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Increased FERC Enforcement of Rules Governing Capitalizing of Overhead Expenses for Electric Utilities and Gas Pipelines

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We have recently seen an increase in audits by the Federal Energy Regulatory Commission’s (“FERC”) Office of Enforcement (“OE”) that take issue with the way electric utilities and interstate natural gas pipelines allocate overhead costs to construction projects. These audits have resulted in potentially significant refunds to customers by electric utilities with formula rates. Similarly, we see the increased attention to these rules adding to litigation risk for electric and gas companies with stated rates when they file their next rate case. Therefore, we recommend that entities subject to FERC’s Uniform System of Accounts work to ensure that they are in compliance with the applicable instructions governing the allocation of overhead costs for construction projects and, if not, consider options to avoid future issues.

Entities subject to FERC’s cost accounting rules are generally permitted to record in plant (rate base) accounts both the direct costs of construction (i.e., the “steel in the ground”) and a portion of overhead costs, such as an allocable portion of the salaries of executives, general staff, and other employees and contractors. This allocation is governed, in part, by 18 C.F.R. Part 101, Electric Plant Instruction (“EPI”) No. 4(B), for electric utilities subject to the Federal Power Act, or by 18 C.F.R. Part 201, Gas Plant Instruction (“GPI”) No. 4(B), for gas pipelines subject to the Natural Gas Act. These instructions are identical and require both electric utilities and natural gas companies to allocate relevant overhead costs with a method that is based on either (a) the actual time employees were engaged in construction activities through timecard distributions, when practicable, or (b) when timecard distribution-based allocation is impractical, studies that estimate the time employees have devoted to construction activities (often called a “labor time study” or just a “time study”), which the instructions require to be conducted “periodically.”

Electric utilities and natural gas companies should take proactive steps to ensure their compliance with EPI No. 4(B) or GPI No. 4(B) because there has been a noticeable increase in the enforcement of these instructions. At least seven FERC audit reports in the past five years have taken issue with the methods of overhead allocation used by both electric utilities and natural gas companies. We expect this number to grow. OE’s Division of Audits and Accounting (“DAA”) has publicly stated that they have observed an increase in erroneous overhead allocation methods in audits of both electric utilities and natural gas pipelines. In our experience, when DAA finds a trend in a particular accounting issue, that issue typically becomes a key focus in future audits.

A finding of non-compliance can result in potentially significant refunds by electric utilities to customers with no automatic recourse for cost recovery. Theoretically, an entity directed to pay refunds should be able to recover the refunded overhead costs as expenses (barring a finding of imprudence). But although OE has directed refunds in certain cases, it has not provided a clear path for entities to then recover the “de-capitalized” costs as expenses. Instead, we have typically seen DAA staff tell entities that they may, if they choose, file with the Commission for approval of a regulatory asset to recover these costs post facto. However, these proceedings are often protested by customers, making it more difficult for utilities to recoup the money they have already spent. In addition, we see increased litigation risk for entities when they file a stated rate, as intervenors are likely to investigate compliance with EPI No. 4(B) or GPI No. 4(B) themselves in an effort to reduce the requested rate base.

While electric utilities and natural gas companies should work with their regulatory counsel to ensure that their particular practices comply with EPI No. 4(B) or GPI No. 4(B), there are a few general procedures that we think are especially important for entities to discuss with their regulatory counsel based on recent FERC audit reports. First, all entities should ensure that they maintain documentation for their allocation of overhead costs associated with construction projects. Second, entities utilizing timecard distributions to determine capitalizable costs should ensure both that their employees receive formal training on time reporting and that such trainings are given periodically. Third, entities deploying representative labor time studies should perform these studies periodically, especially following any major corporate changes, such as a large reorganization. Please feel free to contact the attorneys listed below with any questions you may have or if we can assist in any manner.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.