Hempton letter to Federal Regulatory Energy Commission

8/3/2019 Hempton letter to Federal Regulatory Energy Commission

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218-0452 FERC PDF (Unofficia1) 12/17/2009From: j ohn.hempton@gmai l . com [mal l to :John.hempton@gmal l . com] On Behalf O f J oh n H em p to nSent: W ednesday, D ecem ber 09,20098:21 A MTo: J am e s P ed ers on ; J on We llin gh offCc: S im on M ah erSUbject: COmm en ta ry o n y ou r re ce nt ra te ca se a nn ou nc em en tDea r J on We llin gh off,

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I w rite a very w ell know n blog (B ronte C apital).I am extraordinarily perplexed by the FERC 's view s on the acceptable rate of return on gas pipelines intoChicago. In particular I th ink you have high school m athem atics w rong. I am intending on w riting this outfor m y blog.I have attached a letter w hich contains a prelim inary blog post - and w ould very m uch like your com ments.It goes through the m aths w ith som e rigor - and I think your organisation sim ply has th e m aths w rong .G iven that you have an undergraduate degree in m athem atics I th ink you should be able to confirm thisw ithin a few minutes. You w ill then need to consider carefully how you fix the problem (though I think Ih ave p resen ted a w ay forw ard ).Can w e find a time to talk about this - even ten m inutes? I live in Australia (which I guess makes it odd thaI read your web page) but - then - hey - its a big world . Your late afternoon works for me.Hope to hear from you.Can you please reply to confirm that you have this em ail. [jo:: c-l-2:l>. . . . .Jo hn H em pto n

Chief Investment O fficer ; :Ui ,.. '. '.'Bronte Capital M anagem ent Pty Ltd (A CN : 133876203 A ilS License: 334325)Suite 21018 . .52 0 O xfo rd StreetB on di Jun ctio n 2 02 2Australia

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218-0452 FERC PDF (Unofficia1) 12/17/2009

pipeline to recover an amount (say $x per year) so that the present value of $x per year adds up to$100.Now $x has to be more than $50. Why? Because over 2 years the pipeline has to recover at leastthe $100 that it cost to construct. Depreciation alone is $50 per year - and having the pipelinerecover only $50 per year would mean it made no profit.We could (naively) presume that because $\00 is employed the pipeline needs to make $12 per yearprofit in order to get 12 percent return. So we would set $x at $62. That unfortunately gives us alittle too much return - because - in the second year the pipeline only has $50 of capital employed(they have recovered $50 through depreciation). You can do the maths here (and you assume forsimplification that the cash is all received at year end) then the $62 received after year one would beworth $55.36 discounted at 12 percent and the $62 received in year 2 would be worth $49.43. Addthose up and you get more t han $100.I used the "goal seek" function on Excel to work out the required annual return on the pipelineunder the simplifying assumption that the annual payment is received in two equal increments. Ihave linked the original spreadsheet (to convince you that I have done this correctly).

A B c D E12 Simple model. pipeline. lifespan 2 periods. payment at the end 01each period34

5

Assumed rate of returnNumber of periods(payment at the end ofeachpenod)Assumed cost buildingpipeline

12%

26 S100

78

Annual required return(note we chose this -se that thediscounted return equats the

S59 17 cost of the pipehnePayment9 time Discount factor

1011 1 0 89285714312 2 0.7971938781314 Total discounted return151"

Discountedreturn5528354717S10000

In this case note that the required cash flow each period is $59.17c. You can discount this if youwant by 111.12in the first year (getting $52.80) and by that squared in the second year ($47.17) and10- these numbers add up to $100.Now here is the clinch - which is that we know - by initial assumption here - that the return onequity for this project over its life is exactly twelve percent.But what is the return on average equity in the second year?Return on average equity in the second year!The cash return in the second year is $59.17 cents. [It needs to be that every year to get you a 12percent return on equity over the life of the project.] The pipeline depreciates by $50 per year overits two year life. So the measured profit during the second year is $9.17 (the return less


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John HemptonBronte Capitaljohn(ci)brontecapital comphone +61293876949 - note in Australia

Dear Jon WellinghoffI write one of the most widely read financial blogs on the web (google Bronte Capital). This isprobably the most read blog which provides complicated original finance comment. I have over amillion page views in the past twelve months. I also have close contacts in most ofthe majornewspapers - and in much ofthe capital markets.1am about to post something which makes your department look plain silly. Its easy to fix - andwithin your own personal skill set. Essentially I am suggesting your department cannot do simplehigh school mathematics as to utility regulation.I would dearly like your comment on this before I post it.Hope to hear from you.John Hempton

When regulators can't do maths: gas pipeline editionThe Federal Regulatory Energy Commission (the FERC) is charged - amongst other things - withregulating the rate of return on interstate natural gas pipelines. Rates on these pipelines are by-and-large regulated so as to achieve a targeted 12 percent return on equity. I always thought a 12percent return was generous - but so be it.

Quite of its own volition the FERC has called for a judicial review of rates on Natural Gas Pipelineof America (NGPA) and by extension on the other gas pipelines going into and out of Chicago.This is a peculiar review because - unlike past reviews - the review was called by the Commissionitself and without a complaint from any of the customers using the gas pipeline. [Customers for gaspipelines tend to be large oil and gas companies or large utilities and are usually not shy aboutcalling for a review when rates are out-of-line.]The FERC has argued - from publicly available documents - that the returns on the NGPA are Gust)over 24 percent - and hence (and these are there words) are ''unjust and unreasonable". They uselots of emotive language and have petitioned a judicial review to get the rates cut. You can find thefun document here.

To put it bluntly the FERC stuffed up. Itsimply got the maths wrong because it does notunderstand rates of return and depreciation - a staggering oversight for a body charged withregulating pipelines. Worse - on the maths presented - the rates on the NGPA should be increasedin order to allow for the FERC mandated 12 percent return.This is a pretty nasty allegation - so I need to explain the basic mathematics of regulated returns. Iwill start with the simplest of models that I can.The simplest pipeline modelImagine a pipeline that cost $100 to build. It lasts 2 years. The regulators have to allow the


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is $100, the annual payment is $59.17, i is the usual 12 percent and n is two years. Plug thefollowing into your calculator - it checks out just fine:

$~91- r 1$100= - . 11 1 - .!0.11 ~ (1+0.11)" ~

Now we can rearrange this standard formula to determine A:

Now we can also work out what the year-end capital employed (E) in year j ofn is. That is trivial-it is

E = PV(A)* n- jn

Income in any year (V) is equal to the annual payment less than depreciation. In the formula belowIjust assume that the original cost of the pipeline depreciates in a straight line over n years.

r= .4 _ PV( .AJ1 '7

Now the FERC is really obsessed by the observed return on equity on the pipeline (in this caseabout 24 percent). But lets work out what the observed return on equity should equal:


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depreciation).Capital employed commenced the second year at $50 (being the cost less the $50 of accumulateddepreciation). Itended the second year at $0 - as the whole pipeline had been written offby then.The average capital employed for the second year is thus $25. Given the stated profit is $9.17 thereturn on average equity for the second year - as recorded - will be 36.7 percent.This return will be observed even though the return on the project over its life is only 12 percent.There is nothjnK sinister about an observed 36.7 percent - and more generally there is nothing"unjust and unreasonable" in the observed returns of 24 percent of the Natural Gas Pipeline ofAmerica. These returns are simply a mathematical artefact of the allowed return on equity of 12percent over the life of the pipeline. The observed ROE of 24 percent does lllIl warrant a ratecase - it is as to be expected. Indeed as the pipeline in question is more than half depreciated Iwould have been surprised if the observed ROE was below 24 percent - and the 24 percent ROEdoes not represent a problem or a failure of regulation.What we have here is a regulator who has failed to understand the basic maths of the businesswhich they are meant to be mathematically regulating.The des killing of Amerfean regulatorsI am no longer surprisedat the general deskilling of American regulators. This post demonstratesthat the regulator - whose job it is to regulate the rate of return on gas pipelines - has no idea at allof the basic high school mathematical implications of that regulation. I am used to SEC officialswho can't read a balance sheet or can't see the Madoff fraud when it is laid out in front of them.But the rot spreads more widely. We have bank regulators who were blind or stupid and now wehave utility regulators who can't do basic maths.A more generalised formula for what should be the observed returns on B pipelineWarning - seriously wonky - here 1do the maths to show what the observed ROE should be. Youdon ~need to read this -just accept the regulator has their maths shockingly wrong. But here is away of working out precisely how wrong!Being a nerd I thought I would help the regulator out with their maths - and indeed it is not too hardto derive a generalised formula for the right observed return on a pipeline. But hey - why botherwhen Wikipedia does it for you? Wikipedia gives the present value of a stream of n paymnets ofvalue A as follows:

. A. 1,Pl"(A) =-. 1-. r IZ I . l + i ) " _

PV(A: is the present value of the stream of payments - which in this case should be the~T'lction cost of the pipeline.i is the rate of return - which in the case of FERC should be the regulated rate of return (I2percent), andA is the annual cash return on the project, andn is the number of years over which the project receives its return (which should be the depreciablelife 01 the pipeline - or in the above example 12 percent). Now I would never use a formula out ofWikipedia without checking it (which I did by derivation)but fOImy readers I thought I should just plug in the above example - where the cost of the pipeline


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objective here - and we wound up in this spot because of the mathematical incompetence of theFERC. It is time to stop the rot at the FERC.Stopping the rot at FERCAnd it should stop relatively quickly. Barrack Obama appears to have appointed a competent manto be the head ofthe FERC. Whilst Jon Wellinghoffmay have spent most of his career as anattorney he has - according to his CV - an undergraduate degree in mathematics (University ofNevada 1971). He should be more than capable of checking the maths in this post.I have contacted his office and given him a copy of this post. Jon Wellinghoff endorsed and pressreleased the review of the rates for the various gas pipelines. He is however more than capable ofwithdrawing his request for a review. Indeed I think he has to before the FERC is made a laughingstock as the SEC was after Madoff.I will happily announce when he has reacted appropriately.

JohnPS. The pipelines who would have had their returns slashed under this review include NorthernNatural- which is owned by Warren Buffett's Berkshire Hathaway. I have not received or askedfor a consulting fee but Berkshire holders (many of whom are my readers) should be sending theirthanks ...PPS. I am serious about the deskilling of US regulators. I have spent only a few hours thinkingabout the mathematics and accounting of rate of return regulation in my life - and I spotted androughly quantified this error within five minutes. Regulators who do this all day every day shouldsimply not make mistakes like this.


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rROE =_= nE lpV(A)*in-j)I n. - . 1 _ Pr(.-.I)

i*PV(.l) pr."CA)r! i 1; 1 1

i ! 1- (1+i)r ! .- = . - ; : ; , . - - - , . - - - _ . . . . , ; - ; ; . , . : - : . . . - . . , . . . . . . . -i Pl"CA) ( 1 1 - j) i. nYou can rearrange and simplify this equation any way you like -I can't really be bothered -I amlazy. But hey we now have enough to work out what the observed rate of return should be. Assumethat the initial cost ofthe pipeline is I (it would cancel from top and bottom of the above formula).The depreciation in the FERC document for the pipeline is 50 years - so n is 50. The pipelineoriginally cost $3.728 billion but has accumulated depreciation of $2.273 billion - so we are in 35of 50 - so in the above formula j is 35. We are going to allow the regulated rate of return - which is12% - so i is 0.12. Plug this in and we get the following:

i pr(.i}1 n 1'; 501- i I : 1 Ir 11..i))' I' (l-OL.!)i;: ~ _ iROE = . : : . - = . - ~ _ _ -=-c;o~_~_=-=-'~-,----=r-- = 3 3 . - 1 " , 0 ' 0i,' '-1 1'

Hempton letter to Federal Regulatory Energy Commission

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