October 2001

Wagon Train

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2001/01/19)

As the power buckboard rides faster and faster into the new frontier of deregulation, the local marshals are taking a worried look at whether the wheels of the wagon are sound.

It looks like the buggy may get jacked up for repair soon. It’s no less important a matter than getting deregulation fixed so that there is no rationale for return to re-regulation further down the trail.

At the core of electric industry restructuring is the availability of market-based rates (MBR) for new power generation. What PURPA did for IPPs, MBR does in significant measure for merchant generation in growth markets.

While MBR is not granted without FERC review, the standards have proved to be readily met. Briefly, these include either no ownership of transmission, or no anti-competitive control over transmission, with control most notably mitigated through open access transmission tariffs; showing of no affiliate abuse or reciprocal dealing with parent entities; and the absence or mitigation of market power in generation.

Essentially the same rules apply with respect to the rates for acquired divested utility generation: MBR authorization is usually sought by asset buyers, and is often granted on the same terms as MBR authority for new generation, with particular attention to market power issues. 

This last issue has in the past been resolved by the commission through the folksy application of “hub-andspoke” analysis, i.e. measurement of relevant market shares in both installed capacity and uncommitted capacity, relative to particular point-to-point service. This is approximately the test for separate wagon service on a series of separate roads, each considered independently of all the other adjacent roads and wagon traffic that a late 19th century bronco trust buster might apply. Not surprisingly, there have been fewer than 10 MBR rejections out of over 800 MBR applications. FERC tacitly acknowledges that in its regulations the hub-and-spoke test is so likely to be satisfied that, since 1996, most new generators have been almost automatically entitled to MBR treatment and need not even show the marshal how their hub-and-spoke road will carry wagons.

This was, of course, the idea: the MBR hub-andspoke test was supposed to be a step toward competitive “deregulation.” It was supposed to both promote the blooming of a thousand private power-pumping flowers and lever open the integrated generation-transmission systems of vertical utilities. The approach certainly has begun to work – with just one drawback wildly demonstrated in California. It is possible to have ferocious consumer-painful price swings in an economically competitive market (at least from a hub and- spoke MBR standpoint) due to the way that market is regulatorily structured, since market power can be exercised by some players at least at some times with respect to their plants. It’s hard to ignore the evidence of the California experience. It’s also hard to structure a better MBR mousetrap for anti-competitiveness. But that’s going to happen soon, as current thinking about market structure and about appropriate competitive screens to determine market competitiveness rise higher and higher in the FERC’s consciousness.

The last trail marker, before this new policy perspective is enacted, may be Huntington Beach Development LLC (FERC Docket No. ER01-2390-000), involving the MBR application to FERC of facilities restored by AES to provide additional capacity to power starving Southern California. Seeking cost-based rates as the only measure for what is “just and reasonable” under Federal law (“re-regulation” in today’s jargon), the California Commission sought to resist, alleging that applicable affected markets had not been demonstrated to be “workably competitive” nor AES to have shown that it lacked market power, in light of its ownership of multiple facilities in the region.

To which the Commission (then in transition to its current make-up), coyly and cryptically allowed that – in its florid mating ritual with California market realities – it was “not prepared to abandon the hub-and-spoke analysis in favor of another market analysis framework.” The rationale: the temporary market mitigation measures ultimately established by FERC in response to the California crisis (caps to you and me) would put the Huntington facility’s rates within the newly-sanctioned “zone of reasonableness.” The probable pragmatic rationale: we need more generation in California and won’t get it if only cost-of-service rates are made available. Of course, the FERC market mitigation measures will expire in 2002, leaving both regulatory “reasonableness” and appropriate MBRs for services after that expiring rate limbo.

But while Huntington served as a stopgap answer to a then pending problem, the concurring opinions in the case point the direction to where the Commission’s focus probably will be heading. Commissioner Massey, in dissent, derided the hub-and-spoke standard as “anachronistic and unreliable,” and mocked the Commission’s suggestion that the new quarterly filing requirements provided (or even were intended by FERC to provide) satisfactory monitoring capability. Then newlyappointed Commissioner Brownell, in her concurrence, articulated what is likely to be the Commission’s new focus: “Experience indicates that a methodology that not only looks at individual market shares, but also examines the market itself, would be a far superior method.” What the new methodology or methodologies adopted by FERC may be currently is problematic. The Commission is still reviewing staff reports on the issue at press time. But as Commissioner Brownell emphasized, it will likely tie into assessment of the larger overall market characteristics, including attention to enhanced regulatory market monitoring and enforcement policies. “The market” may come to be the proposed new RTO regions. In short, in the near term, given regulatory uncertainties, it could be tougher to get MBRs. In the long term, in legal principle, existing MBRs could be subject to new challenge, up to and including the cancellation by FERC of MBRs and the imposition of cost-based rates.

Which creates the following paradox: the current system really doesn’t address de facto market power.

If care is not taken, however, the new standard could be tied to the possibly utopian market regulatory models the Commission is now engrafting onto its RTO policy. Those may take a while to actually implement. Even then, if care is not taken, policies could be instituted which do not serve to address the root of much de facto market power – insufficient transmission infrastructure and inadequate attention to congestion pricing issues. In effect, if care is not taken, the effort to better open markets to competition could create barriers to the very development it sought to encourage.

So, we should all watch carefully this wagon train meander on as its wheels turn, trusting neither to its antique hubs and spokes nor yet to the vagaries of promised virtual and perpetual motion arising from new complex market tests.

ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon Markets Group has practiced law related to the finance of environmental and energy projects and companies for 40 years.  In particular, he has analyzed and executed a wide variety and substantial value of project financings.  He chairs the American Bar Association’s Committee on Carbon Trading and Finance, serves on the Board of the American Council for Renewable Energy, and has been a senior official in the Federal Energy Administration.  He is a graduate of Brown University, Yale Law School and Harvard Business School.