August 2003

Wooden Wall

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2003/09/26)
 

The Maginot Line, built in the 1930s, was to be France’s fortress defense line against any subsequent invasion by barbarians from the East. Its reflected “lessons learned” from World War I that defense, not offense, was key to survival. There were two catches regarding the efficacy of that wall: part of the fortress line was left unbuilt because it was thought unnecessary, since the terrain was impassible; another part was unbuilt because it abutted a neutral nation whose neutrality would naturellement never be compromised by invaders. The terrain wasn’t impassable, the neutral nation was compromisable, and the Third Republic was overrun.

Chairman Wood’s version of the Maginot Line (the “Wooden Wall”) (EL01-118-000), “Order Seeking Comments on Proposed Revisions to Market-Based Tariffs and Rates,” has its roots in the Great California Market War, which occurred at a time when FERC’s promulgation of rules allowing wholesale market-based rates under virtually all circumstances proved no match for the “Fat Boy” bombs that Enron and its gothic trading hordes unleashed on California’s ill-constructed deregulation market design.

After belatedly and laboriously uncovering the skullduggery involved in the California Market War and issuing a series of orders, FERC now is tendering new higher standards and requirements for generator entitlement to receive market-based rates. Availability of market-based rates is a keystone to the operations of the deregulated market. Consequently, FERC has stressed in the Order its need to balance three valid and necessary objectives: remedies for anti-competitive behavior, clear rules of the road, and limitation of regulatory uncertainty. Build it right, says the FERC, and “an environment that will attract much needed capital will come – while the barbarians will be kept from the gates of the self-regulating Republic of Electric Deregulation. The new rules would apply, whether the market was governed by an ISO or an RTO, i.e., with or without full implementation of Standard Market Design.

The FERC Order reflects the new-found understanding that it is not a sufficient defense against anti-competitive behavior to prohibit it generically in an Order and to provide for rights of affected parties to obtain refunds or other remedies. Some precision is required. Without explicating its very significant details, the proposed new Market Behavior Rules (MBRs) are essentially as follows:

1. Operate and schedule all generation in compliance with the applicable power market rules (thereby affording FERC direct remedial authority in that regard).
    

2. No “market manipulation,” defined in terms of a non-exclusive list of non-permissible activities, including the abuses established to have occurred in California. (This MBR is subject, however, to what could become known as the “Maginot Caveat”: “…we will appropriately balance our need to remedy anti-competitive behavior with the legitimate needs of market participants for clear rules.”)
    

3. Accurate and factual communications to all regulators.
    

4. Factual information to publishers of indices.
    

5. Detailed record retention for five (5) years.
    

6. No collusion to violate the Seller’s Code of Conduct or the Order No. 889 standards of conduct.
    

7. Profits unjustly obtained by violations are subject to disgorgement, if sought in a timely manner.

As fully fleshed out, these are not insignificant requirements and, properly enforced, should repel classic Enron invaders along the Wooden Wall.

But alas, The Wall Street Journal reports that the “rare star” of the electricity industry, the Southern Company, has cleverly found a “sweet spot” even larger than the Panzer commandos found in and around the Maginot Line in 1940. As the Journal puts it, “The Atlanta Titan Capitalizes on a Regulatory Quirk, Ties Between Its Units.” Gotterdammerung, y’all.

Basically, Southern’s wholesale affiliate, Southern Power, has been supplying 80% of its new power supplies (at, you guessed it, “market-based rates”) to the Southern Company’s regulated, monopoly retail utilities (which are allowed by state legislators and their regulators to pass through the costs). Southern Power can earn much higher wholesale profit margins than its retail corporate siblings. Shifting assets (such as real estate) at bargain prices to an unregulated affiliate thus may shift higher profit potential as well. Up to now, Southern and Entergy have defended the secrecy of information on their wholesale price power contracts as “trade secrets.” (FERC has now begun to reject that particular argument.)

Put generically, the gap in one party’s defensive line has become the sweet spot favored by the other’s offense. Holy Sarbanes-Oxley Wood man, what is to be done? It all comes down to whether the spirit of deregulation will be preserved by strengthening and clarifying the “market-based rates” rules or, whether absent complete national, wholesale/retail structural deregulation, the existing distinction between regulated and unregulated affiliates is one that will be exploited to produce competitively distorted results.

The treatment of market-based rates is important, because FERC has withdrawn from its forward SMD position. The Market Behavior Regulation (“MBR”) line, therefore, is critical to the preservation of the objectives of deregulation. As the FTC has stated recently:

“When regulatory costs disproportionately disadvantage more efficient firms, higher-cost firms continue to serve the market, and customers are likely to face higher prices than would otherwise prevail.”

Like the Maginot Line before it, the MBR line has been designed in a way that leaves room for its excursion. Whether FERC can plug the gap tenaciously with individual proceedings when there remain structure flaws, as it has begun to do, remains to be seen. 

Gen. Maginot, meet Colonel Wood.

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.