March 2003

Looking Reality In The Face: The Need For A New Approach

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2003/06/14)
 

The current semi-deregulated market structure of the electric utility industry does not appear to be a stable one. Taking into account what is happening in the financial markets, regulatory incentives to preserve market operations until excess generation surpluses are absorbed may be appropriate. Here’s why.

Financial Market Trends

While economists and other policymakers continue to argue the cases for deregulation vs. re-regulation, most recently in the context of SMD and related transmission incentive rates, the demands of the capital markets and responses by corporate planners are pushing events ahead of them. Market pressures for firm cash flow to secure debt may overwhelm considerations as to the long-run benefits to consumers that may result from deregulation. That is why FERC must rapidly re-examine its policies relating to utility transfer of assets from the unregulated to the regulated sector. Its most recent approval of such a transfer by Cinergy Service Inc. (EC 02-113) was hedged with expressions of plans for future policy change. The scope of this policy evaluation should be broadened and accelerated.

About two-thirds of U.S. generation still operates in a cost-of-service, rate-of-return environment. Because there is excess capacity in most of the country, with the exception of a few load pockets, wholesale prices may be expected to be driven down to marginal production costs. Unfortunately, in those circumstances, the fixed cost (including the debt service) of project-financed independent plants are not covered. (By contrast, in the regulated environment, utilities will recover their financing costs as part of their cost of service.) Consequently, there exists a threat to the viability of the bonds of individual merchant projects. While it varies regionally, this analysis is exacerbated by the fact that "spark spread" prospects for future merchant generation also are poor, since gas prices seem likely to increase.

Full-scale restructuring likely will follow in some cases, as banks assess the adequacy of their provisions for bad project debt. Given the resulting pressure on project debt, valuation will necessarily depend on recovery potential for project assets. It seems inevitable that, in some cases, debtholders will find themselves thrust into the role of equity owners, and facing the prospect of having to whip assets into shape so they will be attractive to potential buyers.

Investments in traditional vertically-integrated utilities, on the other hand, generally continue to provide access to solid and respectable (albeit not inspiring) cash flows. Companies holding "unregulated" as well as "traditionally regulated" assets, if they are not seeking to sell them to realize cash, understandably may well seek to withdraw them into the shelter of regulation. In Cinergy’s case, where there also was in-service territory load demand to be met, the latter course had greater feasibility and greater appeal. Cinergy’s competitors focused on the harm this would cause to the competitive environment in which they were operating. It was evidently a situation where affiliate abuse potential was present, because utility ownership and operation had supplanted sales that otherwise would have been subject to Commission scrutiny over cross-subsidization and improper exercise of market power. Opportunities for third parties to serve parent utility load also were necessarily constrained in a way they would not have been if a competitive bid had been held.

While FERC upheld the transaction, because it would neither change the parent’s market share nor charge wholesale rates, it recognized that transactions like this would imbalance the competitive market: franchised utilities would be in a position to create "safety nets" for their IPPs, while independent IPPs would not be able to do so. In short, capital investment could be recovered through rate base, under circumstances where operation of market-based rates was unattractive. Correlatively, prices of those IPPs would not be subject to the discipline of a competitive market. FERC, therefore, announced that it was going to modify its approach "to analyzing competitive effects of intra-corporate transactions of this nature."

However, the foregoing discussion of how the capital markets view the precipitous shift in attractiveness of the FERC-constructed, competition-based markets suggests that a more fundamental consideration of issues beyond "affiliate abuse" is required. That is because:

• The capital markets are rejecting the viability of a market-based rate regime to support financing in the absence of firm bilateral arrangements.
   

• The current and apparently likely future deterioration of the spark spread endangers even existing merchant plants predicated on tolling arrangements.
   

• To preserve their economic viability, efforts by regulated utilities and distressed asset purchasers will focus on obtaining conventional cost-of-service treatment.
   

• To assure continuation of healthy "native load service" (as well as, in some cases, by concerns with their integrated utilities or their own concerns about jurisdiction), state commissions are likely to accommodate those trends.
   

• Under those circumstances, arguments that as a result of retail deregulation there is likely to be a reduction of consumer prices, are unlikely to have the policy weight that it once did.

It may well be time to think about more fundamental accommodation to the financial realities of the power marketplace, rather than simply bulling ahead with reform (SMD) or rolling back to the monopoly-based, service territory cost-of-service system in the now much consolidated utility industry.

A new methodology to formulating a transitional approach that is responsive to the cascade of financial difficulties otherwise facing the industry, but which contemplates no subsidies, loan guaranties or similar arrangements, is necessary. Its elements are these:

• Accept the fact that there are excess reserve margins, which differ by region, that most likely will be worked off over a period of the next few years (depending, of course, on the rate of economic resurgence).
   

• Freeze all movement of generating assets from the unregulated sector to the regulated sector, so long as dispatch is RTO-managed.
   

• Proceed with the efforts to establish workable competitive markets without seams and without native load preference through SMD.
   

• Provide some incentive return to the parent holders of independent generation assets frozen in the competitive market sector that will diminish as current reserve margins are reduced, so long as the corporate parents proceed to implement their RTO obligations.
   

• Afford merchant plants not owned by utility affiliates some parallel rate relief so that they may compete in the deregulated market.

There are shorter-run costs to consumers in doing this, and possibly some comparatively negative impact to existing integrated utilities. There is basically, however, only one alternative: let the market work and pick up the pieces afterward. This would result in a waste of physical capital or financial stability, which the United States will have difficulty sustaining in its current condition. It ultimately would be worse for consumers. We are dealing with a transitional situation that can be addressed by transitional rules. These rules should address the financial realities of today’s markets so that the long-term prospects for deregulation (at least in some regions of the country) can be saved. Otherwise, the unintended consequences of company-by-company and project-by-project workouts may make construction of competitive markets a practical impossibility. In short, it is time for Washington policymakers to look reality in the face and consider radical, new industry-encompassing approaches.

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.