Michael A. S. Guth
Risk Management Consulting
Once the chief executive officers (CEOs) of two electric utilities or energy firms have agreed upon terms of a possible merger, they must satisfy the antitrust concerns of state and federal regulators before the merger can be implemented. When reviewing the effects on competition of a proposed horizontal merger (i.e., a merger of two firms that offer the same or similar products on the market), the Federal Energy Regulatory Commission (FERC) uses a delivered price test.
But a CEO can anticipate FERC concerns, and thus respond in advance to the regulators, by examining the same three factors that FERC scrutinizes. First, identify and define all products sold by the merging firms. Second, identify the “destination markets,” which are customers likely to be affected by the merger. The destination markets include all entities directly interconnected to either merger candidate. FERC`s definition of destination markets also includes entities that purchased wholesale electricity from either firm in the past two years. Even though these purchasers may have found alternative sources of supply, so that they are no longer potential purchasers from the merged firm, these purchasers must be listed to gain FERC approval of the merger. Third, identify suppliers that can compete to supply a product produced by the merged firms. The more potential competitors for supply that can be identified, the less concerns FERC will have about market concentration or deleterious effect on competition.
The third item is perhaps the most important of the three broad categories of information that must be supplied to FERC. This item gives the FERC test its name: the delivered price test. A supplier is deemed to be a potential competitor if it has both the physical generating capacity and the financial capacity to deliver power to a destination market at no more than 5 percent above the pre-merger market price. A supplier that meets this condition has passed the delivered price test. The price charged to the destination market and used in the analysis must include wheeling, ancillary services, and other transaction costs.
FERC has long maintained different filing requirements for proposed horizontal versus vertical mergers. In a horizontal merger, FERC is concerned with the lack of competition that might result when the generating plants owned or controlled by two unaffiliated firms come under the control of one single firm as a result of the proposed merger. In a vertical merger, FERC is concerned with market power that can be exerted by a single firm that owns or controls previously unaffiliated businesses that (1) provide inputs to power generation, (2) generate energy products, or (3) purchase or distribute the output of the generation facilities.
In a proposed vertical merger, FERC is looking for signs that the merged entity will be able to reduce or eliminate competition in the upstream or downstream market. On the demand side, competition may be harmed by lowering the prices paid or quantities purchased as inputs. Suppliers of inputs to the generating plants would see their revenues decline as a result of the merger. Raising the prices or lowering the quantities sold as outputs may also harm competition. Other generating plants may find that the merged entity now consumes an increased portion of the power it formerly purchased from a generator, or that the merged entity has decided to redirect its output to another region or industry. Vertical mergers also may permit anticompetitive exchanges of information between an upstream supplier and a former downstream consumer.
Mergers, of course, should be governed by the best interests of the shareholders of the respective firms and the possibility of creating synergies and reducing costs through merger. If it so happens that in a proposed vertical merger the upstream merging firm either (1) sells an input used only in minimal amounts to generate electricity in the downstream geographic market, or (2) sells no input product used in the downstream geographic electricity market, then FERC offers a streamlined vertical screen analysis that customarily leads to approval of the proposed merger.
The ultimate goal of a utility in preparing proposed merger filings for FERC is to show that the proposed merger will not lead to market concentration. FERC Order 592 has specific merger concentration thresholds, which if met, will lead to FERC approval of the merger. Alternatively, if the concentration statistics cannot be computed or otherwise are not applicable to the proposed merger, then the utilities may offer a competitive screen analysis to buttress their argument that the proposed merger will not harm competition.
When the concentration statistics exceed the FERC thresholds, the utilities must generally propose mitigation measures designed to bolster competition. These measures would include establishing a “properly structured” independent system operator, divesting of generating assets, or reforming the transmission tariffs to permit lower-priced sales of electricity (and less recovery of stranded costs per transmission).
During a comment period on its proposed merger analysis rules, FERC received comments from the Edison Electric Institute (EEI), which represents investor-owned utilities, that FERC should adopt a “hypothetical monopolist test” instead of the delivered price test to evaluate a horizontal merger. Both the U.S. Department of Justice and the Federal Trade Commission employ a hypothetical monopolist test. EEI argued that the delivered price approach takes as its starting point the fundamental assumption that sellers of wholesale power can still discriminate among different buyers by charging them different prices. EEI felt that FERC`s open access transmission rules, adopted in FERC Order Nos. 888 and 889, essentially guaranteed nondiscriminatory pricing.
But the national electrical transmission line system is riddled with a lack of capacity and congestion problems. Electricity does not freely flow from regions where the price is cheap to regions where the price is dear. Certainly some power does flow across regions. But the system still contains enough discrepancies in wheeling charges and inadequate transmission line capacity to prevent the realization of a truly competitive electricity market.
Wheeling costs are a particular sore spot. In theory, the transmission line charges are set at reasonable rates by state regulators to permit reasonable recovery of stranded costs and a reasonable rate of return. But in practice, the wheeling costs are becoming so high that they deter firms from shipping power across regions. In virtually every case, utilities that own transmission lines have set their wheeling charges to the maximum rate allowed by regulators, which is good news for their shareholders but bad news for consumers. High wheeling costs also prevent firms outside the region from engaging in arbitrage. Without the mechanism of arbitrage to bring prices across regions into alignment, price discrepancies across electricity products and regions will persist.
FERC already recognized that transmission costs impede economic viability of sources of supply; FERC requires the list of competing suppliers to include only those firms who are economically viable (i.e., can ship power to a region, pay the transmission costs, and still be competitively priced). EEI claimed that FERC`s delivered price test approach fails to recognize arbitrage and thus fails to include potential sellers in the geographic market. In contrast, it could be argued that the impact of rather steep wheeling costs hinders the number of firms who can engage in arbitrage, and thus substantiates antitrust concerns that a merged firm may successfully raise power rates in its region.
The hypothetical monopolist test approach assumes that firms take prices as given, as opposed to selecting the prices they will charge for their output, and looks for situations in which market power may arise. In the absence of price discrimination across regions, each purchaser or destination market would not need to be defined as a separate geographic market. But, as previously mentioned, high wheeling costs and lack of available transmission capacity impede the free flow of electricity across regions. Therefore, the hypothetical monopolist test seems to rest on an unrealistic foundation of competitive price-taking behavior, at least as far as electricity markets could be characterized in 1999.
If one accepts the notion that a generator in North Carolina can move power to upstate New York for small-though not inconsequential-wheeling costs, then suddenly the size and variety of potential competitors increases by tenfold. But FERC merger policy has to be grounded in reality, not a hypothetical frictionless economy with freely flowing electricity across geographic regions. It would be surprising if FERC began its analysis of proposed mergers involving electric utilities by assuming competitive, price-taking behavior in the near term.
Guth may be contacted via e-mail at: email@example.com.