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<title>March 2003: Look Reality in the Face: The Need for a New Approach</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>
March 2003</u></b></p>
<p align="center"><font size="6">Looking Reality In The Face: The Need For A
New Approach</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: 2</em>003/06/14)<br>
</font><span style="font-size: 10.0pt; font-family: Palatino; color: black">
</span></p>
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<p ALIGN="JUSTIFY">The current semi-deregulated market structure of the
electric utility industry does not appear to be a stable one. Taking into
account what is happening in the financial markets, regulatory incentives to
preserve market operations until excess generation surpluses are absorbed
may be appropriate. Here’s why.</p>
<p ALIGN="JUSTIFY"><b>Financial Market Trends</b></p>
<p ALIGN="JUSTIFY">While economists and other policymakers continue to argue
the cases for deregulation vs. re-regulation, most recently in the context
of SMD and related transmission incentive rates, the demands of the capital
markets and responses by corporate planners are pushing events ahead of
them. Market pressures for firm cash flow to secure debt may overwhelm
considerations as to the long-run benefits to consumers that may result from
deregulation. That is why FERC must rapidly re-examine its policies relating
to utility transfer of assets from the unregulated to the regulated sector.
Its most recent approval of such a transfer by Cinergy Service Inc.
(EC 02-113) was hedged with expressions of plans for future policy change.
The scope of this policy evaluation should be broadened and accelerated.</p>
<p ALIGN="JUSTIFY">About two-thirds of U.S. generation still operates in a
cost-of-service, rate-of-return environment. Because there is excess
capacity in most of the country, with the exception of a few load pockets,
wholesale prices may be expected to be driven down to marginal production
costs. Unfortunately, in those circumstances, the fixed cost (including the
debt service) of project-financed independent plants are not covered. (By
contrast, in the regulated environment, utilities will recover their
financing costs as part of their cost of service.) Consequently, there
exists a threat to the viability of the bonds of individual merchant
projects. While it varies regionally, this analysis is exacerbated by the
fact that "spark spread" prospects for future merchant generation also are
poor, since gas prices seem likely to increase.</p>
<p ALIGN="JUSTIFY">Full-scale restructuring likely will follow in some
cases, as banks assess the adequacy of their provisions for bad project
debt. Given the resulting pressure on project debt, valuation will
necessarily depend on recovery potential for project assets. It seems
inevitable that, in some cases, debtholders will find themselves thrust into
the role of equity owners, and facing the prospect of having to whip assets
into shape so they will be attractive to potential buyers.</p>
<p ALIGN="JUSTIFY">Investments in traditional vertically-integrated
utilities, on the other hand, generally continue to provide access to solid
and respectable (albeit not inspiring) cash flows. Companies holding
"unregulated" as well as "traditionally regulated" assets, if they are not
seeking to sell them to realize cash, understandably may well seek to
withdraw them into the shelter of regulation. In Cinergy’s case, where there
also was in-service territory load demand to be met, the latter course had
greater feasibility and greater appeal. Cinergy’s competitors focused on the
harm this would cause to the competitive environment in which they were
operating. It was evidently a situation where affiliate abuse potential was
present, because utility ownership and operation had supplanted sales that
otherwise would have been subject to Commission scrutiny over
cross-subsidization and improper exercise of market power. Opportunities for
third parties to serve parent utility load also were necessarily constrained
in a way they would not have been if a competitive bid had been held.</p>
<p ALIGN="JUSTIFY">While FERC upheld the transaction, because it would
neither change the parent’s market share nor charge wholesale rates, it
recognized that transactions like this would imbalance the competitive
market: franchised utilities would be in a position to create "safety nets"
for their IPPs, while independent IPPs would not be able to do so. In short,
capital investment could be recovered through rate base, under circumstances
where operation of market-based rates was unattractive. Correlatively,
prices of those IPPs would not be subject to the discipline of a competitive
market. FERC, therefore, announced that it was going to modify its approach
"to analyzing competitive effects of intra-corporate transactions of this
nature."</p>
<p ALIGN="JUSTIFY">However, the foregoing discussion of how the capital
markets view the precipitous shift in attractiveness of the FERC-constructed,
competition-based markets suggests that a more fundamental consideration of
issues beyond "affiliate abuse" is required. That is because:</p>
<ul>
<li>
<p ALIGN="JUSTIFY">The capital markets are rejecting the viability of a
market-based rate regime to support financing in the absence of firm
bilateral arrangements.<br>
</li>
<li>
<p ALIGN="JUSTIFY">The current and apparently likely future deterioration
of the spark spread endangers even existing merchant plants predicated on
tolling arrangements.<br>
</li>
<li>
<p ALIGN="JUSTIFY">To preserve their economic viability, efforts by
regulated utilities and distressed asset purchasers will focus on
obtaining conventional cost-of-service treatment.<br>
</li>
<li>
<p ALIGN="JUSTIFY">To assure continuation of healthy "native load service"
(as well as, in some cases, by concerns with their integrated utilities or
their own concerns about jurisdiction), state commissions are likely to
accommodate those trends.<br>
</li>
<li>
<p ALIGN="JUSTIFY">Under those circumstances, arguments that as a result
of retail deregulation there is likely to be a reduction of consumer
prices, are unlikely to have the policy weight that it once did.</li>
</ul>
<p ALIGN="JUSTIFY">It may well be time to think about more fundamental
accommodation to the financial realities of the power marketplace, rather
than simply bulling ahead with reform (SMD) or rolling back to the
monopoly-based, service territory cost-of-service system in the now much
consolidated utility industry.</p>
<p ALIGN="JUSTIFY">A new methodology to formulating a transitional approach
that is responsive to the cascade of financial difficulties otherwise facing
the industry, but which contemplates no subsidies, loan guaranties or
similar arrangements, is necessary. Its elements are these:</p>
<ul>
<li>
<p ALIGN="JUSTIFY">Accept the fact that there are excess reserve margins,
which differ by region, that most likely will be worked off over a period
of the next few years (depending, of course, on the rate of economic
resurgence).<br>
</li>
<li>
<p ALIGN="JUSTIFY">Freeze all movement of generating assets from the
unregulated sector to the regulated sector, so long as dispatch is RTO-managed.<br>
</li>
<li>
<p ALIGN="JUSTIFY">Proceed with the efforts to establish workable
competitive markets without seams and without native load preference
through SMD.<br>
</li>
<li>
<p ALIGN="JUSTIFY">Provide some incentive return to the parent holders of
independent generation assets frozen in the competitive market sector that
will diminish as current reserve margins are reduced, so long as the
corporate parents proceed to implement their RTO obligations.<br>
</li>
<li>
<p ALIGN="JUSTIFY">Afford merchant plants not owned by utility affiliates
some parallel rate relief so that they may compete in the deregulated
market.</li>
</ul>
<p>There are shorter-run costs to consumers in doing this, and possibly some
comparatively negative impact to existing integrated utilities. There is
basically, however, only one alternative: let the market work and pick up
the pieces afterward. This would result in a waste of physical capital or
financial stability, which the United States will have difficulty sustaining
in its current condition. It ultimately would be worse for consumers. We are
dealing with a transitional situation that can be addressed by transitional
rules. These rules should address the financial realities of today’s markets
so that the long-term prospects for deregulation (at least in some regions
of the country) can be saved. Otherwise, the unintended consequences of
company-by-company and project-by-project workouts may make construction of
competitive markets a practical impossibility. In short, it is time for
Washington policymakers to look reality in the face and consider radical,
new industry-encompassing approaches.</p>
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<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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