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The Constellation Experience

Ring-fencing after the subprime meltdown.

Fortnightly Magazine - August 2010

agencies will perceive a strong linkage between parent and subsidiary and there will be little or no credit-rating separation.

The potential downside to ratings separation is that the utility loses the benefit of a financially stronger parent and the ability it might otherwise have had to access capital on better terms on a consolidated basis. Regulators who require strong ring-fencing measures cannot have it both ways. For example, to the extent a utility is encouraged or directed to maintain a relatively high level of equity to debt, the utility in all likelihood will seek a commensurate rate of return reflecting the higher equity level.

Corporate Governance Structure

The separation of parent and subsidiary also can be addressed through corporate governance conditions. The Texas Public Utility Commission approved ring-fencing measures concerning Oncor Electric Delivery Co., a Dallas-area electric distribution utility, which included requiring the 80-percent parent-owned electric distribution subsidiary to have a majority independent board. 30 Based upon the Oncor ring-fencing measures, the attorney general for the State of Maryland argued that BGE should be required to have a majority independent board of directors. Constellation objected to this proposal as a deal-breaker, and the MDPSC did not impose it. The MDPSC did, however, conclude its Phase II order with the observation: “Nothing in this Order should be read as a decision not to exercise our general supervisory authority over BGE in the future, or a decision that we will not initiate further supervisory proceedings if and when we find them appropriate.”  31 Regulators seeking to maximize the ring-fencing separation between parent and subsidiary utility can look to the Oncor example.

State Safeguards

The repeal of PUHCA has created substantial challenges for regulators. Investment-grade holding companies such as Constellation might face unknown risks or exposures to rapidly-changing market conditions. If realized, these risks can place a regulated affiliate utility in financial jeopardy. There is little that regulators can do after-the-fact to protect even a financially-healthy utility subsidiary from credit downgrades or being drawn into a parent’s bankruptcy. In order to be effective, ring-fencing measures must already be in place. When things are going well, however, there might be a regulatory disinclination to take measures seemingly intrusive of management’s freedom of action over its holding company activities. Moreover, by imposing greater separation between the affiliated utility and the rest of the holding company, ring-fencing arguably comes at some efficiency cost. Nonetheless, a significant argument can be made that regulators should err on the side of ratepayer protection. The Enron-Portland General Electric situation is a good example of proactive ring-fencing that paid off. Following the near-bankruptcy of Constellation, the Maryland PSC decided that it was unwilling to let EDF immerse itself in Constellation’s nuclear business without ring-fencing protections for BGE going forward.

In the wake of the economic crisis of 2008, President Roosevelt’s observation made in 1935 rings eerily familiar: “[f]undamentally the holding company problem always has been, and still is, as much a problem of regulating investment bankers as a problem of regulating the power industry.”  32 State utility regulators cannot discipline Wall Street, but