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Frodo's Physics and by Roger Feldman -- Bingham, Dana L.L.P. As smoke from the Twin Towers continued to drift over New In addition, there is the fact of its intellectual fallout: the credibility of the concept of competitive markets and deregulation, so beloved of Skilling and Lay, lies under a cloud. Were these wizards simply figuratively forging the Tolkienesque evil "one ring to hold them in the dark and bind them": the regulatory conceptual bond to ensnare the equally gullible and greedy worlds of prehistoric utilities and intellectually hyperintense academics? Our Frodo, the FERC, now seeks to carry the ring of market power – revealed in California as radiating potential harm resulting from all too ready grant of market-based rates (MBRs) – to a new crucible of economic reason shaped by the price spike experiences in the Midwest and California. That crucible, the market-based rates investigation order (EL01-118-000), requires in relevant part the inclusion of the following language in all market-based tariffs: "As a condition of obtaining and retaining market based rates authority, the seller is prohibited from engaging in anticompetitive behavior or the exercise of market power. The seller’s competitive rate authority is subject to refunds or other remedies as may be appropriate to address any anticompetitive behavior or exercise of market power." A review of the comments FERC has received reveals, however, that our Frodo is like a physicist seeking to apply Newtonian laws of supply and demand economics/physics to a market long since known to be in constant flux under the governance of uncertainty principles. Three aspects of this flaw in Frodonian analysis are: its treatment of time; the certainty of physical location in the time/space continuum; and the effect of pro-active observation on observed phenomena. (1) Time. The fundamental FERC theory of MBR reform is to prevent future bad behavior by attaching an unknown price (i.e., future rate refunds) to current behavior later found to be bad (i.e., existing rates). Those who object to this approach offer not only the legal argument that doing so exceeds FERC’s power under the Federal Power Act, but also the more metaphysical one that governance of future events is best provided by prescriptive rules, advising parties how future events will be governed, and thereafter enforced, once there is violation of those events. (2) Space. FERC would provide, in its newly-promulgated standards, fixed economic definitions of when market power is deemed to be present, based on comparison of the mass of the generator’s capacity versus the peaking supply gap in the market. Imbalance –"physical and economic withholding of supplies" in FERC’s lexicon – is deemed to have occurred when the market price exceeds a supplier’s "full incremental costs." But cost, that seemingly solid rock, is (as one might surmise by analogy from the weary history of PURPA-avoided costs) an elusive fact along the time-space continuum; does it include – and can such pro-posed inclusion be measured – actual costs of providing power, opportunity costs, capital costs, or some amalgam of them all? In addition, how (as well as over what time period) are they to be physically measured? What electron microscope will this our scientific Frodo use? (3) Uncertainty. In an effort to righteously follow market performance and freeze-frame bad behavior in the act, FERC ignores two key variants on Heisenberg’s Law, loosely summarized as the principle that the very fact of observation may impact results. For power markets, the law takes two forms. One variant – a humbling caveat to the would-be deistic ratemaker – was even articulated by the Commission itself: "Every time we intervene in one market, we affect other markets and prevent rather than support the development of efficient, competitive power markets." The other variants, sometimes known – perhaps somewhat un-fairly – as the Gordon Gekko ("Greed is Good") corollaries are: (a) deprivation of the upside potential for market profits ultimately slows investment in markets, which are driven by speculation in the possibility of such upside; and (b) uncertainty as to what regulators will firmly permit, as power sales rates deprives power markets of their ability to serve as capital magnets by reducing certainty as to the investment potential of power projects. In particular, all the petals of the daisy chain of trading can be wilted by one trade being found to be non-MBR in character. In short, Frodo confronts the Enron paradox: a market is sick because of its behavior, but must emulate some of its features or become sicker for failure to do so. Clearly, something must be done. Something really did happen in California that could happen elsewhere. But can Frodo do it while defying the laws of physics, particularly when the capital markets firmly believe they drive financial choices? Perhaps after a full rulemaking in which better-defined guidelines are laid out (notwithstanding that Frodo has drawn his refund/price cap sword already). The haze of Enron scandal pervades the capitol. Can a rulemaking truly be objective and achieve support until that haze is dissipated? There is no law of physics on this point. It is the conundrum known as Gandalf’s Pretzel. 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. |
