energy bill creates new opportunities, new challenges

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The new energy legislation that President Bush signed into law on Aug. 8, 2005, the Domenici-Barton Energy Policy Act of 2005, will help create new opportunities for investment in the electric generation and transmission sectors. But with these opportunities come new responsibilities and new regulatory requirements, with significant risks in the form of greatly increased penalties for violations. Many of the chapters and text of the new requirements have yet to be written, because they will be the subject of rulemakings that the Federal Energy Regulatory Commission (FERC) will conduct over the next six months.

Lenders and investors will want to follow, if not participate in, the upcoming rulemakings, if only to understand the scope and potential impact of the new regulatory environment on their existing investments and on future deals.

new opportunities

One of the most dramatic changes to the existing regulatory environment involves the repeal of the 70-year-old Public Utility Holding Company Act of 1935 (PUHCA), a very stringent statute that has greatly restricted the types of investments utilities could make, and served as a great impediment to non-utilities that may have been interested in investing in electric and gas facilities, but were repelled by the prospect of being regulated as holding companies under PUHCA. Under PUHCA, registered holding companies and their affiliates were subject to reporting and record keeping requirements, and were required to obtain prior approval from the Securities and Exchange Commission (SEC) for a variety of transactions and financings.

While Congress repealed PUHCA, it did not provide a blank check to holding companies. Instead, it established through PUHCA 2005 some new regulatory requirements that will apply to holding companies, which includes any company that owns or controls certain gas and electric companies and assets. Not as stringent as PUHCA 1935, but still potentially significant.

For instance, Congress clarified FERC authority in its review of electric utility mergers. It is clear that FERC has the authority to review stock purchases of another public utility, acquisition of existing generators and, if a holding company is part of a system that includes transmitting utilities or electric utilities, acquisition by the holding company of a transmitting utility, electric utility or other holding company would be subject to FERC review and approval.

The Act also creates more specific rights of FERC to review books and records of holding companies and their electric utility subsidiaries and affiliates to protect customers with respect to jurisdictional rates. States are also permitted access to such books and records with respect to costs that companies attempt to recover through retail rates. What FERC and the states will do with such access and whether the information gained could lead to reduced cost recoveries will be the focus of careful due diligence when considering new investments and the impact they will have on a company’s corporate and rate setting structures.

The books and records that can be reviewed are not limited to those of traditional holding companies that have been subject to PUHCA regulation. The Act makes it clear that if a company is only a holding company by reason of holding interests in exempt wholesale generators (EWGs-a class of exempt generators added to PUHCA by the Energy Policy Act of 1992), qualifying facilities (QFs) or foreign utility companies, it will not be subject to the new books and records requirements. However, with the repeal of PUHCA, it appears FERC will likely not have the authority to approve new EWGs and foreign utility company applications. This means that for a company that strictly owns EWGs now, if it adds one new generation facility in the future, it could become subject to the new books and records provisions, even if its new non-EWG asset constitutes just 1 percent of its portfolio. Whether FERC creates some exemptions as part of its new regulations to implement PUHCA 2005 remains to be seen.

PUHCA repeal may lead to greater transmission company and facility investment. Such investments were difficult to make under PUHCA without subjecting the owners or operators of such companies and facilities to regulation as holding companies. But as new transmission investments are constructed, this may lead to a devaluation of value for existing generation resources. For example, a generator in a constrained area may make significant revenue if competitively priced power cannot be imported into the region because of transmission constraints. If repeal of PUHCA has the effect of creating more investment opportunities in transmission facilities, new lines constructed that relieve constraints and thus allow purchasers to access more competitively priced power may result in reduced revenue to the existing generators.

transmission system reliability

In the aftermath of the blackouts in the Northeast in summer 2003, Congress was determined to find ways to encourage greater transmission investment and to enhance reliability and efficiency of the nation’s transmission grid. The Act establishes an Electric Reliability Organization (ERO) that is subject to FERC review and will create and enforce reliability standards to the bulk power transmission system. The new law also permits the ERO or FERC to impose penalties for violations of FERC-approved reliability standards. State authority to ensure the safety, adequacy and reliability of electric service within the state is not preempted, as long as the state requirement is not inconsistent with any federal reliability standard.

The Act also provides backstop authority to FERC to use eminent domain authority for the construction of transmission lines. This could be greatly beneficial in helping resolve transmission congestion and other bottlenecks that affect interconnections between several states, where no one state can solve the problem. While removing such transmission bottlenecks may enable customers to access more generation resources, owners of generation resources that had been benefiting from having the corner on the market in the congested region may suddenly see a dramatic reduction in demand for power from their facilities. Consequently, investors will want to determine if new potential generation resources they are considering are located in a “national interest electric transmission corridor” designated by the Department of Energy (DOE) under new authority granted under the Act. If they are, and authority to construct a new line is granted by FERC, then this may lead to a devaluation of the existing generation resource.

The Act also requires FERC to establish new rules for incentive-based rates for transmission companies within a year of enactment. To be eligible for these incentive rates, a variety of requirements and standards would have to be met.

greater enforcement authority

The energy bill dramatically expands FERC’s enforcement authority to cover virtually all areas of its electric regulatory authority under the Federal Power Act. As noted above, there will be new reliability requirements and standards. In addition, in part influenced by the market disruptions experienced in the California electric markets, the new law contains new statutory prohibitions on market manipulation and deceptive practices. Congress greatly increased FERC’s authority to impose criminal and civil penalties, with the maximum per-day civil fine amount increased from $10,000 to $1 million. A violation continuing for one year would no longer be subject to a maximum fine of $ 3.65 million, but instead it could reach $ 365 million under the new law. How and when FERC will exercise its expanded enforcement authority is not known at this time, and likely will not be known until FERC deals with specific cases in which it applies its new rules that have yet to be developed.

other provisions potentially affecting deals

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Other generation resources will also face new challenges. QFs, the federally preferred alternative energy facilities that were the recipients of significant benefits under the Public Utility Regulatory Policies Act of 1978, will lose such incentives under certain circumstances. Long the subject of battles between utilities and QFs, the mandatory purchase obligation for QF power, under which electric utilities must buy a QF’s power at the utility’s avoided costs, will be eliminated for existing facilities if a utility can demonstrate, among other things, that such a mandatory purchase obligation is no longer needed because the QF already has a ready market for its power. For new QFs, FERC will set new rules on what types of QFs in the future may still have the benefit of the mandatory purchase obligation. These provisions further underscore the need for careful due diligence when considering buying existing or developing new QF facilities.

The energy bill thus affords new opportunities in the electric sector and reduces historic impediments and regulatory requirements. However, the Act also ushers in new reliability and other regulatory requirements and responsibilities, while empowering FERC with the ability to impose significant penalties for violations of such requirements. Careful due diligence and an understanding of the Act and the rules and regulations that FERC adopts will be needed to implement enhanced opportunities and reduce risks in the electric sector.

William DeGrandis concentrates his practice in the energy regulatory and transactions area, and has represented clients before both state and federal regulatory commissions in power supply, transmission, merger, ratemaking, cogeneration, hydroelectric, utility holding company and related matters. He is partner in the Washington D.C., office of Paul, Hastings, Janofsky & Walker, LLP.

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