FERC Incentives for New Transmission Lines May Help Secure Early Financing

Publication November 12, 2015

The recent selection of independent transmission developers to construct new transmission lines as part of plans by grid operators to upgrade has opened opportunities for “non-incumbents” to finance early-stage development of independent transmission projects.

In the past, only the “incumbent” utilities that own the grid were being selected by the regional transmission organizations and independent system operators that manage the grid to construct the additional capacity.

However, recent decisions by the Federal Energy Regulatory Commission eliminated a long-standing right of first refusal for incumbent utilities to construct transmission in their own service territories under a regional transmission plan. This has created a more level playing field for independent developers to construct new transmission, and some independent developers have been selected in recent RTO solicitations.

Incentives

Congress amended the Federal Power Act in 2005 to direct FERC to establish rate-based incentives to promote new investment in electric transmission facilities.

FERC responded with orders that grant incentives in exchange for a showing of additional risks taken and a willingness to grant regional operational control over the new transmission facilities before project siting, permitting and construction have begun. The potential incentives currently available include an incentive-based return on equity, recovery of construction work in progress and pre-commercial expenses, use of a hypothetical capital structure for purposes of rate-of-return calculation, accelerated depreciation, recovery of costs of abandoned facilities, and deferred cost recovery.

The ability to recover the cost of abandoned facilities reduces the risk associated with non-routine projects. These are projects that must be abandoned for reasons beyond the developer’s control. For projects approved by an RTO, an independent developer would recover the costs through access charges that all users of a grid are required to pay.

Typically an applicant for incentive rates will file at FERC for approval of a cost-of-service tariff that would include one or more incentive features that are available under FERC policy.

To succeed, the applicant must meet a two-part test.

Under the first part, referred to by FERC as the “section 219 test,” an applicant must demonstrate that the transmission facilities for which it seeks incentives will improve reliability of the grid or else reduce the delivered cost of power by relieving congestion. FERC established a rebuttable presumption that this standard is met if one of two things is true. The applicant can prove that the transmission project is the product of a fair and open regional planning process that considered and evaluated projects for reliability or congestion. Alternatively, the applicant can show that the project already has construction approval from an appropriate state commission or state siting authority that considered whether the project improves reliability or reduces the cost of delivered power by reducing congestion.

Most applicants try to meet the section 219 test by submitting independent studies of a project’s reliability and economic benefits.

When an applicant asks for incentives for a project that was not approved in a regional or state transmission plan, FERC has conditioned that approval on the project being included in a regional or state plan at a later date.

The second part of the two-part test is referred to by FERC as the “nexus test,” and it requires a demonstration of a link between the incentive sought and the investment being made. Where authorization for multiple incentives is sought, an applicant must explain how the total package of requested incentives is tailored to address the demonstrable risks or challenges faced by the project. Applicants must provide enough evidence to allow FERC to evaluate each element of the package as well as the interrelationship of all elements of the package.

In evaluating whether requests to be able to recover costs if the project is abandoned have met the nexus test, FERC considers how great a risk there is the developer will have to abandon the project for reasons outside its control. FERC has found environmental, regulatory, siting and rights-of-way acquisition to be elements in specific projects that were beyond the reasonable control of the party seeking the incentive. In a notable recent decision, FERC authorized abandonment cost recovery for a minority owner in a planned transmission project on the grounds that, as a minority owner, the applicant had little control over abandonment decisions, and faced unique financing challenges. FERC has declined to authorize incentives where the applicants only cite risks that are not unique to the project, such as a risk that the project will not be approved in a regional plan, or where applicants fail to describe the risks in enough detail to tie them to the particular project.

If a request for incentives is denied, FERC usually allows the applicant to refile with updated information. Further, FERC has indicated a party may seek recovery of abandonment costs in a proceeding under section 205 of the Federal Power Act after a project is abandoned in fact even if the abandonment cost recovery incentive was not granted in advance.

Recovering Costs

Even if abandonment costs are approved for recovery in advance, this does not guarantee the amounts can be added to transmission rates. Following project abandonment, an applicant must demonstrate in a filing under section 205 of the Federal Power Act that the abandonment was beyond its reasonable control and the costs were prudently incurred. It must also propose a reasonable rate and cost allocation method to recover the costs.

FERC generally defers to the business judgement of transmission developers in assessing whether project costs were prudently incurred. For larger abandoned projects or those presenting complex cost allocation issues or where there has been a significant protest or adverse intervention, FERC has set the matter for hearing.

The amortization periods approved by FERC for abandonment costs have been between one and three years.

Lacking customers is not a barrier to receiving authorization to recover costs if the project is abandoned. However, in the case of an independent developer, the question is how it can recover the authorized costs if the project was never built so that there is no service and, thus, there may be no customers from whom to recover the costs.

Some RTOs have taken steps to address how independent developers can recover the costs of abandoned projects within their systems. For example, the California Independent System Operator provides in its tariff that projects selected in the CAISO’s transmission plan, but canceled prior to operation, can recover costs via a transmission access charge that is collected from all users of the system. PJM, the grid operator in the mid-Atlantic states, plans to file tariff revisions addressing abandonment costs by early 2016. In the absence of RTO tariff provisions addressing the abandonment cost allocation, a non-incumbent may propose a cost allocation method in a cost recovery proceeding following project abandonment, but that allocation method would be more open to challenge by stakeholders within the RTO.

Thus, if the transmission investment has been approved as part of a regional transmission plan, and the transmission owner agrees to transfer control over operation of the assets to the RTO, its FERC-approved incentive rates can be included as part of the regional transmission charge of the RTO. The charges would be allocated in some fashion to the users of the RTO or ISO grid. This approach to transmission cost recovery is also used by the ERCOT system in Texas, although it is not regulated by FERC. The extent and manner in which abandonment costs can be recovered may differ among RTOs.

  A significant, unaddressed issue relates to abandonment cost recovery for interregional projects (across two planning regions). Because FERC has suggested that abandonment costs may not be recovered unless a transmission project has transmission customers or unless cost recovery is provided for in a FERC-approved tariff, the abandonment incentive is effectively unavailable for most interregional projects, absent a cost allocation agreement between the planning regions. An exception may be participant-funded, cost-based projects. FERC has authorized that recovery of costs be allowed for such projects, but there is no precedent on how abandonment costs will be allocated if the project is abandoned.

Sufficient for Financing?

A number of developers that have been selected recently by RTOs to build transmission projects have been filing at FERC for transmission rate incentives, including abandonment cost recovery.

Developers have been trying to get lenders interested in providing very early stage development financing based on a FERC authorization to include abandonment cost recovery if the project is cancelled.

Since this project financing would occur at a stage that is earlier than when banks typically lend, it remains to be seen whether this incentive will be strong enough to attract bank debt. Authorization for abandonment cost recovery does not guarantee that abandonment costs can in fact be recovered since the developer would have to demonstrate its entitlement to cost recovery after the fact. As noted, FERC has generally deferred to the developer’s business judgment on whether costs were prudently incurred. Even if the banks will not lend, equity investors may find the prospect of cost recovery enough of a draw, but at higher required returns.

As a final note, incentive rates do not apply to independent transmission developers that are using negotiated, or market-based, rates for their service, since they simply sign bilateral agreements under which FERC does not approve the specific charges.


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