taking it into account consolidation should advance local and regional interests

Former Federal Energy Regulatory Commission Chair James Hoecker recently pointed to stalled federal efforts to standardize the design of energy market operation, efforts resisted by the “centrifugal forces” of jealously guarded state and local controls, territorial boundaries, and disparate market rules. He joined in the chorus that was predicting that the next iteration of the power industry would be driven not by “sweeping regulatory initiative, but from consolidation of utilities.” According to that chorus, utility growth strategies, no longer cabined by the 1935 version of the Public Utility Holding Company Act, will singularly determine how the power industry looks and operates in coming years. Is this prognostication on target? If so, does it portend a future that politicians, regulators and their consumer constituents should embrace?

Mr. Hoecker’s regulatory successors have confirmed his first observation. Current FERC regulators have clearly abandoned, at least for now, any pretensions to changing the design or organization of the power industry. In a recent rulemaking intended to reform the open access transmission rules and tariff that the agency adopted a decade ago, FERC and its current chair Joe Kelliher were at conspicuous pains to disclaim FERC’s earlier proposed and much-maligned standard market design proposal as well as its former insistence that operational control (if not ownership) of transmission systems be surrendered to independent regional operators. While that rulemaking goes on to propose discrete improvements to the open access rules and tariff (salutary adjustments that will make the operation of power markets more transparent), it does not lead the power industry boldly or otherwise in any particular direction.

Does FERC’s new-found reticence, coupled with Congress’ repeal of the ’35 Act, surrender the field such that earnings growth strategies through mergers, roll ups, acquisitions and other consolidations alone will set the industry’s future course and determine its structure? Without political interference or regulatory demands, many utility managements could be expected to pursue a bigger-is-better mindset and welcome that eventuality. But recent evidence suggests that state and local interests have not surrendered the field. To the contrary, they appear increasingly restive, opposing certain consolidations or, more likely, conditioning their acquiescence on concessions by the consolidating utilities. An active role for these local interests is precisely what Congress had in mind when it replaced the ’35 Act with a federally enforceable right to access holding company books and records. The concessions demanded can be directed at achieving some of the objectives of FERC’s now-abandoned market design and market structure objectives; alternatively, they may implement more localized policy objectives of the states involved, such as improved reliability, pollution controls, and achieving renewable portfolio standards.

Cases in point abound. One year ago in this column I wrote about hunting utility earnings in mergers and acquisitions. Among other deals, I pointed to the proposed Exelon stock acquisition of PSEG. Little did I expect that that acquisition would still be on the drawing board one year later, having finally secured the sign-off of the antitrust division of the Department of Justice in exchange for divesting six power plants with a combined capacity of 5,600 MW, but still in need of the imprimatur of a skeptical New Jersey Department of Public Utilities. A majority of Garden State Assembly members recently voted for a resolution calling on the DPU to reject the merger. Whether the resolution is actually intended to prevent the acquisition or, more likely, urge the DPU to demand a greater share of the savings and profits expected to flow from the consolidation, is debatable.

Mergers and acquisitions that have recently concluded also illustrate the increasingly assertive role of state lawmakers and regulators. Regulators and consumer advocates in some of the states hosting the operating utilities of PacifiCorp challenged MidAmerican Energy Holding Company’s acquisition of PacifiCorp from ScottishPower. When the dust settled, the acquisition was approved by all affected jurisdictions, but only after MidAmerican agreed to grant a $140 million rate credit, construct extensive transmission upgrades, and invest in new pollution controls and 500 MW of new renewable generating capacity, among other concessions.

While Duke’s acquisition of Cinergy met with less public opposition and concluded April 3, 2006, it was conditioned on substantial local concessions: a $117 million rate reduction for North Carolinian customers and a $40 million rate credit to Indianans. And even more recently, Maryland lawmakers have come close to derailing FPL Energy’s proposed acquisition of Constellation Energy Group. What has enraged the lawmakers is not so much the acquisition, but rather the end to the rate freeze that Constellation operating company Baltimore Gas & Electric (BG&E) agreed to in connection with 1999 state legislation restructuring retail power markets in Maryland. In order to get the acquisition back on track, BG&E has had to agree to phase in the 72 percent increase in its rate needed to bring its retail prices to market levels following the six-year freeze.

In addition to demanding divestitures, rate caps or reductions, and new investments, state authorities have also narrowed the qualifications that they will demand of acquirers of utility franchises that operate within their borders. Oregon regulators blocked the Texas Pacific Group, an equity fund, from acquiring Portland General Electric from Enron, and the Arizona Corporation Commission (ACC) similarly rebuffed the Saguaro Utility Group from acquiring UniSource Energy, the parent of Tucson Electric Power Company. In both instances, the would-be buyer was a private equity fund that proposed to acquire a legacy utility franchise using high levels of debt in the context of a business plan that would likely see the fund sell or flip its interest in the utility in a relatively short period of time. As one ACC commissioner explained his vote to reject the Saguaro acquisition, it is not in the public interest for “a monopoly that provides a necessity of life” to be “owned by a small group of private investors who purchase the monopoly by taking on a high degree of debt.”

Local and regional interests, together with the dealmakers, have a seat at the consolidation table, provided they demand one. They have repeatedly shown that they can influence what emerges from utility consolidations. Whether that influence is felt turns on how effectively the local interests are focused and advocated. Since the selling point for most mergers and acquisitions is some form of savings, state politicians and regulators should demand that local customers of the combined or acquired company share in those savings. Demanding too great a share, however, can backfire, as occurred when consumer advocate demands for rate reductions and other financial benefits buried BG&E’s efforts to acquire Potomac Edison. It will be interesting to see the types of demands that are made of future consolidations and how those demands affect the organization of the power industry and the quality and reliability of the services it provides.

Dan Watkiss is a partner with Bracewell & Giuliani in Washington, D.C. His focus is on litigation and arbitration. Contact Dan at Dan.Watkiss@bracewellgiuliani.com.

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The Clarion Energy Content Team is made up of editors from various publications, including POWERGRID International, Power Engineering, Renewable Energy World, Hydro Review, Smart Energy International, and Power Engineering International. Contact the content lead for this publication at Jennifer.Runyon@ClarionEvents.com.

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