In a little over a year, the electric utility industry has seen six significant mergers.1 This trend toward consolidation most likely will increase as the industry becomes more competitive. Consequently, more state commissions (PUCs) will be charged with reviewing the implications of mergers for both shareholder and ratepayer interests.

The difficulty for regulators in any merger review lies in ensuring that "pre-merger" promises truly represent "post-merger" realities. To do this, regulators should maintain a healthy dose of objectivity, and perhaps a little skepticism. Any promises made during merger proceedings should be held to the strictest accountability. As the New Hampshire PUC so aptly notes:

"[P]romises must be weighed in accordance with the underlying financial strength of the enterprise. This ensures that our evaluation is an objective analysis of the merits of the proposed acquisition. To do otherwise would be to risk illusory benefits to ratepayers based upon unsound fundamentals."2

While each merger is unique, all regulators must address one common question: Is the proposed merger in the public interest?

The Public Interest

Different states have quite different statutory obligations in determining the public interest. These standards vary from a broad determination of whether a proposed merger is consistent with the public interest to a narrow determination of whether a proposed merger would result in net harm to ratepayers (em net harm being the weaker of the two standards. Under the "net harm" standard, utilities carry the burden of proof in showing that the merger will not produce more harm than good for ratepayers. Absent from consideration is whether any meaningful and quantifiable net benefits will arise from the proposed merger. Under this standard, a merger could conceivably be approved that provides little or no net benefits to ratepayers.

The broader "public interest" standard has been described as a "landscape as open as the great outdoors." This characterization, however, can be used to unnecessarily limit the scope of regulatory review. Many regulators believe the broader public interest standard encompasses a host of quantifiable (objective) and nonquantifiable (normative) criteria. The Texas PUC, for instance, in its review of the GSU/Entergy merger, outlined a list of both sets of criteria that, to one extent or another, have been used by other

PUCs to review proposed mergers or acquisitions.

The quantifiable/objective criteria proposed by the Texas PUC include: 1) rate impacts, 2) reasonableness of the purchase price of the acquired utility, 3) potential financial condition of the merged utility, 4) investment community's view of the proposed merger, and 5) any advantages in short- or long-term financing for the surviving company as a result of the merger.3 The proposed nonquantifiable/ normative criteria include: 1) service quality, 2) reliability issues, 3) potentially streamlined administrative function, and 4) improved management control and supervision.4 The importance of each

of these criteria depends upon the

circumstances of the proposed merger and the priorities of the PUC reviewing the merger application.

Rate Impacts

Changes in rate levels and structures are often the first and best indicators of how a merger will affect ratepayers. In past mergers, some utilities have proposed rate decreases, others have proposed rate freezes, some have proposed one-time refunds, and still others have proposed rate ceilings or caps. Despite the popularity of such proposals, regulators must ensure that any promised rate changes are consistent with the circumstances of the merger. In particular, are the rate proposals and projected cost savings consistent? And are proposed rate changes caused by the merger or an external condition like emerging competition?

Regulators should also look closely at the motivation behind rate design changes. Overall revenue-neutral rate design changes should be distinguished from interclass revenue-neutral changes. Rate changes should reflect the costs of the merger and not be used for other purposes, such as a preemptive strike against potential retail wheeling threats. Lower rates for industrial customers, at residential ratepayers' expense, will offer a tempting strategy for those merging companies that can afford to employ such devices. Because of the complexities, uncertainty, and opportunities for subterfuge, regulators should consider restricting their investigation of a proposed merger to the merits of the merger alone, deferring rate design changes to a future rate investigation or a later annual merger savings review.

Savings and Synergies

The biggest selling point in any proposed merger is the anticipated cost savings. All merger proposals loosely throw about claims of "synergies," "economies," and "efficiencies." Regulators should require some accountability for such claims.

Savings, however, beg the question "Compared to what?" PUCs should establish a baseline before authorizing a merger. Cost reductions attributable to the preparation for competition would exist absent a merger and should be included in the baseline.

Properly defined, a baseline can be used as part of a tracking mechanism to compare forecasted (pre-merger, stand-alone) and actual (post-merger) expenses. The baseline, however, should be adjusted annually to account for changes in inflation, using the difference between actual expenses and those established in the inflation-adjusted baseline to approximate merger-related savings.

Historically, PUCs have taken different approaches to ensure that ratepayers receive the cost savings projected from a merger. For example, the Connecticut Department of Public Utility Control, in approving the merger between Northeast Utilities and Public Service Co. of New Hampshire, required that in each future rate proceeding the merged companies pass through either 1) 50 percent of the projected administrative and general savings projected, or 2) the actual amount of the savings incurred during that period (em whichever is greater. The Kansas State Corporation Commission, on the other hand, ruled in its review of the Kansas Gas & Electric Co. and Kansas Power and Light Co. merger that savings beyond than the acquisition premium should be shared between ratepayers and stockholders on a 50/50 basis.

Establishing an appropriate sharing mechanism for cost savings will ensure accountability and create positive incentives for the merged companies. To maximize savings incentives for the merged company, PUCs should consider sharing mechanisms between ratepayers and shareholders that employ an increasing scale. That is, merged companies that meet or exceed projected savings could be allowed to keep a gradually larger share of such savings. The greater the savings, the greater the proportion reserved for the company and its shareholders.

Any evaluation of merger-related savings must consider the direct costs of the merger as well. These direct costs typically consist of transaction costs, transition costs (costs associated with early retirement options, severance pay, and other labor-reducing costs), and the acquisition premium. In most circumstances, the acquisition premium will comprise the lion's share of the total direct cost for any one company to acquire another. An acquisition premium exists when the purchase price of the acquired utility exceeds book value. Thus, one of a regulator's first steps should be to ensure that proposed merger savings exceed the acquisition premium. In recent mergers, the regulatory treatment of the acquisition premium has varied, ranging from full to no recovery. Most PUCs, however, have struck a middle ground and allowed utilities to recover the cost of the acquisition premium from the savings that result (em any excess savings are then passed on to customers.

Financial Integrity

Financial integrity carries long-term implications. A historic and projected financial analysis of merging companies should be performed on both a stand-alone and combined basis. Financial factors to examine include: capital structure ratios, bond ratings, cost of debt, preferred stock and common equity, cash flow, interest coverage ratios, dividend payout ratios, and the financial community's response to the proposed merger. Other related factors that influence the overall financial strength and risk of the individual and combined companies include customer mix, generation mix, customer growth potential, and geographic diversity.

A common merger involves the acquisition of a financially weak company by a stronger, healthier neighboring utility. While the merger generally would benefit the weaker company's customers and shareholders, the opposite might be true for the stronger company. In that case, one method of reducing adverse rate impacts to the stronger company's customers is to set rates on a stand-alone basis (e.g., based upon the capital structure and costs of the stronger company alone). Another possible method is to attempt to quantify the additional cost to ratepayers from the weakened financial condition of the stronger utility and to classify it as a direct cost of the merger that could be borne entirely by shareholders (em or shared between ratepayers and shareholders. Occasionally, however, mergers between weak and strong companies may not have an adverse impact on ratepayers. This situation can arise from the difference in capital structures, which can produce a lower overall cost of capital for the stronger company, resulting in lower rates for all customers.

Quality of Service

In keeping with the public interest standard, regulators must evaluate the effects of a merger on the quality of service provided to customers. This would include reviewing the customer service records of both companies, proposed customer service office consolidations and/or eliminations, merger-related changes to reliability, and maintenance programs. In addition, PUCs should ensure that their own actions do not threaten service quality (em for example, allowing maintenance to be deferred if projected merger savings fail to materialize. While regulators may discover some minor short-run problems, mergers should not have any long-run negative impacts on quality of service.

Regulatory Complexities

Mergers often combine utilities that operate in one or more states, thus placing the combined company under the jurisdiction of several state commissions as well as the Federal Energy Regulatory Commission (FERC). This naturally increases potential problems for the companies, and their respective PUCs, in allocating cost savings. Each jurisdiction will strive to claim the most cost savings, while attempting to belittle the allocation of any merger-related common costs. To simplify the process, regulators should consider forming joint committees among all states affected by a merger.

Cost-allocation problems may be compounded, given the complexities that arise due to changes in organizational structure and affiliate relationships between newly merged companies. As retail wheeling becomes more of a reality, regulators should be particularly attentive to cost allocations between regulated and unregulated subsidiaries, with an eye to potential cross-subsidies. Cross-subsidies should also be kept in mind when reviewing cost allocations between various market segments (e.g., residential, commercial, industrial, wholesale, and wheeling). To reduce abuses, PUCs should require strict reporting requirements, audit trails, and access to the books and records of all affiliated companies before approving any merger.

Competitive Effects

Typically, PUCs do not analyze the competitive implications of an electric utility merger (em particularly those that influence wholesale markets. Many regulators have left such issues to the FERC. But competitive (or anticompetitive) actions of the merged company (em even at the wholesale level (em can affect local retail customers. For instance, if a merger could be used to limit transmission access in a particular market area, ratepayers as a whole may suffer from higher purchased-power rates. From a retail perspective, establishing a barrier to entry before the advent of retail competition may be a way of locking up market share and locking out future competitors.

Some states have addressed concerns about merger-related impacts on competition. In its review of the Entergy/Gulf State Utilities merger, the Louisiana Public Service Commission noted that "the Commission should make sure that the merger does not present a threat of harm to competitors."5 The strongest review of the competitive implications of a proposed merger comes from the California Public Utilities Commission (CPUC), in its review of the Southern California Edison/San Diego Gas & Electric merger:

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"[T]he weight of the evidence supports a finding that the proposed merger will have adverse effects on competition in three broad categories (wholesale transmission and bulk-power markets, and the area of affiliate transactions), and that with one exception, these adverse effects cannot be avoided through mitigation measures."6

The approach taken by the CPUC offers an excellent guide (em a thorough review of past actions, present market conditions, and the future potential actions that could be taken by the merged company. While jurisdictional considerations (i.e., federal versus state) may limit the ability of regulators to act upon their findings, they should, at a minimum, review all of the competitive implications of mergers and put the merged utility on notice that regulatory action will be swift if ratepayers are adversely affected by anticompetitive practices. t

David E. Dismukes is an assistant professor in the Center for Energy Studies at the Louisiana State University. Dr. Dismukes received his BA from the University of West Florida and his MS and PhD degrees (economics) from Florida State University. Before joining the LSU faculty, Dr. Dismukes served as an economist on the staff of the Florida Public Service Commission. Kimberly H. Dismukes is an independent regulatory consultant in Baton Rouge, LA. Ms. Dismukes received her BS and MBA degrees (finance) from Florida State University. She previously served as chief legislative analyst with the Florida Office of Public Counsel.

1 Washington Water Power Co./Sierra Pacific Resources ("Altus"); Midwest Resources/Iowa-Illinois Electric & Gas Co. ("Mid-American Energy"); Wisconsin Energy Corp./Northern States Power Co. ("Primergy"); Union Electric Co./Central Illinois Public Service Co. ("Ameren"); Public Service Co. Colorado/Southwestern Public Service Co.; Potomac Electric Power Co./Baltimore Gas & Electric.

2 Re Eastern Utils. Associates, DF 89-085, Order No. 20,094, Apr. 1, 1991, 121 PUR4th 441, 461 (N.H.P.U.C.).

3 Re Gulf States Utils. Co., Dkt. No. 11292, Dec. 29, 1993, 154 PUR4th 176, 183 (Tex.P.U.C.).

4 Ibid.

5 Re Entergy Corp., Dkt. No. U-19904, Order No. 19904, 146 PUR4th 292, 317 (La.P.S.C.).

6 Re SCEcorp., Application 88-12-035, Decision 91-05-028, May 8, 1991, 40 CPUC 2d 159, 225, 122 PUR4th 225, 288 (Cal.P.U.C.).

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