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<title>April 2003: Carrot Upside-Down Cake</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>
April 2003</u></b></p>
<p align="center"><font size="6">Carrot Upside-Down Cake</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 debate over how to accelerate the development of
needed transmission assets, brought to the forefront by FERC’s Docket
PL03-1-000, is proving to be yet another round of the fundamental regulatory
debate of the decade: the "Structuralists" vs. the "Incentivists." FERC
unwittingly has managed to plant a foot firmly and ineffectively in each
camp. The result is that resolution of the real core policy issue of the
decade – allocation of capital between regulated and unregulated assets – is
being muddied.</p>
<p ALIGN="JUSTIFY">Some definitions first. Incentivists believe that if more
of something is desired from capitalists, the dots are connected by offering
them a higher return for it. Structuralists believe that properly
constructed and operating markets will elicit socially desirable responses
from capitalists in a more efficient way. To characterize the debate as
carrot vs. stick ideology is oversimplification; but it points in the right
direction.</p>
<p ALIGN="JUSTIFY">An Incentivist would view the transmission shortfall as a
consequence of the breakdown of the connection between regulation and
desired capital allocation. When overspending on generation capacity –
whether from plant cost overruns or excessive demand estimates – outstripped
need, it was effectively greeted with return disallowances and insufficient
rates of return. No return on regulated assets resulted in fewer regulated
assets being constructed and a decline in transmission expenditure. Further,
better returns in the late ‘90s on deregulated assets than on price return,
capped regulated assets and produced a flight from reliance on regulated
assets in rate base to provide needed profits. Whence distinguished analyst
Leonard Hyman’s assessment of where we are today:</p>
<dir>
<dir>
<p ALIGN="JUSTIFY">"Federal regulators focused on process and structure
rather than simple incentives to investment, so financial prudent
transmission owners decided to defer investment."</p>
</dir>
</dir>
<p ALIGN="JUSTIFY">That some financially imprudent transmission owners also
were cash strapped because of the follies of unbridled deregulation, only
served to exacerbate the looming transmission finance gap. Hyman’s forecast
result is an Incentivist regulatory solution to the problem: massive filings
for rate increases to cover the costs of new capital to cover the cost of
higher spending to maintain reliability.</p>
<p ALIGN="JUSTIFY">Itself somewhat influenced by Incentivist philosophy for
the first time in PL03-1-000, FERC opted for the grant of incentive rates,
in part, simply for the investment in needed additional assets, i.e., a
generic 100 basis-point allowance would be set aside for the treatment of
investment in new transmission facilities determined to be needed by the RTO
planning process (including operational enhancements to transmission
capacity for the grid).</p>
<p ALIGN="JUSTIFY">But FERC, of course, still remains Structuralist at
heart. Its strongest impulse is to foster RTO organization as the core of
achieving the SMD philosophy, articulated in Order No. 2000. Hence, it
proposed grants of 50 basis points on ROE for entities that transfer
operational control of their facilities to RTOs. Moreover, FERC is a
believer that another kind of structured entity within the RTO – the ITC –
is most likely to engage in socially desirable, new transmission
development. The proposed rule’s provision is that if an ITC participates in
an RTO and meets the independent ownership requirement, it would qualify for
an additional incentive equivalent to 150 basis points. Thus, FERC’s
implicit motto – if you build it right, the goods will come from them (even
if it must be on the back of regulated assets). Taken altogether, FERC is
offering quite a carrot cake.</p>
<p ALIGN="JUSTIFY">Deregulation’s true believers want to carry FERC’s logic
further. They want FERC, now that it has swallowed the basic Incentivist
approach, to go whole hog for its application to promotion of Standard
Market Design. In their view, the incentives should only be fully available
to RTOs or ITCs when LMP Congestion Revenue Rights (CRRs) and forward
financial markets have been fully implemented by an RTO. In short,
Incentivism should be put in the service of structuralism – asset results
come later.</p>
<p ALIGN="JUSTIFY">The result for Structuralists is to be feared: "once you
pay more, you get more" becomes the regulator’s mantra. It is but a short
step to asking: "You want more governance or just more goods?" The road to
re-regulation may be paved with Incentivist intentions on the part of
Structuralists. If the RTO process is enlisted in recognizing the full range
of potential supply and demand solutions, e.g., installing generation rather
than transmission, as deregulation activists demand. It may be all that will
happen is freezing of the current partially regulated/partially deregulated
system. Different capitalists will make different judgments as to where
return will be best – regulated or on an incentivized deregulated basis.</p>
<p ALIGN="JUSTIFY">Instead of trying to remedy all problems with an
Incentivist brush as to transmission, FERC should have the courage of its
Structuralist convictions and confine itself to monetary rewards for
physical performance, not market design conformity. The road to
re-regulation is paved with flawed incentives. Carrot-style regulation can
produce carrot upside-down cake.</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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