Temporary Obstacle to US Utility Mergers?

Temporary Obstacle to US Utility Mergers?

June 01, 2005

A decision by an administrative law judge in May highlighted a potential obstacle to utility mergers in the United States.

A judge with the US Securities and Exchange Commission held that the 2000 merger of two US utilities — American Electric Power based in Ohio and Central Southwest based in Texas — violated a 1935 statute that makes formation of multistate utilities difficult.

The 1935 law, called the “Public Utility Holding Company Act,” requires Securities and Exchange Commission approval of most utility mergers.

The SEC approved the merger in June 2000.

However, a US appeals court ruled in January 2002, in a case brought by opponents of the merger, that the SEC had not adequately explained some of the grounds for its approval. After conducting a hearing into the matter, SEC administrative law judge Robert G. Mahony held on May 3 that the merger failed to comply with the PUHCA requirement that the merging utilities must operate in a single area or region.

Legal Issue

PUHCA places limits on utility holding companies. A “holding company” is a company that owns 10% or more of the outstanding voting securities of an electric or gas utility.

Under what is known as the “two-bite rule,” if, following a merger or acquisition, a holding company will have two or more utilities as subsidiaries, then SEC approval is required for the transaction to take place.

If the utility subsidiaries are in more than one state, then PUHCA permits SEC to approve the merger or acquisition only if the utility subsidiaries will form a single “integrated public-utility system.”

An integrated system may be comprised either of electric or gas utilities, but not both. However, under what is known as the “ABC” clauses of section 11 of PUHCA, a holding company may retain one or more “secondary” utilities — gas or electric — if it shows that spinning off the secondary systems would result in the loss of substantial economies, and that keeping them as part of an expanding holding company will not undermine the benefits of localized management, efficient operation, or the effectiveness of regulation.

To prove that two or more utilities will be an “integrated system,” the parties must show four things. First, the assets of the companies must be physically interconnected or capable of physical interconnection. Second, the assets must be capable of economic operation “as a single interconnected and coordinated system.” Third, the two companies must be confined to a “single area or region.” Finally, the combined companies must not be so large as to impair the advantages of localized management, efficient operation and the effectiveness of regulation.

These standards flow directly from the aim Congress had in 1935 when it enacted PUHCA of protecting consumers and investors from the abuses associated with large interstate utility holding companies, which at the time were viewed as “pyramidal structures with a few not always responsible shareholders of the top holding company exercising excessive control over the underlying operating companies.” Holding companies were perceived as able to evade state commission regulation by “scatteration” — the ownership of widely dispersed utility properties that did not lend themselves to effective state regulation.

Contiguous?

In order to satisfy the interconnection standard, the merging utilities do not need to be physically adjacent to one another. It is enough to be linked by transmission over an intervening utility grid.

American Electric Power and Central Southwest argued that they are interconnected because they have reserved 250 megawatts of capacity on the so-called MISO grid, a regional grid operated by the Midwest Independent System Operator. The SEC had said this was enough when it originally approved the merger. However, the US appeals court questioned whether a unidirectional transmission arrangement satisfies the requirement for interconnection, since the term interconnection implies two-way transfers of power. AEP presented evidence to the administrative law judge, when the case was reheard, that 2% of the transactions on the contract transmission path were west to east, along with 98% east to west. The administrative law judge ruled there is no requirement that any specific percentage of the power from one utility in the system be provided to another and, therefore, even a “miniscule” amount of bi-directional transfers was sufficient to satisfy the interconnection standard.

In contrast, the administrative law judge did not buy the argument that the combined utilities satisfy the requirement that the post-merger utility system must be “confined in its operations to a single area or region.”

The US appeals court also had problems with this. It said the SEC had botched the analysis on this issue when it originally approved the merger. The SEC found that because the merged company would be interconnected and capable of economic and coordinated operation, and its size would not impair efficient operation, it should be treated automatically as operating in a single area or region. The court said this approach would allow the merged company to satisfy the single area or region standard, even if, in fact, it does not.

When the case went back to the SEC administrative law judge for further consideration, AEP argued that the combined companies operate in a single region — the “eastern interconnection of North America,” which AEP called a single interdependent “machine.” The companies are spread over three regional transmission organizations, or RTOs. AEP argued that since the three RTOs coordinate their operations, the two utilities at either ends of the RTOs are interconnected. It also argued that an analysis of trade flows in several industries shows that the central portion of the United States, which is served by the combined utilities, comprises a single economic region.

The administrative law judge rejected this approach, finding instead that the “single area or region” standard refers to geography, with other factors such as socio-economics and geology also contributing. The judge said that Ohio and Texas are in different regions of the country. Accordingly, he rejected the merger.

Significance

AEP has appealed the decision to the full Securities and Exchange Commission. This has the effect of placing the decision on hold until the full commission can hear the case. Once the SEC issues an order, regardless of whether the SEC approves or rejects the merger, that order will almost certainly be appealed to the court once again. Since the companies have been merged for more than four years, no matter what decision is ultimately reached, it is unlikely that they will be forced to separate. Indeed, the potential loss of economies of scale might enable CSW to qualify as an “additional system” that AEP can retain to avoid loss of economies under the ABC clause of section 11 of PUHCA.

More significant is the potential effect of the latest decision on any pending or future mergers and on the federal energy legislation being debated currently in Congress.

Importantly, neither the court nor the administrative law judge found anything harmful to consumers or investors about the merger. Indeed, 11 state public utility commissions, as well as the Federal Energy Regulatory Commission, the Nuclear Regulatory Commission, and the US Department of Justice, under the Hart-Scott-Rodino Act, all approved the merger. Moreover, in contrast to the situation in 1935, today the SEC has ample authority to regulate the merged company’s securities issuances and corporate activities, and the 11 state commissions that regulate the merged companies’ utilities have ample authority and resources to regulate rates. As the US appeals court said, the SEC is clearly correct that “PUHCA’s [single] region requirement is outdated in light of recent technological advances. In view of the statute’s plain language, however, only Congress can make that decision….In the meantime, the SEC may not interpret the phrase ‘single area or region’ so flexibly as to read it out of the Act.”

The key question raised by the administrative law judge’s decision is what is a “single area or region” for purposes of PUHCA, and how can potential merger candidates predict whether a transaction will pass muster under PUHCA?

When the SEC has found that the standard was satisfied in the past, it was because the geographic characteristics of the merging territories were “fairly homogeneous.” The SEC has also identified factors such as industrial, marketing and general business activity, transportation facilities and gas utility requirements, that could be relevant to a finding that different service areas are located in a common economic and geographic region.

In light of the need not to interpret the single area or region requirement so flexibly as to read it out of the statute, the best approach may be common sense. Regarding the limits of what is likely to pass muster, it is significant that the SEC’s division of investment management, which participated in the AEP litigation, took the position that, from the perspective of geography, “[t]here is simply no way that [the states in which the combined AEP system operates] are in a single area or region.”

The test may ultimately prove to be the same test as for pornography: the SEC knows a single area or region when it sees it. Clearly mergers within a recognized region, such as the New England states or the Pacific northwest, satisfy the standard. Perhaps a sanity check is whether the customers of the merged company speak with the same accent. As the SEC considers the proposed mergers of Exelon and Public Service Gas & Electric Co., Duke Energy and Cinergy, and Mid-American Energy and PacifiCorp., it is clear that the “single area or region” standard, along with the prospects that Congress will repeal PUHCA this year, will be at the forefront of key issues.

Regardless of how the AEP and CSW merger is ultimately decided, absent PUHCA repeal, the latest decisions will make it more difficult for geographically-distant utilities to merge.

In contrast to the integration standard, which can be solved by spending enough money to acquire transmission or construct interconnection lines between utility systems, there is no way to convert two different geographic regions into one. After being slapped once by the court for failing to enforce the laws on the books, the SEC is unlikely to take a lax approach to this issue when it arises in pending and future cases. Moreover, groups that want to fight utility mergers will clearly be emboldened by their success in the AEP case. The result will be that mergers involving utilities in areas that, on their face, are not in the same region will face a much tougher challenge in being approved, and even if approved, will end up fighting appeals in court. Awaiting court review of an SEC order before closing a merger is not a particularly sensible business strategy given the amount of the time the merging companies end up in limbo. Witness the year and a half that it took for the court to review the SEC decision in the AEP case, and the two and a half years it took for the SEC then to conduct a hearing after the court had heard the case. The consequences, absent PUHCA repeal, will be significant delay in closing transactions that raise questions as to their ability to satisfy the single or region standard.

Ironically, mergers of utilities that are in the same geographic region, while readily satisfying PUHCA, are also likely to have trouble getting approval from the Federal Energy Regulatory Commission. FERC must approve any mergers involving transmission grids or power plants that sell into the wholesale market. In considering mergers, FERC focuses on the market power the merged company will have. If two utilities that own power plants are located near each other, combining their assets generally produces significant increases in the market share that would be held by the merged company. While transfers of control or divestures of generating plants can alleviate the problem, such measures can deprive a merger transaction of significant value.

Until PUHCA is repealed, the concerns that gave rise to this legislation in 1935 will continue to thwart the ability of utilities to combine, whether or not those concerns reflect the same public policy issues today as they did in 1935.

On the PUHCA front, the Senate energy committee voted in May, as part of a broad energy bill, to repeal PUHCA but to give the Federal Energy Regulatory Commission expanded authority to review mergers. The energy bill is expected to be taken up by the full Senate in mid- to late June. It has already passed the House with PUHCA repeal and no expanded FERC merger review authority. PUHCA repeal would remove a large obstacle to the Mid-American proposal to acquire PacifiCorp. The expansion of FERC authority to review mergers would not affect the FERC review in the PacifiCorp case, since the existing FERC merger authority already gives the agency jurisdiction in the PacifiCorp transaction. It is already able to review any proposed changes in control of public utilities. The expanded review authority the Senate wants to give FERC would give it a broader say in sales of standalone power plants.