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<title>February 2002: Frodo's Physics and Gandalf's Pretzel</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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<img src="../images/feldman.gif" alt="Washington Viewpoint by Roger Feldman" border="0" width="375" height="75"><p><b><u><br>
February 2002</u><br>
</b></p>
<p><font size="6">Frodo's Physics and <br>
Grandalf's Pretzel</font></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:
2002</em>/03/09)<br>
</font><span style="font-size: 10.0pt; font-family: Palatino; color: black">
</span></p>
<font FACE="Times New Roman" SIZE="1"><i></i></font>
<p>As smoke from the Twin Towers continued to drift over New<br>
York well after 9/11, so the miasma from Enron’s wreckage<br>
continues to darken the skies of deregulation. There are, of<br>
course, its real world implications of lender credit exposure,<br>
investor recoil from the power industry, trading liquidity shrink-age<br>
and rapid decay in value of other marketing companies.</p>
<p>In addition, there is the fact of its intellectual fallout: the
credibility of the concept of competitive markets and deregulation, so
beloved of Skilling and Lay, lies under a cloud. Were these wizards simply
figuratively forging the Tolkienesque evil "one ring to hold them in the
dark and bind them": the regulatory conceptual bond to ensnare the equally
gullible and greedy worlds of prehistoric utilities and intellectually
hyperintense academics?</p>
<p>Our Frodo, the FERC, now seeks to carry the ring of market power –
revealed in California as radiating potential harm resulting from all too
ready grant of market-based rates (MBRs) – to a new crucible of economic
reason shaped by the price spike experiences in the Midwest and California.
That crucible, the market-based rates investigation order (EL01-118-000),
requires in relevant part the inclusion of the following language in all
market-based tariffs:</p>
<p>"As a condition of obtaining and retaining market based rates authority,
the seller is prohibited from engaging in anticompetitive behavior or the
exercise of market power. The seller’s competitive rate authority is subject
to refunds or other remedies as may be appropriate to address any
anticompetitive behavior or exercise of market power." </p>
<p>A review of the comments FERC has received reveals, however, that
our Frodo is like a physicist seeking to apply Newtonian laws of supply and
demand economics/physics to a market long since known to be in constant flux
under the governance of uncertainty principles. Three aspects of this flaw
in Frodonian analysis are: its treatment of time; the certainty of physical
location in the time/space continuum; and the effect of pro-active
observation on observed phenomena.</p>
<p>(1) Time. The fundamental FERC theory of MBR reform is to prevent future
bad behavior by attaching an unknown price (i.e., future rate refunds) to
current behavior later found to be bad (i.e., existing rates). Those who
object to this approach offer not only the legal argument that doing so
exceeds FERC’s power under the Federal Power Act, but also the more
metaphysical one that governance of future events is best provided by
prescriptive rules, advising parties how future events will be governed, and
thereafter enforced, once there is violation of those events. </p>
<p>(2) Space. FERC would provide, in its newly-promulgated standards, fixed
economic definitions of when market power is deemed to be present, based on
comparison of the mass of the generator’s capacity versus the peaking supply
gap in the market. Imbalance –"physical and economic withholding of
supplies" in FERC’s lexicon – is deemed to have occurred when the market
price exceeds a supplier’s "full incremental costs." But cost, that
seemingly solid rock, is (as one might surmise by analogy from the weary
history of PURPA-avoided costs) an elusive fact along the time-space
continuum; does it include – and can such pro-posed inclusion be measured –
actual costs of providing power, opportunity costs, capital costs, or
some amalgam of them all? In addition, how (as well as over what time
period) are they to be physically measured? What electron microscope will
this our scientific Frodo use?</p>
<p>(3) Uncertainty. In an effort to righteously follow market performance
and freeze-frame bad behavior in the act, FERC ignores two key variants on
Heisenberg’s Law, loosely summarized as the principle that the very fact of
observation may impact results. </p>
<p>For power markets, the law takes two forms. One variant – a humbling
caveat to the would-be deistic ratemaker – was even articulated by the
Commission itself: </p>
<p>"Every time we intervene in one market, we affect other markets and
prevent rather than support the development of efficient, competitive power
markets." </p>
<p>The other variants, sometimes known – perhaps somewhat un-fairly – as the
Gordon Gekko ("Greed is Good") corollaries are: (a) deprivation of the
upside potential for market profits ultimately slows investment in markets,
which are driven by speculation in the possibility of such upside; and (b)
uncertainty as to what regulators will firmly permit, as power sales rates
deprives power markets of their ability to serve as capital magnets by
reducing certainty as to the investment potential of power projects.
In particular, all the petals of the daisy chain of trading can be wilted by
one trade being found to be non-MBR in character. </p>
<p>In short, Frodo confronts the Enron paradox: a market is sick because of
its behavior, but must emulate some of its features or become sicker for
failure to do so. </p>
<p>Clearly, something must be done. Something really did happen in
California that could happen elsewhere. But can Frodo do it while defying
the laws of physics, particularly when the capital markets firmly believe
they drive financial choices? Perhaps after a full rulemaking in which
better-defined guidelines are laid out (notwithstanding that Frodo has drawn
his refund/price cap sword already). The haze of Enron scandal pervades the
capitol. Can a rulemaking truly be objective and achieve support until that
haze is dissipated? There is no law of physics on this point. It is the
conundrum known as Gandalf’s Pretzel. </p>
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<p class="MsoBodyText" align="left" style="margin-bottom:0in;margin-bottom:.0001pt;
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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