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PUHCA Debate - Again

The SEC denies approval of the AEP/CSW merger. What will that mean for industry consolidation?

Fortnightly Magazine - July 2005

the act when it issued a conditional approval of the merger. Those conditions require AEP to open its markets to create a functionally integrated system without the exacting physical and ownership requirements specified under PUHCA.

Judicial Reversal: Raising the Cost of Capital

The SEC's second review was based on a 2002 remand issued by the United States Court of Appeals for the District of Columbia Circuit, which vacated the SEC's merger approval. The appellate court asked the SEC to hold additional proceedings consistent with its opinion, effectively instructing the SEC to strengthen the record with regard to the "single integrated public utility system" standard under the act. Accordingly, investors should have been able to discount some measure of risk associated with the appeals court remand and the nagging uncertainty of blending two registered public utility holding companies under PUHCA.

Furthermore, the ALJ's observation that AEP and CSW are not contiguous could be viewed as disingenuous. The SEC on first review and the FERC were satisfied with the offsetting evidence presented as to the "contiguous" standard, and they ratified the merger. It is obvious (see Figure 1) that these utilities are not contiguous under a literal standard ( i.e., PUHCA), but two independent federal agencies felt comfortable with the mitigating arguments and the preservation of competitive market conditions.

Does this decision ultimately result in "unmerging" AEP/CSW? Probably not. AEP can be expected to appeal, thereby giving the SEC an opportunity to engage in another round of review and hearings, and this time, to construct a stronger record. Under the worst case scenario, the SEC may order AEP to divest itself of some assets. As for pending mergers, specifically the Exelon Corp. and Public Service Enterprises Group Inc. merger, as well as the Duke Energy Corp. and Cinergy Corp. merger, all four companies should be able to pass PUHCA scrutiny, although the process is likely to be slow and costly.

The Changing Utility Risk Profile

The ALJ's decision leaves investors to ask which rules of law govern the energy sector today. Deregulation and competitive market initiatives were supposed to lower costs and improve customer choice. However, in most cases, the opposite happened. Reliability and financial integrity were compromised, resulting in volatile electric rates. There have been more utility bankruptcies in the past five years than at any other time since PUHCA was passed.

Electric utilities traditionally were considered part of the most secure industry in the United States, characterized by:

  • Earnings stability;
  • Low common stock volatility;
  • Secure common dividends-enabling utility stocks to serve as bond surrogates;
  • An average "AA" credit rating in 1980 (as measured by S&P);
  • Rarity of any electric utility rated below "BBB" (investment grade);
  • Suitability as investment vehicles for "widows and orphans"; and
  • A 53-year absence of Chapter 11 filings by utilities, from passage of the act in 1935 until 1988.

Events over the past decade have changed these features, especially as deregulation and competitive markets have developed without corresponding federal legislation, resulting in:

  • Earnings instability;
  • Increased common stock volatility;
  • Proliferation of common dividend cuts or omissions;
  • An average S&P