But the fly in the ointment is computer modeling, where no one yet agrees on how to mirror the real world.
A promise made is a promise kept, even in the halls of government.
And so it was that in mid-November, after a four-year wait, the Federal Energy Regulatory Commission (FERC) issued Order 642, its new final rule on filing requirements for mergers involving public utilities.1 With the new rule, effective Jan. 29, the commission at last honored the pledge it had made back in December 1996, when it had issued a new "policy statement"2 indicating a desire to change its approach.
Order 642 announces no policy departures. On the face, it simply establishes filing requirements to support applications for mergers and other asset transactions that are subject to FERC's jurisdiction under Section 203 of the Federal Power Act. Nevertheless, in its preamble the order does offer valuable guidance on how the commission will look at future mergers with major competitive consequences. Order 642 also is important for what it does not do.
Order 642 rejects certain parties' requests for a merger "moratorium," and leaves unchanged the FERC's requirements concerning a merger's impact on ratepayers and on federal and state regulation. Order 642 also announces that competition-related showings will not be required for transactions to join a regional transmission organization (RTO), sell transmission facilities, or accomplish internal corporate reorganizations. FERC also reaffirms its policy of not evaluating a merger's effect on retail competition unless a state lacks authority under state law and "asks us to do so."
Overall, the order provides plain guidelines for the preparation of merger applications, and a quite lucid summary of FERC's underlying merger policy. Order 642 should improve the quality of merger applications, and thus ensure that all considerations relevant to the public interest implications of a merger are brought to the surface, fully discussed by interested parties, and fully evaluated by FERC in reaching its ultimate decision.
Horizontal Deals: Measuring "Downstream" Impacts
The new rule reaffirms the use of the Competitive Analysis Screen (CAS), as set forth in "Appendix A" of FERC's 1996 merger policy statement. Among other things, the CAS analyzes which suppliers can participate as sellers within a given destination market-both before and after the proposed merger-to allow the commission to weigh the effect of the deal on wholesale power markets. One key question for the FERC in issuing Order 642 was to decide how to define and categorize destination markets, and how to measure impacts on those markets.
The destination markets that must be evaluated in the CAS consist at least of the service areas of those utilities directly and indirectly connected with the merging companies, and those areas in which the merging companies historically have traded electricity. Declaring that energy companies are entering new geographic markets, Order 642 adds the new requirement that applicants identify any destination markets where they reasonably may be perceived as potential competitors. Applicants are excused from submitting a CAS only if they can demonstrate that their merger would have no more than competitive impacts.3
In performing a CAS, the applicants must define relevant product and geographic markets. Order 642 retains as relevant products non-firm energy, short-term capacity (or firm energy), and long-term capacity. Perhaps sensitized by California-related concerns that the real-time market can be a focus of potential anticompetitive activity,4 Order 642 adds spinning and non-spinning reserves and imbalance energy as new products for CAS evaluation.
For defining the geographic market, Order 642 retains the delivered-price test, which includes suppliers in a destination market if they can physically reach the market and if their price is no more than 5 percent above the pre-merger market price. Applicants also are required to provide "sensitivity analyses," at least some of which would assume the completion of announced but not consummated mergers.
The rule also requires merger applicants to submit extensive market and transmission capacity data, including data on firm transmission rights and transmission congestion contracts, in order to assure the proper identification of all relevant destination markets and all the electric supply with physical or financial access to those markets. The FERC presumes in the new regulations that capability on transmission interfaces that become internal to a merged firm will be unavailable to alternate suppliers unless (1) the merged company lacks generating capacity to use the interface capability, (2) applicants commit to making some interface capability available, or (3) alternate suppliers have purchased the capability long-term.
The rule also reaffirms reliance on the Herfindahl-Hirschman Index (HHI) statistic for identifying those horizontal mergers that have major competitive impacts. The HHI statistic is derived for each destination market by summing the squares of the percentage shares of the market participants pre- and post-merger to determine (1) the degree of concentration in the destination market, and (2) the merger-related increase in market concentration. The increase in the HHI relative to the degree of market concentration determines whether a merger raises anticompetitive concerns.
Policy by Bean Counting
Are computers the answer?As the FERC developed its merger rule, it asked the industry how it might use computer models to simulate the dynamic complexity of wholesale power markets. That might allow the FERC to look beyond narrow geographic areas, to capture the effects of arbitrage.
And while the comments appeared largely favorable on the use of computers, doubts still emerged, prompting the commission to postpone the question to a technical conference "at some future date."
- Tracking the Market
"The [FERC] fails to allow for arbitraging. ... [F]ocusing only on particular destination markets ... ignores the reality that other neighboring markets may have alternative supplies that could help limit profitability ... thus constraining the exercise of market power." -
- Try Using Computers
"FERC may wish to take advantage of advances in computer simulation modeling techniques to examine more alternative scenarios ... We expect that more flexible, reliable, and accurate models will be developed and might soon be commercially available. ..." -
- But Do It Right
"[T]he main advantage of models of the type proposed by the commission is that they simulate the interaction among all loads and resources, resulting in power flows that arbitrage between markets. ... However, the [FERC] proposes to zero out all loads except the destination market load. ... This destroys the power of the model." -
- Better Yet, Forget It
"These markets do not suffer easily the approximations that were so useful and convenient in regulated markets. ... [W]e are not aware of the existence of any model that is generally recognized to be competent. ..." -
-B.W.R.
However, noting that the CAS is conservative, the order's preamble states that the mere presence of CAS violations (i.e., HHI increases above acceptable levels) will not necessarily cause rejection of a merger or require mitigation measures in order to gain merger approval. According to the preamble, market conditions (e.g., demand and supply elasticity), ease of entry and market rules, and technical conditions (such as types of generation involved) each can cast light on whether a particular merger may harm competition. As an illustration, the preamble cites the recent ComEd/PECO decision.5 FERC there determined that the base load characteristics of the applicants' nuclear generation, which produced a significant HHI increase, prevented its use as part of a capacity-withholding strategy to exercise market power. In two other recent cases, NSP/New Century and CP&L/Florida Progress, FERC similarly found that the CAS violations were not the kind indicating that the merged companies could exercise horizontal market power.6
The order's preamble provides helpful commentary on the treatment of power sale contracts in CAS analysis. FERC's view had been that capacity sold under contracts for a year or longer should be classified as the purchaser's capacity and part of the purchaser's market share. However, recognizing that control over unit output is essential to implementing an anticompetitive scheme, the preamble emphasizes the need to determine whether the seller or the purchaser has actual control over the operation of the unit from which the capacity is sold.
Order 642 also requires applicants to include with the merger filing any mitigation remedies that may be appropriate. FERC distinguishes between behavioral remedies (e.g., according transmission priority to certain customer classes) and structural remedies (e.g., divestiture). The preamble does not say, but does imply, that a behavioral remedy may suffice if the competitive concerns raised by the CAS appear to be short-lived in nature. Conversely, longer-term problems may require structural remedies.
The preamble's helpful commentary on the treatment of power sale contracts suggests that a temporary sale of capacity, coupled with an effective mechanism to divest the seller of control over the operation of the unit, will constitute satisfactory mitigation, particularly where the FERC expects the period of competitive concern to be short-lived. FERC praises commitments to join RTOs as a pro-competitive means for mitigating merger-related market power increases.
Vertical Deals: Looking Upstream
Order 642 establishes the filing requirements for vertical mergers, chiefly between gas and electric companies, that may foster market power at an "upstream" level (e.g., gas as boiler fuel for electric generators) which enables a firm to charge anticompetitive prices in a second "downstream" market (e.g., electric generation). And while the rule reiterates many of the requirements for horizontal mergers (HHI statistics, the CAS, and effects on competition), it also adds some unique requirements for approving vertical deals.
According to FERC, the mischief of a vertical merger-the creation of the opportunity or incentive for the merged firm to exploit its position in the upstream gas supply market in order to charge anticompetitive prices in the downstream electric generation market-can be accomplished in several ways. These include increasing the price of, or withholding the supply of gas, engaging in concerted anticompetitive activity in the upstream markets with other participants in those markets, sharing competitively significant information, or through regulatory evasion raising the price of gas sold internally to a downstream regulated electric utility. In all cases, the end result is anticompetitively high electricity prices.
A vertical merger can create competition issues only where the applicants have both upstream and downstream market power. FERC frequently finds no market power concerns if the applicants lack market power either upstream or downstream or where the merged firm's upstream markets are geographically remote from its downstream markets.7 Order 642 also specifies that vertical analysis is not needed when the upstream product sold by the merged firm is used to produce no more than a amount of the downstream product.
Assuming there are vertical problems, applicants must determine whether the upstream markets are highly concentrated (i.e., exhibit an HHI statistic of 1,800 or higher). Since a minimum of six suppliers is necessary arithmetically to reduce the HHI statistic below the highly concentrated level, nearly all upstream markets will be found to be highly concentrated. The traditional CAS and the delivered-price test then are used to evaluate concentration in the downstream electric markets. In this analysis, the merged company is treated as owning all the electric applicant's electric generation, plus all the electric generation receiving natural gas service from the gas applicant.8 In addition, whereas the acceptability of a horizontal merger depends on the merger-related increase in market concentration, a vertical merger would be viewed as creating competition problems simply because the upstream and downstream markets are highly concentrated.
Order 642 does not reverse FERC's policy of accepting "behavioral" mitigation in the form of its pipeline standards to justify vertical mergers raising potential anticompetitive concerns.9 In the merger, FERC applied the pipeline standards to the relationship between a gas distributor and its electric marketing affiliates.10 In the merger, FERC applied the pipeline standards to the relationship between an interstate pipeline and each of its affiliated energy companies.11 In that case, FERC specifically rejected an applicant's objection that "energy" was overly broad and that the standards should be limited to a narrower class of affiliates. FERC's chief objectives in and were to prevent discriminatory service offerings and the competitive misuse of commercially sensitive information. Of course, restrictions on sharing of information and employees also hinder management's ability to obtain merger efficiencies and cost savings. Along another remedial avenue, in the merger of two vertically integrated electric utilities, FERC found transmission vertical market power remedied by membership in an independent system operator/RTO.12
Computer Modeling: As Yet Unresolved
The limitation of the traditional CAS method is that each destination market is modeled in isolation from other destination markets. The result is that the same capacity (e.g., cheap nuclear or hydro capacity) could be viewed as simultaneously "in" more than one destination market, thus potentially overstating or understating the competitive impacts of a merger.
In Order 642's preamble, FERC continues to express hope for computer modeling simulation analysis as a solution to this problem. Simulation analysis would account for opportunity costs and power flows in a dynamic power supply setting; it would simultaneously model all destination markets, and determine, at least conceptually, the impact of a merger on all destination markets in a setting that mirrors actual commercial markets. The fly in the ointment is the absence of consensus on how to perform these computer analyses. Instead of providing "how to" guidelines, FERC promises to convene a technical conference at some unspecified time. Nevertheless, FERC emphasizes that computer-based simulation models will form a useful tool for analyzing mergers in the future.
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3 See generally .
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6 See generally
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9 Pipeline Standards, 18 CFR Part 161, §250.16.
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11 approving a convergence merger based on the applicants' inability to affect prices profitably in the downstream electric markets.
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