Section 60. Order adopting policy statement for recovery of costs associated with take-or-pay liability

On August 7, 1987, the Federal Energy Regulatory Commission ("FERC") entered Order No. 500 in its attempt to mitigate the effects of take-or-pay liability.¹ In that Order, FERC announced its adoption, on an interim basis, of two pass-through mechanisms to spread the liability associated with take- or-pay contracts throughout all segments of the gas industry. As we noted in our July 6, 1988 Order for Notice and Comment, as a result of FERC's action, large amounts of take-or-pay liability are being or have been authorized to be passed from interstate gas pipelines to downstream gas utilities, including those in Virginia. Some Virginia gas utilities are currently passing take-or-pay related costs through their purchase gas adjustment ("PGA") clauses to their customers. Because of the potential impact these costs may have on Virginia gas utilities and their ratepayers, we have initiated the instant docket to consider adoption of a policy which will provide for the opportunity to recover these costs in the most equitable and efficient manner possible. We considered the following policies:

(1) Automatic recovery of take-or-pay costs in the same manner that contract demand charges are recovered through utility purchase gas adjustment clauses (hereafter policy option 1);

(2) Allocation of costs associated with fixed surcharges to both firm and interruptible gas commodity costs (hereafter policy option 2);

(3) Recovery of take-or-pay fixed surcharges on the basis of estimated gas transportation volumes and commodity sales. If this approach were adopted, a utility would be permitted an opportunity to recover the costs associated with fixed take-or-pay surcharges during a defined time period. The opportunity to recover these costs would be the same as the opportunity to recover any other costs during the specified period. A formula could be developed to determine the acceptable estimates of throughput, including known and definite load losses, customer growth, normal weather, and the utility's ability to compete. The take-or-pay fixed surcharges would terminate at the end of the specified time period (hereafter, policy option 3).

(4) Allocation of take-or-pay liability on the basis of customer purchase deficiencies. This policy alternative would use a base purchase period against which recent sales purchases could be compared. Costs associated with fixed take-or-pay surcharges could be apportioned in relation to the decreases in sales volumes purchased by gas customers. This policy alternative resembles the Order No. 500 allocation mechanism employed by FERC (hereafter policy option 4).

In our July 6th Order, the Commission invited interested parties, including the staff and jurisdictional gas companies, to file written comments addressing the factual or legal issues related to the four policy alternatives described above. In addition, interested parties were given the opportunity to request oral argument.

In response to that invitation, 22 parties filed comments, and nine requested oral argument. Parties filing comments included: Southwestern Virginia Gas Company ("Southwestern"), United Cities Gas Company ("United"), James River Corporation ("James River"), General Electric Company ("GE"), Commonwealth Gas Pipeline Corporation ("Pipeline"), Columbia Gas of Virginia ("Columbia"), Lynchburg Gas Company ("Lynchburg"), Northern Virginia Natural Gas and Shenandoah Gas Company ("WGL Companies"), the City of Richmond ("City"), Hadson Gas Systems, Inc. ("Hadson"), Westvaco Corporation ("Westvaco"), Anheuser-Busch Companies et als. (Anheuser-Busch), Virginia Industrial Gas Users ("Industrial Users"), Virginia Natural Gas, Inc., ("VNG"), Suffolk Gas Company ("Suffolk"), Allied-Signal, Inc. ("Allied"), Commonwealth Gas Services, Inc. ("Services"), and Roanoke Gas Company ("Roanoke"). The Commission's staff ("staff") also filed comments. The Division of Consumer Counsel did not participate in this proceeding. On July 20, 1988, we issued an order reserving the afternoon of July 29, 1988, for oral argument.

I. SUMMARY OF COMMENTS AND ARGUMENT.

Many of the local gas distribution companies, Pipeline, and industrial customers served by both LDCs and Pipeline supported policy option 1, i.e., recovery of take-or-pay related fixed surcharges through the demand portion of the PGA, in their comments. Commentators supporting option 1 or a variation thereof included Pipeline, Lynchburg, Columbia, WGL, Westvaco, Anheuser-Busch, Cos., Inc., Celanese Fibers, Inc., Owens- Illinois Company, IBM, Allied, and VNG. Advocates of this policy alternative generally argued that since the customers, not the utility, received the benefits of lower wholesale costs of natural gas through the PGA, it was appropriate for these customers to now receive take-or- pay costs through the PGA as offsets to the earlier savings.

Several of the gas utilities supporting option 1 argued that the Commission could not adopt any policy that purposefully disallowed recovery of take-or-pay costs by means of an allocation scheme which would not permit recovery of these costs, nor could it disallow these costs absent a showing that they were imprudently incurred. These companies stated that any disallowance of these costs would, absent a showing of imprudence, violate the filed rate doctrine. Nantahala Power & Light Co. v. Thornburg, 76 U.S. 953 (1986). Appalachian Power Co. v. Public Service Comm'n of West Va., 812 F.2d 898 (4th Cir. 1987). They asserted that these cases held that the Commission could not find that federally-mandated take-or-pay costs were imprudently incurred by Virginia utilities as a group or individually in the context of this proceeding. Indeed one commentator suggested that these cases could be read as preempting the Commission from disallowing Pipeline's recovery of Order No. 500 take-or-pay demand charges. Pipeline's Comments at 25.

Commentators supporting option 1 did so because they found it to be administratively convenient and because it assured complete cost recovery. In addition, many of the industrial end users favoring PGA treatment for take-or-pay dollars depend upon transportation of spot purchases or interruptible sales service to satisfy the bulk of their gas supply needs. End users receiving such services are generally not subject to the PGA of the gas utilities serving them for those services.

Many of these same commentators took the position that the second and third policy options would not allow gas utilities to compete with alternate fuels since addition of associated surcharges would render gas service noncompetitive with the prices of these fuels. Several parties further urged the Commission to reject the cumulative deficiency approach as a form of illegal retroactive ratemaking, and as difficult to administer, given the diverse and changing customer population of LDCs.

Some of the commentators supported options other than PGA recovery or modifications of PGA recovery. For example, United Cities supported recovery of take-or-pay costs on a volumetric throughput basis to be applied to all sales and transportation services. In support of this option, United Cities noted that it would recover costs from the broadest possible base of customers.

Columbia and Lynchburg's joint comments urged that recovery of the fixed surcharges should reflect the distinct nature of the costs. They maintained that reformation costs, which are essentially forward-looking, should be charged through the PGA to both firm and interruptible sales customers. However, because past take-or-pay liabilities represent transitional costs, Lynchburg and Columbia submitted that these costs should be shared between sales and transportation classes on a volumetric basis. During oral argument, these parties stated that if the Commission did not wish to consider any modification of the four policy options under consideration, they would support policy option 3.

The City of Richmond's comments focused upon the appropriate allocation policy for Pipeline. The City urged the Commission to implement option 4 and require Pipeline to allocate costs on the same basis those costs were incurred. Such a sales deficiency approach, in the City's opinion, would be fair, provide appropriate economic signals, and create stability for future take-or-pay cost decisions.

While the Industrial Users' comments recommended that the Commission should permit recovery of take-or-pay costs in the same manner that contract demand charges were recovered through PGA clauses, they also noted that the Commission should find a way for Virginia gas utility shareholders to bear a portion of the costs associated with take-or-pay. The Industrial Users stated that the Commission should recognize the need for flexibility among Virginia utilities to take account of their differing circumstances.

Joint comments filed by VNG and Suffolk joined other Pipeline customers to emphasize the uniqueness of Pipeline's treatment from that of LDCs. They then urged the Commission to employ the purchase deficiency methodology used by the FERC in Order No. 500 to allocate take-or-pay costs among Pipeline's customers but not to use such an approach for LDCs. VNG and Suffolk stated that the cumulative deficiency methodology matched the purchase patterns that resulted in the cost allocation to Pipeline to the customers engaging in such purchasing practices. Finally, VNG and Suffolk urged the Commission to adopt policy option 3 only if:

1. All ceilings were eliminated on interruptible rates to enable LDCs to take full advantage of the market opportunities to recover take-or-pay costs;

2. The Commission also authorized flexible take-or-pay surcharges to enable LDCs to respond to the market;

3. The Commission allowed LDCs with a margin sharing feature to collect take-or-pay costs prior to any sharing of margin with firm customers; and

4. The fixed amortization periods were eliminated to recognize the variable nature of the price differential between gas prices and prices of competing fuels.

Services' comments observed that all four of the policy options under consideration were flawed. Of the four, Services noted that it supported policy option 3 if the amortization period was flexible to allow full recovery of take-or- pay costs. Services supported this approach because it believed that take-or-pay costs were incurred to serve all markets and customers of Services and other LDCs or provide a more market oriented industry, thereby benefitting both sales and transportation customers alike. Therefore, it believed that all of its sales and transportation customers should pay these costs.

Services criticized option 1, PGA flow through of these surcharges, as placing too much of a burden on firm sales customers. Services noted that ". . . the filed tariffs of Services [did] not break tariff rates into demand and commodity components. All costs [were] rolled into the weighted average cost of gas, making determination of contract demand charges difficult." Services' Comments at 23.

Services found policy option 2 unacceptable because it could force interruptible sales customers to transportation or completely off-line as they converted to alternative fuel. It characterized policy option 4 as unworkable. Services noted that it would be nearly impossible for it to make determinations regarding customer purchase deficiencies for over 62,000 retail customers. Due to a constantly changing customer base, Services asserted that adoption of policy option 4 would leave unanswered questions such as how to treat customers who no longer have gas service, modify the type of service they receive, or join the system as new customers.

Roanoke also submitted comments. In its comments, it urged the Commission to join Virginia LDCs in their participation in FERC proceedings involving interstate pipelines and to encourage LDCs to develop and implement initiatives for the passthrough of take-or-pay surcharges finally approved. In addition, Roanoke supported a variation of policy options 1 and 3.

Roanoke urged the Commission to adopt policies permitting it to amortize the recovery of take-or-pay costs from firm service customers over a 60 month period, together with interest, at the same rates from time to time allowed on customer deposits and refunds. Roanoke also suggested that firm customers be credited with periodic surcharge collections from interruptible sales customers during a five year amortization period under a special incremental surcharge tariff designed to recover from interruptible sales the difference between the PGA adjusted commodity sales rate and as much as the equivalent value of No. 2 fuel oil. Roanoke stated that the foregoing mechanism would permit it to recover fixed and volumetric surcharges related to take-or-pay liability in the same manner that contract demand charges are recovered under Roanoke's PGA. In this way, Roanoke believed it could recover a portion of its take-or-pay costs from industrial customers, who, in Roanoke's opinion, were primarily responsible for creating this cost burden.

In its filed comments, GE took the position that because industrials and other end users within the Commonwealth did not participate in the writing of take-or-pay contracts, they should not participate in the dissolving of these contracts. GE cautioned that tampering with gas prices would cause every end user with the capability to do so to start burning oil.

Finally, the Commission's staff filed comments. Its comments observed that all the players in the industry, including interstate pipelines, local utilities, and end users contributed to take-or-pay problems. The staff stated that efforts to assess take-or-pay culpability directly to any of these groups would be highly subjective and difficult to prove. The staff's comments identified various sources of take-or-pay costs. For example, a portion of take-or-pay costs are associated with buying-out-or-down problem contracts and may be a source of prospective benefits. staff further noted that there were some historical benefits associated with the incurrence of take-or-pay costs. Staff Comments at 4. Staff noted that significant savings to end users resulted from spot market purchases. The staff believed that jurisdictional utilities received no direct benefit from the savings associated with spot purchases and therefore, it could not support a direct assessment of take-or-pay costs to these local utilities. Staff Comments at 6.

Staff also characterized take-or-pay costs as an obstacle to open access transportation and the associated competitive benefits. Viewed in this light, take-or-pay costs may be considered in the nature of an access fee for nondiscriminatory transportation. Staff generally supported recovery of take-or-pay costs through a volumetric surcharge, provided that the policy was applied with flexibility and sensitivity to each LDC's competitive situation. Staff acknowledged that a volumetric surcharge option had certain flaws and recommended that where gas competition with alternate fuels was rendered impossible after application of the surcharge, the Commission permit recovery of these costs through an alternative mechanism.

The staff also joined many of the other commentators and recognized that alternative approaches for allocation of Pipeline's take-or-pay liability may be appropriate in light of Pipeline's unique characteristics. These characteristics include Pipeline's readily identifiable customer population and the significant portion of Pipeline's nongas costs attributable to take-or-pay costs.

II. THE COMMISSION'S JURISDICTIONAL AUTHORITY.

As we noted in our July 6th Order for Notice and Comment, the FERC has properly recognized our authority to reallocate the fixed surcharges related to take-or-pay and buy-out and buy-down transactions in Order No. 500:

The Commission [FERC] does not believe that Nantahala precludes state regulators from designing LDC rates, or, in appropriate circumstances, from reviewing the prudence of LDCs' purchasing decisions insofar as they affect take-or-pay costs . . . . Therefore, the Commission believes state regulators could consider reclassifying take-or-pay costs billed as a fixed charge as commodity costs and incorporating such costs into LDC sales or transportation rates, or both, thereby spreading such costs to the maximum possible extent as well as subjecting them to market forces. Alternatively, state agencies may wish to consider the option of not reclassifying fixed take-or-pay charges and instead allocating such charges to the LDC's customers based on their cumulative purchase deficiencies.

The Commission can exercise its jurisdiction only within its legitimate sphere, which in this instance involves establishing cost allocation procedures and rates for recovery by pipelines of take-or-pay costs from their jurisdictional customers. The development of cost allocation procedures and rates for the LDCs are matters to be determined by state regulatory authorities. Order No. 500, III FERC Stats. & Regs., Para. 30,761 at 30,790 (Aug. 14, 1987).

FERC has properly acknowledged our authority to prescribe the design for the rates and charges of jurisdictional gas utilities. Section 1(b) of the Natural Gas Act of 1938 ("NGA"), 15 U.S.C. § 717(b) (1982), and the Hinshaw Amendment, 15 U.S.C. § 717 (c), clearly reserve this area to the regulatory authority of states. The Hinshaw Amendment granted an exemption from federal regulatory jurisdiction to natural gas companies if both the receipt and ultimate consumption of gas occur within a single state, provided the rates, service, and facilities are subject to regulation by a state commission. A certification by a state commission to the FERC that the state is exercising such jurisdiction constitutes conclusive evidence of such regulatory power or jurisdiction. 15 U.S.C. § 717(c).

We have certified to FERC that we regulate one such pipeline - Commonwealth Gas Pipeline Corporation. LDCs are gas companies operating in the local distribution of natural gas. Hence the cases cited by commentators addressing wholesale election power transactions in interstate commerce are inapposite because those cases, unlike the instant case, refer to matters directly affecting wholesale rates which are within the FERC's jurisdiction. Here, the gas companies we regulate are within our jurisdiction under the provisions of the federal law.

Our authority to design rates for our jurisdictional gas companies under the Virginia Constitution, statutes, and case law is unquestioned. As Commonwealth Gas Services, Inc. has observed in its comments at page 16:

Article IX, Section 2 of the Virginia Constitution grants to this Commission the power and charges the Commission with the duty of regulating the rates, charges and services of public utilities within the Commonwealth. Title 56 of the Code of Virginia, dealing with public service companies, and particularly Chapter 10 thereof dealing with heat, light, power, water and other utility companies generally, sets forth the power and authority of the Commission to consider and determine rates, tolls, charges and schedules of public utilities to be just and reasonable and to insure that such rates, tolls, and charges are related to aggregate actual cost incurred by the public utility in servicing its customers. Such rates also are to provide a "fair return on the public utility's rate base used to serve those jurisdictional customers.' § 56-235.2 of the Code of Virginia.

Indeed as the Virginia Supreme Court has observed:

In fixing rates within the limits of what is confiscatory to the utility on the one side, and exorbitant as against the public on the other side . . . there is a reasonably wide area within which the Commission is empowered to exercise its legislative discretion.

Norfolk v. Chesapeake and Potomac Tel. Co. of Va., 192 Va. 292,300 (1951).

III. STATEMENT OF POLICY

The Commission obviously enjoys considerable flexibility under both federal and Virginia statutes to design a mechanism for recovery of take-or-pay liability. Review of the comments demonstrates that all of the policy alternatives have associated problems which must be addressed.

One of the approaches under consideration was the cumulative deficiency methodology to allocate costs associated with the take-or-pay liabilities. We are compelled to find that the cumulative deficiency methodology should be rejected for LDCs. As virtually every LDC that participated in this proceeding has noted, such a methodology would be impossible to administer given the diversity of respective LDC customer populations.

Further, we reject the second policy alternative-allocation of costs associated with the fixed surcharges to both firm and interruptible gas commodity costs. This policy could have a deleterious effect on an LDC's ability to retain interruptible customer loads. As the WGL Companies' comments have observed, any surcharge affecting the rate charged to interruptible customers would probably make that rate less attractive vis-a-vis other fuels. Imposing additional take-or-pay expenses on interruptible customers would, for example, force the WGL Companies to experience reductions in margins on their interruptible sales. Reduced margins are directly absorbed by utilities outside of a rate case. In view of the large percentage of take-or-pay exposure already included in FERC-approved surcharges, additional charges in interruptible rates will inappropriately reduce WGL and other utilities' margins. WGL Comments at 13-14.

The third methodology is, in our opinion, inappropriate because, as VNG and other commentators have noted, it too will severely constrain the relative ability of Virginia LDCs to compete with alternate fuels. To the extent that Virginia utilities must depend on industrial loads for a large percentage of their operating revenues, both the financial viability of these companies and the stability of the base gas rates charged to their firm customers may be jeopardized by the adoption of this policy alternative.

After review of this record, we are compelled to find that option 1 is the most appropriate course of action. While no one option under consideration allocates costs in a completely equitable manner, this approach has the advantages of being easy to administer and assuring complete recovery of take-or-pay related costs. In addition, this approach will not unduly complicate the efforts of Virginia utilities to compete with alternate fuels.

Additionally, a slightly different tack must be taken as to the division of take-or-pay costs for LDCs serving multiple jurisdictions, e.g., WGL. As to these companies, a cumulative deficiency approach must be used to split the Virginia jurisdictional portion of take-or-pay costs out of the total company costs. Once these costs have been identified, then the jurisdictional company may proceed to recover the identified jurisdictional portion of these costs through its PGA.

Finally, we find that the record supports treating Commonwealth Gas Pipeline as a unique entity. As virtually every party to this proceeding has noted, Pipeline is unique by virtue of, among other things, its limited customer pool and the extremely high percentage of its gas costs which are take-or-pay related. Pipeline's limited number of customers allows a more precise measurement of the benefits associated with take-or-pay. Additionally, Pipeline's unique circumstances provide for a better identification of the causes of take-or-pay liability. Consequently we find that Pipeline should be permitted to develop a mechanism for recovery of its take-or-pay related costs separate and distinct from the policy established herein for LCDs. Its recovery mechanism should reflect the historic as well as the prospective benefits derived from gas purchasing practices which have increased take-or-pay liability. In developing this recovery mechanism, we encourage Pipeline to work actively with its customers. Should Pipeline and its customers be unable to reach agreement with regard to a recovery of the take-or-pay costs in an expeditious manner, this Commission will not hesitate to prescribe a recovery mechanism.

Accordingly, IT IS ORDERED that all jurisdictional gas distribution utilities may recover the fixed demand charges associated with take-or-pay liability and contract reformation through their purchase gas adjustment clauses. It is further Ordered that Pipeline shall forthwith file tariffs complying with the principles identified above with regard to take-or-pay liability. It is finally Ordered that there being nothing further to be done herein, this matter is hereby dismissed.

Lacy, COMMISSIONER, concurring in part and dissenting in part:

For the last two years Virginia natural gas companies and customers have been anticipating the flow-down of costs associated with the buy-out or buy-down of take-or-pay contracts. During that time, we have examined the legality, practicality, and fairness of the available options for recovery of these costs. While no solution is ideal, all involved do agree that these costs are transitional in nature and must be resolved before the natural gas industry can realize its market potential.

The cost recovery mechanism chosen by the majority, automatic recovery through the PGA clause, while the least complex to administer, does not reflect a fair allocation of cost recovery. I believe recovering take-or-pay acquisition costs from a broader customer base, including sales, transportation, and interruptible customers, lessens the financial burden to any one class of customer and more accurately reflects a philosophy that responsibility for these costs cannot be assigned to any one segment of the industry. In my opinion, such a mechanism, combined with the flexibility for each local gas distribution company to justify some variant or modification to allow continued competitive operations, while administratively more complex than the PGA, represents a reasonable and more equitable resolution to this difficult but transitional situation.

I concur with the majority holding regarding take-or-pay related costs for Commonwealth Gas Pipeline.

¹Regulation of Natural Gas Pipelines After Partial Well head Decontrol, Docket No. RM87-34-000, III FERC Stats. & Regs., Paragraph 30,761 (Order No. 500) (hereafter Order No. 500).

Historical Notes

Derived from Case No. PUE880028, eff. September 27, 1988.

Statutory Authority

§§ 56-234, 56-235.1, 56-235.2 and 56-247 of the Code of Virginia.