November 2004

Forever Young, Forever Morning After

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2005/01/08)
 

The pattern of purveyors electric energy policy in the past few decades has been to broach a theory based on theoretical economics; to allow it to be torqued by the regulatory process until it emerges theoretically fine, with limited reference to how it will be creatively exploited by entrepreneurs utilizing the financial markets; to glory in the efflorescence of proliferating project developments resulting from the policy; and then to scramble to pick up the pieces when market excesses distort the operational profile of the marketplace. It is a story of forever young, forever morning after. Will the enchantment, forever assuming that policy models can trump creative capitalism.

• So it was with PURPA machines, awarded cost based rates on hockey stick projections, the fatuous export of the privatization model and the morning after assessments of overpriced markets.

• So it was with merchant power plants predicted on phantom sales reflecting dimly foreseen tech driven burgeoning demand, the proliferation of aggressive project leveraging and commitment of trading excess, and the morning after assessments of supply glut, distressed assets and the collapse of merchant power credit ratings.

Comes then the present. The old deregulation initiatives stagger about, confined mostly to high priced blue states that drank the competition nostrum as the solution to high prices while red states lie glutted and strewn with underutilized combined cycle gas plants marginalized by spark spread shifts and the self serving imperious scorn of the lords of the native loads. The cry of  “back to basics” is heard in the land as the roseate glowing prospect of rate basing new assets glimmers is in the eyes of utilities, and their bankers alike. Back to the future; on to the next up growth cycle.

But there is a ghost as this banquet: the rubble of partly finished and non-competitive plants held by lenders; the residue of unwanted facilities held by utilities outside of service territory. For some of these facilities, there seems to be no market clearing price low enough to make their power competitive. And a rogue spirit as well. For an increasingly larger number of facilities there seems to be the prospect of life after “merchant hood” - possession by an increasing number of equity funds, hedge funds or specialty consultant investment groups, counting for profits on a variety of theories - secular upswing on load requirements, market pocket availability; enhancements to value; rebirth after falling off the power contract cliff.

But there is generally one common feature among these buyers; of these facilities; they are not in it for the long run. They have a target return, a possibility of refinancing at a lower capital cost and, above all, a focus on exit strategy when target return can be achieved, generally at a rate (fully leveraged) at least competitive with assets in other industries.

And to whose hands is passage of these assets likely? Increasingly, the prospect is that it will be the traditional utilities, as they move back to basics, flattening the profile for competition, and leaving behind the structures of the old PUHCA rules deemed obsolete in the new competitive market environment. Suddenly the FERC screens for market power, or for allowing market based rates seem candidates for “Ebay” “antique”: inapplicable to the market demands of “willing” buyers for willing sellers. Greater attention is required to market structure issues in this new setting.

Enter the catchup policy conundrum: whether to foster this movement of assets to stronger hands; seek to foster diversity of disposition candidates; limit the competitive portion of acquisitions of the “new resurgents”, who may rate base whatever they bring? Thus, then the reality to which regulators should be seeking to adapt. To assure if not competition, at least consumer protection in the resulting mix of asset transfers. If not a national RPS, at least some incentive to use green technologies. If not new generation capacity, at least enhanced system distribution. In short, regulators need to provide that the “army surplus” of deregulated assets’ which floods the market, is put on by players who in some way are partial toward efficient public service or operations of facilities in a way at least conducive to greater system reliability.

With such large dollars at stake, as well as the competitive profile of new facility entrants able to weather the marketplace. FERC and State regulators face a variation of the challenge which all regulators with “deregulated” industries ultimately face, making sure that depositions of assets; so stronger hands is beneficial through planning incentives and sanctions, to the public interest - which manifestly is unlikely to be the beneficiary of retail competition. It involves paying greater attention to ways in which trading, DG and grid strengthening are brought into play as surrogates for multiple ownership within service territories. It involves more than keeping order among the bottom feeding catfish. It involves the challenge of assuring that the morning after is not just a hangover, as are many other power policy efforts have been. Perhaps a rethinking of how and by whom resources planning should be conducted would throw light on this situation as well.

In short, what is required is a recognition of where the financial markets are likely to take the physical assets they have brought into being who the acquiring parties are likely to be; and what types of guidance and/or protection are reasonable under the circumstances. Time to accept the wisdom gained in earlier ages of reform; to decide what goals policy makers really are in place to protect, and to prevent financial excesses from leading regulation into harmful eddies of boom, bust or gouge. No longer young, but determined to have a sounder morning after.

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.