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<title>March 2001: California Dreaming</title>
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<p align="left"><font face="Arial"><strong><small>About The Author:<br>
<br>
</small></strong><span lang="X-NONE" style="color: black"><font size="2">
ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon
Markets Group has practiced law related to the finance of environmental and
energy projects and companies for 40 years. In particular, he has analyzed
and executed a wide variety and substantial value of project financings. He
chairs the American Bar Association’s Committee on Carbon Trading and
Finance, serves on the Board of the American Council for Renewable Energy,
and has been a senior official in the Federal Energy Administration. He is
a graduate of Brown University, Yale Law School and Harvard Business School.</font></span></font></p>
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<td width="75%" valign="top"><img src="../images/feldman.gif" alt="Washington Viewpoint by Roger Feldman" border="0" WIDTH="375" HEIGHT="75"><p><b><u><br>
March 2001</u><br>
</b></p>
<p><b><font face="Arial" size="6">California Dreaming</font></b></p>
<p><strong>by Roger Feldman -- Bingham, Dana L.L.P.<br>
</strong><font face="Arial" size="2">(<em>originally published by PMA OnLine Magazine:
200</em>1/03)<br>
</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">Recently, I had occasion to refer to
the Dictionary of Project Finance for a definition of "regulatory
risk." This one-way mirror on the power industry wall provided the
following cryptic blurb: </font></p>
<blockquote>
<p ALIGN="JUSTIFY"><font face="Arial"><i>A circumstance subject to
public governance affecting supplier revenue volatility adversely,
generally characterized by one or more of the following: competing
economic theories as purported basis for problem resolution,
inadequately defined authority of regulatory bodies, political interests
not directly related to problem resolution, and severe fractionalization
of economic interests of consumers affected by the circumstance. </i></font></p>
<p ALIGN="JUSTIFY"><font face="Arial"><i>See <b>California Energy
Regulation.</b> <br>
Synonyms <b>Three Ring Circus</b> or <b>formula for apocalypse</b>.</i> </font></p>
</blockquote>
<p ALIGN="JUSTIFY"><font face="Arial">The Dictionary goes on to explain
that "regulatory risk" represents a deterrent to means of
finance dependent all or in part on projected future cash flow in the
absence of third party credit support arrangements.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">Well, Houston, I think we have a
power finance "regulatory risk" situation shaping up. It springs
from the non-pragmatic, wacky form of public policy dialogue that seems to
be endemic to the contemporary Washington scene. To judge from the public
debate, what we have is an Armageddon for the economic theory of
deregulation: one of those issues that these days red-blooded Americans
send to the courts. Some players purport to believe that once this
intellectual issue is resolved, the policy questions will fall away.
Always a na�ve viewpoint. Here’s the state of matters today.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">First, there are those who assert
that the California experience proves that power deregulation does not
work, and that we should return to regulation, i.e., re-regulation.
Certainly in California the popularly held view is that deregulation was a
portal to sharp dealing on the trading exchanges and price spike
manipulation. A key feature of re-regulation in this view seems to be
price controls of one type or another as well. Ratepayers, after all vote.
Enlightened re-regulationists are prepared to recognize that the laws of
supply and demand have something to do with prices too. Apparently, more
in response to emergency than ideology, re-regulation at the California
state level has morphed into a statist doctrine as well: State purchase of
transmission; state expedition of new plant development; state financing
and equity kicker ownership in utilities; state development. It worked in
the USSR didn’t it?</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">Confronting the re-regulationists,
from an intellectual standpoint, are the true believers in free market
economics. For them, the California debacle is the moment of truth for
proponents of the mixed economic model of private sector and government
imposed regulatory mechanisms. California was not <u>de</u>regulation
after all; there were still quite a number of regulations left
standing-not counting the ISO public participants queued all the way into
the hall. Now, they assert these muddle-headed quasi socialists must give
way to the recognition that a free and unfettered competitive marketplace
is the best and only resource allocation mechanisms.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">Sometimes, however, this line of
argument has led, to more pragmatic analysis of where California went
wrong- which analysis does not by itself, unhappily, reveal all that
California must now do to get it right. Noted repeatedly by analysts of
this agnostic persuasion are the following facts: the California utilities
pushed for system reform to deregulate wholesale prices but leave retail
prices capped (at what they thought would be a high enough level for them
to benefit); the unregulated out-of-state generators blocked the utilities’
efforts to have a right to enter long term contracts in order to hedge
power supply risk; the consumers refused (and still refuse!) to be exposed
to the market prices which might have resulted in some conservation, as
well as stimulating new plant development; the actual configuration of the
power grid (and the still incomplete Federal open access rules) do not
permit the wholesale power suppliers to respond to opportunities actually
presented; the environmentalists, through the State, blocked the needed
necessary construction of new plants (pitching a 10 year shutout, albeit
against little utility resistance); the utilities dropped their
conservation plans, with State blessing, (because deregulation was
supposed to solve all problems, per the utilities). Thus, flawed
deregulation, rather than the concept of deregulation is the villain for
these moderate deregulationists.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">Lurking in the chasin between the
re-regulationists and deregulators lies the cynical political center. For
its denizens, the problem is even simpler than those polar ideologues
recognize: it’s a supply and demand gap. So far, so good. But for these
purported realists, energy supply covers a pretty wide ambit since, for
political reasons the cynical political center wants it to. As <u>The Wall
Street Journal</u> reports on the new Administration’s response to the
Western states’ energy crisis: "It was not lost on anyone (at a
White House staff meeting) that the energy crisis in the West may also be
an opportunity to build support to a sense of urgency for their national
energy agenda." In other words, drilling in the Arctic National
Wildlife Reserve is to be touted by the Administration as translating into
lower power prices in California. A new national energy act is being
scripted in reliance on this viewpoint. (They’re even bringing back the
old Federal Energy Administration head as an advisor – his other hat is
heading NASDAQ, strangely pertinent experience, that…).</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">Meanwhile on Valentine’s Day the
FERC, left to retain operating market order built on this shifting
ideological sand, came up with a two part mock Solomonic order allowing
the California utilities to schedule and transmit their own generation
over their own lines, but denying Cal ISO efforts to schedule third-party
transactions in the absence of adequate assurance of payment from third
party sources. And where would that credit support come from: perhaps,
suggests FERC, a creditworthy state agency or specific state bond issue.
Thus do the adherents of free markets redirect the heavy lifting to others
(of other political parties) if deregulation is to be made to work. The
dream lives on at FERC that if the price goes to $100,000 a megawatt, the
speed with which new plants will go up in California is increased.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">Slowly out of the rubble produced by
the re-regulation/deregulation demolition derby is emerging recognition of
the potential of demand management as a result of price responsiveness by
large customers. It is an approach utilities in Georgia, Illinois and PJM
have followed with some success. It is an approach new information
technology can abet. It is even an approach which Mr. Greenspan seems to
have implicitly endorsed in his characteristically cryptic observation to
the Congress that "The sharp increase in energy prices in the US does
not appear to have a broad economic affect other than to depress aggregate
demand." Demand Resource Management, while no panacea, also
represents a potential bridge between the re-regulation and deregulation
forces, since it entails applying market principles in a manner, which
benefits consumers as well as producers.</font></p>
<p ALIGN="JUSTIFY"><font face="Arial">Moreover, through its application,
however, a degree of regulatory uncertainty otherwise present for new
generation facilities (i.e. the extent of spikes) can be reduced. That is
not a claim parties to either side of the polarizing
re-regulation-deregulation debate can make convincingly to the capital
markets. Or, as the Project Finance Dictionary defines
"compromise" "A means of stabilizing projected cash flow on
a probabilistic basis by addressing the supply and demand aspects of
regulatory uncertainty in a comprehensible manner." Synonyms: <i>"Deregulation
Preservation"</i> or <i>"California Dreaming (on a sunny
day)."</i></font></p>
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text-align:left"><font face="Arial" size="2">
<span lang="X-NONE" style="color: black">ROGER FELDMAN, Co-Chair of Andrews
Kurth LLP Climate Change and Carbon Markets Group has practiced law related
to the finance of environmental and energy projects and companies for 40
years. In particular, he has analyzed and executed a wide variety and
substantial value of project financings. He chairs the American Bar
Association’s Committee on Carbon Trading and Finance, serves on the Board
of the American Council for Renewable Energy, and has been a senior official
in the Federal Energy Administration. He is a graduate of Brown University,
Yale Law School and Harvard Business School.</span></font></p>
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