Shaky merger policy finds the FERC at war with itself.

"IN HIS DELIGHTFUL ARTICLE, "THE FOLKLORE OF Deregulation," published this summer in the Yale Journal on Regulation, federal judge Richard Cudahy notes the ethereal nature of "virtual electricity." This new product, he explains,"exists only as a blip on a computer screen and will never give one a shock." "Reality," he notes, has "retreated to the money part of the system."

We could use a dose of that reality in looking at electric utility mergers.

Over the Veteran's Day holiday, I found time to read some 650 pages of regulatory policy and industry comments on electric utility mergers filed this past spring and summer at the Federal Energy Regulatory Commission (see Docket No. RM98-4-000). The FERC wants to codify the nonbinding policy statement it issued in 1996 in Order 592, and extend that policy to vertical mergers.

Back when Alfred Kahn convinced the federal government to deregulate the rates charged by the nation's passenger airlines, no one correctly anticipated how the new business would operate (em the hub-and-spoke model, fares fluctuating at a whim.

That's the challenge for the FERC. How can it sift the "good" mergers from the "bad" when no one can predict what utilities will look like in just a few years? The FERC wants to avoid putting too much electric generation in the hands of a single firm that also controls access to transmission or "inputs" (such as natural gas) that play a significant role in electricity production. But why should that be necessary now? After all, the FERC presumably ensured open access to transmission in Orders 888 and 889. Natural gas pipelines and local distribution companies remain largely regulated. The FERC rules should make it impossible to use control of gas assets to leverage market power in electric generation.

To complicate matters, utilities are divesting generating capacity, becoming "wires companies," where size might be desirable. Market power may end up with retail aggregators, wielding a controlling share of energy purchases in retail markets. But the FERC says it won't examine that, even if effects seem severe (as in the defunct Constellation merger), or even if state regulators ask for help, as shown in the Nov. 10 ruling that set a hearing on the pending merger between American Electric Power Co. and Central and Southwest Corp.

At its core, the FERC's electric utility merger policy admits a failure of regulation. Robert Bork said it all in the title of his 1978 book, The Antitrust Paradox: A Policy at War With Itself.

IN ITS NOTICE OF PROPOSED RULEMAKING, issued on April 16, the FERC proposed to codify the analytic screen described in Order 592 for horizontal mergers and carry it over to vertical mergers. That proposal attracted convincing opposition on various ideas from all over the electric industry. The most revealing comments came from the Edison Electric Institute; the American Public Power Association (joined by the Transmission Access Policy Study Group); The Southern Company; Sempra Energy; state regulators from New York, Missouri, and Ohio; the National Rural Electric Cooperative Association; the Electric Consumers Resource Council (joined by the American Iron and Steel Institute and the Chemical Manufacturers Association); and the consulting firm of Putnam Hayes & Bartlett.

The FERC policy would identify the pre-merger market shares in electric generation products in wholesale markets and compare them with market shares predicted after the merger. It would focus on the predicted change in HHI figures (Herfindahl-Hirschman Index), by estimating how much product could be supplied economically by other suppliers. It would consider limitations of geography, variable costs, transmission constraints, and native-load reservations. For vertical mergers, any generating plants owned by a company supplying inputs (such as natural gas, for gas-fired plants) would be deemed as owned in common by the input supplier.

Thus, for any market, the FERC would track all sellers that might conceivably be involved. But it would ignore the level of buyer demand, as well as whether the suppliers might do better by selling their generation in different locations at a higher price.

Comments from EEI attacked the FERC's "delivered price test." EEI offered analysis from economist Mark Frankena, now senior v.p. of Economists Inc., of Washington, D.C., and a former deputy director for antitrust in the Bureau of Economics at the Federal Trade Commission. The consulting firm Putnam Hayes & Bartlett essentially agreed, describing the FERC's effort as a "need to put names on electrons."

MANY ISSUES APPEAR PROBLEMATIC. They indict not only the merger policy, but the FERC's underlying theory of functional unbundling without any forced divestiture of generation from transmission. Here are the most convincing critiques:

• Opportunity Costs. EEI, Southern, APPA/TAPS, and PHB discredit the FERC's DPT method, which ignores arbitrage and gridwide opportunity costs. NY PSC says concentration of generation may have benefit (em that transmission regulation won't dispel all monopoly power.

• Retail Impacts. ELCON, state regulators, see blurring of wholesale retail markets. NRECA says retail issue will go unexamined, since states won't admit a lack of authority (em the sine qua non for FERC review.

• Other Pending Mergers. Should HHI figures treat other pending mergers as fact? If not, notes NY PSC, initial analysis would be "meaningless" if other deals occur by the time case ends.

• Vertical Mergers. PHB, EEI, see little threat, since gas/electric mergers simply "realign sales patterns," and make boost efficiency.

• Confidentiality. PHB, EEI, see advantages to Hart-Scott-Rodino procedure, where market data stays confidential. EEI offers study by Mike Naeve suggesting FERC wants to conduct study in the open (with assistance from intervenors) to cover for its lack of manpower. APPA/TAPS predicts merger applicants will give the "run-around" to the FERC, rather than divulge data.

• Structural Separation. Sempra Energy offers an easier path: Dispense with all data collection and market share calculation. It can't be done in a changing industry. Instead, approve merger only if applicants divest all generation and form an independent system operator.

Putnam, Hayes and Barlett raises another troubling point. It notes that since most mergers will fail the objective analytic screen, the decision will hinge on subjective factors, such as how the FERC treats efforts at mitigating market power.

"Is membership in an ISO a de facto requirement, as many observers believe? ¼ What competitive harm is it believed to solve. ¼ If no conforming ISO is available, what interim mitigation, if any, is required?"

PHB concludes: "From the moment when the application is filed, the ex parte rules come into force. Neither applicants nor intervenors have any window into the staff's deliberations."

EEI gets the last word:

"As a significant number of companies will have divested some or all of their generation assets, mergers of transcos or 'wires' businesses may come before the Commission. Mergers of wires companies, which will remain subject to price and access regulation should raise virtually no significant market power problems and indeed should be viewed positively."

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