September 2005

Storm Winds of 2005

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2005/10/14)
 

The future of merchant power depends on where capital will flow in the future. Presently capital — from new sources including hedge funds, private equity and other special purpose funds — has been directed to the trading of existing assets, not the development of new facilities. As these plants age, and their contracts expire, those existing assets become “merchant” in their own right. So too do distressed assets emerging from Chapter 11. The regulatory environment for them becomes even more pertinent.

Evaluation of the Energy Policy Act of 2005 therefore requires comprehending the entirety of the Energy Policy Act of 2005. That’s why the run-down which follows of the Act is entirely pertinent to all players in the development or the resuscitation of the merchant power industry.

Viewed from the perspective of impact on capital flows into the utility industry, significant provisions of the Energy Policy Act of 2005 (“Energy Policy Act”) may be grouped into four basic categories:

1. Those provisions liberalizing the ability of parties to innovate in their purchase and sale of market assets.
 
2. Those affecting the predictability of regulatory treatment of the industry.

3. Those opening or closing new capital outlets for investors or potential investors in the power industry or related energy areas.
 
4. Those possibly diverting capital investments to nearer term opportunities in the energy field.

Here is a brief rundown of conclusions on each of these issues and a brief summary of the Act’s provisions which support them. In the course of the next two days, it will be informative to get the panelists’ views on this characterization and evaluation of the Act.

INNOVATION-PURCHASE & SALE
1. The repeal of PUHCA, even though accompanied by redelegation of certain reduced authority to FERC and preservation of residual state authorities should enlarge the marketplace for new non-utility investors; contribute to consolidation of utility companies and will place pressure on traditional IPP ownership models of entities. This will be facilitated by the Act’s partial streamlining of the merger approval process.

PUHCA REPEAL
* Title XII, §§1261-1277 of the Act repeals PUHCA, which provided for, among other matters, SEC advance approval for acquisitions creating holding companies (10% ownership or more); holding company securities issuances; intercorporate transactions; and multistate or geographically discontinuous ownership of assets. The Act effectively limited third party, e.g., private equity, managerial control of utilities and placed limits on the non-utility business activities of foreign acquirers. To be substituted within four months of the Act is FERC (and state) review of books and records related to rulemaking and regulation of certain transactions among holding company affiliates. FERC now also has regulatory authority for review of holding company system overhead and cost allocations. Note, however, that the Act does not repeal state authority over acquisitions, nor the merger review authority of FERC, DOJ and the NRC, where applicable.

MERGER REVIEW
* Since a key element in FERC “public interest factor” review (as well as DOJ and FTC) is the competitive impact of the merger, proposed mergers of utilities of the same geographic market will continue to be examined for adverse impacts. Specifically, Federal Power Act § 203 remains in place, as amended by Act § 1289 merger review provisions. Key streamlining features of this review are: contemplated in the act, required FERC adoption of procedures for expedited consideration of applications. (Actions not acted on in 360 days are deemed granted).

* Under the Act, however, there is broad expansion of the types of transactions over which FERC would have jurisdiction. Sale of generation assets only (even without transmission or other “jurisdictional assets”) is now to be included within FERC purview, if the generation assets are used in interstate sales; as are mergers of (a) holding companies and transmitting companies now subject to FERC jurisdiction; (b) utility - non-utility subsidies and (c) cross encumbrances of assets.

PREDICTABILITY OF REGULATORY TREATMENT
2. The basic emphasis of the Act is on creation of a more reliable grid, in which efficient dispatch has been bolstered, although not enshrined in a single standard market design. Efforts to improve the transparency of the trading markets and preclude their manipulation are enhanced. While open access continues to be supported as general matter and expanded to other grid participants, the effective gutting of PURPA and absence of other “wedge” measures for non-utilities to capture utility credit suggests a further force for centralization of control of the utility industry. Optionality value of investments will have to be assessed with this consideration in mind.

BULK POWER RATIONALIZATION
* The other primary thrust of Title VII is to further facilitate the rationalization of the bulk power system, although not in the fully detailed manner contemplated by Standard Market Design. The key element under §1221 is the certification of an Electric Reliability Organization (ERO) to develop reliability standards which may be enforced by the, Commission, ISOs or RTOs as designated. Re-enforcement is provided for FERC’s authority to assure non-discriminatory access not only to IOU but also to non-regulated transmitting utilities under §1231. (PMAs and TVA are now also authorized to participate in RTOs).

NATIVE LOAD PROTECTION
* Importantly, however, under §1233 the rights of load serving entities to protect their ability to provide firm transmission service to “native load” on a priority basis is protected. Retail utilities thereby are enabled to afford themselves preferential transmission access to serve their “own retail customers.”

PURPA REDUCTION
* Reflecting a similar Congressional inclination to bolster the transmission system but reduce the extent of non-utility players in it. Subtitle E §§ 1251-1254 amends PURPA in a manner which, in effect, guts the requirement of compulsory “must buy” utility purchases and utility “must sell” provisions which enabled QFs to optimize their power export capability. These capabilities in particular provided a basis for the “QF” industry which has existed since the ‘80s. The “must buy” requirement only applies if a regional market is not “competitively workable” - a subject for dispute outside of RTO regions. (It does not undercut state utility required purchase standards for renewables.) The definition of qualified “cogeneration” has been shrunk to basically limit the use of cogeneration to the non-utility marketplace, while expanding utility ownership.

IMPROVEMENT OF TRADING MARKETS
* Markets using the grid are to be strengthened, FERC is directed by §§ 1281, 1282 to enhance the power trading market by strengthening its oversight and governance of abuses. Price transparency will be actively facilitated by FERC, including the issuance of rules for the dissemination of information about the availability and prices of wholesale electric energy and transmission service. Injunctions may be obtained against persons engaged in market manipulation. Rules to prohibit the filing of false information and the use of “any manipulative or deceptive device or contrivance” will be published. FERC is also directed to enter an MOU with the CFTC.

POWER INDUSTRY INVESTMENT-TRANSMISSIONS
3. The power industry activity to which most incentives for innovation is given is transmission — both for investment and development of new companies. In addition, the incentives for clean coal and nuclear facilities may have a longer term influence on the market. Analogously, the regulatory incentives for LNG should both attract further capital to this sector and storage, but also may provide needed support for large non-distributed sources of generation.

TRANSMISSION
* The primary focus in Article VII Subtitle D on “Transmission Rate Reform” is capital creation within the electric power industry is transmission. Incentive-based ratemaking for transmission facilities is specifically authorized to encourage investment and participant funding plans (even by non-RTO members). There is also to be encouragement of deployment of advanced transmission technologies. Taken together with the PUHCA provisions permitting freer asset transfer, the possibilities for ITC creation are enhanced.

* Possibly also facilitating development of transmission is an effort to emulate the right-of-way siting authority which FERC has exercised with respect to interstate gas pipelines (backed by eminent domain authority). The DOE is required to designate “national interest electric corridors” in areas with capacity constraints or congestion. Where states do not authorize or otherwise impair project development, a procedure for Federal eminent domain and “just compensation” — is provided. It may or may not be sufficient to deal with all the permitting requirements presented at the Federal and state levels.

CAPITAL DIVERSIONS
4. A significant proportion of the Energy Policy Act tax incentive program as well as loans, grants, loan guarantees, and research & development grants are directed toward renewable electric energy technology including biofuels. Analogous incentives are directed toward coal-based alternative liquid and gaseous fuels. Some capital otherwise directed to utility finance seems likely to be diverted in those directions — particularly where the financial credit of utilities or refiners can be captured in structured deals as a result of Act incentives. Other high tech loan guarantees and R&D incentive programs seem less likely to have near term private capital diversion potential.

* Of greatest potentially greatest significance in terms of capital market diversion from traditional utility assets are the tax incentives provided for different types of renewable energy resources, notably Production Tax Credit for power production from specified qualified energy resources. Title XIII extended the availability of these credits through 2007; enlarged the list of Qualified Energy Facilities and extended the term of the credits for certain of these resources to 10 years. The non-refundable PTC is as much as 1.9 cents per kilowatt hour.

Merchants and other transitional assets must be acute to catch the winds of change which the Energy Policy represent. The Energy Policy Act can be a helpful gust or a storm warning.

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.