresponding

risks

overn all gas and oil rate proceedings

involving the establishment of ROE that are now pending before the Commission,

whether at hearing or in a decisional phase at the Commission.

I.

Background

A.

The DCF Model

3.

The Supreme Court has stated that “the return to the equity owner should be

commensurate with the return on investments in other enterprises having corresponding

risks. That return, moreover, should be sufficient to assure confidence in the financial

integrity of the enterprise, so as to maintain its credit and to attract capital.”3 Since the

1980s, the Commission has used the DCF model to develop a range of returns earned on

investments in companies with corresponding risks for purposes of determining the ROE

to be awarded natural gas and oil pipelines.

4.

The DCF model was originally developed as a method for investors to estimate the

value of securities, including common stocks. It 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.”4 With simplifying assumptions, the

DCF model results in the investor using the following formula to determine share price:

P = D/(r-g)

3 FPC v. Hope Natural Gas Co., 320 U.S. 591 (1944). Bluefield Water Works &

Improvement Co. v. Public Service Comm’n, 262 U.S. 679 (1923).

4 CAPP v. FERC, 254 F.3d 289, 293 (2001) (CAPP).

the stock’s risk.”4 With simplifying assumptions, the

DCF model results in the investor using the following formula to determine share price:

P = D/(r-g)

3 FPC v. Hope Natural Gas Co., 320 U.S. 591 (1944). Bluefield Water Works &

Improvement Co. v. Public Service Comm’n, 262 U.S. 679 (1923).

4 CAPP v. FERC, 254 F.3d 289, 293 (2001) (CAPP).

Docket No. PL07-2-000

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where P is the price of the stock at the relevant time, D is the current dividend, r is the

discount rate or rate of return, and g is the expected constant growth in dividend income

to be reflected in capital appreciation.5

5.

Unlike investors, the Commission uses the DCF model to determine the ROE (the

“r” component) to be included in the pipeline’s rates, rather than to estimate a stock’s

value. Therefore, the Commission solves the DCF formula for the discount rate, which

represents the rate of return that an investor requires in order to invest in a firm. Under

the resulting DCF formula, ROE equals current dividend yield (dividends divided by

share price) plus the projected future growth rate of dividends:

r = D/P + g

6.

Over the years, the Commission has standardized the inputs to the DCF formula as

applied to interstate gas and oil pipelines. The Commission averages short-term and

long-term growth estimates in determining the constant growth of dividends (referred to

as the two-step procedure). Security analysts’ five-year forecasts for each company in

the proxy group (discussed below), as published by IBES, are used for determining

growth for the short term. The long-term growth is based on forecasts of long-term

growth of the economy as a whole,6 as reflected in the Gross Domestic Product (GDP

which are drawn from three different sources.7 The short-term forecast receives a two-

thirds weighting and the long-term forecast receives a one-third weighting in calculating

the growth rate in the DCF model.8

5 Id

g-term growth is based on forecasts of long-term

growth of the economy as a whole,6 as reflected in the Gross Domestic Product (GDP

which are drawn from three different sources.7 The short-term forecast receives a two-

thirds weighting and the long-term forecast receives a one-third weighting in calculating

the growth rate in the DCF model.8

5 Id. National Fuel Gas Supply Corp., 51 FERC ¶ 61,122, at 61,337 n.68 (1990).

Ozark Gas Transmission System, 68 FERC ¶ 61,032, at 61,104 n.16. (1994).

6 Northwest Pipeline Company, 79 FERC ¶ 61,309, at 62,383 (1997) (Opinion

No. 396-B). Williston Basin Interstate Pipeline Company, 79 FERC ¶ 61,311, at 62,389

(1997) (Williston I), aff’d, Williston Basin Interstate Pipeline Co. v. FERC, 165 F.3d 54,

57 (D.C. Cir. 1999) (Williston v. FERC).

7 The three sources used by the Commission are Global Insight: Long-Term

Macro Forecast – Baseline (U.S. Economy 30-Year Focus); Energy Information Agency,

Annual Energy Outlook; and the Social Security Administration.

8 Transcontinental Gas Pipe Line Corp., 84 FERC ¶ 61,084, at 61,423-4 (Opinion

No. 414-A), reh’g denied, 85 FERC ¶ 61,323, at 62,266-70 (1998) (Opinion No. 414-B),

aff’d sub nom. North Carolina Utilities Commission v. FERC, 203 F.3d 53 (D.C. Cir.

2000) (unpublished opinion). Northwest Pipeline Co., 88 FERC ¶ 61,057, reh’g denied,

88 FERC ¶ 61,298 (1999), aff’d CAPP v. FERC, 254 F.3d 289 (D.C. Cir. 2001).

ntal Gas Pipe Line Corp., 84 FERC ¶ 61,084, at 61,423-4 (Opinion

No. 414-A), reh’g denied, 85 FERC ¶ 61,323, at 62,266-70 (1998) (Opinion No. 414-B),

aff’d sub nom. North Carolina Utilities Commission v. FERC, 203 F.3d 53 (D.C. Cir.

2000) (unpublished opinion). Northwest Pipeline Co., 88 FERC ¶ 61,057, reh’g denied,

88 FERC ¶ 61,298 (1999), aff’d CAPP v. FERC, 254 F.3d 289 (D.C. Cir. 2001).

Docket No. PL07-2-000

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7.

Most gas pipelines are wholly-owned subsidiaries and their common stocks are

not publicly traded. This is also true for some jurisdictional oil pipelines. Therefore, the

Commission must use a proxy group of publicly traded firms with corresponding risks to

set a range of reasonable returns for both natural gas and oil pipelines. For both oil and

gas pipelines, after defining the zone of reasonableness through development of the

appropriate proxy group for the pipeline, the Commission assigns the pipeline a rate

within that range or zone, to reflect specific risks of that pipeline as compared to the

proxy group companies.9 The Commission has historically presumed that existing

pipelines fall within a broad range of average risk. A pipeline or other litigating party has

to show highly unusual circumstances that indicate anomalously high or low risk as

compared to other pipelines to overcome the presumption.10

8.

The Commission historically required that each company included in the proxy

group satisfy the following three standards.11 First, the company’s stock must be publicly

traded. Second, the company must be recognized as a natural gas or oil pipeline

company and its stock must be recognized and tracked by an investment information

service such as Value Line. Third, pipeline operations must constitute a high proportion

of the company’s business

ny included in the proxy

group satisfy the following three standards.11 First, the company’s stock must be publicly

traded. Second, the company must be recognized as a natural gas or oil pipeline

company and its stock must be recognized and tracked by an investment information

service such as Value Line. Third, pipeline operations must constitute a high proportion

of the company’s business. Until 2003, the Commission’s policy was that the third

standard could only be satisfied if a company’s pipeline business accounted for, on

average, at least 50 percent of a company’s assets or operating income over the most

recent three-year period.12

9.

However, in recent years fewer corporations have satisfied the Commission’s

standards for inclusion in the gas and oil pipeline proxy groups. Mergers and

acquisitions have reduced the number of publicly traded corporations with natural gas

pipeline operations. Most of the remaining corporations are engaged in such significant

non-pipeline business that their pipeline business accounts are significantly less than

50 percent of their assets or operating income. At the same time, there has been a trend

toward MLPs owning natural gas pipelines. This trend has been even more pronounced

in the oil pipeline industry, with the result that there are now no purely oil pipeline

corporations available for inclusion in the oil pipeline proxy group and virtually all traded

9 Williston v. FERC, 165 F.3d at 57 (citation omitted).

10 Transcontinental Gas Pipe Line Corp., 90 FERC ¶ 61,279, at 61,936 (2000).

11 Id. at 61,933.

12 Williston Basin Interstate Pipeline Company, 104 FERC ¶ 61,036, at P 35 n.46

no purely oil pipeline

corporations available for inclusion in the oil pipeline proxy group and virtually all traded

9 Williston v. FERC, 165 F.3d at 57 (citation omitted).

10 Transcontinental Gas Pipe Line Corp., 90 FERC ¶ 61,279, at 61,936 (2000).

11 Id. at 61,933.

12 Williston Basin Interstate Pipeline Company, 104 FERC ¶ 61,036, at P 35 n.46

(2003) (Williston II).

Docket No. PL07-2-000

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oil pipeline equity interests are owned by MLPs. Thus, for both oil and gas pipeline rate

cases, the composition of the proxy group has become a significant issue, and the central

question is whether, and how, to include MLPs in the proxy group.

B.

The MLP Business Model

10.

MLPs consist of a general partner, who manages the partnership, and limited

partners, who provide capital and receive cash distributions, but have no management

role. The units of the limited partners are traded on public exchanges, just like corporate

stock shares. In order to be treated as an MLP for Federal income tax purposes, an MLP

must receive at least 90 percent of its income from certain qualifying sources, including

natural resource activities. Natural resource activities include exploration, development,

mining or production, processing, refining, transportation, storage and marketing of any

mineral or natural resource, including gas and oil.13

11.

MLPs generally distribute most available cash flow to the general and limited

partners in the form of quarterly distributions. At their inception, MLPs establish

agreements between the general and limited partners, which define cash flow available

for distribution and how that cash flow is to be divided between the general and limited

partners. Most MLP agreements define “available cash flow” as (1) net income (gross

revenues minus operating expenses) plus (2) depreciation and amortization, minus

butions. At their inception, MLPs establish

agreements between the general and limited partners, which define cash flow available

for distribution and how that cash flow is to be divided between the general and limited

partners. Most MLP agreements define “available cash flow” as (1) net income (gross

revenues minus operating expenses) plus (2) depreciation and amortization, minus

(3) capital investments the partnership must make to maintain its current asset base and

cash flow stream.14 Depreciation and amortization may be considered a part of “available

13 See Wachovia Securities, Master Limited Partnerships: A Primer,

November 10, 2003, (Wachovia Primer 1) at 1, 3-4, reproduced in full in Docket

No. OR96-2-012, Ex. SEP ARCO-22 and also in Kern River Gas Transmission

Company, Docket No. RP04-274-000, Ex. No. BP-19 filed October 25, 2005;

J.P. Morgan, Industry Analysis, Energy MLPS, dated March 28, 2002 (J.P. Morgan 2002

Energy MLPs) at 5-6, reproduced in full in Docket No. OR92-8-025, Ex. No. SWST-18,

filed October 20, 2005; Wachovia Capital Markets, LLC, Equity Research Department,

Master Limited Partnerships: Primer 2nd Edition, A Framework for Investment dated

August 23, 2005 (Wachovia 2nd Primer) at 8-9, reproduced in full in Docket No. RP06-

72-000 at Ex. S-36, filed May 31, 2006); Coalition of Publicly Traded Partnerships,

Publicly Traded Partnerships: What they are and how they work (undated) (Publicly

Traded Partnerships) at 1-3, reproduced in full in Docket No. RP06-72-000 at Ex. S-35,

filed May 31, 2006, and Docket No. OR96-2-012, Ex. No. BP-19, filed October 25, 2005;

CAPP Reply Comments, Attachment A at 2-3; APGA Additional Comments dated

December 21, 2007.

14 The definition of available cash may also net out short term working capital

(continued…)

d) (Publicly

Traded Partnerships) at 1-3, reproduced in full in Docket No. RP06-72-000 at Ex. S-35,

filed May 31, 2006, and Docket No. OR96-2-012, Ex. No. BP-19, filed October 25, 2005;

CAPP Reply Comments, Attachment A at 2-3; APGA Additional Comments dated

December 21, 2007.

14 The definition of available cash may also net out short term working capital

(continued…)

Docket No. PL07-2-000

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cash flow,” because depreciation is an accounting charge against current income, rather

than an actual cash expense. Thus, depreciation does not reduce the MLP’s current cash

on hand. The MLP agreement may provide for the general partner to receive increasingly

higher percentages of the overall distribution if it raises the quarterly distribution. This

gives the general partner incentives to increase the partnership’s business and cash

flow.15

12.

The general partner has discretion not to distribute the entire amount of available

cash flow for the proper exercise of the business, to create reserves for capital

expenditures, for the payment of debt, and for future distributions. However, pipeline

MLPs have typically distributed 90 percent or more of available cash flow. As a result,

the MLP’s cash distributions normally include not only the operating profit component of

“available cash flow,” but also the depreciation component. This means that, in contrast

to a corporation’s dividends, an MLP’s cash distributions generally exceed the MLP’s

reported earnings. The pipeline MLP’s ability to distribute a high percentage of available

cash flows reflects the stable cash flows underpinning its businesses.16

13.

Because of their high cash distributions, MLPs have financed capital investments

required to significantly expand operations or to make acquisitions through debt or by

issuing additional units rather than through retained cash, although the general partner

has the discretion to do so

a high percentage of available

cash flows reflects the stable cash flows underpinning its businesses.16

13.

Because of their high cash distributions, MLPs have financed capital investments

required to significantly expand operations or to make acquisitions through debt or by

issuing additional units rather than through retained cash, although the general partner

has the discretion to do so. These expansions financed through external debt are intended

to provide a return equal to the cost of the capital plus some additional return for the

existing unit holders, i.e., it is accretive. Thus, the return on any newly issued units is

expected to be sufficiently high to avoid dilution of the current distributions to the

existing unit holders.17

14.

MLPs may also provide significant tax advantages to their unit holders. Some

MLPs allocate depreciation, amortization, and tax credits to the limited partners and away

from the general partner. In some cases, the limited partner may have no net taxable

income reported on the income tax information document (the K-1) the limited partner

borrowings, the repayment of capital expenditures, and other internal items.

15 Wachovia Primer 1 at 6-7; J.P. Morgan 2002 Energy MLPs at 5, 14; Wachovia

2nd Primer at 9, 15-19.

16 J.P. Morgan 2002 Energy MLPs at 11-13; Wachovia 2nd Primer at 24-25;

Enbridge Initial Comments Attachment A, Wachovia Capital Markets, LLC, MLPs: Safe

to Come Back Into the Water (Wachovia MLPs) dated August 20, 2007, at 2-4.

17 Id.

ment of capital expenditures, and other internal items.

15 Wachovia Primer 1 at 6-7; J.P. Morgan 2002 Energy MLPs at 5, 14; Wachovia

2nd Primer at 9, 15-19.

16 J.P. Morgan 2002 Energy MLPs at 11-13; Wachovia 2nd Primer at 24-25;

Enbridge Initial Comments Attachment A, Wachovia Capital Markets, LLC, MLPs: Safe

to Come Back Into the Water (Wachovia MLPs) dated August 20, 2007, at 2-4.

17 Id.

Docket No. PL07-2-000

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receives from the partnership each year, a pattern that may continue for years. In that

case, the limited partner will not pay any taxes on the cash received from the partnership

in the year of the distribution. To the extent a limited partner is allocated items of

depreciation, credit, or losses that exceed the limited partner’s ownership percentage,

income taxes will be due on the difference when the unit is sold. However, this may not

occur for many years. Over time the real cost of the future taxes declines while the future

return of any tax savings that is reinvested increases. This can significantly increase the

return to the investor over the holding period of the limited partnership unit.18

15.

Moreover, distributions in excess of earnings are not taxed as long as the limited

partner has a tax basis. Rather, the limited partner’s tax basis is reduced and again any

taxes are deferred until the unit is sold. By this tax deferral, the cash flow distributed in

excess of earnings can be made available for reinvestment much earlier than would be the

case of a corporate share.19 This reduces the limited partner’s risk because the limited

partner’s cash basis in the unit is reduced, but the distribution would not normally reduce

the market price of the unit nor, if the firm has access to external capital, would this

necessarily reduce its long term growth potential.

C.

The Recent Cases on the Shrinking Proxy Group

1.

Natural Gas Pipeline Cases

16

e share.19 This reduces the limited partner’s risk because the limited

partner’s cash basis in the unit is reduced, but the distribution would not normally reduce

the market price of the unit nor, if the firm has access to external capital, would this

necessarily reduce its long term growth potential.

C.

The Recent Cases on the Shrinking Proxy Group

1.

Natural Gas Pipeline Cases

16.

The Commission first addressed the problem of the shrinking natural gas pipeline

proxy group in Williston II, 104 FERC ¶ 61,036 at P 34-43. In that NGA section 4 rate

case, the Commission relaxed the requirement that natural gas business account for at

least 50 percent of the corporation’s assets or operating income. Instead, the Commission

approved the pipeline’s proposal to use a proxy group based on the corporations listed in

the Value Line Investment Survey’s list of diversified natural gas firms that own

Commission-regulated natural gas pipelines, without regard to what portion of the

company’s business comprises pipeline operations. The proxy group approved in that

case included four corporations that satisfied the Commission’s historic standards20 and

18 See PSCNY Initial Comments at 12-13 and Attachment 1 thereto at 2; Wachovia

Primer at 4-5; Publicly Traded Partnerships at 2-3; Wachovia 2nd Primer at 1, 5, 20-22;

J.P. Morgan 2002 Energy MLPs at 18-19.

19 Id.

20 The Commission noted that two of those four companies were in the process of

merging so that in the future there would be only three pipeline corporations that satisfied

our historic proxy group standards. Williston II, 104 FERC ¶ 61,036 at P 35.

achovia

Primer at 4-5; Publicly Traded Partnerships at 2-3; Wachovia 2nd Primer at 1, 5, 20-22;

J.P. Morgan 2002 Energy MLPs at 18-19.

19 Id.

20 The Commission noted that two of those four companies were in the process of

merging so that in the future there would be only three pipeline corporations that satisfied

our historic proxy group standards. Williston II, 104 FERC ¶ 61,036 at P 35.

Docket No. PL07-2-000

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five corporations with less pipeline business and more local distribution business than the

Commission had previously allowed. The Commission set Williston’s ROE at the

median of this proxy group.

17.

The Commission next addressed the proxy group issue in a 2004 order in Petal

Gas Storage, L.L.C., 97 FERC ¶ 61,097 (2001), reh’g granted in part and denied in part,

106 FERC ¶ 61,325 (2004) (Petal). In that case, a jurisdictional storage company with

market-based rates had applied for a certificate under NGA section 7 to construct pipeline

facilities to transport gas from its existing storage facility to a new interconnection with

Southern Natural Gas Co. The Commission found that Petal was not a new entrant in the

jurisdictional gas transportation business, but was simply expanding its existing business

and had not shown that it faced any unusual risks. Ordinarily in such circumstances the

Commission would use the pipeline’s own currently approved ROE for its existing

services in determining an initial incremental rate for the expansion. However, because

Petal had market-based rates for its existing services, there was no such currently

approved ROE to use. Therefore, the Commission calculated the initial rate for Petal’s

expansion using the same median ROE which it had approved in Williston, which was the

most recent litigated gas pipeline section 4 rate case.

18.

When the Commission next addressed the proxy group issue, in High Island

Offshore System, L.L.C. (HIOS),21 and Kern River Gas Transmission Company (Opinion

No

proved ROE to use. Therefore, the Commission calculated the initial rate for Petal’s

expansion using the same median ROE which it had approved in Williston, which was the

most recent litigated gas pipeline section 4 rate case.

18.

When the Commission next addressed the proxy group issue, in High Island

Offshore System, L.L.C. (HIOS),21 and Kern River Gas Transmission Company (Opinion

No. 486),22 the Williston II proxy group had shrunk to six corporations. Moreover, the

Commission found that two of those corporations should be excluded from the proxy

group on the ground that their financial difficulties had lowered their ROEs to such a low

level as to render them unrepresentative.23 This left only four corporations eligible for

the proxy group under the standards adopted in Williston II, three of whom derived more

revenue from the distribution business than the pipeline business. The two pipelines

contended that, in these circumstances, the Commission should include natural gas

pipeline MLPs in the gas pipeline proxy group. They asserted that MLPs have a much

higher percentage of their business devoted to pipeline operations than most of the

corporations eligible for the proxy group under Williston II, and therefore are more

representative of the risks faced by pipelines.

21110 FERC ¶ 61,043, reh’g denied, 112 FERC ¶ 61,050 (2005).

22 117 FERC ¶ 61,077 (2006), reh’g pending.

23 HIOS, 110 FERC ¶ 61,043 at P 118. Opinion No. 486, 117 FERC ¶ 61,077 at

P 140-141.

ns than most of the

corporations eligible for the proxy group under Williston II, and therefore are more

representative of the risks faced by pipelines.

21110 FERC ¶ 61,043, reh’g denied, 112 FERC ¶ 61,050 (2005).

22 117 FERC ¶ 61,077 (2006), reh’g pending.

23 HIOS, 110 FERC ¶ 61,043 at P 118. Opinion No. 486, 117 FERC ¶ 61,077 at

P 140-141.

Docket No. PL07-2-000

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19.

In HIOS and Opinion No. 486, the Commission rejected the proposals to include

MLPs in the proxy group, and approved proxy groups using the four corporations still

available under the Williston II approach of basing the proxy group on the Value Line

Investment Survey’s group of diversified natural gas corporations that own Commission-

regulated pipelines. In HIOS, the Commission set the pipeline’s ROE at the median of

the four-corporation proxy group. In Opinion No. 486, the Commission took the same

general approach as in HIOS, but set the pipeline’s ROE 50 basis points above the

median to account for the fact its pipeline operations have a higher risk than its

distribution business.24

20.

In rejecting the proposals to include MLPs in the proxy group in both cases, the

Commission made clear that it was not making a generic finding that MLPs cannot be

considered for inclusion in the proxy group if a proper evidentiary showing is made.25

However, the Commission pointed out that data concerning dividends paid by the proxy

group members is a key component in any DCF analysis, and expressed concern that an

MLP’s cash distributions to its unit holders may not be comparable to the corporate

dividends the Commission uses in its DCF analysis. In Opinion No. 486, the

Commission explained its concern as follows:

Corporations pay dividends in order to distribute a share of their earnings to

stockholders. As such, dividends do not include any return of invested capital to

the stockholders. Rather, dividends represent solely a return on invested capital

e comparable to the corporate

dividends the Commission uses in its DCF analysis. In Opinion No. 486, the

Commission explained its concern as follows:

Corporations pay dividends in order to distribute a share of their earnings to

stockholders. As such, dividends do not include any return of invested capital to

the stockholders. Rather, dividends represent solely a return on invested capital.

Put another way, dividends represent profit that the stockholder is making on its

investment. Moreover, corporations typically reinvest some earnings to provide

for future growth of earnings and thus dividends. Since the return on equity

which the Commission awards in a rate case is intended to permit the pipeline’s

investors to earn a profit on their investment and provides funds to finance future

growth, the use of dividends in the DCF analysis is entirely consistent with the

purpose for which the Commission uses that analysis. By contrast, as Kern River

concedes, the cash distributions of the MLPs it seeks to add to the proxy group in

this case include a return of invested capital through an allocation of the

partnership’s net income. While the level of an MLP’s cash distributions may be

a significant factor in the unit holder’s decision to invest in the MLP, the

Commission uses the DCF analysis solely to determine the pipeline’s return on

equity. The Commission provides for the return of invested capital through a

separate depreciation allowance. For this reason, to the extent an MLP’s

distributions include a significant return of invested capital, a DCF analysis based

24 Id. at P 171-176.

25 Id. at P 147. See also HIOS, 110 FERC ¶ 61,043 at P 125.

ine the pipeline’s return on

equity. The Commission provides for the return of invested capital through a

separate depreciation allowance. For this reason, to the extent an MLP’s

distributions include a significant return of invested capital, a DCF analysis based

24 Id. at P 171-176.

25 Id. at P 147. See also HIOS, 110 FERC ¶ 61,043 at P 125.

Docket No. PL07-2-000

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on those distributions, without any adjustment, will tend to overstate the estimated

return on equity, because the ‘dividend’ would be inflated by cash flow

representing return of equity, thereby overstating the earnings the dividend stream

purports to reflect.26

21.

The Commission stated that it could nevertheless consider including MLPs in the

proxy group in a future case, if the pipeline presented evidence addressing these

concerns. The discussion in the order suggested that such evidence might include some

method of adjusting the MLPs’ distributions to make them comparable to dividends, a

showing that the higher “dividend” yield of the MLP was offset by a lower long-term

growth projection, or some other explanation why distributions in excess of earnings do

not distort the DCF results for the MLP in question.27 However, the Commission

concluded that Kern River had not presented sufficient evidence to address these issues,

and that the record in that case did not support including MLPs in the proxy group.

22.

In addition, Opinion No. 486 pointed out that the traditional DCF model only

incorporates growth resulting from the reinvestment of earnings, not growth arising from

external sources of capital.28 Therefore, the Commission stated that if growth forecasted

for an MLP comes from external capital, it is necessary either (1) to explain why the

external sources of capital do not distort the DCF results for that MLP or (2) propose an

adjustment to the DCF analysis to eliminate any distortion.

2.

Oil Pipeline Cases

23

not growth arising from

external sources of capital.28 Therefore, the Commission stated that if growth forecasted

for an MLP comes from external capital, it is necessary either (1) to explain why the

external sources of capital do not distort the DCF results for that MLP or (2) propose an

adjustment to the DCF analysis to eliminate any distortion.

2.

Oil Pipeline Cases

23.

In some oil pipeline rate cases decided before HIOS and Opinion No. 486, the

Commission included MLPs in the proxy group used to determine oil pipeline return on

equity on the ground that there were no corporations available for use in the oil proxy

group.29 In those cases, no party raised any issue concerning the comparability of an

MLP’s cash distribution to a corporation’s dividend. However, that issue did arise in the

first oil pipeline case decided after HIOS and Opinion No. 486, which involved SFPP’s

Sepulveda Line.30 The Commission approved inclusion of MLPs in the proxy group in

26 Opinion No. 486, 117 FERC ¶ 61,077 at P 149-150.

27 Proposed Policy Statement at P 10-11.

28 Id. at P 152.

29 SFPP, L .P., 86 FERC ¶ 61,022, at 61,099 (1999).

30 SFPP, L.P., 117 FERC ¶ 61,285 (2006) (SFPP Sepulveda Order), rehearing

pending.

Docket No. PL07-2-000

- 11 -

that case on the grounds that the included MLPs in question had not made distributions in

excess of earnings. The order found these facts sufficient to address the concerns

expressed in HIOS and Opinion No. 486.

D.

Court Remand of Petal and HIOS

24.

Both Petal and HIOS appealed the Commission’s orders in their cases to the

United States Court of Appeals for the District of Columbia Circuit

t case on the grounds that the included MLPs in question had not made distributions in

excess of earnings. The order found these facts sufficient to address the concerns

expressed in HIOS and Opinion No. 486.

D.

Court Remand of Petal and HIOS

24.

Both Petal and HIOS appealed the Commission’s orders in their cases to the

United States Court of Appeals for the District of Columbia Circuit. The court

considered the appeals together, and it vacated and remanded the proxy group rulings in

both cases.31 The court emphasized that the Commission’s “proxy group arrangements

must be risk-appropriate.”32 The court explained that this means that firms included in

the proxy group should face similar risks to the pipeline whose ROE is being determined,

and any differences in risk should be recognized in determining where to place the

pipeline in the proxy group range of reasonable returns.

25.

The court recognized that changes in the gas pipeline industry compel a change in

the Commission’s traditional approach to determining the proxy group, and the court

stated that “controversy about how it should change has been bubbling up in a number of

recent cases,” citing both Williston II and Opinion No. 486. But the court found that the

cases on appeal “seem[] to represent an arrival point of sorts for the Commission,”

pointing out that Opinion No. 486 had reversed an administrative law judge for deviating

from the HIOS proxy group.33

26.

The court held that the Commission had not shown that the proxy group

arrangements it approved in Petal and HIOS were risk-appropriate. The court pointed out

that the Commission had rejected the inclusion of MLPs in the proxy group on the

ground that MLP distributions, unlike dividends, might provide returns of equity as well

as returns on equity. While stating that this proposition is not “self-evident,” the court

accepted it for the sake of argument

y group

arrangements it approved in Petal and HIOS were risk-appropriate. The court pointed out

that the Commission had rejected the inclusion of MLPs in the proxy group on the

ground that MLP distributions, unlike dividends, might provide returns of equity as well

as returns on equity. While stating that this proposition is not “self-evident,” the court

accepted it for the sake of argument. Nonetheless, the court stated that nothing in the

Commission’s decision explained why the companies selected by the Commission for

inclusion in the proxy group are risk-comparable to HIOS. The court stated that when the

31 Petal Gas Storage, L.L.C. v. FERC, 496 F.3d 695 (D.C. Cir. 2007) (Petal v.

FERC).

32 Petal v. FERC, 496 F.3d at 697, quoting Canadian Association of Petroleum

Producers v. FERC, 254 F.3d 289 (D.C. Cir. 2001).

33 Opinion No. 486 reversed the ALJ’s inclusion of the two financially troubled

pipelines in the proxy group

Docket No. PL07-2-000

- 12 -

goal is a proxy group of comparable companies, it is not clear that natural gas companies

with highly different risk profiles should be regarded as comparable.

27.

The court further stated that in placing Petal and HIOS in the middle of the proxy

group in terms of return on equity, the Commission expressly relied on the assumption

that pipelines generally fall into a broad range of average risk as compared to other

pipelines. However, the court stated, this assumption is decisive only given a proxy

group composed of other pipelines. Thus, the court reasoned that if gas distribution

companies generally face lower risk than gas pipelines,34 a risk-appropriate placement

would be at the high end of the group. The court stated that the Commission erred by

failing to explain how its proxy group arrangements were based on the principle of

relative risk.

28.

Therefore, the court vacated the Commission’s orders with respect to the proxy

group issue

ed that if gas distribution

companies generally face lower risk than gas pipelines,34 a risk-appropriate placement

would be at the high end of the group. The court stated that the Commission erred by

failing to explain how its proxy group arrangements were based on the principle of

relative risk.

28.

Therefore, the court vacated the Commission’s orders with respect to the proxy

group issue. The court stated that on remand, it did not require any particular proxy

group arrangement, but stated that the overall arrangement must make sense in terms of

the relative risk and in terms of the statutory command to set just and reasonable rates

that are commensurate with returns on investments in other enterprises having

corresponding risks.

II.

The Proposed Policy Statement

29.

A month before the court’s decision in Petal v. FERC, the Commission reached a

similar conclusion that its proxy group arrangements for gas and oil pipelines must be

reexamined. Accordingly, on July 19, 2007, the Commission issued a Proposed Policy

Statement, in which it proposed to modify its policy to allow MLPs to be included in the

proxy group. The Proposed Policy Statement found that:

Cost of service ratemaking requires that firms in the proxy group be of

comparable risk to the firm whose equity cost of capital is being determined in a

particular rate proceeding. If the proxy group is less than clearly representative,

this may require the Commission to adjust for the difference in risk by adjusting

the equity cost-of-capital, a difficult undertaking requiring detailed support from

the contending parties and detailed case-by-case analysis by the Commission.

Expanding the proxy group to include MLPs whose business is more narrowly

34 The court noted that this seems likely.

ire the Commission to adjust for the difference in risk by adjusting

the equity cost-of-capital, a difficult undertaking requiring detailed support from

the contending parties and detailed case-by-case analysis by the Commission.

Expanding the proxy group to include MLPs whose business is more narrowly

34 The court noted that this seems likely.

Docket No. PL07-2-000

- 13 -

focused on pipeline activities would help provide a more representative proxy

group.35

30.

However, the Commission proposed to cap the cash distribution used to determine

an MLP’s return under the DCF method at the MLP’s reported earnings. The

Commission found that this was necessary to exclude that portion of an MLP’s

distributions constituting return of equity. The Commission provides for the return of

equity through a depreciation allowance. Therefore, the Commission stated that the cash

flows used in the DCF analysis should be limited to those which reflect a return on

equity. The concern was the pipeline could double recover its depreciation expense. The

Commission also proposed to require a showing that the MLP has had stable earnings

over a multi-year period, so as to justify a finding that it will be able to maintain the

current level of cash distributions in future years. The Proposed Policy Statement found

that these requirements should render the MLP’s cash distribution comparable to a

corporation’s dividend for purposes of the DCF analysis.

31.

Under the Proposed Policy Statement, the Commission would leave to individual

cases the determination of which specific MLPs and corporations should be included in

the proxy group. The Commission proposed to apply its final policy statement to all gas

and oil cases that have not completed the hearing phase as of the date the Commission

issues its final policy statement

DCF analysis.

31.

Under the Proposed Policy Statement, the Commission would leave to individual

cases the determination of which specific MLPs and corporations should be included in

the proxy group. The Commission proposed to apply its final policy statement to all gas

and oil cases that have not completed the hearing phase as of the date the Commission

issues its final policy statement. The Commission stated that it would consider on a case-

by-case basis whether to apply the final policy statement in cases that have completed the

hearing phase.

III. The Record in the Policy Statement Proceeding

A.

Pre-Technical Conference Comments

32.

Twenty-two initial comments and thirteen reply comments were filed in response

to the Proposed Policy Statement36 and fall into two categories: (1) those of gas and oil

pipelines and the related trade associations (Pipeline Interests),37 and (2) those of gas and

35 Proposed Policy Statement, 120 FERC ¶ 61,068 at P 17.

36 Comments related to the technical conference are discussed infra and are

characterized as conference comments or conference reply comments.

37 The Pipeline Interests include: the Association of Oil Pipe Lines (AOPL); El

Paso Corporation (El Paso); Enbridge Energy Partners, L.P. (Enbridge); the Interstate

Natural Gas Association of America (INGAA); MidAmerican Energy Pipeline Group

(MidAmerican); the National Association of Publicly Traded Partnerships (NAPTP);

(continued…)

nts or conference reply comments.

37 The Pipeline Interests include: the Association of Oil Pipe Lines (AOPL); El

Paso Corporation (El Paso); Enbridge Energy Partners, L.P. (Enbridge); the Interstate

Natural Gas Association of America (INGAA); MidAmerican Energy Pipeline Group

(MidAmerican); the National Association of Publicly Traded Partnerships (NAPTP);

(continued…)

Docket No. PL07-2-000

- 14 -

oil producers and shippers, public and municipal utilities, state public service

commissions, and related trade associations (Customer Interests).38 Two comments were

also submitted by individuals in their business or personal capacity.39

33.

The comments focus on three issues: (1) whether MLPs should be included in the

gas pipeline proxy group at all; (2) whether the proposed cap on the MLP cash

distributions used in the DCF analysis is necessary or adequate; and (3) whether the

short- and long-term growth component of the DCF model should be modified given the

financial practices of MLPs. Secondary points include the potential distorting effects of:

MLP tax treatment, the large payouts by MLPs, the general partner’s incentive

distribution rights (IDRs), and the relative returns to the limited and general partners.

34.

All parties recognize that MLPs are the only available entities for inclusion in the

oil pipeline proxy group. The Pipeline Interests also all assert that the Commission

correctly proposed to include MLPs in the gas pipeline proxy group. In contrast, most of

the Customer Interests assert that there are enough corporations available for inclusion in

the gas pipeline proxy group and that there is no need to include MLPs.

35.

Both the Pipeline and Customer Interests question the proposed earnings cap on

MLP distributions, with the Pipeline Interests asserting the cap is unnecessary and the

Customer Interests asserting the cap should be lower

of

the Customer Interests assert that there are enough corporations available for inclusion in

the gas pipeline proxy group and that there is no need to include MLPs.

35.

Both the Pipeline and Customer Interests question the proposed earnings cap on

MLP distributions, with the Pipeline Interests asserting the cap is unnecessary and the

Customer Interests asserting the cap should be lower. The Pipeline Interests assert that an

MLP’s share price reflects investors’ projection of all cash flows it will receive from the

MLP, including distributions in excess of earnings. Therefore, any cap on the

Panhandle Energy Pipelines (Panhandle); Spectra Energy Transmission, LLC (Spectra);

TransCanada Corporation (TransCanada); and Williston Basin Interstate Pipeline

Company (Williston).

38 The Customer Interests include: the American Gas Association (AGA); the

America Public Gas Association (APGA); the Air Transport Association of America; the

Canadian Association of Petroleum Producers (CAPP); Indicated Shippers (consisting of

Area Energy, LLC, Anadarko E&P Company LP, Anadarko Petroleum Corporation,

Chevron USA Inc., Coral Energy Resources LP, Occidental Energy Marketing Inc., and

Shell Rocky Mountain Production, LLC); the Natural Gas Supply Association (NGSA);

the Process Gas Consumers Group; the Public Service Commission of New York

(PSCNY); Tesoro Refining and Marketing Company (Tesoro); the Northern Municipal

Distributors Group (NMDG) and the Midwest Region Gas Task Force Association filing

jointly; and the Society for the Preservation of Oil Shippers (Society).

39 The individual comments include Crowley Energy Consulting, supporting the

Customer Interests, and Barry Gleicher, supporting the Pipeline Interests.

ork

(PSCNY); Tesoro Refining and Marketing Company (Tesoro); the Northern Municipal

Distributors Group (NMDG) and the Midwest Region Gas Task Force Association filing

jointly; and the Society for the Preservation of Oil Shippers (Society).

39 The individual comments include Crowley Energy Consulting, supporting the

Customer Interests, and Barry Gleicher, supporting the Pipeline Interests.

Docket No. PL07-2-000

- 15 -

distributions while still using a dividend yield reflecting the full share price would lead to

distorted results.40 The Customer Interests agree that the adjustment to MLP distributions

is necessary to remove a double count attributed to depreciation, but they also uniformly

assert that the proposed adjustment is inadequate to compensate for a wide range of

financial factors that distinguish MLPs from Schedule C corporations.

36.

On the growth rate issue, the Pipeline Interests in their initial comments generally

agree that, if MLPs have greater distributions than a corporation, then the MLP may have

less growth potential than a corporation. However, they argue that this fact does not

require any additional adjustment, since any lower growth potential would be reflected in

a reduced IBES growth forecast. The Pipeline Interests also state that distributions in

excess of earnings do not prevent reinvestment or organic growth. They assert that

pipeline MLPs have ready access to capital markets given their stable cash flows and the

projected expansion of the pipeline system, which can be the basis for organic growth.41

37.

In contrast, the Customer Interests assert that MLPs have significantly lower

growth potential than corporations due to their distributions in excess of earnings,

particularly over the long term.42 They cite studies by established investment firms

suggesting that the long term growth potential of MLPs is less than the long term growth

factor now included in the DCF model

growth.41

37.

In contrast, the Customer Interests assert that MLPs have significantly lower

growth potential than corporations due to their distributions in excess of earnings,

particularly over the long term.42 They cite studies by established investment firms

suggesting that the long term growth potential of MLPs is less than the long term growth

factor now included in the DCF model. Moreover, they argue that given the high level of

MLP distributions and declining opportunities for acquisitions with high returns, MLP

growth must now come from investment of external funds in projects that will enhance

organic growth of existing business lines.43

38.

Some of the Customer Interests further argue that there are inadequate investment

opportunities to support capital investment, and in the relatively near future the present

level of MLP distributions will be maintained only by borrowing or issuing additional

40 AOPL initial comments at 8, 10; INGAA initial comments at 13-14; Spectra

initial comments at 4; NAPTP initial comments at 4.

41 AOPL comments at 21-24 and attachments; Enbridge Energy reply comments at

5; INGAA comments at 22-24; TransCanada reply comments at 8-10.

42 APGA reply comments at 11-15; CAPP initial comments at 1; CAPP reply

comments at 6-7, and attachment at 3-4; NYPSC initial comments at 19-21, 23, including

attachments of financial materials from major investment houses; NYPSC reply

comments at 4-7; Tesoro reply comments at 25-27.

43 Id.

ts; Enbridge Energy reply comments at

5; INGAA comments at 22-24; TransCanada reply comments at 8-10.

42 APGA reply comments at 11-15; CAPP initial comments at 1; CAPP reply

comments at 6-7, and attachment at 3-4; NYPSC initial comments at 19-21, 23, including

attachments of financial materials from major investment houses; NYPSC reply

comments at 4-7; Tesoro reply comments at 25-27.

43 Id.

Docket No. PL07-2-000

- 16 -

limited partners’ units.44 Therefore, they argue, sustainability of MLP growth is a major

issue that must be examined in rate proceedings as this implies a lower equity cost-of-

capital component in the pipeline’s rate structure.45 The Customer Interests also assert

that the Commission’s traditional DCF model has never permitted the inclusion of

externally generated funds in the growth component of the model. Thus, to the extent the

IBES projections include such external funds, they assert that this compromises the

forecasts.

39.

Finally, NGSA urge the Commission to initiate a new proceeding to consider

alternatives to the DCF methodology for determining gas pipeline ROEs. AGA requests

a technical conference to discuss the issues further, which as noted, the Commission

granted with regard to the growth factors.46 Two commenters assert that any change in

policy should apply prospectively and should not apply to proceedings for which the

hearing record is completed, e.g., the Kern River proceeding.47

B.

Technical Conference and Post-Technical Conference Comments

40.

After review of the initial comments summarized above, the Commission issued a

supplemental notice on November 15, 2007, requesting additional comments solely on

the issue of MLP growth rates, and establishing a technical conference to discuss that

issue. The technical conference was held on January 23, 2008

ng.47

B.

Technical Conference and Post-Technical Conference Comments

40.

After review of the initial comments summarized above, the Commission issued a

supplemental notice on November 15, 2007, requesting additional comments solely on

the issue of MLP growth rates, and establishing a technical conference to discuss that

issue. The technical conference was held on January 23, 2008. The Commission

concluded that supplementing the record before the Commission could resolve the issue

of how to project MLP growth rates assuming that the Commission ultimately decides to

permit the use of MLPs in the proxy group. The Commission focused the technical

conference on the appropriate method for determining MLP growth and, in particular,

that which should be used if the Commission did not cap the distributions used to

determine the dividend yield. Thus, whether to include MLPs in the proxy group or to

limit the distributions to earnings were not issues before the technical conference. The

technical conference was transcribed for use in the record herein.

41.

Thirteen parties submitted comments in response to the November 15 notice, on

three main topics: (1) the short-term growth component; (2) the long-term growth

44 Crowley Energy Consultant initial comments; Society at 5-6.

45 Id.

46 AGA initial comments at 8.

47 Id. at 8, 25; NGSA initial comments at 3, 11.

or use in the record herein.

41.

Thirteen parties submitted comments in response to the November 15 notice, on

three main topics: (1) the short-term growth component; (2) the long-term growth

44 Crowley Energy Consultant initial comments; Society at 5-6.

45 Id.

46 AGA initial comments at 8.

47 Id. at 8, 25; NGSA initial comments at 3, 11.

Docket No. PL07-2-000

- 17 -

component; and (3) the weighting of these two components.48 Of these, eight parties

requested to participate on the panels and the Commission accepted all of the individuals

proffered by these parties.49 To summarize, two of the panelists represented parties that

continued to assert that MLPs should not be included in the ROE proxy group.50 More

consistent with the premise of the conference, three panelists stated that there needed to

be an adjustment to the long term GDP component the Commission currently uses in its

DCF model.51 Two stated that MLPs would grow at a slower rate than corporations in

the long-term phase of growth. However, six other panelists asserted that an MLP as a

whole could grow as fast as a corporation in the terminal phase, but most conceded that

the use of an incentive distribution rights (IDRs)52 would cause the limited partnership

interests to grow at slower rate than the MLP as a whole.53 In addition, three panelists

questioned the reliability of the IBES forecasts for use in developing the short- term

48 APGA, AOPL, CAPP, Enbridge, INGAA, MidAmerica, NAPTP, NGSA,

PSNYC, State of Alaska, Tesoro, TransCanada, and Williston.

49 Professor J. Peter Williamson on behalf of the Association of Oil Pipelines,

Mr. J. Bertram Solomon on behalf of the American Public Gas Association, Mr. Michael

J. Vilbert on behalf of the Interstate Natural Gas Association of America, Mr. Park

Shaper and Mr. Yves Siegel on behalf of the National Association of Publicly Traded

Partnerships, Mr

laska, Tesoro, TransCanada, and Williston.

49 Professor J. Peter Williamson on behalf of the Association of Oil Pipelines,

Mr. J. Bertram Solomon on behalf of the American Public Gas Association, Mr. Michael

J. Vilbert on behalf of the Interstate Natural Gas Association of America, Mr. Park

Shaper and Mr. Yves Siegel on behalf of the National Association of Publicly Traded

Partnerships, Mr. Patrick Barry on behalf of the Public Service Commission of New

York, Mr. Thomas Horst on behalf of the State of Alaska, and Mr. Paul Moul on behalf

of TransCanada Corporation.

50 PSCNY and APGA. CAPP, NGSA, and Tesoro supported this position but did

not participate on the panel.

51 PSCNY, APGA, and State of Alaska as well as the NGSA.

52 As discussed further below, an incentive distribution provision in an MLP

partnership agreement provides for an increasing large percentage of distributions to the

general partner as the cash distributions per limited partnership share increase over time.

The maximum incentive distribution to the general partner varies with the partnership

agreement, but may be as high as 47 percent. .

53 Two spoke for NAPTP and one each for AOPL, INGAA, the State of Alaska,

and TransCanada. Williston, Enbridge, and MidAmerican also asserted that there is no

reason to conclude the growth would not at least equal GDP. They did not speak to the

issue of the limited partner growth rate that might be lower as a result of the incentive

distributions to the general partner.

as 47 percent. .

53 Two spoke for NAPTP and one each for AOPL, INGAA, the State of Alaska,

and TransCanada. Williston, Enbridge, and MidAmerican also asserted that there is no

reason to conclude the growth would not at least equal GDP. They did not speak to the

issue of the limited partner growth rate that might be lower as a result of the incentive

distributions to the general partner.

Docket No. PL07-2-000

- 18 -

projection54 and one stated that the longer term growth component of the formula should

be weighted at no greater than 10 percent.55

IV. Discussion

42.

Based on its review of all the comments and the record of the technical

conference, the Commission is adopting the following policy concerning the composition

of the natural gas pipeline and oil pipeline proxy groups: (1) consistent with the

Proposed Policy Statement, the Commission will permit MLPs to be included in the

proxy group for both gas and oil pipelines; (2) the proposed earnings cap on the MLPs’

distributions will not be adopted; and (3) the Commission will use the same DCF analysis

for MLPs as for corporations, except that the long-term growth projection for MLPs shall

be 50 percent of projected growth in GDP.

A.

Whether to Include MLPs in the Gas and Oil Pipeline Proxy Groups

1.

Comments

43.

The first issue is whether to include MLPs in the proxy group used to determine a

pipeline’s return on equity. No commenter contests the Commission’s statement that, in

oil pipeline proceedings, MLPs are the only firms available for inclusion in the proxy

group.56 In addition, the Pipeline Interests all assert that the Commission correctly

proposed to include MLPs in the gas pipeline proxy group. They agree with the

Commission that this will result in a more representative proxy group that reflects long-

term trends within the gas pipeline industry and assert that the resulting returns will

encourage further investment in both the gas and oil pipeline industries

on, the Pipeline Interests all assert that the Commission correctly

proposed to include MLPs in the gas pipeline proxy group. They agree with the

Commission that this will result in a more representative proxy group that reflects long-

term trends within the gas pipeline industry and assert that the resulting returns will

encourage further investment in both the gas and oil pipeline industries. Including MLPs

in the proxy group would reduce the need for difficult adjustments to projected equity

returns to accommodate differences in risk among the different types of firms that might

reasonably be included in the proxy group.

44.

In contrast, most of the commenters representing the Customer Interests assert that

there are enough corporations available for inclusion in the gas pipeline proxy group that

there is no need to include MLPs. They further argue that the differences between the

54 APGA, PSCNY, and State of Alaska.

55 TransCanada, Additional Comments dated December 21 at 12.

56 AOPL initial comments at 5. Tesoro initial comments at 2. See also Society

initial comments addressing the possible inclusion oil pipeline MLPs in the proxy group.

Docket No. PL07-2-000

- 19 -

MLP and corporate business model render any use of MLPs inconsistent with the DCF

model. APGA expressly states that the Commission should abandon the Proposed Policy

Statement.57

45.

The NMDG asserts that the Commission has not established that there is any

reason to issue the Policy Statement or to relieve a pipeline applicant of the burden of

establishing why any MLPs should be included in the proxy group. In this vein,

Indicated Shippers assert that the Commission should consider alternative procedures for

defining the proxy group, and that the improvement in El Paso Natural Corporation’s and

the William Company’s financial situation and the creation of the Spectra Group suggest

that the corporate gas proxy group is becoming more representative

y any MLPs should be included in the proxy group. In this vein,

Indicated Shippers assert that the Commission should consider alternative procedures for

defining the proxy group, and that the improvement in El Paso Natural Corporation’s and

the William Company’s financial situation and the creation of the Spectra Group suggest

that the corporate gas proxy group is becoming more representative.

46.

Finally, NGSA urges the Commission to initiate a new proceeding to consider

alternatives to the DCF methodology for determining gas pipeline ROEs. NGSA

generally supports including MLPs in the proxy group, subject to adjustments, as a means

of continuing to use the DCF method on a temporary basis. But it argues that a better

long-term solution to determining gas pipeline ROEs would be to stop using the DCF

method, and instead adopt a risk premium approach to determining ROE. It asserts that

the risk premium approach is used in Canada and does not require adjustments to account

for variations in corporate structure.58 INGAA states in its reply comments that the DCF

methodology is not necessarily the only financial model that may be used, and asks the

Commission to clarify that parties may propose other approaches in individual rate

cases.59

2.

Discussion

47.

As the Commission pointed out in the proposed policy statement, the Supreme

Court has held that “the return to the equity owner should be commensurate with the

return on investment in other enterprises having corresponding risks. That return,

moreover, should be sufficient to assure confidence in the financial integrity of the

enterprise, so as to maintain its credit and to attract capital.”60 In order to attract capital,

“a utility must offer a risk-adjusted expected rate of return sufficient to attract

57 APGA initial comments at 14.

58 NGSA initial comments at 13-15.

59 INGAA reply comments at 18.

60 FPC v. Hope Natural Gas Co., 320 U.S. 591, 603 (1044).

of the

enterprise, so as to maintain its credit and to attract capital.”60 In order to attract capital,

“a utility must offer a risk-adjusted expected rate of return sufficient to attract

57 APGA initial comments at 14.

58 NGSA initial comments at 13-15.

59 INGAA reply comments at 18.

60 FPC v. Hope Natural Gas Co., 320 U.S. 591, 603 (1044).

Docket No. PL07-2-000

- 20 -

investors.”61 In other words, the utility must compete in the equity markets to obtain

capital.

48.

The Commission performs a DCF analysis of publicly-traded proxy firms to

determine the return on equity that markets require a pipeline to give its investors in order

for them to invest their capital in the pipeline. As the court explained in Petal Gas

Storage, L.L.C. v. FERC, the purpose of the proxy group is to “provide market-

determined stock and dividend figures from public companies comparable to a target

company for which those figures are unavailable. Market-determined stock figures

reflect a company’s risk level and when combined with dividend values, permit

calculation of the ‘risk-adjusted expected rate of return sufficient to attract investors.’”62

It is thus crucial that the firms in the proxy group be comparable to the regulated firm

whose rate is being determined. In other words, as the court emphasized in Petal, the

proxy group must be “risk-appropriate.”63

49.

The Commission continues to believe that including MLPs in the gas and oil

proxy groups will, as required by Petal, make those proxy groups more representative of

the business risks of the regulated firm whose rates are at issue. While there has been

some modest expansion of the number of publicly-traded diversified natural gas

companies that could be included in the proxy group, this does not change one basic fact.

This is that more and more gas pipeline assets are being transferred to publicly-traded

MLPs, whose business is narrowly focused on pipeline activities

isks of the regulated firm whose rates are at issue. While there has been

some modest expansion of the number of publicly-traded diversified natural gas

companies that could be included in the proxy group, this does not change one basic fact.

This is that more and more gas pipeline assets are being transferred to publicly-traded

MLPs, whose business is narrowly focused on pipeline activities. As a result, these

MLPs are likely to be more representative of predominantly pipeline firms than the

diversified gas corporations still available for inclusion in a proxy group. As such,

including MLPs in the gas pipeline proxy group should render the proxy group more

“risk-appropriate,” consistent with Petal. Moreover, MLPs are the only publicly traded

ownership form for oil pipelines and are the most representative group for determining

the equity cost of capital for oil pipelines.

50.

As the court also emphasized in Petal, when a proxy group is less than clearly

representative, there may be a need for the Commission to adjust for the difference in risk

by adjusting the equity cost-of-capital, a difficult undertaking requiring detailed support

from the contending parties and detailed case-by-case analysis by the Commission.

61 CAPP, 254 F.3d at 293.

62 Petal, 496 F.3d at 697, quoting Canadian Association of Petroleum Producers

v. FERC, 254 F.3d 289 (D.C. Cir. 2001).

63 Id. 6.

ifference in risk

by adjusting the equity cost-of-capital, a difficult undertaking requiring detailed support

from the contending parties and detailed case-by-case analysis by the Commission.

61 CAPP, 254 F.3d at 293.

62 Petal, 496 F.3d at 697, quoting Canadian Association of Petroleum Producers

v. FERC, 254 F.3d 289 (D.C. Cir. 2001).

63 Id. 6.

Docket No. PL07-2-000

- 21 -

Expanding a proxy group to include MLPs whose business is more narrowly focused on

pipeline activities should help minimize the need to make adjustments, because the proxy

group should be more representative of the regulated firms whose rates are at issue.

51.

While this Policy Statement modifies Commission policy to permit MLPs to be

included in the proxy group, the Commission is making no findings at this time as to

which particular corporations and/or MLPs should be included in the gas or oil proxy

groups. The Commission leaves that determination to each individual rate case. In order

to assist the Commission in determining the most representative possible proxy group in

those cases, the parties and other participants should provide as much information as

possible regarding the business activities of each firm they propose to include in the

proxy group, including their recent annual SEC filings and investor service analyses of

the firms. This information should help the Commission determine whether the interstate

natural gas or oil pipeline business is a primary focus of the firm and whether investors

view an investment in the firm as essentially an investment in that business. While the

Commission is not precluding use of diversified corporations or MLPs in the proxy

group, the probable difference in the risk of the natural gas pipeline business and the risk

profile of a diversified gas corporation with substantial local distribution activities has

been highlighted by the parties and specifically recognized by the court in Petal.64

52

stment in that business. While the

Commission is not precluding use of diversified corporations or MLPs in the proxy

group, the probable difference in the risk of the natural gas pipeline business and the risk

profile of a diversified gas corporation with substantial local distribution activities has

been highlighted by the parties and specifically recognized by the court in Petal.64

52.

As discussed further below, the Commission recognizes that there are significant

differences in the cash flows to investors and growth rates of corporations and MLPs.

However, as discussed below, the Commission believes that those issues may be

accounted for in a correctly performed DCF analysis, and therefore these differences do

not preclude inclusion of MLPs in the proxy group.

53.

Finally, the Commission has concluded that it will not explore other methods of

determining the equity cost of capital at this time. The DCF model is a well established

method of determining the equity cost of capital,65 and other methods such as the risk

premium model have not been used by the Commission for almost two decades. In the

Commission’s judgment, the uncertainty that would be created by reopening its

procedures to include other approaches outweighs any limitations in its current pragmatic

64 Id. at 6-7.

65 See Illinois Bell Telephone Co. v. FCC, 988 F.2d 1254, 1259 n. 6 (D.C. Cir.

1993), stating, “The DCF method ‘has become the most popular technique of estimating

the cost of equity, and it is generally accepted by most commissions. Virtually all cost of

capital witnesses use this method, and most of them consider it their primary technique.’”

quoting J. Bonbright et al., Principles of Public Utility Regulation 318 (2d ed. 1988).

C, 988 F.2d 1254, 1259 n. 6 (D.C. Cir.

1993), stating, “The DCF method ‘has become the most popular technique of estimating

the cost of equity, and it is generally accepted by most commissions. Virtually all cost of

capital witnesses use this method, and most of them consider it their primary technique.’”

quoting J. Bonbright et al., Principles of Public Utility Regulation 318 (2d ed. 1988).

Docket No. PL07-2-000

- 22 -

approach to the financial characteristics of MLPs. Therefore the alternatives suggested

by certain of the parties will not be pursued further here. Nothing submitted at the

January 23rd technical conference warrants different conclusions.

B.

The Proposed Adjustment to MLP Cash Distributions

1.

Comments

54.

Both the Pipeline and Customer Interests attack the proposed earnings cap on

MLP distributions, with the Pipeline Interests asserting the cap is unnecessary and the

Customer Interests asserting the cap should be lower. The Pipeline Interests assert that

there is no need to adjust the distributions included in the DCF model. They argue that

investors include all cash flows that are generated by an MLP in applying a DCF model

and do not distinguish between a return of investment and a return on investment66 since

depreciation is an accounting concept that is used to calculate an MLP’s earnings that is

not relevant to determining the cash flows included in a DCF analysis.67 The Pipeline

Interests further assert that an unadjusted DCF calculation does not result in the double

recovery of the depreciation component of an MLP’s cost-of-service.68

55.

Moreover, the Pipeline Interests assert that, because all parts of the DCF model are

linked, if the distribution component is reduced, this will necessarily affect the growth

component of the model

CF analysis.67 The Pipeline

Interests further assert that an unadjusted DCF calculation does not result in the double

recovery of the depreciation component of an MLP’s cost-of-service.68

55.

Moreover, the Pipeline Interests assert that, because all parts of the DCF model are

linked, if the distribution component is reduced, this will necessarily affect the growth

component of the model. They assert that any adjustment limiting the distributions used

to earnings will result in below market returns to investors and thus any such adjustment

is arbitrary.69 As an alternative, they suggest that if an MLP’s distributions are

unrepresentative, it is wiser to exclude that MLP from the sample as an outlier.70 They

further assert there have been corporations in the proxy group that have distributed

66 AOPL initial comments at 16, 18; Spectra Energy initial comments at 14;

NAPTP initial comments at 3.

67 INGAA initial comments at 5-6, 15-18; NAPTP initial comments at 4-5;

MidAmerican initial comments at 5; Panhandle initial comments at 3 and attachment;

Williston initial comments at 11.

68 INGAA initial comments at 15-17 and 20-21.

69 AOPL initial comments at 8, 10; INGAA initial comments at 13-14; Spectra

initial comments at 4; PAPTP initial comments at 4.

70 INGAA initial comments at 13; Spectra Energy initial comments at 5, 19-20.

Docket No. PL07-2-000

- 23 -

dividends in excess of earnings for years and the Commission has never required an

adjustment.71 They claim that in any event there are practical problems with an earnings

cap because earnings are reported quarterly (unlike distributions which are reported

monthly) and such reports are unedited and may require seasonal adjustments.72

56

nts at 5, 19-20.

Docket No. PL07-2-000

- 23 -

dividends in excess of earnings for years and the Commission has never required an

adjustment.71 They claim that in any event there are practical problems with an earnings

cap because earnings are reported quarterly (unlike distributions which are reported

monthly) and such reports are unedited and may require seasonal adjustments.72

56.

The Customer Interests support the Commission’s initial conclusion that an

adjustment to MLP distributions is necessary to remove a double count attributed to

depreciation, but they also uniformly assert that the proposed adjustment is inadequate to

compensate for a wide range of financial factors that distinguish MLPs from Schedule C

corporations. Thus, they assert that further adjustments to the distributions should be

made to reflect the tax advantages that flow to MLPs,73 the alleged distortions that result

from incentive distributions to the general partner,74 and the fact that distributions may

also include cash derived from the sale of assets, bond issues, and the issuance of further

limited partnership units.75 Several also assert that for an MLP’s distribution to be

comparable to that of a corporation, the percentage of the MLP’s distribution included in

the DCF model should be no higher than the percentage of earnings corporations

typically include in their dividend payments, or about 60 percent.76 Finally, to the extent

that INGAA and others assert that depreciation is not a direct source of cash flow for

distribution, the Customer Interests cite to investor literature and MLP filings with the

SEC disclosure that state exactly the opposite.77

71 INGAA initial comments at 18; MidAmerica initial comments at 6.

72 AOPL initial comments at 24-25; Spectra Energy initial comments at 17-18.

73 Crowley Energy at 2; Indicated Shippers initial comments at 24; PSCNY initial

comments at 12-13; Society initial comments, passim

P filings with the

SEC disclosure that state exactly the opposite.77

71 INGAA initial comments at 18; MidAmerica initial comments at 6.

72 AOPL initial comments at 24-25; Spectra Energy initial comments at 17-18.

73 Crowley Energy at 2; Indicated Shippers initial comments at 24; PSCNY initial

comments at 12-13; Society initial comments, passim.

74 APGA at 7-8; Crowley Energy at 2; Indicated Shippers comments at 24; NGSA

at 6; Society initial comments passim.

75 Crowley Energy initial comments; Society, passim; Tesoro reply comments at

26.

76 CAPP initial comments at 3, 6; Indicated Shippers initial comments at 23;

PSCNY initial comments at 6; Tesoro initial comments at 15.

77 APGA initial comments at 11; CAPP reply comments at 3-4; NGSA reply

comments at 9-10; Tesoro reply comments at 19-21.

Docket No. PL07-2-000

- 24 -

2.

Discussion

57.

The Commission concludes that a proposed earnings cap on the MLP distributions

that would be included in the DCF model should not be adopted. On further review, the

Commission concludes that its concern with the distinction between return on capital and

return of capital improperly conflates cost-of-service rate-making techniques with the

market-driven DCF method used for determining the pipeline’s cost of obtaining capital

in the equity markets. This is inconsistent with the DCF model’s internal structure.

58.

The fundamental premise of the DCF model is that a firm’s stock price should

equal the present value of its future cash flows, discounted at a market rate commensurate

with the stock’s risk. No commenter seriously contends that an investor would

distinguish between cash flows attributable to return on capital, and those attributable to

return of capital, in performing a DCF analysis. In short, under the DCF model, all cash

flows, whatever their source, contribute to the value of stock

value of its future cash flows, discounted at a market rate commensurate

with the stock’s risk. No commenter seriously contends that an investor would

distinguish between cash flows attributable to return on capital, and those attributable to

return of capital, in performing a DCF analysis. In short, under the DCF model, all cash

flows, whatever their source, contribute to the value of stock. The Commission agrees

that, since the DCF model uses the total unadjusted cash flows to determine a stock’s

value, it is theoretically inconsistent to use lower adjusted cash flows when using the

DCF model to determine the return required by investors purchasing the stock.

59.

More specifically, the investor first determines what risk should be attributed to a

prospective investment and the related return that would be required in order to make the

investment. For example, the investor may conclude that the minimum return from the

investment must be 10 percent on equity. The investor then looks at the total cash flows

from all sources over time, including the current distribution (or dividend) and its

projected growth. The DCF model yields a price for the share that reflects the present

value of those cash flows at the discount rate.

60.

In contrast, the Commission solves the DCF formula for the return required by the

investor, not the price of the stock. This results in the Commission calculating the proxy

firm’s ROE as the sum of (1) the proxy firm’s dividend yield and (2) the projected

growth rate. The Commission determines dividend yield by dividing the proxy firm’s

cash distribution (or dividend) by its current stock price. As the court in Petal pointed

out, both the stock price and distribution (or dividend) figures of the proxy firms are

market-determined

ommission calculating the proxy

firm’s ROE as the sum of (1) the proxy firm’s dividend yield and (2) the projected

growth rate. The Commission determines dividend yield by dividing the proxy firm’s

cash distribution (or dividend) by its current stock price. As the court in Petal pointed

out, both the stock price and distribution (or dividend) figures of the proxy firms are

market-determined. Moreover, an investor’s projection of the MLP’s growth prospects

would be affected by the actual level of its distributions, with distributions in excess of

earnings generally perceived as reducing the growth projection because less cash flow is

available for reinvestment in the firm.78 The pipeline industry generally acknowledged

78 Because a corporation typically retains a portion of its earnings, general

financial theory suggests that it is able to use internally generated funds to obtain a higher

growth rate. An MLP’s higher level of distributions theoretically produces a lower

projected growth rate. In fact, the most recent IBES projections for the four corporations

(continued…)

Docket No. PL07-2-000

- 25 -

this fact in earlier rate proceedings as well as in this proceeding, or at least until its later

phases.79 As illustrated in Appendix B to this Policy Statement, a DCF analysis using

market-determined inputs for each of the variables in the DCF formula appropriately

determines, consistent with Petal, the percentage return on equity a pipeline must offer in

the equity market in order to attract investors, whether the proxy firms are corporations or

MLPs.

61

or at least until its later

phases.79 As illustrated in Appendix B to this Policy Statement, a DCF analysis using

market-determined inputs for each of the variables in the DCF formula appropriately

determines, consistent with Petal, the percentage return on equity a pipeline must offer in

the equity market in order to attract investors, whether the proxy firms are corporations or

MLPs.

61.

If the Commission were to cap the distribution used to determine an MLP’s

dividend yield at below the market-determined level, but use the actual market price of

the MLP’s publicly traded units and a growth projection reflecting the actual level of

distributions, the DCF analysis would fail to achieve its intended purpose of determining

the return the equity market requires in order to justify an investment in the pipeline.

That is because there would be a mismatch among the inputs the Commission used for

the variables in the DCF formula. The DCF analysis presumes that the market value of

an MLP’s units is a function of the entire present and future cash flow provided by an

investment in those units. Given this interlocking nature of the variables in the DCF

formula, INGAA and the other pipeline commenters are correct that limiting the

distribution input to earnings, while using market values for the other inputs to the DCF

formula, would result in the calculation of a return below that implied in the share price.80

included in the gas pipeline proxy group in Appendix A average 10.5 percent, while the

IBES growth projections for the six MLPs average only 6.67 percent.

79 See AOPL Initial Comments, Williamson Aff

urn below that implied in the share price.80

included in the gas pipeline proxy group in Appendix A average 10.5 percent, while the

IBES growth projections for the six MLPs average only 6.67 percent.

79 See AOPL Initial Comments, Williamson Aff. at 6-7; AOPL Reply Comments

at 6-7; Panhandle Initial Comments, Attachment dated August 30, 2007, Analysis of the

Use of MLPs in the Group of Proxy Companies Used For Determining Gas and Oil

Pipeline Return on Equity at 10-11; Transwestern Pipeline Company, LLC, Docket

No. RP06-614-000, Ex. TW-56 filed September 29, 2006, at 23-24; High Island Offshore

System, L.L.C., Docket No. RP96-540-000, Ex. HIO-73 filed August 26, 2006 at 28-29;

Texaco Refining and Marketing Inc, et al. v. SFPP, L.P., Docket No. OR96-2-012, Ex.

SEP SFPP-56 dated February 14, 2005 at 9-10; Mojave Pipeline Company, Docket No.

RP07-310-000, Ex. MPC-70 dated February 2, 2007 at 28-32 (including tables and charts

on the relative growth rates of corporations and MLPs); Kern River Gas Transmission

Company, Docket No. RP04-274-000, Ex. KR-107 at 17.

80 The earnings cap on the distribution would artificially reduce an MLP’s

dividend yield below that assumed by the investor in valuing the stock. Adding the

artificially reduced dividend yield to a growth projection that reflects the MLP’s reduced

growth prospects due to its high actual distributions would inevitably result in an ROE

lower than that actually required by the market.

at 17.

80 The earnings cap on the distribution would artificially reduce an MLP’s

dividend yield below that assumed by the investor in valuing the stock. Adding the

artificially reduced dividend yield to a growth projection that reflects the MLP’s reduced

growth prospects due to its high actual distributions would inevitably result in an ROE

lower than that actually required by the market.

Docket No. PL07-2-000

- 26 -

62.

In addition, use of a proxy MLP’s full distribution in determining ROE will not

cause a double recovery of the depreciation component included in the pipeline’s cost-of-

service rates. In a rate case, the Commission determines the dollar amount of the ROE

component of the cost-of-service of the pipeline filing the rate case by multiplying (1) the

percentage return on equity required by the market by (2) the actual rate base of the

pipeline in question. Having found that use of a proxy MLP’s full distribution is

necessary for the DCF analysis to accurately determine the percentage return on equity

required by the equity markets, it necessarily follows that the same percentage should be

used in determining the dollar amount of the ROE component of the pipeline’s cost of

service. Awarding the pipeline an ROE allowance based on that percentage of its own

rate base will give the pipeline an opportunity to provide its investors with the return on

their investment required by the market. Such an ROE allowance does not implicate the

separate depreciation allowance the Commission also includes in a pipeline’s cost of

service to provide for return of investment.

63.

The Commission therefore concludes that it is not analytically sound to cap the

distributions to be included in the DCF model by the MLP’s earnings. As discussed

below, the record is more convincing that if any adjustment is required, this issue centers

on the projected growth of the MLPs. Given this, it is not necessary to discuss the

appropriate level for any earnings cap.

64

t.

63.

The Commission therefore concludes that it is not analytically sound to cap the

distributions to be included in the DCF model by the MLP’s earnings. As discussed

below, the record is more convincing that if any adjustment is required, this issue centers

on the projected growth of the MLPs. Given this, it is not necessary to discuss the

appropriate level for any earnings cap.

64.

Having concluded that an earnings cap adjustment would be inappropriate, the

Commission also concludes that it is not necessary to address the long term sustainability

of MLPs as a whole, or those of the particular MLP whose rates are under review. As has

been discussed, the DCF model has two components. One is the cash distribution in the

current period and the second is the discounted value of the anticipated growth in that

distribution. The increase in distribution is driven by the anticipated growth in earnings

that generates the cash to be used for the distribution. If projected earnings suggest that

the distribution cannot be sustained, this will be reflected in the projected cash flow for

the firm and ultimately the MLP unit price.81 In this regard, some MLPs will inevitably

do better and others not as well, and from the Commission’s point of view, this will be

reflected in the required rate of return developed by the DCF model.

65.

For this reason, as the Pipeline Interests suggest, if an MLP’s financial condition

or growth rate is outside the norm for the industry, or is unrepresentative, the best way to

deal with this issue is to exclude that particular MLP from the proxy group sample, just

81 The investor requires a minimum return that reflects the perceived risk of the

investment. Thus, if the cash flows decline, so will the price of the stock assuming the

percentage return required remains the same.

y, or is unrepresentative, the best way to

deal with this issue is to exclude that particular MLP from the proxy group sample, just

81 The investor requires a minimum return that reflects the perceived risk of the

investment. Thus, if the cash flows decline, so will the price of the stock assuming the

percentage return required remains the same.

Docket No. PL07-2-000

- 27 -

as the Commission has done with unrepresentative diversified gas corporations. Finally,

the Commission has previously held that the issue of whether MLPs are an appropriate

investment vehicle for the pipeline industry as a whole is a matter that is best left for

Congress, the body that authorized MLPs in the first instance. Thus the Commission will

not address that issue, or the appropriateness of the tax deferral aspects of MLPs further

in this proceeding.82 Nothing presented at the technical conference warrants different

conclusions.

66.

The Commission now turns to the issue of how to project the growth rates of

MLPs. For the reasons discussed below, the Commission finds that the differences

between MLPs and corporations, and particularly the MLPs’ lower growth prospects due

to their distributions in excess of earnings, are appropriately accounted for in the growth

projection component of the DCF model.

C.

The Short Term Growth Component

67.

This section of the Policy Statement discusses whether changes should be made to

the short-term growth component of the DCF model. For the short-term growth estimate

the Commission currently uses security analysts’ five-year forecasts for each company in

the proxy group, as published by IBES. IBES is a service that monitors the earnings

estimates on over 18,000 companies of interest to institutional investors. More than

850 firms contribute data to IBES to be used in its projections and the information is

provided on a subscription basis.

1.

Comments

68

on currently uses security analysts’ five-year forecasts for each company in

the proxy group, as published by IBES. IBES is a service that monitors the earnings

estimates on over 18,000 companies of interest to institutional investors. More than

850 firms contribute data to IBES to be used in its projections and the information is

provided on a subscription basis.

1.

Comments

68.

The Pipeline Interests support the continued use of five-year IBES forecasts for

short-term growth projections in the DCF model with regard to MLPs. In general, they

argue that, while no growth forecast is perfect, IBES provides the best available

information regarding what investors expect in companies. They state that IBES

estimates are unbiased and publicly available. They add that since IBES estimates are

company-specific, they already adjust for any differences among the entities analyzed,

including whether the company is organized as an MLP or corporation.

82 See SFPP, L.P., 121 FERC ¶ 61,240, at P 20-61 (2007) for an extensive

discussion of these income tax allowance and tax deferral policy issues relating to MLPs.

Moreover, any tax advantages are normally reflected in the MLP unit price. See also

INGAA Reply Comments at 12-13; MidAmerica, Reply Comments at 4-5; AOPL Reply

Comments at 11-12; Tr.121-22; AOPL Post-Technical Conference Comments at 14.

SFPP, L.P., 121 FERC ¶ 61,240, at P 20-61 (2007) for an extensive

discussion of these income tax allowance and tax deferral policy issues relating to MLPs.

Moreover, any tax advantages are normally reflected in the MLP unit price. See also

INGAA Reply Comments at 12-13; MidAmerica, Reply Comments at 4-5; AOPL Reply

Comments at 11-12; Tr.121-22; AOPL Post-Technical Conference Comments at 14.

Docket No. PL07-2-000

- 28 -

69.

For example, NAPTP supports the IBES estimates because the various items that

may affect the growth rate expected by the market, such as the effect of IDRs to the

general partner, are already factored into IBES projections.83 Williston Basin argues that

since IBES data is drawn from many financial analysts, and since the information is

widely accepted in the financial industry, use of IBES helps reduce subjectivity when

estimating appropriate short-term growth forecasts.84 TransCanada acknowledges that

IBES may underestimate short-term growth for MLPs, but argues that modifying IBES

would only further understate short-term growth rates and compound any problems

brought on by trying to estimate growth for MLPs.85 The AOPL similarly argues that

studies have shown that IBES estimates understate short-term growth rates for MLPs and

therefore the growth projections are conservative.86

70.

However, certain parties recommend that the Commission discontinue using IBES

estimates for MLPs to project short-term growth rates in its DCF model. These parties

argue there is considerable uncertainty of whether the individual forecasts IBES is

reporting reflect earnings growth or distribution growth. The State of Alaska asserts that

IBES growth estimates of distributions per share are incomplete and unreliable for use in

the DCF calculation. It argues that there are not a sufficient number of stock analysts

providing IBES with distribution per share growth estimates to get a reliable estimate for

the purposes of calculating the cost of equity for pipeline companies

r distribution growth. The State of Alaska asserts that

IBES growth estimates of distributions per share are incomplete and unreliable for use in

the DCF calculation. It argues that there are not a sufficient number of stock analysts

providing IBES with distribution per share growth estimates to get a reliable estimate for

the purposes of calculating the cost of equity for pipeline companies. Speaking for the

State of Alaska, Dr. Thomas Horst notes that of the 37 gas and oil companies he

examined data for, there was not a single case where IBES received two or more

estimates of distributions per share growth rates.87

71.

APGA states that through communications with personnel at Thompson Financial,

the owner of IBES and the publisher of its forecasts, it verified that the five-year analysts’

growth rate projections reported by IBES for MLPs are projections of earnings per unit,

and not distributions per unit.88 PSCNY also considers IBES projections unreliable, since

83 NAPTP, Initial Technical Conference Comments at 3.

84 Williston, Additional Comments dated December 21 at 2.

85 TransCanada, Additional Comments dated December 21 at 12-13.

86 AOPL, Initial Technical Conference Comments at 5, Williamson Post-Technical

Conference Aff. at 3, 8.

87 State of Alaska, Reply Comments dated February 20 at 5.

88 APGA, Reply Technical Conference Comments at 5-6.

83 NAPTP, Initial Technical Conference Comments at 3.

84 Williston, Additional Comments dated December 21 at 2.

85 TransCanada, Additional Comments dated December 21 at 12-13.

86 AOPL, Initial Technical Conference Comments at 5, Williamson Post-Technical

Conference Aff. at 3, 8.

87 State of Alaska, Reply Comments dated February 20 at 5.

88 APGA, Reply Technical Conference Comments at 5-6.

Docket No. PL07-2-000

- 29 -

they do not account for such parameters as IDRs. It questions whether analysts can truly

estimate MLP growth beyond two years. It also questions whether lower earnings

retention necessarily would translate into lower short-term IBES growth rates relative to

corporations.89 CAPP expresses concerns that the analysts that produce IBES growth

estimates continue to be concentrated within the same financial institutions that also

underwrite the securities of the subject companies, invest in those securities, and furnish

other financial services to the subject enterprises90 and also notes the uncertainty of

whether the forecasts are for earnings or distributions.91

72.

However AOPL maintains that historical records confirm that what analysts

actually report to IBES is distribution growth. It adds that Yves Siegel, Wachovia’s

representative, confirmed that Wachovia provides projected MLP distribution growth to

IBES, and not earnings growth.92 NAPTP asserts that, for projecting the short-term

growth rates of MLPs, the Commission should use analysts forecasts of growth in the

MLP’s distributable cash flow for all of its equity holders and that, while not perfect, this

is the best information that is available.93

2.

Discussion

73.

The Commission’s longstanding policy is to use security analysts’ five-year

growth forecasts as reported by IBES to determine the short-term growth rates for each

proxy company. In Opinion No 414-A,94 the Commission explained that the growth rate

to be used in the DCF model is the growth rate expected by the market

his

is the best information that is available.93

2.

Discussion

73.

The Commission’s longstanding policy is to use security analysts’ five-year

growth forecasts as reported by IBES to determine the short-term growth rates for each

proxy company. In Opinion No 414-A,94 the Commission explained that the growth rate

to be used in the DCF model is the growth rate expected by the market. Thus, the

Commission seeks to base its growth projections on “the best evidence of the growth

rates actually expected by the investment community.”95 Moreover, the Commission

stated, the growth rate expected by the investment community is not, quoting a Transco

witness, “necessarily a correct growth forecast; the market may be wrong. But the cost of

89 NYPSC Initial Technical Conference Comments at 5-6.

90 CAPP Supplemental Comments dated December 21 at 3-4.

91 CAPP Initial Technical Conference Comments at 7.

92 AOPL Initial Technical Conference Comments at 4-5.

93 NAPTP Post-Technical Conference Comments at 1-3.

94 85 FERC ¶ 61,323 at 62,268-9.

95 Id. at 62,269.

Docket No. PL07-2-000

- 30 -

common equity to a regulated enterprise depends upon what the market expects not upon

precisely what is going to happen.”96

74.

The Commission held that the IBES five-year growth forecasts for each company

in the proxy group are the best available evidence of the short-term growth rates expected

by the investment community. It cited evidence that (1) those forecasts are provided to

IBES by professional security analysts, (2) IBES reports the forecast for each firm as a

service to investors, and (3) the IBES reports are well known in the investment

community and used by investors

r each company

in the proxy group are the best available evidence of the short-term growth rates expected

by the investment community. It cited evidence that (1) those forecasts are provided to

IBES by professional security analysts, (2) IBES reports the forecast for each firm as a

service to investors, and (3) the IBES reports are well known in the investment

community and used by investors. The Commission has also rejected the suggestion that

the IBES analysts are biased and stated that “in fact the analysts have a significant

incentive to make their analyses as accurate as possible to meet the needs of their clients

since those investors will not utilize brokerage firms whose analysts repeatedly overstate

the growth potential of companies.”97

75.

Based on the comments, the Commission concludes that the IBES five-year

growth forecasts should also be used for any MLP included in the proxy group. While

the Commission recognizes that there may be some statistical limitations to the IBES

projections, the record here demonstrates that it remains the best and most reliable source

of growth information available. IBES publishes security analysts’ five-year growth

forecasts for MLPs in the same manner as for corporations. No party questions the

Commission’s findings in past cases that investors rely on the IBES projections in

making investment decisions, because they are widely available and generally reflect the

input of a number of financial analysts. Also, since IBES projections are company-

specific, they should already adjust for any differences among the entities analyzed,

including any reduced growth prospects investors expect due to the fact an MLP makes

distributions in excess of earnings. In fact, the most recent IBES projections for the

seven MLPs included in the gas pipeline proxy group in Appendix A, Table 1, average

6.86 percent, while the IBES growth projections for the four corporations average of

10.75 percent

ifferences among the entities analyzed,

including any reduced growth prospects investors expect due to the fact an MLP makes

distributions in excess of earnings. In fact, the most recent IBES projections for the

seven MLPs included in the gas pipeline proxy group in Appendix A, Table 1, average

6.86 percent, while the IBES growth projections for the four corporations average of

10.75 percent. Thus, those MLP growth projections are about 400 basis points below

those for the corporations.

76.

As discussed above, several parties assert that the security analysts’ five-year

growth forecasts appear generally to be forecasts of growth in earnings, rather than

distributions. They point out that the relevant cash flows for the DCF model are the

MLP’s distributions to the limited partners, and therefore the growth projections used in

the DCF analysis should be growth in distributions, not earnings. Despite these concerns,

the Commission again concludes that the IBES short-term growth projections provide the

96 Id.

97 Transcontinental Gas Pipe Line Corp., 90 FERC ¶ 61,279, at 61,932 (2000).

Docket No. PL07-2-000

- 31 -

best estimate of short-term growth rates for MLP distributions. Professor J. Peter

Williamson, on behalf of AOPL, reviewed historical IBES five-year growth forecasts for

five oil pipeline MLPs since the mid-1990s. IBES had published five to nine growth

forecasts for each the MLPs, with a total of 39 forecasts. Williamson compared each of

these 39 forecasts to the MLP’s actual growth in earnings and distributions during the

subsequent five-year period. He found that 29 of the 39 IBES five-year forecasts, or

74 percent, were closer to the actual average distribution growths over that time span than

the actual earnings growths

ne growth

forecasts for each the MLPs, with a total of 39 forecasts. Williamson compared each of

these 39 forecasts to the MLP’s actual growth in earnings and distributions during the

subsequent five-year period. He found that 29 of the 39 IBES five-year forecasts, or

74 percent, were closer to the actual average distribution growths over that time span than

the actual earnings growths. In his study, Williamson also found that historical records

fail to support any claims that the IBES forecasts are biased or tend to overstate future

growth.98 In fact, 22 of the 39 forecasts were lower than the actual distribution growth,

and 17 were higher. Thus, far from showing a pattern of overestimating actual growth in

distributions, the IBES growth projections underestimated growth in distributions

56 percent of the time, a conservative result. Accordingly, regardless of whether

financial analysts stated they are reporting projected earnings growth or projected

distribution growth for MLPs, the Commission finds the five-year growth rates that IBES

reports are acceptable since they closely approximate distribution growth for MLPs,

which is the short-term input for the DCF model.

77.

As noted, the State of Alaska expresses concerns that there are an insufficient

number of stock analysts providing IBES with estimates which are expressly identified at

forecasts of MLP distribution per share growth to obtain reliable short-term growth

projections for MLPs. At the technical conference, Mr. Horst presented a chart showing

the number of IBES report counts for 37 oil and gas pipeline companies – both

corporations and MLPs. The chart breaks the analyst report counts down into earnings

reports and distribution reports

re expressly identified at

forecasts of MLP distribution per share growth to obtain reliable short-term growth

projections for MLPs. At the technical conference, Mr. Horst presented a chart showing

the number of IBES report counts for 37 oil and gas pipeline companies – both

corporations and MLPs. The chart breaks the analyst report counts down into earnings

reports and distribution reports. It shows that analysts made an average of 3.1 earnings

reports for each MLP and an average of 0.8 distribution reports for each MLP.99

However, as discussed above, Williamson’s analysis of a historical period suggests that

actual MLP growth in the short term tracks IBES earnings projections better than

distribution projections. Moreover, Mr. Horst’s averages include many smaller, less

frequently traded MLPs and thus understate the number of analysts that are likely to

follow the larger, more established pipeline MLPs likely to be included in a proxy group.

The Commission therefore concludes that the number of reports made by analysts for oil

and gas companies MLPs is acceptable for use in the DCF model.

98 AOPL, Post-Technical Conference Comments, Williamson Aff. at 2-6.

99 State of Alaska, Comments dated December 21, Second Horst Aff. at 4-5; Reply

Comments dated February 20 at 5, Third Horst Aff. at 16-17, 21.

Docket No. PL07-2-000

- 32 -

78.

Some of the Customer Interests are agreeable to the continued use of IBES

forecasts, but only under certain conditions. Specifically, PSCNY contends that, should

the Commission continue to use IBES forecasts in its DCF model, any MLP the

Commission allows in a proxy group must be market-tested and representative of a

natural gas pipeline company

-17, 21.

Docket No. PL07-2-000

- 32 -

78.

Some of the Customer Interests are agreeable to the continued use of IBES

forecasts, but only under certain conditions. Specifically, PSCNY contends that, should

the Commission continue to use IBES forecasts in its DCF model, any MLP the

Commission allows in a proxy group must be market-tested and representative of a

natural gas pipeline company. PSCNY contends that IBES would be acceptable if the

MLP is tracked by Value Line, has been in operation for at least five years as an MLP,

and derives 50-percent of its operating income from, or has 50 percent of its assets

devoted to, interstate natural gas transportation operations. PSCNY also contends that

the Commission should exclude MLPs from proxy groups when their growth projections

are illogical or anomalous.100

79.

The Commission agrees in principle with PSCNY’s position that IBES forecasts

should only be used for an MLP that is tracked by Value Line, has been in operation for

at least five years as an MLP, and derives at least 50 percent of its operating income

from, or 50 percent of its assets devoted to, interstate operations. Thus, when developing

its proxy group, a pipeline should select MLPs that are well established and have assets

that are predominantly gas and oil pipelines. Such pipelines are those most likely to have

risk comparable to the pipeline seeking to justify its rates. However, there may be

particular MLPs that do not satisfy these criteria, but are still appropriate for inclusion in

the proxy group. The pipeline must justify including such an MLP in its proxy group.

Thus, while the Commission encourages pipelines to follow the guidelines suggested by

PSCNY, it will not make them a condition of including a particular MLP in the proxy

group. As suggested by the parties, the Commission will continue to exclude an MLP

from the proxy groups if its growth projection is illogical or anomalous.

80

eline must justify including such an MLP in its proxy group.

Thus, while the Commission encourages pipelines to follow the guidelines suggested by

PSCNY, it will not make them a condition of including a particular MLP in the proxy

group. As suggested by the parties, the Commission will continue to exclude an MLP

from the proxy groups if its growth projection is illogical or anomalous.

80.

Two parties state that, should the Commission continue to use IBES projections to

estimate short-term growth rates in its DCF model for MLPs, it must modify the

estimated rates. Tesoro states that, if the Commission makes no adjustments to dividend

distributions of MLPs, it should significantly reduce its IBES short-term growth estimates

to recognize the fact that an MLP cannot indefinitely sustain its operations when

distributions consistently exceed earnings. It argues that, if the Commission caps MLP

distributions at earnings, it would still have to reduce IBES rates in order to recognize the

fact that proxy group members would not be reinvesting retained earnings in ongoing

operations, thereby achieving lower growth rates. Tesoro only recommends no

adjustments to short-term growth estimates if the Commission caps distributions at a

level below earnings, offering 65-percent of earnings as an example.101

100 PSCNY Supplemental Comments dated Dec. 21 at 3-5.

101 Tesoro, Comments on Growth dated December 21 at 3-4, 5-7.

rations, thereby achieving lower growth rates. Tesoro only recommends no

adjustments to short-term growth estimates if the Commission caps distributions at a

level below earnings, offering 65-percent of earnings as an example.101

100 PSCNY Supplemental Comments dated Dec. 21 at 3-5.

101 Tesoro, Comments on Growth dated December 21 at 3-4, 5-7.

Docket No. PL07-2-000

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81.

The State of Alaska recommends that if a pipeline company’s distributions per

share exceed its earnings per share (as is frequently the case with pipeline MLPs), then

the expected growth rate of the pipeline’s distributions per share should be adjusted to

equal (1) the expected growth of its earnings per share, multiplied by (2) the ratio of the

pipeline’s earnings per share to its distributions per share. According to Alaska, if a

pipeline company distributes more cash than its current earnings, then the projected

growth in earnings per share should also be adjusted by the ratio of the pipeline’s

earnings per share to its distributions per share.102

82.

The Commission rejects these proposals by Tesoro and the State of Alaska. As

already discussed, to the extent investors expect an MLP’s distributions in excess of

earnings to reduce its growth prospects, that fact should be reflected in the IBES five-

year growth projections themselves, without the need for any further adjustment. MLPs

must publicly report their earnings and distribution levels. Therefore, the security

analysts are aware of the degree to which each MLP is making distributions in excess of

earnings. The security analysts presumably take that information, together with all other

available information concerning the MLP, into account when making their projections.

Moreover, these proposals would have a similar effect as capping the distributions used

to calculate dividend yield at or below the level of the MLP’s earnings

ree to which each MLP is making distributions in excess of

earnings. The security analysts presumably take that information, together with all other

available information concerning the MLP, into account when making their projections.

Moreover, these proposals would have a similar effect as capping the distributions used

to calculate dividend yield at or below the level of the MLP’s earnings. For the reasons

previously discussed, the Commission finds that any cap on an MLP’s distributions used

in the DCF model at a level below the actual distribution is inconsistent with the basic

operation of the DCF model. Thus, using a straight IBES five-year projection without

modification presents the best method of estimating an MLP’s short-term growth rate.

83.

APGA further suggests revising IBES growth rates by averaging them with the

comparable growth forecasts reported by Zacks Investment. It states that this averaging

could help remove anomalous or outlying growth rates. It offers as an example, on

December 10, 2007, IBES projected a five-year growth rate of 7.60 percent for Kinder

Morgan Energy Partners (KMEP), whereas Zacks Investment projected a 33.70 percent

growth rate for that company. APGA argues that the Commission should also use Value

Line reports to test the reasonableness of projected growth rates for MLPs.103

84.

The Commission will not require that IBES growth rates be averaged with the

corresponding company’s growth rates as reported for Zacks Investment at this time, or

102 State of Alaska, Comments dated Dec. 21 at 3-4; Second Horst Aff. at 2-3, 5-

11.

103 APGA, Additional Comments dated Dec. 21 at 3, 9-10.

f projected growth rates for MLPs.103

84.

The Commission will not require that IBES growth rates be averaged with the

corresponding company’s growth rates as reported for Zacks Investment at this time, or

102 State of Alaska, Comments dated Dec. 21 at 3-4; Second Horst Aff. at 2-3, 5-

11.

103 APGA, Additional Comments dated Dec. 21 at 3, 9-10.

Docket No. PL07-2-000

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that Value Line reports be used to test the reasonableness of projected growth rates for

MLPs. Finally, PSCNY requests that the Commission clarify that Thomson Financial

Data posted on Yahoo.com may be used in the DCF formula, since Thomson Financial

owns IBES.104 The Commission clarifies that the growth projections to be used in the

DCF model are those reported by IBES. If they are the same growth projections posted

by Thomson Financial Data on Yahoo.com, then they are acceptable for the DCF model.

D.

The Long Term Growth Component

1.

Comments

85.

As this point the critical issue is whether the long term growth component of the

Commission’s DCF methodology should be modified in determining the equity cost of

capital for an MLP. As has been discussed, for more than a decade the Commission has

required that projected long-term growth in GDP be used as the corporate long term

(terminal) growth component of the DCF calculation. The discussion at the technical

conference disclosed four general positions. The AOPL,105 NAPTP,106 INGAA,107 and

TransCanada108 asserted that the use of long term GDP is equally applicable to MLPs as

to corporations.109 However, the APGA,110 PSCNY,111 and the State of Alaska112 all

104 PSCNY, Supplemental Comments dated Dec. 21 at 5.

105 AOPL, Post-Technical Conference Comments at 7-9, 13.

106 NAPTP Additional Comments dated Dec. 21 at 1, 10-11; Post-Technical

Conference Comments at 4-8.

107 INGAA, Additional Initial Comments dated Dec

s as

to corporations.109 However, the APGA,110 PSCNY,111 and the State of Alaska112 all

104 PSCNY, Supplemental Comments dated Dec. 21 at 5.

105 AOPL, Post-Technical Conference Comments at 7-9, 13.

106 NAPTP Additional Comments dated Dec. 21 at 1, 10-11; Post-Technical

Conference Comments at 4-8.

107 INGAA, Additional Initial Comments dated Dec. 21 at 2-3; Post-Technical

Conference Reply Comments at 3-6.

108 TransCanada Post-Technical Comments at 2-5.

109 MidAmerican and Williston supported this position.

110 APGA Additional Comments dated Dec. 21 at 4, 7-8; Initial Post-Technical

Comments at 2, J. Bertram Solomon Aff. at 4-8.

111 PSCNY, Supplemental Comments dated Dec. 21 at 5, 8-9 and appended

Prepared Statement of Patrick J. Barry for the January 23, 2008 Technical Conference;

Initial Post-Technical Conference Comments at 14-16.

112 State of Alaska, Comments dated Dec. 21 at 3-4 and Second Horst Aff. at 3, 5-

(continued…)

Docket No. PL07-2-000

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made suggestions for a reduction to the GDP growth projection to reflect the different

retention and investment practices of MLPs.113 In a different vein, INGAA suggested the

use of the average of the projected long term inflation rate and projected long term GDP

as a proxy for the lower growth rate of the limited partnership interests, but only if the

Commission concluded that some reduction in the MLP long term growth rate was

warranted.114 NAPTP further argued that there must be an upward adjustment of the

limited partnership growth rate to reflect the equity cost of capital of the limited and

general partners, and thus that of the entire firm.115

86.

The Pipeline Interests also generally assert that an MLP’s terminal growth can be

at least equal to that of a corporation, and perhaps exceed it. They assert that MLPs are

able to raise external capital in a tax efficient manner

ustment of the

limited partnership growth rate to reflect the equity cost of capital of the limited and

general partners, and thus that of the entire firm.115

86.

The Pipeline Interests also generally assert that an MLP’s terminal growth can be

at least equal to that of a corporation, and perhaps exceed it. They assert that MLPs are

able to raise external capital in a tax efficient manner. Because an MLP does not retain

cash it does not immediately need and can distribute without the tax penalty, it is under

less pressure to invest idle capital. Rather, an MLP can wait until sounder investment

opportunities are available and pursue them more discreetly, which results in a more

consistent return from the projects selected.116 Moreover, while the computation is very

complicated, the tax-deferral aspects of MLP limited partnership interest normally result

in a higher per unit price when issued and thus a lower cost of equity capital to the

issuing MLP. For these reasons the Pipeline Interests conclude that MLPs should readily

find profitable investment opportunities despite their lower retention ratios.117

87.

The Pipeline Interests further assert that the record demonstrates that MLPs have a

long term history of growing distributions and an overall growth rate that has at times

been higher than that of corporations.118 They cite to the example of KMEP in particular

7. Reply Comments dated February 20, 2008 at 6.

113 NGPA and Tesoro also supported a lower long term growth rate for MLPs.

114 INGAA Additional Initial Comments dated Dec. 21 at 3-4 and Vilbert Report

attached thereto, passim;

115 NAPTP Reply Comments dated Sept. 19 at 2-4; Additional Comments dated

Dec. 21 at 9-12.

116 NAPTP Post-Technical Conference Comments at 9; TransCanada Post

Technical Conference Comments at 8-9.

117 NAPTP, id. 2, 5-6. TransCanada, id

o supported a lower long term growth rate for MLPs.

114 INGAA Additional Initial Comments dated Dec. 21 at 3-4 and Vilbert Report

attached thereto, passim;

115 NAPTP Reply Comments dated Sept. 19 at 2-4; Additional Comments dated

Dec. 21 at 9-12.

116 NAPTP Post-Technical Conference Comments at 9; TransCanada Post

Technical Conference Comments at 8-9.

117 NAPTP, id. 2, 5-6. TransCanada, id.

118 NAPTP Additional Comments dated Dec. 21 at 4-8,

Docket No. PL07-2-000

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and that KMEP has been able to grow its distributions in good or poor financial

environments.119 They therefore conclude that there is no reason to conclude that MLPs

cannot continue to grow at least as fast as corporations or that the relatively high

distribution growth rate for the industry as a whole will not be sustained.120 However,

INGAA concedes that even if an MLP as a whole can grow as fast as a corporation, the

limited partnership interests would grow less rapidly than the MLP as a whole because of

the IDRs121 most MLPs have granted their general partners.122 The Pipeline Interests also

argue that investors will not invest in enterprises that have a projected growth rate that is

less than GDP and that such firms are likely to fail.123

119 NAPTP Additional Comments dated December 21 at 8.

120 NAPTP and Post-Technical Conference Comments at 11-12 AOPL Post-

Technical Conference at 9-10 and Williamson Post Technical Conf. Aff. Ex. at 1 and 2.

121 IDRs operate as follows. Most MLP agreements provide that the limited

partners own 98 percent of the equity when the firm is first created and the general

partner 2 percent. Thus, given a distributable cash of $1,000, the limited partners would

obtain $980 (98 percent) and the general partner $20.00 (2 percent)

l Conference at 9-10 and Williamson Post Technical Conf. Aff. Ex. at 1 and 2.

121 IDRs operate as follows. Most MLP agreements provide that the limited

partners own 98 percent of the equity when the firm is first created and the general

partner 2 percent. Thus, given a distributable cash of $1,000, the limited partners would

obtain $980 (98 percent) and the general partner $20.00 (2 percent). The partnership

agreement also provides that as the total cash available for distribution increases, a

greater share goes to the general partner, including that which would be available in

liquidation. For example, the partnership agreement may provide that once distributable

cash is $3,000, the general partner will receive 2 percent based on its partnership interest

and 48 percent based on the IDRs.

At that point the limited partners’ share of the distribution is $1,500 (50 percent)

and the general partner’s share is also $1,500 (50 percent). Thus, while the limited

partners’ distribution has grown in the relevant time frame (by 50 percent), it has not

grown as fast as it would have absent the general partner’s IDR. Absent the IDR the

general partner’s share would only be $60. Since a proportionately smaller share of

future value flows to the limited partners in the initial years, the projected long term

growth rate for a limited partnership interest will be lower. Therefore the limited

partnership interests have lower return than that of the general partner.

122 INGAA Additional Initial Comments dated December 21 at 5; TransCanada.

123 AOPL, Post-Technical Comments at 7-8. TransCanada, Additional Comments

dated Dec. 21 at 2, 4-5.

ited partners in the initial years, the projected long term

growth rate for a limited partnership interest will be lower. Therefore the limited

partnership interests have lower return than that of the general partner.

122 INGAA Additional Initial Comments dated December 21 at 5; TransCanada.

123 AOPL, Post-Technical Comments at 7-8. TransCanada, Additional Comments

dated Dec. 21 at 2, 4-5.

Docket No. PL07-2-000

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2.

Discussion

a.

Should the MLP long-term growth projection be lower

than projected growth in GDP?

88.

As discussed in the previous section, in determining the appropriate growth

projections to use in its DCF analysis, the Commission seeks to approximate the growth

projections investors would rely upon in making their investment decisions. This

principle applies equally to the long-term growth projection, as to the short-term growth

projection. When the Commission first established its policy of basing the long-term

growth projections on projected growth in GDP in Opinion No. 396-B and Williston I, the

Commission stated in both cases, “The purpose of using the DCF analysis in this

proceeding is to approximate the rate of return an investor would reasonably expect from

a pipeline company.” 124 The Commission found, “the record shows that Merrill Lynch

and Prudential Bache do not attempt to make long-term growth projections for specific

industries or companies in doing DCF analyses. Instead they use the long-term growth of

the United States economy as a whole as the long-term growth forecast for all firms,

including regulated businesses.”125 The Commission thus relied heavily on evidence

concerning investment house long-term growth projections in deciding to base its long-

term growth projections for corporations that were properly included in the proxy group

on the long-term growth of GDP. In affirming this aspect of Williston I, the D.C

a whole as the long-term growth forecast for all firms,

including regulated businesses.”125 The Commission thus relied heavily on evidence

concerning investment house long-term growth projections in deciding to base its long-

term growth projections for corporations that were properly included in the proxy group

on the long-term growth of GDP. In affirming this aspect of Williston I, the D.C. Circuit

similarly relied on the fact that the record “demonstrated that major investment houses

used an economy-wide approach to projecting long-term growth . . . and that existing

industry-specific approaches reflected investor expectations and many unfounded

economic assumptions.”126

89.

Consistent with this precedent, the key question in deciding what long-term

growth projection the Commission should use in its DCF analysis of MLPs is whether

investors expect MLP long-term growth rates to be less than projections of growth in

124 Opinion No. 396-B, 79 FERC ¶ 61,309 at 62,383. Williston I, 79 FERC at

62,389.

125 Opinion No. 396-B, 79 FERC ¶ 61,309 at 62,382. Williston I, 79 FERC

¶ 61,311 at 62,389. As the Commission pointed out in a subsequent case, the exhibits in

both the Opinion No. 396-B proceeding and Williston I, describing Prudential Bache’s

methodology stated that it used a lower long-term growth projection for electric utilities,

because of their high payout ratios. System Energy Resources, Inc., 92 FERC ¶ 61,119,

at 61,445 n.23 (2000).

126 Williston Basin Interstate Pipeline Co. v. FERC, 165 F.3d 54 (D.C. Cir. 1999).

nt case, the exhibits in

both the Opinion No. 396-B proceeding and Williston I, describing Prudential Bache’s

methodology stated that it used a lower long-term growth projection for electric utilities,

because of their high payout ratios. System Energy Resources, Inc., 92 FERC ¶ 61,119,

at 61,445 n.23 (2000).

126 Williston Basin Interstate Pipeline Co. v. FERC, 165 F.3d 54 (D.C. Cir. 1999).

Docket No. PL07-2-000

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GDP. The record established here shows that at least two major investment houses

project terminal growth rates for MLPs that are notably lower than the current

4.43 percent projected growth in GDP. Citicorp Smith Barney (Citicorp)127 projects a

1 percent terminal growth rate for pipeline MLPs. Wachovia projects terminal growth

rates for individual MLPs that vary from zero to 3.5 percent.128 The Wachovia projection

for each MLP which the Commission is likely to include in a proxy group129 is for a

2.5 percent terminal growth rate.130 The Pipeline Interests did not submit any evidence of

a major investment house projecting long-term growth rates for MLPs equal to or above

the growth in GDP. Thus, applying the same approach as that in Opinion No. 396-B and

Williston I, the record supports a finding that investors project MLP growth rates

significantly below the growth in GDP.

90.

To counter this conclusion, the Pipeline Interests argue that these lower figures

reflect the investment houses’ desire to use “conservative” estimates in order to prevent

unrealistic investor expectations. However, as discussed above, the Commission has

found in earlier cases that investment houses try to give the most accurate information to

their investors. In any event, it is appropriate for the Commission to use growth

127 Society, Reply Comments at 11, citing: Citicorp Master Limited Partnership

Monitor and Reference Book, Citigroup Investment Research (March 2007) at 28, Figure

24

on has

found in earlier cases that investment houses try to give the most accurate information to

their investors. In any event, it is appropriate for the Commission to use growth

127 Society, Reply Comments at 11, citing: Citicorp Master Limited Partnership

Monitor and Reference Book, Citigroup Investment Research (March 2007) at 28, Figure

24.

128 Comments of Enbridge Energy Partners, L.P., Attachment A, Wachovia Equity

Research Paper dated August 20, 2007 at 9-12; Wachovia Equity Research dated

January 30, 2008, MLP Outlook 2008: Cautious Optimism at 39-44.

129 These are the MLPs listed in Tables 1 and 2.

130 NAPTA, in its Post-Technical Conference Comments, provided a publication

by Morgan Stanley Research which, among other things, reported on our January 23,

2008 technical conference. That publication, at page 3, states, “At Morgan Stanley, we

assume an MLP will increase its cash flow – 1.5%-3.0% per year beyond 2012.

Importantly we make the same assumption in forecasting long-term growth for our C-

Corp companies.” Pipeline MLPs: What’s in the Pipeline, Morgan Stanley Research at 3.

These projections are also less than the current projection of 4.43 percent long-term

growth in the economy as a whole. However, we give greater weight to the Citigroup

and Wachovia publications, because those publications include specific long-term growth

projections for individual MLPs, whereas the Morgan Stanley publication simply sets

forth a general range it uses without specifying how that range is distributed among

individual firms. Also, the Citigroup and Wachovia analyses were not issued in response

to the technical conference.

the Citigroup

and Wachovia publications, because those publications include specific long-term growth

projections for individual MLPs, whereas the Morgan Stanley publication simply sets

forth a general range it uses without specifying how that range is distributed among

individual firms. Also, the Citigroup and Wachovia analyses were not issued in response

to the technical conference.

Docket No. PL07-2-000

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estimates that reflect the investment houses’ view of what investors should realistically

expect from an investment in an MLP. Moreover, the fact that some MLPs have grown

rapidly in the past does not mean necessarily that they will maintain the same growth rate

in the future. In fact, KMEP’s projected growth rate is expected to drop in future

years.131 This record also demonstrates that a rate of long term growth is dependent on

the base years selected. Thus, the Customer Interests focus on more recent years to show

that the growth rate has slowed for many MLPs.132

91.

The Pipeline Interests also argue that investors will not invest in entities with a

projected long term growth rate that is less than the long-term growth in GDP.133

However, the fact is that, despite major investment houses advising their clients that

MLPs will have long-term growth rates below GDP, investors have continued to invest in

MLPs, and in increasing amounts through 2007. Historically this was true even though

the Commission’s analyses continue to indicate that the IBES five-year growth

projections for MLPs are lower than those for corporations.134

92.

At bottom, the key financial assumption advanced by the Pipeline Interests is that

MLPs and corporations have equal access to capital. However, the Customer Interests

advance credible reasons why MLPs may not have as ready access to capital markets in

the future given the MLPs’ unique financial structure. This would reduce the total capital

pool available to the MLPs, thus reducing their growth prospects

e key financial assumption advanced by the Pipeline Interests is that

MLPs and corporations have equal access to capital. However, the Customer Interests

advance credible reasons why MLPs may not have as ready access to capital markets in

the future given the MLPs’ unique financial structure. This would reduce the total capital

pool available to the MLPs, thus reducing their growth prospects. These include a greater

exposure to interest rate risk,135 the increased cost of capital that a high level of IDRs

imposes on an MLP,136 and lower future returns from either acquisitions or organic

131 APGA, Post-Technical Conference Reply Comments, Solomon Aff. at 4.

132 APGA, Post-Technical Conference Reply Comments at 4-5 and attached

Solomon Aff. at 4-9.

133 TransCanada, Additional Comments at 5; AOPL Post-Technical Conference

Comments at 8.

134 See Appendix A, which displays in part the comparative corporate and MLP

short term growth projections. Cf. PSCNY Post Technical Conference Comments at 7-8.

135 Indicated Shippers Initial Comments at 21, citing Citicorp Smith Barney;

AGPA Reply Comments at 5; Wachovia August 20, 2007 Report, supra, at 1-2;

136 PSCNY Supplemental Comments at 3, n. 8 and Initial Post-Technical

Conference Comments at 12.

Docket No. PL07-2-000

- 40 -

investments as the MLP industry matures.137 This latter point is of greater importance to

MLPs because they are limited by law to a narrower range of investment opportunities

than a schedule C corporation. These arguments suggest why the long term forecasts by

investment houses investors rely on could conclude that the long term growth rate for

MLPs would be less than the long term GDP the Commission uses for corporations.

Each addresses the consistency of investment opportunities and as such consistency of

access to capital markets that MLPs are dependent on to maintain long term growth.

93

e arguments suggest why the long term forecasts by

investment houses investors rely on could conclude that the long term growth rate for

MLPs would be less than the long term GDP the Commission uses for corporations.

Each addresses the consistency of investment opportunities and as such consistency of

access to capital markets that MLPs are dependent on to maintain long term growth.

93.

In particular, the Commission concludes that corporations (1) have greater

opportunities for diversification because their investment opportunities are not limited to

those that meet the tax qualifying standards for an MLP and (2) are able to assume

greater risk at the margin because of less pressure to maintain a high payout ratio. It is a

corporation’s higher retention ratio that allows this greater flexibility. This is consistent

with the fact that Prudential Bache projected the long-term growth rates of electric

utilities to be less than that of the economy as whole because of their greater dividend

payouts and lower retention ratios.138 Therefore, investors would quite reasonably

conclude that MLP long term growth rates would be lower than that of tax paying

corporations, because MLPs have fewer opportunities to participate in the broad economy

that underpins the Commission’s current use of long-term growth in GDP.

94.

Thus, while it is true that the Commission uses GDP as a proxy for long term

growth, the point here is not whether some firms, including MLPs may have a growth

rate that is more or less than the proxy over time. The issue is whether MLPs have the

same relative potential as the corporate based economy that has been the basis for the

Commission’s assumption that a mature firm will grow at the same rate as the economy

as whole. For the reasons stated, the Commission concludes that the collective long term

growth rate for MLPs will be less than that of schedule C corporations regardless of the

past performance of MLPs the Pipeline Interests have inserted in the record

corporate based economy that has been the basis for the

Commission’s assumption that a mature firm will grow at the same rate as the economy

as whole. For the reasons stated, the Commission concludes that the collective long term

growth rate for MLPs will be less than that of schedule C corporations regardless of the

past performance of MLPs the Pipeline Interests have inserted in the record.

b.

What specific projection should be used for MLPs?

95.

We now turn to the issue of exactly what long-term growth projection below GDP

should be used in MLP pipeline rate cases. As the Commission recognized when it

established its policy of giving the long-term growth projection only one-third weight,

while giving the short-term growth projection two-thirds weight, “long-term growth

137 PSCNY Initial Post-Technical Conference Comments at 9-10 and cited Value

Line attachments; Reply Comments at 5-6 citing Merrill Lynch, n. 16.

138 System Energy Resources, Inc., 92 FERC ¶ 61,119, at 61,445 n.23 (2000).

Docket No. PL07-2-000

- 41 -

projections are inherently more difficult to make, and thus less reliable, than short-term

projections.”139 Thus, as the Commission has stated with respect to the other aspects of

its long-term growth projection policy, the Commission is “required to choose from

among imperfect alternatives”140 in deciding what specific long-term growth projection

should be used for MLPs.

96.

The technical conference panelists advanced four methods of determining long-

term growth projections for MLPs which are less than the growth in GDP. After

reviewing all four, the Commission adopts the APGA proposal to use a long-term growth

projection for MLPs equal to 50 percent of long term GDP.141 At present, that proposal

results in a long-term growth projection of 2.22 percent. This is within the range of long-

term growth projections used by investment houses for MLPs discussed in the preceding

section

less than the growth in GDP. After

reviewing all four, the Commission adopts the APGA proposal to use a long-term growth

projection for MLPs equal to 50 percent of long term GDP.141 At present, that proposal

results in a long-term growth projection of 2.22 percent. This is within the range of long-

term growth projections used by investment houses for MLPs discussed in the preceding

section. For example, Wachovia projects terminal growth rates for individual MLPs that

vary from zero to 3.5 percent,142 and its projection for each MLP which the Commission

is likely to include in a proxy group is for a 2.5 percent terminal growth rate.143

Therefore, in light of the inherent difficulty of projecting long-term growth, the

50 percent of GDP proposal would appear to result in a long-term growth projection that

139 Transcontinental Gas Pipe Line Corp., 84 FERC ¶ 61,084, at 61,423 (1998).

140 Northwest Pipeline Corp., 88 FERC ¶ 61,298, at 61,911 (1999).

141 APGA Additional Comments dated Dec. 21 at 2-3, 8; Outline for the

Presentation of Bertrand Solomon on the Behalf of APGA dated January 23, 2008 at 3;

Initial Post-Technical Conference Comments. J. Bertrand Solomon Aff. at 3-4, 6-7 and

supporting exhibits.

142 Comments of Enbridge Energy Partners, L.P., Attachment A, Wachovia Equity

Research Paper dated August 20, 2007 at 9-12; Wachovia Equity Research dated

January 30, 2008, MLP Outlook 2008: Cautious Optimism at 39-44.

143 The Commission will not use the specific long-term MLP growth projections of

the investment houses to determine the cost of equity for specific firms for the same

reasons we have not done so with respect to the projections of long-term growth in GDP

the Commission uses for corporations

t 9-12; Wachovia Equity Research dated

January 30, 2008, MLP Outlook 2008: Cautious Optimism at 39-44.

143 The Commission will not use the specific long-term MLP growth projections of

the investment houses to determine the cost of equity for specific firms for the same

reasons we have not done so with respect to the projections of long-term growth in GDP

the Commission uses for corporations. As the Commission explained in Michigan Gas

Storage Co., 87 FERC ¶ 61,038, at 61,162-5 (1999) and Williston Basin Interstate

Pipeline Co., 87 FERC ¶ 61,264, at 62,005-6 (1999), there is no evidence as to how the

investment house figures were derived which limits their utility in determining the cost of

equity for an individual firm. However, as here, the Commission has relied on the

perceptions of the investment community in developing a generic long term growth rate.

See also Opinion No. 396-B, 79 FERC ¶ 61,309 at 62,384.

Docket No. PL07-2-000

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falls within any reasonable margin of error for such projections, while giving recognition

to the fact that investors expect MLPs’ long-term growth to be less than that of GDP.144

97.

The Commission also concludes that the other three proposed methods of

projecting MLP long-term growth rates all have flaws justifying their rejection. The

State of Alaska and the NYPSC propose methods which would result in varying long-

term growth projections for each MLP, based upon financial information for each of the

MLPs to be included in a proxy group. These proposals are contrary to the

Commission’s policy of using a single long-term growth projection for all corporations,

based on the fact that it is not possible to make reliable company-by-company long-term

growth projections.145 The State of Alaska and NYPSC have provided no basis to

conclude that they have provided a more reliable way to make long-term growth

projections for individual MLPs. Their difficulty in doing so reinforces the

Commission’s traditional practice in this regard.

98

l corporations,

based on the fact that it is not possible to make reliable company-by-company long-term

growth projections.145 The State of Alaska and NYPSC have provided no basis to

conclude that they have provided a more reliable way to make long-term growth

projections for individual MLPs. Their difficulty in doing so reinforces the

Commission’s traditional practice in this regard.

98.

The State of Alaska suggests adjusting the GDP long term growth projection used

for each MLP based on its current positive or negative retention ratio.146 Thus, if an

MLP’s retention ratio was positive, then 100 percent of long term growth in GDP would

be used. If the retention ratio was less than one, then the long term growth in GDP would

be reduced accordingly. This theory essentially caps the long term growth rate at the

earnings of the entities involved. As such, it suffers from the same weakness as the

original proposal to cap the distribution component included in the model at earnings.

Consistent with the premise of the DCF model that a stock is worth the present value of

all future cash flows to be received from the investment, investors base their DCF

analyses on the MLP’s entire cash distributions, including projected cash flows generated

by external investments, which to date is the bulk of the investment for the MLP model.

In addition, because MLPs rely substantially on external capital to finance growth, the

fact one MLP currently pays out more of its earnings than another MLP does not

necessarily mean that the first MLP’s long-term growth prospects are less than the second

MLP’s. Moreover, Alaska’s proposed method assumes each MLP’s current retention

144 As the D.C. Circuit stated with respect to our choice of the relative weighting

of the short- and long-term growth projections, the choice of the long-term growth

component is also an exercise “hard to limit by strict rules.” CAPP v. FERC, 254 F.3d at

290.

145 Opinion No

Moreover, Alaska’s proposed method assumes each MLP’s current retention

144 As the D.C. Circuit stated with respect to our choice of the relative weighting

of the short- and long-term growth projections, the choice of the long-term growth

component is also an exercise “hard to limit by strict rules.” CAPP v. FERC, 254 F.3d at

290.

145 Opinion No. 396-B, 79 FERC ¶ 61,309 at 62,382.

146 State of Alaska, Comments dated December 21 at 3-4 and Second Horst Aff. at

3, 5-7. Reply Comments dated February 20, 2008 at 6.

Docket No. PL07-2-000

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ratio will continue indefinitely into the future, without any support for the accuracy of

such an assumption.

99.

The NYPSC recommends use of a modified form of the sustainable growth model

the Commission uses to determine electric return on equity.147 Under that method, the

Commission determines growth based on a formula under which growth = br + sv, where

b is the expected retention ratio, r is the expected earned rate of return on common equity,

s is the percent of common equity expected to be issued annually as new common stock,

and v is the equity accretion rate. The br component of this formula projects a utility’s

growth from the investment of retained earnings, and the sv component estimates growth

from external capital raised by the sale of additional units. The NYPSC would assume

zero growth from investment of retained earnings (the br component) and then base the

long-term growth projection for each MLP on projected growth from external capital

resulting from the sv component of the br + sv formula.

100. A fundamental problem with this approach is that the Commission has

consistently held that the br + sv formula only produces a projection of short-term

growth, similar to the IBES projections.148 This follows from the fact that the inputs used

in the formula are all drawn from Value Line data and projections reaching no more than

five years into the future

nt of the br + sv formula.

100. A fundamental problem with this approach is that the Commission has

consistently held that the br + sv formula only produces a projection of short-term

growth, similar to the IBES projections.148 This follows from the fact that the inputs used

in the formula are all drawn from Value Line data and projections reaching no more than

five years into the future. In addition, there would be great uncertainties in projecting

any of the inputs to the formula, such as the retention ratio, the amount and timing of

equity sales, and the projected price of the sale for any longer period. Moreover, setting

the br component at zero assumes that an MLP can only grow through the use of external

capital. This does not reflect accurately the retention and investment flexibility vested in

an MLP’s general partners or the fact that some MLPs may reinvest a fairly high

proportion of the free cash available. Therefore this methodology does not appropriately

adjust the long term GDP component that the Commission now uses for corporations.

101. Finally, INGAA provided a complex model designed to calculate the equity cost

of capital for an MLP as a whole.149 This model was developed by Mr. Vilbert and

147 PSCNY, Supplemental Comments dated Dec. 21 at 5, 8-9 and appended

Prepared Statement of Patrick J. Barry for the January 23, 2008 Technical Conference;

Initial Post-Technical Conference Comments at 14-16.

148 See Southern California Edison Co., 92 FERC ¶ 61,070, at 61,262-3 (2000).

149 INGAA, Additional Initial Comments dated Dec. 21 at 4-5 and Report on the

Terminal Growth Rate for MLPs for Use in the DCF Model by Michael J. Vilbert dated

December 21, 2007 (Vilbert Report), particularly at 10.

the January 23, 2008 Technical Conference;

Initial Post-Technical Conference Comments at 14-16.

148 See Southern California Edison Co., 92 FERC ¶ 61,070, at 61,262-3 (2000).

149 INGAA, Additional Initial Comments dated Dec. 21 at 4-5 and Report on the

Terminal Growth Rate for MLPs for Use in the DCF Model by Michael J. Vilbert dated

December 21, 2007 (Vilbert Report), particularly at 10.

Docket No. PL07-2-000

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attempts to calculate the equity cost of capital for both the limited and the general

partners. At their inception, MLPs establish agreements between the general and limited

partners, which define how the partnership’s cash flow is to be divided between the

general and limited partners. Such agreements give the general partners IDRs, which

provide for them to receive increasingly higher percentages of the overall distribution, if

the general partners are able to increase that distribution above defined levels. The

INGAA model recognizes that, as a result of these incentive distribution rights, a DCF

analysis of the MLP as a whole should (1) include higher projected growth rates for the

general partner interest than for the limited partner interest and (2) a correspondingly

higher value for general partner interests than the MLP units which would, in turn, reduce

the general partner’s current “dividend” yield. However, since there are relatively few

publicly traded general partner interests, in most cases the estimated equity cost of capital

for the general partner can only be derived through various assumptions that markup the

limited partner’s cost of capital.

102. INGAA drew two significant conclusions from Mr. Vilbert’s analysis. First,

application of the Commission’s existing DCF methodology solely to the limited partner

interest in the MLP would generate returns relatively close to those that would be

required to reflect the growth rate, and cost of equity capital, for the MLP as whole

ons that markup the

limited partner’s cost of capital.

102. INGAA drew two significant conclusions from Mr. Vilbert’s analysis. First,

application of the Commission’s existing DCF methodology solely to the limited partner

interest in the MLP would generate returns relatively close to those that would be

required to reflect the growth rate, and cost of equity capital, for the MLP as whole.

Second, if the Commission remains concerned that a DCF analysis using data solely for

the limited partner interest,150 together with a long-term growth rate equal to the growth

in GDP, may overstate the appropriate return based on the limited partners’ projected

growth, the long-term growth projection could be adjusted by averaging projected long

term GDP and the projected long term inflation rate.151 The latter would have to be

updated regularly to test its accuracy.

103. Mr. Horst, the witness for the State of Alaska, responded that the INGAA model

was mathematically correct, but that the model’s assumptions about the rate of growth

and incentive distributions were open to question and the results would overstate the

equity for the MLP as a whole.152 INGAA filed a reply to Mr. Horst’s arguments by

Mr. Vilbert that first calculates the actual DCF values for eight publicly traded general

150 In such a DCF analysis the dividend yield would be calculated by dividing the

distribution to the limited partner by the limited partner share price.

151 INGAA Additional Initial Comments dated Dec. 21 at 4-6; Vilbert Report at

18-19.

152 State of Alaska, Reply Comments dated February 20, 2008 at 6 and Third Horst

Aff. at 6-15.

ded general

150 In such a DCF analysis the dividend yield would be calculated by dividing the

distribution to the limited partner by the limited partner share price.

151 INGAA Additional Initial Comments dated Dec. 21 at 4-6; Vilbert Report at

18-19.

152 State of Alaska, Reply Comments dated February 20, 2008 at 6 and Third Horst

Aff. at 6-15.

Docket No. PL07-2-000

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partner interests.153 Mr. Vilbert then compares the resulting value of the general partner

interests for the same eight firms generated by the model. The results calibrate more

closely to the eight market samples than the analysis produced by Mr. Horst but, like

Mr. Horst’s analysis, tend to overstate the value of the general partner interest.

104. The Commission will not use the INGAA model for several reasons. First, the

internal operations of the model are relatively opaque, and the model appears to have a

relatively wide range of error. Second, as the court stated in Petal Gas Storage, L.L.C. v.

FERC,154 the purpose of the proxy group is to “provide market-determined stock and

dividend figures from public companies comparable to a target company for which those

figures are unavailable.” While INGAA used eight publicly traded general partner

interests to test the validity of the model, most of those interests are not related to MLPs

that have been proffered in rate proceedings before the Commission. In the absence of

such market-determined figures for the general partner interest of the MLPs to be

included in the proxy group, use of the INGAA model would necessarily entail deriving

an estimated equity cost of capital for the general partner through various assumptions

that markup the limited partner’s cost of capital. In these circumstances, use of the

INGAA model would be inconsistent with the purpose of the proxy group of providing a

fully market-based estimated cost of capital.

105

uded in the proxy group, use of the INGAA model would necessarily entail deriving

an estimated equity cost of capital for the general partner through various assumptions

that markup the limited partner’s cost of capital. In these circumstances, use of the

INGAA model would be inconsistent with the purpose of the proxy group of providing a

fully market-based estimated cost of capital.

105. INGAA alternatively suggested that the returns from the current methodology be

reduced somewhat to reflect the admittedly lower growth rate of a MLP’s limited

partnership interests. However, its proposal to do that by averaging GDP growth

projections with the Federal Reserve’s target inflation rate appears to have no analytical

basis. Therefore, INGAA’s recommendations will not be accepted here.155

106. Based upon the above discussion, the Commission concludes that the long term

growth component for an MLPs equity cost of capital should be 50 percent of long term

GDP, rather than the full long term GDP currently used for corporations.

153 INGAA, Post-Technical Supplemental Comments dated March 12, 2008 at 2-4

and Vilbert Aff. attached thereto, passim. The Commission will accept INGAA’s

March 12 filing because INGAA had no earlier opportunity to reply to the material

contained in the State of Alaska’s February 20, 2008 filing.

154 496 F. 3d 695 at 699.

155 See AOPL Post-Technical Comments at 3-4, which suggest that the complexity

of Mr. Vilbert’s model and the use of its assumption indicate that it is more appropriate to

rely on the limited partners’ distributions in a DCF analysis.

filing because INGAA had no earlier opportunity to reply to the material

contained in the State of Alaska’s February 20, 2008 filing.

154 496 F. 3d 695 at 699.

155 See AOPL Post-Technical Comments at 3-4, which suggest that the complexity

of Mr. Vilbert’s model and the use of its assumption indicate that it is more appropriate to

rely on the limited partners’ distributions in a DCF analysis.

Docket No. PL07-2-000

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c.

Proposed upward adjustments to the long term

component

107. NAPTP asserted that the Commission should increase rather than decrease the

long term growth component used to determine an MLP’s equity cost of capital to reflect

the general partner component of an MLP’s equity.156 It asserts that equity cost of capital

must be determined for the MLP as a whole, not just for the limited partners. NAPTP

asserts that the return, and hence the projected growth rate, must generate sufficient cash

flows to support the IDRs provided the general partner under most MLP agreements. To

this end, it marked up the growth rate of the limited partners to reflect the portion of the

equity effectively controlled by the general partner through its IDRs. Thus, growth rate

for the limited partners was 10 percent and general partner received a total of 50 percent

of the distributions, the growth rate for the general partner could be as high as 20 percent.

The Shipper Interest partners argued that this only rewarded the general partner for its

excessive distributions and would inordinately increase the MLPs equity cost of capital.

108. Both INGAA’s witness Vilbert and the State of Alaska’s witness Horst rejected

the NAPTP approach on mathematical grounds

he distributions, the growth rate for the general partner could be as high as 20 percent.

The Shipper Interest partners argued that this only rewarded the general partner for its

excessive distributions and would inordinately increase the MLPs equity cost of capital.

108. Both INGAA’s witness Vilbert and the State of Alaska’s witness Horst rejected

the NAPTP approach on mathematical grounds. Both argue that the gross-up fails to

properly value the general partner’s interest at multiples that reflect the general partner

interest’s relative risk to that of the limited partners.157 Furthermore, Vilbert argues that

the general partner’s risk, while always greater than that of the limited partner, declines

as the MLP matures and the general partner’s share of distributions increases.158 As this

occurs, the growth rate of the general partner’s interest slows and approaches that of

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