April 2003

Carrot Upside-Down Cake

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

The debate over how to accelerate the development of needed transmission assets, brought to the forefront by FERC’s Docket PL03-1-000, is proving to be yet another round of the fundamental regulatory debate of the decade: the "Structuralists" vs. the "Incentivists." FERC unwittingly has managed to plant a foot firmly and ineffectively in each camp. The result is that resolution of the real core policy issue of the decade – allocation of capital between regulated and unregulated assets – is being muddied.

Some definitions first. Incentivists believe that if more of something is desired from capitalists, the dots are connected by offering them a higher return for it. Structuralists believe that properly constructed and operating markets will elicit socially desirable responses from capitalists in a more efficient way. To characterize the debate as carrot vs. stick ideology is oversimplification; but it points in the right direction.

An Incentivist would view the transmission shortfall as a consequence of the breakdown of the connection between regulation and desired capital allocation. When overspending on generation capacity – whether from plant cost overruns or excessive demand estimates – outstripped need, it was effectively greeted with return disallowances and insufficient rates of return. No return on regulated assets resulted in fewer regulated assets being constructed and a decline in transmission expenditure. Further, better returns in the late ‘90s on deregulated assets than on price return, capped regulated assets and produced a flight from reliance on regulated assets in rate base to provide needed profits. Whence distinguished analyst Leonard Hyman’s assessment of where we are today:

That some financially imprudent transmission owners also were cash strapped because of the follies of unbridled deregulation, only served to exacerbate the looming transmission finance gap. Hyman’s forecast result is an Incentivist regulatory solution to the problem: massive filings for rate increases to cover the costs of new capital to cover the cost of higher spending to maintain reliability.

Itself somewhat influenced by Incentivist philosophy for the first time in PL03-1-000, FERC opted for the grant of incentive rates, in part, simply for the investment in needed additional assets, i.e., a generic 100 basis-point allowance would be set aside for the treatment of investment in new transmission facilities determined to be needed by the RTO planning process (including operational enhancements to transmission capacity for the grid).

But FERC, of course, still remains Structuralist at heart. Its strongest impulse is to foster RTO organization as the core of achieving the SMD philosophy, articulated in Order No. 2000. Hence, it proposed grants of 50 basis points on ROE for entities that transfer operational control of their facilities to RTOs. Moreover, FERC is a believer that another kind of structured entity within the RTO – the ITC – is most likely to engage in socially desirable, new transmission development. The proposed rule’s provision is that if an ITC participates in an RTO and meets the independent ownership requirement, it would qualify for an additional incentive equivalent to 150 basis points. Thus, FERC’s implicit motto – if you build it right, the goods will come from them (even if it must be on the back of regulated assets). Taken altogether, FERC is offering quite a carrot cake.

Deregulation’s true believers want to carry FERC’s logic further. They want FERC, now that it has swallowed the basic Incentivist approach, to go whole hog for its application to promotion of Standard Market Design. In their view, the incentives should only be fully available to RTOs or ITCs when LMP Congestion Revenue Rights (CRRs) and forward financial markets have been fully implemented by an RTO. In short, Incentivism should be put in the service of structuralism – asset results come later.

The result for Structuralists is to be feared: "once you pay more, you get more" becomes the regulator’s mantra. It is but a short step to asking: "You want more governance or just more goods?" The road to re-regulation may be paved with Incentivist intentions on the part of Structuralists. If the RTO process is enlisted in recognizing the full range of potential supply and demand solutions, e.g., installing generation rather than transmission, as deregulation activists demand. It may be all that will happen is freezing of the current partially regulated/partially deregulated system. Different capitalists will make different judgments as to where return will be best – regulated or on an incentivized deregulated basis.

Instead of trying to remedy all problems with an Incentivist brush as to transmission, FERC should have the courage of its Structuralist convictions and confine itself to monetary rewards for physical performance, not market design conformity. The road to re-regulation is paved with flawed incentives. Carrot-style regulation can produce carrot upside-down cake.

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.