Opportunities and Risks

Opportunities and Risks

August 01, 2002

This has been a year of change for the US power industry. Many companies have put assets up for sale. State regulators are wondering whether to freeze any further deregulation. The federal government has investigations underway into “wash trades” in domestic electricity markets. California is trying to break long-term contracts that it signed just last year to buy electricity. A new national energy bill has passed both houses of Congress and could become law this fall.

The following are excerpts from a discussion about the significance of the latest regulatory and legislative developments in the United States that took place at a Chadbourne conference in Quebec in late June.

The speakers are Sheila M. McDevitt, senior vice president and general counsel of TECO Energy, Eugene Peters, vice president for legislative affairs of the Electric Power Supply Association, the national trade association for the US independent power industry, Vincent P. Duane, vice president and assistant general counsel of Mirant Corporation, Sanford L. Hartman, vice president and associate general counsel of PG&E National Energy Group, Christopher Seiple, director of North American electric power studies for Cambridge Energy Research Associates, Jeanne Connelly, vice president – federal relations for Calpine Corporation, Robert J. Munczinski, managing director of French bank BNP Paribas, Lynn N. Hargis, a former assistant general counsel of the Federal Energy Regulatory Commission for electric utility regulation and now a Chadbourne lawyer, Bruce Davis, assistant general counsel of Mirant Corporation, and Dr. Robert B. Weisenmiller, one of the leading experts on the California electricity market and a founder of MRW Associates, Inc. in Oakland, California. The moderator is Keith Martin.

MR. MARTIN: We had a call last week to discuss the most important regulatory developments of the last few months. Everyone had at the top of his or her list the possible slowdown in electricity deregulation. Sheila McDevitt, start us off: what is the issue? Nervousness About Competition

MS. McDEVITT: It is whether the experience in California and with Enron will lead states and the federal government either to put on hold plans to move forward with electricity deregulation or possibly even to retrench and reexamine those deregulation models that have already been put in place.

MR. MARTIN: Gene Peters, is the trade association following which states are backtracking or are considering shelving new plans to deregulate?

MR. PETERS: I never use the word “deregulation.”

MS. McDEVITT: Restructuring.

MR. PETERS: A lot of my business is vocabulary and that’s an important point. MR. MARTIN: Why is it important?

MR. PETERS: First, we are not deregulated. We never were. We never will be. It is essentially a revolving regulatory context. Two, if you spend as much time as I do on Capitol Hill, you know that “deregulation” generally means hands off or laissez faire. It is not a good word. For example, if you talk to [Senator] Byron Dorgan [from North Dakota], he can’t make a trip today to Fargo — thanks to airline deregulation — without paying less than $1,000, so he has a very clear vision of what deregulation is, and he doesn’t like it.

MR. MARTIN: Are there some states that are backtracking and others that are just stopping any forward motion?

MR. PETERS: There are two issues here. One is retail restructuring and the other is the wholesale market. At a retail level, at last count 24 states had passed some form of restructuring legislation. It is safe to say the remaining states have put any similar plans on hold. Everyone is merely watching New York, Pennsylvania and Massachusetts now to see how they fare. MR. MARTIN: Are there states that are backtracking?

MR. PETERS: One way to measure the potential for backsliding is to watch how many new rate-based facilities are being proposed. You have not seen that in general except in places where you would expect to see it anyway. When we start to see rate-based facilities proposed in Ohio, Pennsylvania and New York, we are in trouble. At the moment, you see them in Florida. You see them in TVA territory. No surprises there.

MR. MARTIN: Vince Duane, is there a danger of backtracking in the 24 states that have already restructured their electricity markets?

MR. DUANE: Maybe I am more skeptical than the others, but I think there has been backtracking already. The political climate at the moment favors those forces that have not traditionally supported change and innovation. Their tide is quite high and they are using it very effectively. You are even seeing a renaissance in public power and municipalization in some areas — places like New York — that we have not seen for some time. The behavior of the ISO in that market is currently so unaccommodating to merchant generation that I do not see anyone building new merchant generation in areas like eastern New York, where there is a critical need for power, unless it is by the New York Power Authority or a utility that can put the assets into rate base.

MR. MARTIN: So even if there is no backtracking in the legislature, there may be backtracking in how the rules are enforced?

MR. PETERS: Most states that passed these laws left the fine print to local regulators. What we are seeing is that the public utility commissions that are supposed to create and implement these rules are not doing it. They are all saying, “Look what happened to California. Let’s just hunker down here.”

MS. McDEVITT: I think it is growing pains. You have to take a more positive view — a longer-term view. This business is not a snapshot in time. We must have faith that the need for electricity is there and there are ways to create competitive markets that actually work. ISOs and RTOs are an essential part of the answer, but they are only a step.

MR. MARTIN: Sheila is our positive thinker.

MR. PETERS: The name of this panel is “Opportunities and Risks.”The ground rules ought to be that we are not allowed to talk about risks unless we mention an opportunity.

MS. McDEVITT: That’s right. Many speakers who preceded us talked about problems, but you can take problems and make them into opportunities.

MR. MARTIN: Sandy Hartman, what is the significance for generators? I can see that there might be fewer opportunities for independent generators. Are there broader consequences from what has been described here?

MR. HARTMAN: I tend to look at this differently. There is currently a real surplus of power so it is academic whether the industry has been hurt by backsliding on market access for independent generators. I don’t mean to offend any regulators in the room, but regulators don’t like to make decisions. They don’t like to decide who pays and how much. If they don’t need to do it, they don’t. So this pattern of ebbing and flowing and going back and forth should be expected. I am really interested to see the first state commission that actually approves a cost-based 1,000 megawatt combined-cycle plant without any competitive bidding, without any market tests, and says, “We think we are going to need it, and we are just going to pass through the cost to the ratepayers.” Nobody has had to do it quite like that yet, and I think everyone has in many ways forgotten that we got to where we are for a reason. Things will work out.

MR. MARTIN: Chris Seiple, you have a comment.

MR. SEIPLE: Some of what was just described is occurring. Mid-American got PUC approval recently to build a coal-fired power plant in the midwest. There are utilities in the central United States that are having discussions with their regulators about their desire to grow and return to a rate-based strategy. These utilities are telling the regulators, “We have an oversupply in our market area. There is an opportunity for us to acquire some of these IPP facilities and bring them back into rate base.” My sense is they have gotten a favorable response from their state PUCs. We have also seen utilities, like Cinergy, trying to transfer some of their merchant facilities back into rate base. I think the signs are there.

Public Relations Battle

MR. MARTIN: Let me ask this. One of you made the comment earlier — I don’t know whether it was Sandy Hartman or Vince Duane — that there is basically a public relations battle going on between which is the better model: the vertically-integrated utility or, say, the PJM model. Who is winning that battle?

MR. DUANE: I agree with Chris Seiple. I think there has been a reversal because we as independent generators have taken certain things for granted. One of them is we assumed consumers understood that, as a general proposition, deregulation, or liberalization of the markets, is a good thing. That question is now being reexamined. People are asking, “Do we want our energy markets served by public utilities with their public service notion of social responsibility?” They are very different companies than the Mirants and Dynegys and Williams of the world which are rather agnostic in that regard. We have obligations to shareholders. We are ruthless in some senses, as someone characterized it, in seeking out market inefficiencies and making sure the markets correct around those inefficiencies. Public policymakers are asking, “Is that really what we want in our energy markets or is energy too important or too different to be left to free markets?”

MR. MARTIN: Sheila McDevitt, who is winning the public relations battle? You sit on both sides of the fence.

MS. McDEVITT: The average consumer doesn’t even understand the issue nor does he or she want to have to shop among power producers, at least as of this moment. The public reads about the headline disasters, but doesn’t understand that there is a distinction between companies engaged in speculative trading and the generators who sell power from their own power plants. The public is not really the audience for generators. Their audience is their shareholders — who are reached through Wall Street analysts — and the banks who finance their projects. It is that audience to whom the generators need to get the message that the industry is fundamentally sound.

MR. DUANE: The question people have to ask is, “Do we need retail competition in order to support healthy, robust competitive wholesale markets in electricity?” If the answer to that question is yes, then I think we have a serious problem because I don’t see us winning the retail battle. Consumers don’t understand it. A lot of them don’t want it. A lot of them are fearful of it. A lot of states are retrenching and politicians are saying, “Why should I stick my neck out on this after California?” It is not going to happen. I myself don’t think the two must go together. I think you can support a competitive wholesale market with an active role for state PUCs to force load-serving entities to purchase wisely, prudently and effectively in the wholesale market from merchant generators and power marketers. It doesn’t have to mean opening up markets at the retail level.

Government Investigations

MR. MARTIN: Let me move to the next regulatory development that is affecting us. It is the ongoing investigations by various federal agencies — the Federal Energy Regulatory Commission, the Securities and Exchange Commission, the Commodity Futures Trading Commission — into use of Enron-style trading practices and market manipulation in California and into wash trades in US electricity markets. CMS said wash trades accounted for 78% of its total electricity trades in 2000 and 72% in 2001. FERC is threatening to revoke the authority for five generators to sell power at market rates. The grid operator in California asked FERC to revoke such authority for six generators that it accuses of having gamed the system in California. Vince Duane, your thoughts about the ongoing investigations?

MR. DUANE: Let me tell you how I think we viewed this as the year progressed. Initially, the strategy was to confine the Enron issues to ones of accounting disclosure, reporting, creative financial engineering — things of that sort, and the — MR. MARTIN: That’s a long list to be confined to.

MR. DUANE: But it is all confined to one area.

MR. MARTIN: Broad corporate management issues?

MR. DUANE: Exactly. These are issues that could have happened to anybody selling Girl Scout cookies or electricity or pharmaceuticals or anything. The troubles are showing up in the Tycos and WorldComs of the world. The point is it is not an indictment of the wholesale energy business. It is not an indictment of deregulated energy business. Unfortunately, with the revelations around the Enron trading strategies in California, we now have a war on a second front that is much more focused on this industry and the behaviors in the wholesale trading and merchant energy market.

MR. MARTIN: Sandy Hartman, how do you see this playing out for the industry, over what time period and with what result?

MR. HARTMAN: I think it is going to take a fair amount of time, and it will proceed on two or three different levels. The first is the overall corporate governance issue must be fixed. That’s a much broader issue than the power industry. Second, as long as we are awash in power, arguably it doesn’t matter if decisions about electricity markets aren’t made for the next couple of years. Third, eventually, even in California, decisions are going to have to be made about whether people will be paid for delivering services, whether it is the load-serving entity, the generator or the gas supplier. I think I successfully dodged your question. [Laughter]

MR. MARTIN: Okay. Jeanne Connelly, same question.

MS. CONNELLY: I was just going to say one of the problems with all of the recent revelations around energy trading is that it has undone the educating that we tried to do in the past year about what underlying structural problems exist in California, and we were beginning to make headway. Now they believe that it was simply manipulation of the market. So we have lost almost an entire year of educating public policymakers about what lessons should be drawn from the chaos last year in California. The other problem is that it is diverting the attention of FERC. The current FERC chairman, Pat Wood, wants to move further toward competition. Instead, the agency is now bogged down in more investigations, more market monitoring. This inevitably slows down the process of moving toward competition.

MR. HARTMAN: Keith, if I could add one other point? We tend to focus on Congress and the state legislatures and regulators. There is a raft of private lawsuits right now winding through the courts — the creativity of which I find remarkable — that are the fallout from the chaos last year in California. These lawsuits are going to take a fair amount of time to work through the courts. They get into very complicated technical questions about federal preemption, about whether you are going to have independent causes of action under state laws, and many of us are struggling with what to say in securities disclosures about them. It is impossible for companies to quantify what their liability is because the cases raise novel and untested theories of liability. Imagine joint defense groups comprising 80% of the industry. The point is that once everything is cleared away on the political side, the industry will still have to contend with this litigation. At the end of the day, the lawsuits create risk, and it is a risk to capital and a risk to investing.

Power Marketers

MR. MARTIN: Vince Duane, another consequence of California, Enron and the revelations about wash trades is that many independent power companies with trading affiliates are finding it hard to continue in the trading business. They need to bring in partners. You believe those partners may eventually be banks or insurance companies. Why?

MR. DUANE: Yes, but I am not sure how much of the financial travails of the trading companies should be attributed to Enron or California as much as to a better understanding of what this industry is all about and an appreciation that it takes a tremendous amount of collateral to support the credit obligations of what is a high volume, very volatile business. A lot of the people in that business no longer have an investment grade profile and yet investment grade is critically important to minimizing the amount of collateral that is used to support that business. The question is what do you do? The answer that many are coming to is to look for someone with a strong balance sheet as a partner. The banks have shown a renewed interest recently in this area. Banks have dipped in and out of the energy commodity trading business over the past 10 years. They have trading expertise. They have the balance sheets and the creditworthiness. The piece they may be missing on the power side is assets, and you have to ask the question whether some of these banks are going to end up owning some of these assets — whether they want to or not — through foreclosures.

MR. MARTIN: Bob Munczinski, a question?

MR. MUNCZINSKI: My bank, BNP Paribas, is a trader in gas but not electricity. I want to mention a study that Cambridge Energy Research Associates did. They tried to value the entire chain using 2000 data. I don’t recall the exact number, but it was around $239 billion. Can anyone guess what value was ascribed to trading out of that $239 billion? One billion dollars in 2000. My question — maybe a comment — is in my 29 years as a banker, I have never seen an industry where there has been so much talk given to a sector that provides so little value added. I frankly do not understand why capital would flow to support trading activities.

MR. HARTMAN: I have been in this business about 15 years. This is a very personal observation. I have never fully understood — maybe it’s because I am not an economist — how all of this does integrate together unless you view a trading business as creating value separate and apart from providing liquidity, from addressing market inefficiencies and from managing the output of assets. That is one of the great debates about the structure of this industry. Maybe it is that you can get your picture on the front of Fortune magazine overlooking a trading floor. I don’t know the answer to your question. It is exactly the question to be asked.

MR. MUNCZINSKI: In an efficient capital market, if this were a real business that can generate substantial returns, capital would flow. The real issue is that a lot of us don’t believe that this is a sector that is going to generate sufficient return given the collateral and credit intensity that this business requires.

MR. MARTIN: Vince, you get the final word on this.

MR. DUANE: Thank you. First off, I have tremendous respect for Cambridge Energy Research Associates, but I don’t think they understand trading at all. And they are not alone. To respond to the question about why should capital flow into the business, one thing on which we can all agree is electricity is a volatile commodity. If it is going to be traded in the wholesale market, there is a tremendous need for risk management. The electricity market is necessarily not as liquid and efficient a market as the market in other commodities because of the physical dimensions to it. Next point: compare a power company with a 10 priceto-earnings multiple historically to a trading house. Arguably, someone engaged in a much more volatile commodity with a lot of physical and operational inefficiencies — not to mention all these other regulatory issues — should deserve a higher multiple and should be attracting more capital than it is currently trading, and there should be a perceived greater need for the services that the trading house provides. There is a lot of inherent efficiency in how we trade natural gas and electricity currently. We may have a notional amount on our book that is out of the money by hundreds of millions of dollars, but the book is balanced and the amount at risk — even for a large trading company — is in the single digits. However, we are not posting collateral based on the net exposure. We are posting collateral on the full amount of the out-of-market position. If we can get to a point where we can net and clear the costs of collateral, we would go a long way to solving the trading companies’ problem. I think the banks are an interim step.

Attacks on Contracts

MR. MARTIN: Moving on. This panel made a list before the conference of the most significant regulatory developments in terms of impact on the industry. Next on the list is the move by the California government and Sierra Pacific to void contracts. California has asked the Federal Energy Regulatory Commission for help getting out of 32 contracts it signed last year to buy electricity long-term from 22 power companies. Sierra Pacific charges that the prices it agreed to pay last year are “unjust and unreasonable.” Sandy Hartman, explain the issue.

MR. HARTMAN: This is actually really easy to explain. It boils down to three words: “We won’t pay.” Let me put this in a broader context. This is one prong in a series of activities that are being undertaken to put the maximum amount of pressure on generators either to give money back or reduce their prices. This is prong one. “You didn’t have your rates properly filed.”“There was a dysfunctional spot market that affected the long term market.” At the end of the day, FERC will probably sit there like a big potted plant. The second part of this, though, is don’t underestimate the relationship between plaintiffs’ attorneys and regulatory lawyers. It is no coincidence that, when you pick up these pleadings, you see the same allegations being made in state court that are being made at FERC. Third, it is no coincidence that state rate commissions take very hawkish views on this. In a sense, PG&E National Energy group was lucky. We had our liquidity crisis a year ago when the CPUC said, “No, we are not passing through these rates.” Well, why not? Three words, “We won’t pay.” They didn’t give a reason why. The market didn’t work.

MR. MARTIN: California has asked FERC to let it get out of 32 contracts that were entered into last year when electricity prices were high. Does this cast doubt on the inviolability of long-term contracts? Such contracts are the basis on which many power plants are financed. Were long-term contracts inviolable in the first place?

MR. HARTMAN: A little historical perspective on that one. There is a book called Cadillac Desert about water in California. A farmer signed a contract in the 1920’s or a little earlier when the big irrigation projects were just getting underway. He was asked, “Are you worried about signing these long-term contracts for all this water?” His exact words were, “No. Long-term contracts are meant to be broken.” Different people approach contracts differently and, in different parts of the country, frankly, there is a lot more sanctity of contract than in other parts of the country. The real debate is not whether contracts are going to be renegotiated or abrogated. It is what does the market need to do and what do the regulators need to do to attract the capital to build the infrastructure to supply the products that are needed. The California contracts are contracts that were signed quickly to solve a problem. It comes as no surprise that the state is now trying to renegotiate them.

MR. DUANE: I see it a little differently. I see it as symptomatic of a much broader problem of asymmetrical reregulation. We have plenty of long-term contracts at Mirant that we would love to jettison. We are losing money on them, but at Mirant, a deal is a deal and we stick with it. Unfortunately, when we have a contract that seems to make money, there is political pressure to modify it. God help us if this is the way we are going to conduct a business because it will come down to who has the strongest political constituency, and the independent generators and trading companies today have no political constituency — absolutely none whatsoever. Just one more point: the irony is you have two utilities in California that were on the brink of insolvency just a year ago, one in bankruptcy and one teetering on the edge of bankruptcy, and you had a merchant generation business on the other end. Today, look at what has happened. You have one utility — PG&E — trading at a share price in the low twenties and reinstituting a dividend program while it is still in bankruptcy while the Mirants and Dynegys and Williamses are trading at $8 a share. The fact of the matter is the utilities are making a hell of a lot of money right now and nobody is paying attention to that and nobody is saying, “How come the consumers in the state of California aren’t sharing in the benefits from that?”

MR. MUNCZINSKI: What is the difference between China and California? At least in China, they let you complete the projects before reneging on the contract. A few months ago, our bank found it hard to imagine FERC ever allowing California to renege on its contracts, but since the “Get Shorty” disclosure and disclosures of other Enron trading strategies — this is more of a question than a comment — I wonder if the FERC experts in the room can now foresee FERC deciding to abrogate contracts on grounds that there was proven market manipulation?

MR. MARTIN: Lynn Hargis, you were the assistant general counsel at FERC for electric rates, what do you think?

MS. HARGIS: I can easily see FERC ordering refunds. The question is whether FERC will get away with it in the court of appeals, where the issue is sure to land eventually. The Federal Power Act is designed to respect contracts, but to allow FERC to change them when the public interest demands it. What the courts ultimately will do, we won’t know for a few years.

MR. HARTMAN: I want to add two points to that. One is I think Lynn is absolutely right. As long as these bad facts keep coming out, the political pressure increases for FERC to do something more than it would do normally. The other is an historical point. I used to license nuclear power plants, and I remember when the Washington Public Power Supply System defaulted. I remember reading article after article saying, “This is the end as we know it of municipal bonds.” Spreads were a little higher in the northwest for a couple of years, but at least as best as I can recall, when the dust settled at the end of the day, it really didn’t matter and life went on.

MR. DAVIS: There is precedent for what we are seeing in California. It is no different than what New Jersey, New York and other states tried to do in the 1990’s when power prices plummeted and the utilities were left with obligations under long-term contracts with QFs to buy power at prices that were by then significantly above market. Some power plant owners resisted and held out and, ultimately, I don’t think the courts supported what the public service commissions were doing. There were other generators who felt the pressure and renegotiated their contracts. I think that’s what California is trying to do now. I hope the outcome at the Federal Energy Regulatory Commission and in the courts will be the same as before.

MR. MARTIN: Time to shift gears. Let me ask Bob Weisenmiller, who has an excellent piece on the current situation in California in the June NewsWire, is the power crisis over in California or are we going to see a reprise?

Mess in California

DR. WEISENMILLER: At this stage, we have at least two or three phenomena going on. The first one is the California fiscal situation is enormously bad. For those of you who watched the California state government fumble with the energy crisis last year, be aware that the exact same thing is going on with the state budget, only the difficulties are compounded by the fact that this is an election year. No one is prepared to take decisive actions on the budget, certainly not in an election year. The budget shortfall next year could well be on the order of $40 billion. About $6.5 billion of that is accounted for by the DWR contracts.

MR. MARTIN: Have the underlying problems with the electricity market been fixed? Are we just in the phase where the politicians must work through the political fallout from how the crisis last year was handled?

DR. WEISENMILLER: The state is really struggling with what the vision is. Last year, the talk was about moving to public power. Governor Davis is running for reelection and may run next year for president. There is an enormous political currency this year in bashing generators and traders. Enron has given the politicians a lot of fuel for that. The point is there is the political momentum this year for a move to public power, but the state faces a dilemma. It must decide whether using public funds to build new power plants is the best use of scarce public funds.

MR. MARTIN: The number of megawatts that was expected to come on line this summer has not come on line on schedule. Is this a sign that California will be facing the same problems next year or the year after that it had in 2001 when there were rolling blackouts and high prices?

DR. WEISENMILLER: Possibly. There is a group of projects — about 8,000 megawatts or so — that is well under construction and moving forward. These new facilities will go a long way to make up the deficit that California worked its way into over the past decade. Having said that, some people in our industry have said that volatility is good for the power business — certainly for traders. However, volatility is bad for the public. The question the government faces is how to dampen volatility. The theory used to be to have a sufficient reserve margin built so that even if it is a very dry year or a very hot year — even if there are lots of outages — there will not be price spikes. The idea was to have a 15 to 20% — even 25% — reserve margin just in case. The problem in a deregulated market is who is going to build power plants to supply the reserve margin “just in case.”

MR. MARTIN: In your article in the June NewsWire, you made the statement, “There are some niche opportunities [in California today] where the balance of financial risks and returns is attractive.” What are those niche opportunities?

DR. WEISENMILLER: Number one, a lot of the problems that owners of QF projects faced last year have been worked through. QF projects seem relatively straightforward at this point. There is a lot of emphasis in California now on selfgeneration projects. There remain questions about how the regulatory situation will play out and whether there will be an exit fee for self generators to exit the system and how that works, but there is a very strong push by large industrials to generate their own electricity and regain control over their own destinies. I think the restructured DWR contracts that Calpine negotiated provide a model for others for how to dodge the regulatory bullet. The state now has sort of a Calpine model for baseload or a Calpine model for peakers. If that works for some of the other projects, then those projects will move forward and step out of the current firestorm. Beyond that, it becomes more difficult. For generators thinking of putting assets into the ground, a couple of years from now those assets may be very valuable, but you have a lot of volatility and risk in the short term.

New Legislation

MR. MARTIN: Let’s move in the remaining time to the national energy bill that is moving through Congress. It passed the House in July. It passed the Senate in April. It is now in “conference” between the two houses to iron out differences and could soon be on the president’s desk. There are things in it to which the industry should be paying attention. Jeanne Connelly, what are the odds that it will become law this fall?

MS. CONNELLY: I’m an optimist on this subject. I think the odds are pretty high. The Bush administration wants an energy bill. The president has made it one of his top priorities for this year. Billy Tauzin, the congressman who was chosen to chair the conference committee, said recently:“Those of you who know me know better than to under-estimate me. We will have a bill.” Senator Bingaman, who will be the chief Senate conferee, is a very substantive, quiet kind of guy. He put a lot of time and effort into getting this bill through the Senate. On the other side, there is always the possibility that party leaders will decide they would rather have a political issue for the election, but I think there are many more cards stacked in favor than against.

MR. MARTIN: Gene Peters, do you agree?

MR. PETERS: The first question is, “What bill are we talking about?” You have two very different bills that passed in the House and Senate. Notably, the Senate bill has an electricity title that the House bill doesn’t. If the question is the odds of a bill passing with substantive electricity provisions in it, they are probably about 60%. MR. MARTIN: EPSA is currently supporting the bill?

MR. PETERS: We are supporting the electricity provisions in the Senate bill — absolutely.

MR. MARTIN: Jeanne, what would you say are the three most important provisions in the bill about which people in this room should be aware?

MS. CONNELLY: I actually think the most important provisions are the tax incentives that relate to energy, whether they are for renewables or clean coal technology or cogeneration or plants on Indian land. When you come to the electricity title, probably the only part of it that is really important for the industry is what we call “FERC lite.” It gives FERC authority over the transmission of electricity over the parts of the national grid that are owned by public power entities like [the Tennessee Valley Authority] and [the Bonneville Power Administration] plus municipals and co-ops. Then it is more important to —

MR. MARTIN: Stop there for a moment. “FERC lite” would give FERC the ability to order municipal utilities to wheel power for generators?

MS. CONNELLY: To have open access transmission. It is called FERC “lite” because it is not absolute authority over the pricing of that transmission.

MR. MARTIN: Okay. And third on your list?

MS. CONNELLY: Third is what is not there. What’s important is that there were efforts on the Senate floor to move away from competition. They were defeated. The thing to watch in conference is whether some of these backtracking provisions make it into the final bill.

PURPA Repeal

MR. MARTIN: Lynn Hargis, I think you have a different view of what is significant. What is at the top of your list?

MS. HARGIS: The Senate bill would drop the current 50% limit on utility ownership of qualifying facilities under PURPA. [Ed. The “Public Utility Regulatory Policies Act” is a 1978 law that requires regulated utilities to buy electricity from cogeneration facilities and certain power plants that burn waste fuels at the “avoided cost” the utility would spend to generate the electricity itself.] Although there are not many new qualifying facilities being built, I think in terms of existing ones, when utilities get the green light to own them, they will. The 50% limit is one of the things that preserved a role for independent generators for a long time.

MR. MARTIN: Let me stop you there for a moment because the Senate bill repeals PURPA altogether, right?

MS. CONNELLY: No, it repeals the obligation of utilities to purchase on a prospective basis and then only if FERC makes a finding that there is true competition in the market.

MR. MARTIN: And do you think FERC will make that finding?

MS. HARGIS: No way.

MR. MARTIN: Perhaps in certain markets? What is the “market”? Is it the whole country or how large an area?

MS. HARGIS: It will go market by market, region by region, and I think that FERC will have a hard time finding true competition in a lot of places. For instance, in the southeast, either in the Southern Company or Entergy territory, FERC would have a hard time saying today that there is a competitive market. Since utilities in these areas will still be obligated to buy power from QFs, you will have an interesting situation. There is nothing to prevent the utilities in these areas from owning their own QFs.

MR. MARTIN: Okay. And then there is another provision in the bill —

PUHCA Repeal

MS. HARGIS: The biggest thing of all, I think, is that the bill would repeal PUHCA. [Ed. The “Public Utility Holding Company Act” is a 1935 law that inhibits the formation of large utility conglomerates that cross state lines.] As all of you know who have attended this conference over the years, this is the 13th year I have predicted we are on the verge of PUHCA repeal. [Laughter] I just don’t think anyone understands any longer what PUHCA does. To me, it’s like going into a house and saying, “Let’s get a modern look and take out that wall.” You take out that wall and it turns out it’s a load-bearing wall, and the house falls in. This is my fear for what happens when the Public Utility Holding Company Act is repealed.

MR. MARTIN: You believe the utility industry is in for a major restructuring if PUHCA is repealed. Gene Peters and Jeanne Connelly, you are not particularly concerned about this. Why?

MR. PETERS: First of all, it is hard to imagine a much more uncertain future right now anyway with or without PUHCA repeal. Second, SEC enforcement of PUHCA has been non-existent for a long time. I think most members of the trade association think PUHCA is essentially an anachronism. Repeal could lead to a major consolidation, but we haven’t heard from members that any of them is concerned.

MR. DUANE: As an EPSA member, I share that opinion and that has historically been the opinion of the merchant energy companies. PUHCA is an anachronism and you have to get rid of it. However, there has been an interesting evolution as we find ourselves in the predicaments that we are in today. A lot of people are predicting significant consolidation. You have a perverse incentive where, if you are a party who wants to be acquired, you almost prefer to see PUHCA remain in effect because it limits the pool of eligible companies that can be acquired without major hassles by foreign utilities or the large domestic utilities.

MR. MARTIN: Many people expect PUHCA repeal to be a great thing for investment bankers because it opens the door to lots more acquisitions and mergers.

MR. PETERS: But keep in mind the Senate bill also provides for increased merger review by the federal government. This is going to be a point of contention between the House and Senate in conference. The Republicans, who control the House, have pushed essentially to get rid of section 203 of the Federal Power Act, which is FERC’s major review authority. The language that is in the Senate bill actually expands that merger authority in some potentially odd but significant ways. Just because PUHCA goes away doesn’t mean that the rubber stamp comes out at FERC. I just don’t see that happening.

MS. McDEVITT: PUHCA has not been a roadblock for any of the recent consolidations. People structure around it.The only thing the government has enforced — and I’m not sure it has been enforced lately — is a limit on investments in unrelated businesses. Keep in mind that you not only have the FERC review, whatever it turns out to be, but you also have [Federal Trade Commission] and [Department of Justice] review, whoever ends up getting the ball, and they do traditional, hard core, very detailed, antitrust evaluations. In 1935 when PUHCA was enacted, these reviews did not exist the way they do today.

Renewables Mandate

MR. MARTIN: One thing that none of you has mentioned about the bill is the renewables mandate. Jeanne Connelly, tell us about it.

MS. CONNELLY: They call it the renewable portfolio standard. It requires utilities over a set period of time to ramp up the percentage of renewables that make up their portfolio of energy. There is a penalty if they don’t. They can pay 1.5¢ per kilowatt hour instead of purchasing the mandated percentage of renewables. It is the only thing in the legislation that environmental groups find positive.

MR. MARTIN: What percentage of power would have to come from renewable resources?

MS. CONNELLY: Ten percent by 2020.

MR. MARTIN: And what is the percentage today?

MS. CONNELLY: I think that renewables — if you don’t count hydropower — account for between 2% and 3% of energy today. With hydropower, it may be between 7% and 8%. The bill does not define renewables to include hydropower, so the utilities must eventually close a significant gap.

MR. MARTIN: So another 7% to 8% of electricity distributed by utilities will have to come from renewables by 2020. Is that just in the Senate bill or also in the House?

MS. CONNELLY: It’s only in the Senate bill, but it is the only thing the environmental groups think they are getting out of the legislation so they are fighting hard to keep it in.

MR. PETERS: This is clearly a provision that is going to be drafted in conference. What is in the Senate bill will not survive in its current form.

MR. MARTIN: Any closing thought by anyone in the room?

MR. PETERS: Yes. We haven’t talked as much about opportunities. At the end of the day, let’s not lose sight of the fact that the FERC agenda is still very positive toward wholesale competitive markets. FERC still has on its agenda this year standard market design, the [regional transmission organization, or] RTO initiatives, and standardized interconnection. At the end of the day, the federal regulators are not being swayed by the political hyperbole from the west coast. Turning to the legislation, we feel very good about what happened in the Senate. It is no accident that the Senate bill gives FERC additional authority and regulatory powers over people the agency hasn’t traditionally regulated and that the bill is silent on some of the initiatives that FERC has underway that help open markets. On the downside, one of the most depressing things about the Enron trading-strategy memo surfacing when it did is it happened immediately after we got the bill through the Senate and did very well there. But we remain positive about our prospects in conference.