Business & Money
The Securities and Exchange Commission denies approval of the AEP/CSW merger. What will that mean for industry consolidation?
What's wrong the Public Utility Holding Company Act of 1935 (PUHCA)? Perhaps the date! On May 3, 2005, a Securities and Exchange (SEC) administrative law judge (ALJ) handed down a ruling that denied the application of American Electric Power Co. (AEP) seeking approval of its acquisition of Central and South West Corp. The ALJ concluded that AEP did not satisfy the requirements pursuant to Section 10 of PUHCA. Simply put: the merged AEP/CSW "does not constitute a 'single integrated public-utility system'" under the Act, according to the ruling.
Beyond the implications for any single company, the ALJ's decision illustrates the polarization between energy policy and legislation (namely, PUHCA). As such, in order to underwrite the nation's energy future, investors need some reassurance that the industry is operating under contemporary economic, social, and technological advances, rather than under depression-era rules.
The 1935 act clearly did not contemplate a competitive marketplace for electricity. Quite the contrary. Now the SEC judge's opinion has resurrected PUHCA as an investor concern by creating uncertainty over a merger that closed five years ago.
Legislation should be updated to reflect the prevailing energy economic climate. Both the Senate and the House claim to be on the same page when it comes to energy reform. However insofar as PUHCA is concerned, they are not reading the same book. Debate over PUHCA has been underway for decades. It seems as though there hasn't been a year in the energy industry's history in which the controversial Depression-era law restricting mergers and acquisitions has not either been up for revision or slated to be removed from the books altogether.
In fact, confidence was so high that PUHCA would be repealed in 1992 (attendant to the 1992 National Energy Policy Act) that an entire section of DOE's for 1993 was devoted to consolidation resulting from the inevitable repeal. This was not the first time the industry had been down this path. In the 1970s, a veteran utility analyst said PUHCA was obsolete and likely to be abolished. Hard to believe that nearly 30 years later, the law has not been changed-although energy prices, policies, technology, and the overall utility risk profile have changed drastically.
A conflict between provisions of the act and current energy policy now has become embedded in the system, and investors cannot be expected to respond favorably. Either the law has to change or the movement to competitive markets has to be abandoned. An ongoing schizophrenic situation will cause the capital markets (both debt and equity) to exact an increasing risk premium, thereby undermining the desired price savings arising from competition.
When Policy and Law Collide: Who Wins?
The AEP/CSW merger is noteworthy not only for the intense regulatory scrutiny, but in how it represents a transition to broader, competitive markets. The transaction was reviewed and approved years ago by the Federal Energy Regulatory Commission (FERC), the SEC, and 11 states.
Then on May 3, an SEC law judge found that "AEP has failed to establish that the combined AEP/CSW system is confined in its operations to a single area or region," and concluded that "the combined AEP/CSW system does not constitute a single integrated public-utility system under the act."
Didn't someone in the federal government look at a map? The ALJ's finding of a proposed breach of regulatory principal or law five years after the fact involving two agencies of the federal government (the direct challenge of the SEC's findings, and by implication those of the FERC) raises serious questions about the system of checks and balances in this country. Members of these two agencies are nominated by the president and approved by Congress, and as such they have the highest level of accountability. The public, especially the investing public, should be able to have some faith in the staying power of their combined decisions.
Would AEP spend the money, time, and effort to acquire CSW if management was not compelled by a growing national sentiment for increased competition? Moreover, would CSW have accepted the offer if its management did not share the same view? At the time, there was a movement calling for an end to the historic land-locked monopolies and a broadening of the breadth and depth of the electricity markets. It was, therefore, reasonable for AEP to expect a contemporary interpretation of the four most restrictive PUHCA provisions:
1. Interconnection Requirement- The capability of physical interconnection;
2. Coordination Requirement-The capability of operating as a single interconnected and coordinated system;
3. Single Area or Region Requirement-Confinement to a single area or region; and
4. Localization Requirement-The system must not be so large as to impair the advantage of local operating management, efficiencies and regulation.
The FERC's rulemaking changes further support AEP's and CSW's position. For example, in December 1999, FERC issued , calling on transmission-rich utilities either to form or join a regional transmission organization (RTO) that in effect created "virtual transmission integration" systems. Creation of RTOs, as well as other structural and operating changes in place today, arguably could satisfy the troubling PUHCA requirements-infrastructure changes that were inconceivable in 1935.
Conditional approval of the AEP/CSW merger by FERC clearly weaves prevailing energy policy into its written decision and addresses the anti-competitive (and speculative investment) points of law under the act, satisfying the public interest standard by:
Providing greater customer choice, which increases competition; Lowering prices for consumers through more efficient markets; and Increasing reliability for non-discriminatory transmission systems.
Through the newly expanded market created by RTOs and flexible interpretation of the "contiguous" requirements, the AEP/CSW merger could defuse the anti-competitive issue and allow the SEC and FERC to permit the AEP/CSW merger.
Are investors to believe that federal regulators are merely a rogue group shaping energy policy unchecked? FERC clearly was aware of the spirit of 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 () that these utilities are not contiguous under a literal standard (, 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 "BBB" credit rating today, despite financial recoveries in the past two decades; Non-investment grade ratings for some utilities; An industry that any fiduciary would not deem appropriate for "widows and orphans"; and Five Chapter 11 filings between 2001 and 2003, one in 1988, and one in 1992 (excluding an out-of-court reorganization in 1992).
What is the outlook for electric utilities? It is difficult to envision fundamentals improving unless and until energy policy and law are fully synchronized. Deregulation has been encouraged since the early to mid-1990s, but for the most part, these initiatives occurred at the administrative level rather than at legislative level. For instance, by 2001, 25 states had adopted deregulation policies, while the remaining half of the United States had not-a 50/50 split. Is it any wonder Congress can't reach a consensus on PUHCA reform? In some instances state regulators requested clarifying legislation before embarking upon restructuring.
At the federal level, the absence of current energy legislation is best illustrated by the SEC's need to revisit the AEP/CSW merger application. Does strictly holding AEP to the criteria of PUHCA accurately reflect current energy policy? Over the long run, the capital markets cannot be expected to respond favorably to the discord between policy and law because it creates uncertainty and increases risk.
Energy Legislation 2005: Here We Go Again
In April 2005 the House passed H.R. 6, the Energy Policy Act of 2005, a comprehensive bill that would (among other things): (1) repeal PUHCA; (2) ensure open access to the interstate transmission grid for all generators; (3) reform The Public Utility Regulatory Policies Act (PURPA); (4) establish mandatory, enforceable reliability rules to reduce the risk of power outages; (5) promote the use of technology to meet the nation's energy future, such as authorizing funding for the Hydrogen Fuel Initiative; (6) increase the use of domestic clean coal and renewable fuels; and (7) renew the nuclear energy initiative with Price-Anderson Act liability insurance revisions, as well as clarify tax treatment of nuclear decommissioning costs.
But repeal was short lived. The Senate was quick to exclude PUHCA repeal from its version of the energy bill, holding the act or any modifications to it political hostage. The leverage engendered by the act has rendered it much too powerful to merely repeal without exacting concessions from special-interest groups. PUHCA's fate likely will rest in the hands of a conference committee, not based on the need for change but rather as a political chip in a high-stakes game where energy policy is seemingly of secondary importance.
Congress needs to face a painful economic reality: Consolidation is a natural economic consequence of deregulation. Companies merge to reduce operating expenses and become more competitive and efficient. As a result, they are able to offer customers lower rates.
When the market requires higher prices to induce supply, regulation cannot be reintroduced without destabilizing the entire industry. The recent failure of several new power companies reflects the difficulty of operating between the regulated and deregulated worlds.
A thoughtful modification of PUHCA may be the common-sense compromise that finally breaks the mystique surrounding the 70-year-old law. It should allow for:
1. Competitive electricity markets;
2. Better flow of energy-more efficient use of limited energy resources;
3. Lower consumer prices as a result of more efficient markets;
4. Improved capital attraction and lower cost to consumers;
5. Utilities as an investment vehicle for Social Security reform (returning utilities to the safe-haven status they traditionally enjoyed); and
6. Enhanced national security.
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