EDITOR'S NOTE: Significant capital is required to support the development of new gas pipeline infrastructure linking production and consumption. In this article, Black & Veatch's Rick Porter explores regulatory risk as a factor in the attraction of investment capital to regulated gas pipelines – the regulatory risk attendant to the recovery of previously invested capital, currently invested capital, and future investments of capital. Are the risks associated with the recovery of previously invested capital an indicator of the risk for future investment? Can the regulatory model provide sufficient incentives for future capital investment? The author poses the right questions and provides the answers as well.
Richard W. Porter, Black & Veatch, Houston
In a memorable scene from the 1967 movie, "The Graduate," Mr. Robinson offers Benjamin Braddock some optimistic career advice saying, "I just want to say one word to you. Just one word. Plastics."
We all understood the import of that advice as the growing petrochemicals industry and the plastics revolution permeated all phases of our lives.
In a remake of that movie today, Mr. Robinson would still be optimistic. However, today he would advise, "I just want to say one word to you. Just one word. Infrastructure." Of course, those of us in the natural gas industry would immediately understand.
Attracting investment to link production to consumption
Black & Veatch recently completed its annual survey and report, 2012 Strategic Directions in the North American Natural Gas Industry, and optimism is a recurrent theme among the responders. On the supply side, the consensus is that abundant gas supplies will remain the norm for an extended period. Just as important, market demand is expected to grow as, among other things, coal-fired power plants are replaced with gas-fired units.
Yet, while optimistic about the future of gas as a whole, the participants were less than optimistic about the impact of industry regulation. In fact, over 42% of the respondents agreed that energy policy and regulation could have a negative or very negative effect on the industry. In addition, a significant portion of responders indicated that regulatory uncertainty was an important consideration when evaluating future investment.
This concern regarding investment in the industry is particularly troubling since a subtext of the survey results suggests that the future of the gas industry may revolve around a single issue – the growth of natural gas infrastructure. The ability of the regulated gas pipeline industry to attract capital at competitive rates is essential to meeting the infrastructure challenge. Participants in the capital markets regularly vote on their evaluation of the industry's ability to efficiently respond to this challenge. How capital markets currently vote should inform our opinions regarding the allocation of capital across the natural gas value chain, from wellhead to burner tip.
In the unregulated or less regulated sectors of the natural gas industry, (i.e., the upstream and midstream markets), the level of investment risk is proving sufficiently manageable. This is evidenced by, among other things, the explosive growth in gas production. Following this growth in production is the development of the associated facilities, such as gas gathering systems, required to bring marketable gas to the pipeline transmission grid.
In contrast, the regulated sector of the industry (i.e., gas transmission pipelines) is struggling with multiple questions complicating the evaluation of investment risk. How will the regulated industry recover the investment in currently underutilized or stranded infrastructure? How will the regulated industry recover the investment required to sustain and maintain the integrity of its aging infrastructure? How will the regulated industry attract the investment required for the new infrastructure necessary to transport the burgeoning supply to the growing markets?
The impact of the regulatory model on infrastructure investment
It is important to remember that natural gas pipelines do not make money selling either gas or energy. In the current regulatory model, pipelines make money by investing capital in infrastructure and selling pipeline capacity. Theoretically, every unit of capacity sold provides recovery of a portion of the capital investment, plus a reasonable rate of return on the investment.
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Natural gas pipelines are long-lived and immobile assets. Consequently, the historical construction of pipeline systems and the recovery of pipeline investments are predicated upon the continued existence of long-term contracts providing firm capacity for ratable transportation services between stable natural gas supply sources and consistent market demand points. The regulatory model has established rules, regulations, and policies supporting this delivery framework.
With the exit of interstate pipelines from their traditional gas aggregator / gas merchant role, the underlying cost incurrence and cost recovery relationship for pipelines began to change recent shifts in natural gas supply basins have further skewed this historical relationship. As demand for natural gas increases, expanding beyond its traditional role as a direct energy source to a fuel for energy generation, one must consider how the regulatory model will adapt and provide the surety that investors, pipelines, and consumers require.
Recovery of investment in underutilized and stranded infrastructure
In recent years, significant production of shale-sourced natural gas from non-traditional supply basins has altered the capacity requirements of pipeline shippers. Contemporaneously, utilization of pipeline capacity in certain regions declined as shippers sourced larger portions of their supply portfolio in the developing shale plays. In particular, the impact on shippers and pipelines that relied heavily on Gulf of Mexico (GOM) based supply to fill their portfolios and capacity has been dramatic.
It is useful to view this in the context of the GOM pipelines, as this is the situation where the tenets of basic economics are most evident. Here, the fundamental problem is a shortage of demand for transportation service (i.e., too little gas production) relative to the abundance of supply of transportation service (i.e., too much available pipeline capacity). This suggests that the regulatory model must find ways to encourage the restoration of supply and demand equilibrium to the market to ensure long-term secure transportation access to current and future GOM production.
How will the regulatory process recognize the cost of this underutilized investment while striking a balance between the pipeline and its ratepayers? At this time, the industry has not coalesced around any specific methodology or strategy to address the potential stranding of pipeline capacity. In short, the current approach seems to be to deal with this transition on a case-by-case basis.
While the Federal Energy Regulatory Commission (Commission) has previously intervened in the process to promote cost recovery of transition type costs, the current situation can be differentiated from past markets in at least two ways. First, when the Commission provided transition cost recovery for amounts incurred as a result of restructuring under Order No. 636, that rate relief was provided to manage the result of direct regulatory action. In contrast, the cost issues associated with capacity underutilization and stranded facilities are largely the result of market forces.
In addition, the transition cost relief provided by Order No. 636 was intended to close out a finite regulatory liability and to shift to the new regulatory model defined by the Commission's findings under Section 5 of the Natural Gas Act. However, it is not clear where the market will take future pipeline operations. Consequently, it is difficult to construct solutions if one cannot determine if the problem is transitory, or a permanent restructuring of the pipeline industry.
Recovery of investment for sustaining and retaining existing infrastructure
The regulatory model is predicated upon the establishment of rates for services based on costs incurred in a normal operating year. Increasingly, pipelines are spending significant capital dollars and incurring major operating expenses on one-time or limited term events. The inability of the pipeline to secure timely recovery of these expenditures within the existing regulatory construct creates ongoing financial stress for a pipeline, its shareholders and its ratepayers.
One need look no further than the hurricane season of 2005 to understand the financial impact of one of these events. During 2005, a number of offshore and near-shore pipelines sustained severe damage to their facilities as a result of Hurricanes Katrina and Rita. In some instances limited cash reserves precluded pipelines from restoring operations and certain facilities were never restored to service.
In addition, a downward trend in gas production and the associated decline in throughput complicated the financial equation faced by pipelines as their owners evaluated whether or not they should rebuild, repair, or abandon their systems. This evaluation was further encumbered by the lack of an existing approved regulatory mechanism to recover the cost of restoring pipeline operations. To fill the cost recovery void some pipelines proposed surcharge mechanisms to promote greater cost recovery from this declining throughput.
While some methodologies have been proposed for managing the cost of damages from natural disasters, no industry-wide solution is yet available to deal with other major cost exposures. For example, pipeline safety and integrity issues are quickly percolating to the forefront, driven by events such as population encroachment onto previously isolated sections of pipe. These issues are further impacted by the ongoing maintenance and operational challenges associated with the aging pipeline infrastructure.
What solutions will the regulatory model propose to provide pipelines with recovery of the significant one-time costs to repair, retain, and rebuild their systems? Pipelines have proposed both a) surcharges to recover anticipated pipeline integrity expenditures previously recovered through maximum tariff rates and b) tracking mechanisms for the anticipated increases in safety related costs such as smart pigging and similar safety monitoring. In the end, the gas pipeline industry needs solutions that provide recovery of these costs in a balanced manner that minimizes the impact of regulatory lag and encourages the continued investment of capital to preserve and maintain the gas transportation infrastructure.
Recovery of investment for development of new infrastructure
The explosive growth of shale production has created the need for significant regional pipeline expansion. At the federal level, this requires the preparation and prosecution of a Certificate of Public Convenience and Necessity which, depending on the issues involved and the level of participation by interested parties, can be a relatively lengthy process. Often approval of the requested authority by the Commission does not preclude subsequent litigious activity by others which may eventually prove fatal to the project.
Almost simultaneously, the demand for gas as a power fuel is increasing as a) gas prices become competitive with coal and b) environmental concerns and regulatory requirements dictate the replacement of coal fired plants with new gas fired units. The expansion of the call for gas as a power fuel places significant demands upon the operations and capacity of existing pipelines that were constructed for delivery of gas at uniform rates of flow as the energy source, not for delivery at variable rates of flow as a fuel for the energy source. This expanding demand for capacity requires new and significant flexibility in both pipeline operations and future services that, in turn, dictates a need for a more flexible, pipeline infrastructure.
The Commission has recognized the impending intersection of the natural gas and electric markets. To that end it has initiated a framework for discussions surrounding the increased reliance on natural gas capacity and the associated delivery of gas as a fuel for power generation. Although this process is in its nascent stages, it has already identified areas which require significant study.
As the Commission executes its charge to promote the reliability of natural gas pipelines and the electric grid, there will be new challenges. In its recent Order 1000, the Commission charged RTOs with the obligation to develop regional plans for infrastructure in a manner promoting reliability and the efficient allocation of capital. This necessarily means that inflection points may arise as the market determines whether a gas pipeline or an electric transmission line is the economically efficient way to provide energy to a given destination.
Aligning infrastructure requirements and capital risk
What incentives should exist in the regulatory framework to induce capital to invest in the necessary infrastructure expansions? Today's infrastructure investor has a shorter investment horizon than those who initially built the interstate pipeline grid. Furthermore, that investor will likely have a different investment model which requires the generation of significant and consistent cash flow, not a static return on investment in facilities. This suggests that the regulatory model must become more flexible and focus as much on generating positive operating margins and less solely on an opportunity to recover and earn a static return on investment over an extended period.
This is an exciting time to be active in the natural gas industry. The supply and demand for gas as both a power source and as a power fuel provides significant opportunities for infrastructure growth from the wellhead to the burner tip. Whether or not sufficient infrastructure remains in place, or is constructed to meet increased demands may largely depend on the ability of the regulatory process to efficiently attract capital and reward those who elect to build and operate these systems.
About the author
Rick Porter is director of Black & Veatch Management Consulting, providing regulatory advisory services to clients in the oil and gas industry. He specializes in natural gas and oil pipeline regulatory support. Porter is an expert in natural gas regulatory matters. Among other things, he manages the delivery of turnkey regulatory services to pipelines and midstream companies, providing a customizable and cost-efficient regulatory management alternative that promotes a company's regulatory and financial goals. He advises clients on matters relating to pipeline rates and services, regulatory compliance, regulatory policy and strategy development, project development, and M&A regulatory due diligence. For over 30 years, Porter has managed regulatory departments of, or provided regulatory services in connection with every major natural gas pipeline in the United States. Prior to Black & Veatch, Porter was the founder and manager of The Pythia Group LLC, a regulatory consulting group. He began his energy career in 1979 with Panhandle Eastern Pipe Line Company, later managing the regulatory efforts of Arkla Energy Resources, ANR Pipeline Company, and Enterprise Products Partners. An instructor, speaker, and author on regulatory issues, Porter lives in Houston.