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<title>June 2003: "SMDWhite (Flag) Paper Caper"</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>
June 2003</u></b></p>
<p align="center"><font size="6">"SMDWhite (Flag) Paper Caper"</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>003/08/11)<br>
</font><span style="font-size: 10.0pt; font-family: Palatino; color: black">
</span></p>
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<p ALIGN="JUSTIFY">When a "standard design" for the powerhouse is
redesignated a "platform," it is a good indication that a political tornado
has blown its roof off. Its chances of implementation must be questioned
when even the revised paper’s issuance is not enough to deter the Senate
Energy and Natural Resources Committee to vote to remand SMD to FERC and gag
FERC’s issuance of orders until July 2005. It is understandable that there
should be the resonance of a tinny arf to the Chairman’s reassurances.</p>
<p ALIGN="JUSTIFY">What does FERC’s migration from White Paper to White Flag
mean for the economic future of merchant and independent power, and the
markets’ evaluation of existing power assets and companies? Remember – this
is the same SMD that Standard & Poors recently explicitly asserted was
critical to the resuscitation of the merchant power market.</p>
<p ALIGN="JUSTIFY">Most of the analyses of the problems of the merchant
power industry today boil down to identification of regional power
supply-demand imbalances, breakdown of the market trading mechanism, flaws
in local market design, and physical insufficiency of the grid to permit the
type of trading that would reward new, more efficient units. The impact of
all of these factors was multiplied by excesses in the financing of merchant
companies and merchant plants, which now have created the overhanging ledge
of necessary project refinancing and teetering distressed assets that, as
likely as not, will bring new classes of equity investors into the market.</p>
<p ALIGN="JUSTIFY">The original concept of SMD was to restore confidence in
the deregulated model by remedying the flaws that experience with Order No.
2000 had highlighted, and by building out the framework for innovative
development of the transmission system. In the process of doing this, since
it involved change in the way the utility business was run and therefore
overseen, a greater degree of Federal centralization was deemed necessary.
That centralization appears to have been damaged permanently.</p>
<p ALIGN="JUSTIFY">Consequently, in evaluating the practical ramifications
of the FERC Wholesale "power platform" White Flag, the most important
question is how the absence of its centralization will affect the real world
financial situation which the capital markets face today. Response requires
delineation of how the power markets would look if the platform was
implemented as written, and consideration of how it would address the
financial issues presented.</p>
<p ALIGN="JUSTIFY">Broadly speaking (and subject to much technical
clarification), the marketplace would have the following characteristics:</p>
<ul>
<li>
<p ALIGN="JUSTIFY">There will be ISOs and RTOs (not necessarily of
appropriate geographic size), administering transmission and creation of
spot markets to meet real-time energy needs, but not having the broad,
regional system management authority that FERC originally had envisaged.
Vertically-integrated companies may be members.<br>
</li>
<li>
<p ALIGN="JUSTIFY">State jurisdiction will be preserved, in particular,
over matters such as bundled transmission rates, determination of resource
adequacy, protection of native load customers’ transmission rights,
availability of FTRs in support of congestion pricing, and the setting of
the form and charges of access fees. Congestion management will not be
required to include LMP. Regional state committees will emerge as
important players, determining regional power adequacy, to what extent
participant-funding transmission development will be possible, and
effecting intra-state coordination.<br>
</li>
<li>
<p ALIGN="JUSTIFY">Market monitoring will be conducted by RTO/ISO
independent market monitors – which will report both to FERC and to
regional and state authorities. <br>
</li>
<li>
<p ALIGN="JUSTIFY">The White Flag recognizes - but does not suggest how,
in the future:</li>
</ul>
<blockquote>
<blockquote>
<blockquote>
<p ALIGN="JUSTIFY">"Market mitigation measures must work together with
measure on resource." </p>
</blockquote>
</blockquote>
</blockquote>
<p ALIGN="JUSTIFY">How useful will this "platform" be in responding to the
issues facing the industry? The more probable answers are the following:</p>
<ul>
<li>
<p ALIGN="JUSTIFY">Management of transmission and dispatch will become
more regularized. However, such management will not be homogenous or
likely, by itself, to advance the cause of interregional power sales or
disparities of reserve margins between regions. Regional power marketing
may be enhanced, but the "seams" issues could be as pronounced as ever.
The role of state commissions and regional bodies in setting future rules
may cloud the rate of future transmission development.<br>
</li>
<li>
<p ALIGN="JUSTIFY">There will be less upheaval in the patterns of
operation of the current transmission system environment, as native load
market rights will be protected. It is possible that the extent to which
new transmission is developed will be impeded, as issues for
responsibility for payment are disputed.<br>
</li>
<li>
<p ALIGN="JUSTIFY">Those with current market power (including integrated
utilities) are more likely to withstand assaults on their existing
position as transmission suppliers, and to effectively preserve that
market power.</li>
</ul>
<p ALIGN="JUSTIFY">From the perspective of merchant power developers,
therefore, the following conclusions are likely:</p>
<ul>
<li>
<p ALIGN="JUSTIFY">While the market will continue to move toward the type
of structure that merchant plant developers desire, their ability to
mitigate or overcome entrenched market power seems likely to be reduced,
rather than enhanced.<br>
</li>
<li>
<p ALIGN="JUSTIFY">It is possible that the cutback in SMD will contribute
to interest in those companies where re-regulation has taken hold or
simply never left. Those assets that are capable of earning a return
within the framework of regulated utilities may become more attractive.<br>
</li>
<li>
<p ALIGN="JUSTIFY">As perception of the market as supporting significant
new upside potential through trading diminishes, the types of investors
likely to remain active are more likely to be those with lower IRR
expectations, greater comfort with a more traditional regulatory
environment, or high interest in leveraging stable cash flows. This could
impair the prospects for fresh money becoming available to deal with
problems in the merchant markets that already have developed.<br>
</li>
<li>
<p ALIGN="JUSTIFY">The prospects for more stable commodity trading of
power will be enhanced, but resurgence of the model of developing of
assets for purposes of trading around them is likely to be diminished.<br>
</li>
<li>
<p ALIGN="JUSTIFY">The prospects for new transmission development will be
enhanced by the ongoing FERC role, but diminished by the extent to which
future decisions affecting transmission will be made at the state and
regional level.<br>
</li>
<li>
<p ALIGN="JUSTIFY">Just to realize the expectations of the compromised
White Flag will require not only existing institution building (RTO/ISO)
to continue, but also a whole new complex of state and regional
collaborative institutions also will have to be developed.</li>
</ul>
<p ALIGN="JUSTIFY">In sum, a period of not expecting too much change in
favor of the independent and merchant players, and a solidification of the
position of well-capitalized, service territory-based, integrated or
partially-integrated utilities is to be expected. The capital market
situation may emerge in which large surviving players are best positioned to
take advantage of a more orderly RTO/ISO world where, while management of
wholesale operations and trading are improved, incumbency in a given service
territory is the trump card. The best financing mechanisms available for
remaining independents and merchant facilities may be for plants whose
projected output is discounted in value to modest commodity levels and
backed by third party credit enhancements.</p>
<p ALIGN="JUSTIFY">Before the industry and the financial community salute
the new White Flag that FERC has hoisted, it may be time to offer new
creative alternatives, e.g., transitional incentive structures that enhance
the likelihood that there will be a deregulated industry of consequence
after the shakeout of the next year is completed. Otherwise the White Paper
caper will have yielded merchants’ floor prices and a shaky platform.</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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