END-USERS

Tennessee’s NPV Method Runs Afoul of the DC Circuit

n June 1996, Tennessee Gas Pipeline pro- I posed to move from a “first come, first served” approach to a bid system for the award of “generally available” firm capacity on its system. Capacity would be awarded to the bidder whose bid had the highest net present value (NPV). Tennessee defined NPV in terms of the incre- mental revenue it would bring to the system.

.I proposed to move from a “first come, first served’”

approach to a bid system . - . Fight before the Commission

The first thing that caught the attention of industrial end-users1 and certain other interve- nors was that Tennessee proposed no cap on the duration of contracts that would be considered for NPV evaluation. In other words, a shipper bidding for a 40-year term at a discount rate might well beat another shipper bidding for 10 years at maximum rates. The industrials and others pro- tested this lack of a cap, and the Federal Energy Regulatory Commission (FERC) agreed. Tennes- see then amended its proposal to place a 20-year cap on bids for NPV evaluation purposes. Again, industrials and others protested, ultimately argu- ing that the commission should limit Tennessee to a cap of five years, identical to the cap prescribed by the commission in Order 636-C, dealing with allocation of capacity in right-of- first-refusal (ROFR) situations.

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Edward J. Grenier Jr. is a partner in the Washington, DC law firm of Sufherland, Asbill & Brennan. He is also general counsel of the Process Gas Consumers Group.

. . - shipper bidding for a 40- year term at a discount rate

might well beat another shipper bidding for 10 years at

maximum rates.

The commission rejected the protests and accepted Tennessee’s proposed 20-year cap on the ground that it was consistent with the commission’s policy of awarding capacity to those who value it the most. The commission also noted that economic efficiency would be achieved through the lower turnover that results from longer contracts. However, the commis- sion made a crucial finding that would later come back to haunt it in the court of appeals: Tennessee definitely has, and can exercise, market power, and any NPV cap longer than 20 years would lead to an unduly discriminatory exercise of market power by Tennessee.

. . - noted that economic efficiency would be achieved

through the lower turnover. . -

Some time after Tennessee made its initial filing, it informed its customers that the term “generally available capacity” would include capacity involved in an existing firm-shipper’s attempt to change primary receipt or delivery points (“meter amendments”). Shippers have a clear right to make such meter amendments under Tennessee’s tariff, pursuant to commis- sion policy dating back to Order 636. Because NPV was calculated based upon the incremental revenue brought to the pipeline, a shipper simply switching a primary receipt or delivery point, without more, would have a NPV of zero.

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That means that it would always lose to any other shipper at that point that would bring even a small amount of incremental revenue to the pipeline. In fact, during the proceedings before the commission, Tennessee amended its tariff to make explicit that the NPV of a meter amend- ment would be zero.

Needless to say, Tennessee’s proposal con- cerning meter amendments caused a storm of protests, not only by the industrials, but also by LDCs located at the far downstream end of Tennessee’s system. Of course, Tennessee de- fended its position, and the commission agreed with Tennessee. The commission suggested that a shipper desiring a meter amendment could make a bid with a NPV of greater than zero. If it was receiving a discount, it could offer a higher rate, all the way to the max rate. It could bid for additional firm capacity, beyond that which it currently holds. Finally, it could extend its zones of service.

. . . proposal concerning meter amendments caused a storm

of protests. - . To translate the commission’s suggestions

into a concrete example, let us assume the existence of an LDC in Pennsylvania that re- ceives a 10 percent discount on its firm contract of 100,000 million Btu’s a day. If that LDC were to accept the commission’s suggestions, it could (1) give up its discount, (2) agree to buy a total of 150,000 million Btu’s a day, and/or (3) buy service all the way to Boston-all in order to have the right to make a meter amendment. Presumably, the only way such an LDC could even consider making such economically irra- tional choices would be its assumption that its state commission would allow it to pass the added costs on to its rate-payers. Such choices make absolutely no economic sense, and a gas user with choice would clearly switch to some other fuel or make some other arrangements.

However, the New England LDCs had an even stronger objection. They were already paying max rates; there was no more firm capacity available for them to buy, even if they wanted it; and they were already paying for the entire length of the system. Thus, they would be stuck with a NPV of zero whenever they sought a meter amendment.

At the end of the day, notwithstanding several rounds of rehearing, the commission

adhered to its decisions about both the 20- year cap and meter amendments. Not surpris- ingly, petitions for review were filed in the U.S. Court of Appeals for the D.C. Circuit challenging the orders with respect to those two points.

Court’s Decision Industrial end-users and distributors located

in New England argued that, though they did not object to allocation of capacity on the basis of the NPV of bids, they found Tennessee’s approach objectionable on the two grounds raised before the commission. In particular, they argued that (1) there was no substantial evi- dence supporting use of a 20-year cap for NPV purposes and (2) relegating firm shippers desir- ing meter amendments to a NPV of zero was arbitrary and capricious and not the product of reasoned decision making.

It took the court only one month after oral argument to reach its decision.*The court agreed with petitioners on both issues and remanded “to the Commission to better ex- plain or modify its approval of the twenty- year cap and of Tennessee’s use of the NPV method of allocating pipeline capacity in the context of requests from existing shippers for meter amendments.” The court did not vacate the commission’s orders, thus, Tennessee’s flawed system remains in effect pending com- mission action on remand.

In discussing the 20-year cap issue, the court went back to basics and reminded the commis- sion that, in relation to their customers, pipe- lines, as natural monopolies, are often in an economically powerful position and can exert market power. In doing this, the court relied heavily on its relatively recent decision about Order 636.3 The court there had indicated that “[a rate] cap may prevent an end run around the maximum rates approved by FERC, a concern when monopoly conditions are present.” The UDC case dealt in part with the commission’s approval of a 20-year cap for the purpose of evaluating bids by shippers seeking capacity for which a shipper has a ROFR. The court there held that FERC had failed to answer challenges that 20 years was unreasonably long and re- manded to the commission to better explain or modify its decision. On remand in that case, the commission explored the latest evidence about contract duration and reduced the ROFR cap to five years.*

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The court found completely unpersuasive the commission’s (and Tennessee’s) argument that the ROFR situation was different in that, there, the right of an existing customer to hold onto capacity was at stake. In contrast, the argument goes, Tennessee’s filing involved “gen- erally available capacity,” in which existing customers had no vested interest. Instead, the court accepted the rationale advanced by peti- tioners that capacity is capacity, and market power is market power. As noted, what came back to haunt the commission was its admission in a footnote in one of its orders that Tennessee could indeed engage in “an unduly discrimina- tory exercise of monopoly power” if the NPV cap were any longer than 20 years or there was no cap at all. Because the only “evidence” the commission alluded to in its Tennessee orders was that there were “some” contracts of 10- or 15-year duration still around, the court found that approval of a 20-year cap was tantamount to approval of no cap at all. The court noted that the commission failed to explain why the evi- dence it compiled in reaching its decision in Orders 636-C and 636-D was not usable in the Tennessee proceeding.

. . . found that approval of a 20-year cap was tantamount to

approval of no cap at all.

The court was equally not persuaded by the commission’s reasoning about meter amend- ments. The court found, correctly, that the commission had failed to explain how custom- ers at the end of Tennessee’s system could take the steps the commission suggested (pay more, take more capacity, extend zones of service) when it was plain that they could not do so. The commission’s additional explanation that such customers could always use the new receipt or delivery points they wanted on a secondary basis also failed to pass judicial muster. By definition, secondary point service is inferior to primary point service and is not an adequate substitute for it

Significance of the Court’s Decision The court’s decision is highly significant for

end-users and, indeed, all shippers. First, the court reminded the commission that its main task under the Natural Gas Act of 1938 (NGA) is not assuring the maximization of pipeline rev- enues and profits; it is to protect shippers and

ultimate consumers. The commission is cer- tainly on the right track in attempting to bring market forces to bear in the pipeline transpor- tation market. However, the commission must do so in a rational way that in fact prevents exercise of pipeline market power. Also, the commission must insist on a rational system for the allocation of capacity through bidding- one that will not trample on shippers’ rights.

- . - commission’s additional explanation that such

customers could always use the new receipt or delivery

points they wanted on a secondary basis also failed I - -

Because the Tennessee-type version of NPV for bid evaluation has already been adopted on at least one other pipeline (Northwest), the court’s decision here should stop the spread of a methodology that is seriously flawed in the two respects addressed by the court. Thus, the decision should have real impact in individual pipeline settings.

At least as importantly, the decision may give the commission pause in moving forward with either ROFR proposal in its rulemaking in RM98-10-000. There, the commission proposes to abolish the five-year matching cap or perhaps eliminate the ROFR altogether. Either proposal would seriously hurt end-users and other shippers.

At minimum, the commission would have to come up with quite an explanation if it elimi- nated the cap or the ROFR itself. Here we have a court decision in 1999 reviewing relatively recent commission orders (the latest of which was in January 1998) stating that Tennessee (like other pipelines) can exert market power and that a meaningful bidding cap is needed to restrain such market power. Could the commis- sion convince the court (and even itself) that now, a short time later, the pipelines could no longer exert market power of the sort that should be restrained by a bid duration cap? Only time will tell the answer to this question.

Notes 1. The Process Gas Consumers Group (PGC) filed a series

of protests on behalf of industrial users, raising various issues discussed in this column.

2. Process Gas Consumers Group, et al. v. FERC, No. 98- 1075 (May 21, 1999).

3. United Distribution Cos. v. FERC, 88 F.3d 1105 (D.C. Cir. 1996).

4. Orders 636-C and 636-D.

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