As a former independent power producer, George Lagassa is sympathetic to the woes of the merchant power industry. Until just a few years ago, he held the license to a micro-hydro qualifying facility (QF) in New Hampshire, so he understands what it takes to compete in a regulated-franchise industry. Yet, as the principal of Mainstream Appraisals in North Hampton, N.H., Lagassa is also a dedicated pragmatist. He sees the industry's consolidation trend as a sort of correction in the U.S. power market.
"IPPs might be squawking about fair-market value, but I'd submit that value is largely what you define it to be," Lagassa says. "If an owner is obligated to sell a plant, for whatever reason, then that asset is inherently distressed. A distressed asset, by definition, will not sell for fair-market value."
Meanwhile, 1,500 miles to the west in Oklahoma, Pete Delaney is hoping to buy one such asset. Delaney, an executive vice president at OGE Energy Corp., has his eye on the 520- MW McClain plant, now owned by the bankrupt NRG Energy. The Oklahoma Corporation Commission approved OGE's plan to acquire the plant, but the deal has been delayed by interventions at the Federal Energy Regulatory Commission (FERC).
Competitive power suppliers are crying foul, charging that OGE is freezing out competing generators, and that the utility should have conducted a competitive solicitation before deciding to acquire the McClain facility. But Delaney is quick to respond.
"It's a false belief that we can go out and get a great contract for supplies to serve our retail customers," he says. "When we look at the other supply options, buying this plant is the hands-down winner all the way around-on cost, efficiency, location, and risk."
Delaney asserts that generators within reasonable transmitting range of OGE's load don't want to tie up their output with a 30-year purchased power agreement (PPA) priced at today's depressed wholesale rates. Even if they would, such contracts today pose troublesome counterparty credit risks. "The rating agencies view long-term PPAs as debt equivalents," Delaney says. OG&E already buys $120 million of power annually under contracts with AES, Calpine, and PowerSmith Generating, but it is concerned about the prospect of exposing itself to a generator with financial difficulties. "Signing a long-term contract with a 'B'-rated entity brings substantial counterparty risk," he says.
Conversely, by acquiring the McClain plant, OGE can lock in a secure source of liquidation-priced capacity for the lifetime of the facility, which is only three years old, and generates some of the most efficient power in the region.
With his voice betraying more than a hint of frustration, Delaney asks, "If we can't buy McClain, which is clearly cheaper than building a plant, where does that leave us? Are we supposed to charge retail customers higher rates so that federal regulators can force a market solution that isn't economic?"
Another 1,500 miles to the west, Jan Smutny-Jones is experiencing a persistent sensation of déjà vu.
As the executive director of the Independent Energy Producers (IEP) trade association in Sacramento, Calif., Smutny-Jones was an early advocate for the potential of competition in power generation. Such reformers battled the American utility-industrial complex all the way to the U.S. Supreme Court-and won.
Or did they?
"We're seeing a very disturbing national trend that is taking several different forms," Smutny-Jones says. "Various parts of the country are taking a huge step backward."
He's referring to the growing trend toward utilities bringing formerly unregulated power assets into the regulated rate base, either directly, by acquiring or transferring ownership, or indirectly, through special-purpose affiliates and contracts. Many such deals, Smutny-Jones says, have the effect of freezing out competitive suppliers and leaving ratepayers holding the risk. Others act as a safety net, he says, for affiliated companies that have failed in their unregulated business ventures (see sidebar above, "No Safety Nets Allowed").
"You need a long-term memory in this business to recall that the good-old days of cost-plus regulation weren't all that good," he says. "It's obvious that utilities would like to get back into the generation business, because it's a great deal having ratepayers trapped to cover your managerial mistakes. But that's not appropriate."
Vertical integration is returning to the U.S. utility industry. The combination of illiquid wholesale markets, tighter credit requirements and a preponderance of distressed merchant plants has set the stage for utilities to acquire unregulated generation capacity to serve retail loads. And while even detractors admit that each of these transactions might have merit, they argue that the trend raises difficult questions about what supply procurement practices are appropriate in today's halfway-deregulated power market. "Without a doubt, the decades-long trend away from utility-owned generation has reversed," says Jeff Bodington, principal of financial advisory Bodington & Co. in San Francisco. (See Figure 1, "U.S. Power Plants Sold, 2003," p. 35). "Now the question is, how much will we backtrack?"
In 2003, just over 1.4 GW of unregulated generating capacity was converted into rate-based assets, for the bargain price of $585 million. In the coming months, if major deals already announced proceed, at least another 5.6 GW of unregulated capacity will move into the regulated rate base. (See Figure 2, "Building Rate Base," p. 37).
This trend is fueled by a variety of factors, but the key trigger in many cases seems to be the fear of blackouts. "Utilities see shortages coming," Bodington says. "In part, utilities were shocked by the Northeast blackout last year, and in particular some municipals want to island themselves so they can be insulated from regional problems. With the many difficulties in the power industry, one of the surest ways for a utility to get regulatory approval of new capacity is to put it in its rate base."
Many such deals, however, are coming under fire. The merchant power community, for example, has a litany of complaints about this trend. They argue that in general, such transactions might reduce competition by removing suppliers from the market. These deals tend to be inherently discriminatory, they say, and some of them amount to procurement decisions being made without the benefit of a transparent and fair approach to determining least-cost options. Many argue that a competitive solicitation is the only way to know whether a given transaction is the optimal one for ratepayers.
"You'd think states would want to do bidding to make sure ratepayers are getting the best deal," says Julie Simon, vice president of policy with the Electric Power Supply Association (EPSA). "Instead, they are taking the utility's word for it." The problem, Simon argues, is that utilities have a vested interest in owning generating capacity rather than contracting for it.
"They make a return on equity by putting assets into their rate base, and that's how you get into a situation where ratepayers are paying more than they should," she says. "This is a serious problem because without bidding, you can't know if these deals are valid."
Questions involving the prudence of utilities' procurement plans fall within the purview of state regulators, and these very regulators have approved affiliate transactions in which power assets are being acquired or transferred into ratebase without using a competitive solicitation process. The growing list of states that have approved such deals include California, Indiana, Kentucky, Oklahoma, and arguably Missouri. Merchant power advocates also are closely watching proceedings in Arizona, Florida, Georgia, Louisiana, Pennsylvania, and Wisconsin.
"If the state regulators determine that retail ratepayers won't get ripped off, then the FERC should defer to that determination," says Larry Eisenstat, a partner with Dickstein, Shapiro, Morin & Oshinsky, and head of its electric power practice. "But the FERC can't defer on the question of how these deals affect the wholesale market." Indeed, FERC is taking a close look at some major rate-basing proposals currently on its docket. Examples include the aforementioned OGE Energy/McClain acquisition, as well as: (1) Southern California Edison's (SCE) proposed assimilation of the 1,054-MW Mountainview project now under construction; (2) Ameren's plan to rate-base two plants totaling nearly 550 MW; and (3) Cinergy's plan to integrate 712 MW of unregulated assets into the rate base of PSI Energy. The Cinergy plan has received FERC's provisional blessing and seems to be nearing the finish line.
The Ameren and Cinergy deals are particularly noteworthy because they would transfer assets that are already owned by affiliates of the acquiring utilities. Others, including the SCE-Mountainview transaction and another deal proposed by Duquesne Light, involve affiliates acquiring third-party assets and selling the output to the affiliated utility. Such transactions prompted FERC to apply strict standards for determining if an affiliate transaction is fair and legitimate.
At a conference hosted by Merrill Lynch in late January, FERC Chairman Pat Wood confirmed that the commission is looking closely at rate-basing deals and their effects on competitive wholesale markets.
"I will admit some concern about the acquisition of temporarily distressed generation assets by local utilities that would otherwise be buying under a long-term contract," Wood said. "We're concerned about not only deals with affiliates, but deals that make power markets more concentrated as opposed to more disaggregated. That means less competition, and it ultimately means that we have to back into a regulated market, which I don't think any of us wants to do."
Such sentiments being expressed at FERC give utilities pause, but they insist that bringing unregulated plants into the rate base will prove to be irrelevant from a wholesale-market perspective. "If you ran the market-power numbers, they would come out the same whether the utility purchased a power plant or its output under a long-term contract," says Ed Comer, general counsel of the Edison Electric Institute (EEI) in Washington. "In either case, they'd control the power. The critical question is whether the deal serves retail customers."
Merchant power advocates, however, argue that such statements belie utilities' real motives-to build ratebase and squelch competition. "Currently there is no merchant market in the United States," Smutny-Jones says. "Everything is predicated on contracts. When you have a major buyer refusing to enter into power purchase contracts, [nearby merchant plants] sooner or later are bound to become distressed. It's a self-perpetuating prophecy."
The conflicts between utilities and merchant generators-not to mention federal and state regulators-seem unlikely to abate any time soon, but signals coming from both camps suggest that room exists for compromise. During 2004, the industry and its regulators will be challenged to find such compromise solutions.
For example, the California Public Utilities Commission (CPUC) approved Edison's Mountainview acquisition because the commission saw an imminent and growing need for power capacity in SCE's service territory. At the same time, though, CPUC found "vexing weaknesses" with the structure of SCE's proposed transaction. So the commission attached caveats to its approval to insulate ratepayers from some of the risks SCE proposes to undertake.
Such a give-and-take approach might allow regulators to approve individual transactions, while also addressing lingering concerns about competition and market power
"If [FERC] really is concerned with protecting the wholesale market, it should take steps to ensure that when transactions such as this occur, they occur on the condition that the wholesale market remains or becomes viable," Eisenstat says. For example, if a utility is not a member of a regional transmission organization (RTO), the commission could condition approval on the utility joining an RTO, upgrading its transmission network or agreeing to take measures that would enhance wholesale competition. Such measures might entail including all available suppliers in its economic dispatch processes, or agreeing to competitively procure all of its future energy requirements.
"If a utility has market power, it should only be permitted to maintain that power if it's clear that any effort to exercise it has been or will be mitigated," Eisenstat says.
Many utilities, likewise, will probably be open to compromises that satisfy FERC's market concerns. "We offered upfront to upgrade transmission to help import capacity," Delaney says. "We're not trying to frustrate competition in wholesale markets. We've actively led and supported the development of an RTO here. We simply want to do our job of serving retail customers as effectively as we can."
Recovering Lost Ground
Clearly, the stakes are high on both sides of the issue-which is why the subject of rate-basing unregulated plants will generate a lively debate in the months ahead. For utilities and state commissioners, supply margins, reliability, and credit factors are at issue. For merchant players, the industry's very survival might be at risk.
"If FERC can't show that all generators are competing on a level playing field, then investors will be extremely reluctant to invest in anything but the regulated side," Eisenstat says.
Such concerns might seem misplaced in an industry currently suffering from too much investment in facilities, but this overbuilt situation won't last forever. Within just a few years, many regions will begin feeling the pinch of load growth. In the meantime, how procurement policies evolve could determine the ability of unregulated generators to access these growing markets-a disturbingly familiar situation for veteran independent power advocates.
"While Edison says [Mountainview] is a one-off deal, they are very active in the state legislature trying to get changes in the law that will make it easier for them to build power plants and recommit ratepayers for up to 30 years of stranded costs with no meaningful regulatory review," Smutny-Jones says. "If that's the road we are heading down, it will be a disaster."
Compromise solutions seem unlikely to satisfy all stakeholders or to cure what ails the merchant power market. But if implemented thoughtfully, they could be constructive. By allowing utilities to pursue attractive rate-basing deals, while helping merchant generators to obtain commensurate access to a deeper marketplace, compromise options might actually allow the competitive wholesale market to recover some of the ground it has lost in the past two years.
If that happens, maybe Smutny-Jones will finally be able to shake off that annoying sense of déjà vu.
No Safety Nets Allowed
Among the many issues that competitive power suppliers raise in the debate over bringing formerly unregulated power plants into the rate base is the concern over affiliate cross-subsidy. In some of the proposed arrangements, utilities are absorbing assets that are already owned by an unregulated affiliate. The question becomes whether these deals are negotiated on an arm's-length basis, and if they have the effect of charging retail ratepayers for risks incurred in unregulated markets.
"Where the utility seems to be bailing out a non-regulated subsidiary by putting a plant into the rate base, they will be accused of helping the subsidiary rather than the public good," notes David Moody, a vice president with Stone & Webster Management Consultants in Cambridge, Mass.
Such behavior will elicit uncomfortable questions from state and federal regulators, and indeed it already has. Both Ameren and Cinergy propose to rate-base plants that previously operated as competitive wholesale generators. Federal and state regulators alike have identified this approach as discriminatory.
In its ruling on Cinergy's petition, the FERC stated, "The ability of a franchised utility to assume its affiliated merchant's generation when market demand declines gives the affiliated merchant a 'safety net' that merchant generators not affiliated with a franchised utility lack… The safety net could be a barrier to entry that harms the competitive process in general and raises prices to customer in the long run because affiliated merchant generation with a safety net option will not be subject to the price discipline of a competitive market."
This issue is not necessarily a deal-killer, however; FERC approved Cinergy's petition, after all, but only with caveats and a promise to closely scrutinize subsequent proposals that use this structure. "The commission will in the future modify its approach to analyzing competitive effects of intra-corporate transactions of this nature," the commission stated. - M.T.B.
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