The Triumph of the Regulated Utility Model?

Issue 4 and Volume 89.

by Larry Eisenstat and Richard Lehfeldt, Dickstein Shapiro LLP

The competitive power industry was born in conflict more than 30 years ago, and in conflict it remains. Before 1978, mostly only regulated utilities were permitted to build, own or operate electric generation, distribution or transmission facilities. Then, the question was whether there were too many utilities or whether efficient mergers were possible, given the constraints of the Public Utility Holding Company Act of 1935.

In the early 1980s, Edward Tirello predicted there would be “50 in five”—within five years, mergers and acquisitions would result in only 50 U.S. utilities. Opinions differ on whether he was wrong or 30 years ahead of his time.

Congress through the Public Utility Regulatory Policies Act of 1978 (PURPA) created the competitive generation industry mostly out of whole cloth, although the incumbent industry staved off more comprehensive legislation by persuading Congress to impose size and technology limitations on the new nonutility entrants and by championing the defeat of most transmission-access provisions. Development of PURPA-qualified facilities took off after Three Mile Island when the utility sector stopped developing nuclear plants. And by passing the Fuel Use Act, Congress limited utilities’ ability to develop fossil-fired generation. As a result—and increasingly throughout the 1980s—the competitive power sector gained market share, credibility, experience and attention.

The next boost came via the Energy Policy Act of 1992, which lifted PURPA’s size and technology limits (competitive power developers could build any size or type of power plant they chose) and restored the transmission-access provisions that had been stripped from the National Energy Act of 1978. Soon industry sages began to predict the end of traditional utilities and the emergence of a model in which monopoly utilities would control only the wires and competitive suppliers would own, operate and develop generation.

Reformation did not last long partly because the regulatory apparatus moved too quickly and aggressively in trying to transform the industry to a competitive model, but in much larger part because in 2001 the California wholesale markets went haywire, and Enron vanished shortly thereafter. Regulators stopped further deregulation initiatives. The previously surging competitive generation sector that was intended to compete with regulated plants on the basis of price only fell victim to its members’ being perceived as Enron Lite. The merchant model for developing plants could not work once it became the norm to mitigate sellers’ energy bids when wholesale prices were deemed too high, but not to protect the suppliers’ opportunity to earn a reasonable return via capacity payments where, because they could not take advantage of price spikes, prices were too low for such suppliers to otherwise recover their costs. As a result of this regulatory mismatch, the mammoth project financings of the early 2000s, which were predicated on the stability of forward price curves, all but vanished.

In the past few years the incumbent utility industry has surged back. State commissions, chastened by the Enron collapse and political fallout, gravitated back to the devil they knew and began to approve and rate-base the kind of large capital projects that for many years had primarily become the province of the competitive power industry, or at least subject to some kind of competitive discipline. The latter, by contrast, has been stymied by capital flight and reluctance of independent system operators and regulators to create the conditions that would permit these vast capital projects to be financed. The nation is as unsure about what to build as it is about who should build and under what regulatory model construction should proceed.

A new model has emerged—neither IPP nor traditional utility, but a virtual utility. Virtual utilities are formed most commonly by large, integrated electric power companies (such as MidAmerican, Exelon, NRG and AES) that own one or more traditional utilities and are continuing to develop and trade power to supply their new load. Typically these companies use their generators to provide power to their load-serving utilities and hedge their merchant risks against the more stable returns available from their utility operations.

There is much to recommend, but this model is not the only replacement to the merchant model. Forecasting and planning for a system’s needs at the utility level or more regional level could be supported in most instances by all-source competitive bidding with long-term contracts to enable debt financing. By contrast, long lead time, technically complex, hugely expensive and highly risky capital projects such as new nuclear and clean-coal plants might be better suited to traditional rate-based construction rather than the project finance model.

Informed policy choices regarding regulatory rules are preferable to the repetitive battles before federal and state regulatory bodies. Our nation must move forward, and regulators can no longer postpone decisions about the large capital investments required to meet economic and environmental objectives. It’s time to return to an inclusive approach rather than continue the winner-takes-all slog fest.

Larry Eisenstat is the head of Dickstein Shapiro LLP’s energy practice. Reach him at [email protected] or 202-420-2224.
Richard Lehfeldt is a partner in Dickstein Shapiro LLP’s energy practice. Reach him at [email protected] or 202-420-2215.

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