June 2003

"SMDWhite (Flag) Paper Caper"

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2003/08/11)
 

When a "standard design" for the powerhouse is redesignated a "platform," it is a good indication that a political tornado has blown its roof off. Its chances of implementation must be questioned when even the revised paper’s issuance is not enough to deter the Senate Energy and Natural Resources Committee to vote to remand SMD to FERC and gag FERC’s issuance of orders until July 2005. It is understandable that there should be the resonance of a tinny arf to the Chairman’s reassurances.

What does FERC’s migration from White Paper to White Flag mean for the economic future of merchant and independent power, and the markets’ evaluation of existing power assets and companies? Remember – this is the same SMD that Standard & Poors recently explicitly asserted was critical to the resuscitation of the merchant power market.

Most of the analyses of the problems of the merchant power industry today boil down to identification of regional power supply-demand imbalances, breakdown of the market trading mechanism, flaws in local market design, and physical insufficiency of the grid to permit the type of trading that would reward new, more efficient units. The impact of all of these factors was multiplied by excesses in the financing of merchant companies and merchant plants, which now have created the overhanging ledge of necessary project refinancing and teetering distressed assets that, as likely as not, will bring new classes of equity investors into the market.

The original concept of SMD was to restore confidence in the deregulated model by remedying the flaws that experience with Order No. 2000 had highlighted, and by building out the framework for innovative development of the transmission system. In the process of doing this, since it involved change in the way the utility business was run and therefore overseen, a greater degree of Federal centralization was deemed necessary. That centralization appears to have been damaged permanently.

Consequently, in evaluating the practical ramifications of the FERC Wholesale "power platform" White Flag, the most important question is how the absence of its centralization will affect the real world financial situation which the capital markets face today. Response requires delineation of how the power markets would look if the platform was implemented as written, and consideration of how it would address the financial issues presented.

Broadly speaking (and subject to much technical clarification), the marketplace would have the following characteristics:

• There will be ISOs and RTOs (not necessarily of appropriate geographic size), administering transmission and creation of spot markets to meet real-time energy needs, but not having the broad, regional system management authority that FERC originally had envisaged. Vertically-integrated companies may be members.
   

• State jurisdiction will be preserved, in particular, over matters such as bundled transmission rates, determination of resource adequacy, protection of native load customers’ transmission rights, availability of FTRs in support of congestion pricing, and the setting of the form and charges of access fees. Congestion management will not be required to include LMP. Regional state committees will emerge as important players, determining regional power adequacy, to what extent participant-funding transmission development will be possible, and effecting intra-state coordination.
   

• Market monitoring will be conducted by RTO/ISO independent market monitors – which will report both to FERC and to regional and state authorities.
   

• The White Flag recognizes - but does not suggest how, in the future:

"Market mitigation measures must work together with measure on resource."

How useful will this "platform" be in responding to the issues facing the industry? The more probable answers are the following:

• Management of transmission and dispatch will become more regularized. However, such management will not be homogenous or likely, by itself, to advance the cause of interregional power sales or disparities of reserve margins between regions. Regional power marketing may be enhanced, but the "seams" issues could be as pronounced as ever. The role of state commissions and regional bodies in setting future rules may cloud the rate of future transmission development.
   

• There will be less upheaval in the patterns of operation of the current transmission system environment, as native load market rights will be protected. It is possible that the extent to which new transmission is developed will be impeded, as issues for responsibility for payment are disputed.
   

• Those with current market power (including integrated utilities) are more likely to withstand assaults on their existing position as transmission suppliers, and to effectively preserve that market power.

From the perspective of merchant power developers, therefore, the following conclusions are likely:

• While the market will continue to move toward the type of structure that merchant plant developers desire, their ability to mitigate or overcome entrenched market power seems likely to be reduced, rather than enhanced.
   

• It is possible that the cutback in SMD will contribute to interest in those companies where re-regulation has taken hold or simply never left. Those assets that are capable of earning a return within the framework of regulated utilities may become more attractive.
   

• As perception of the market as supporting significant new upside potential through trading diminishes, the types of investors likely to remain active are more likely to be those with lower IRR expectations, greater comfort with a more traditional regulatory environment, or high interest in leveraging stable cash flows. This could impair the prospects for fresh money becoming available to deal with problems in the merchant markets that already have developed.
   

• The prospects for more stable commodity trading of power will be enhanced, but resurgence of the model of developing of assets for purposes of trading around them is likely to be diminished.
   

• The prospects for new transmission development will be enhanced by the ongoing FERC role, but diminished by the extent to which future decisions affecting transmission will be made at the state and regional level.
   

• Just to realize the expectations of the compromised White Flag will require not only existing institution building (RTO/ISO) to continue, but also a whole new complex of state and regional collaborative institutions also will have to be developed.

In sum, a period of not expecting too much change in favor of the independent and merchant players, and a solidification of the position of well-capitalized, service territory-based, integrated or partially-integrated utilities is to be expected. The capital market situation may emerge in which large surviving players are best positioned to take advantage of a more orderly RTO/ISO world where, while management of wholesale operations and trading are improved, incumbency in a given service territory is the trump card. The best financing mechanisms available for remaining independents and merchant facilities may be for plants whose projected output is discounted in value to modest commodity levels and backed by third party credit enhancements.

Before the industry and the financial community salute the new White Flag that FERC has hoisted, it may be time to offer new creative alternatives, e.g., transitional incentive structures that enhance the likelihood that there will be a deregulated industry of consequence after the shakeout of the next year is completed. Otherwise the White Paper caper will have yielded merchants’ floor prices and a shaky platform.

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.