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<title>November 2003: "Blackout Janus"</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>
November 2003</u></b></p>
<font SIZE="6"><b>
<p align="center">Blackout Janus</p>
</b></font>
<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>003/11/01)<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>
<font SIZE="3">
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<p>Like the Roman God, Janus, who looked both forward and backward
simultaneously to gain a realistic perspective on events, the power industry
must assess whether the recent Blackout has or will affect the marketplace
value of transmission and transmission-supported generation assets in play
today, and whether the long-predicted flood of asset transactions will be
released.</p>
<p>Here is one assessment:</p>
<ul>
<li>Regarding transmission, as with most crises, once a national need is
identified – in this case grid improvement – more funds, or incentives to
invest more funds, are likely to become available. Whether such
funds and incentives stimulate the merchant transmission market and
enhance the value of existing assets, will depend both on whether (i)
satisfactory reform of the regulatory environment also is stimulated, so
that sound investment projections can be made, and (ii) the new
incentives made available favor aggressive application of structured
finance techniques, or use of more traditional corporate finance to
support deals by more traditional players.<br>
</li>
<li>In theory, existing generation assets value could receive a collateral
boost from the Blackout, i.e., perceived public need for supply
redundancy. This would not correspond to the actual more granular patterns
of valuation. In practice, the value of enhanced non-utility ownership of
generation also will depend on regulatory reform. Therefore, the value of
existing assets will be enhanced, for some, as the deregulated model gives
way to the re-regulated model up to the point where they can no longer
compete with rate-based assets.<br>
</li>
<li>Distributed generation could receive an impetus from the Blackout
because of its role as a reliability support mechanism. The extent of
public impetus for this development may reflect the extent to which the
relationship between enhancement of distribution, through installation of
key DG facilities and improved transmission operations, is perceived.
Targeted public policy supporting DG project finance may be required. In
any case, the value of already interconnected DG is likely to be enhanced.</li>
</ul>
<p>How could such a clear-cut signal as the Blackout produce such
uncertain and ambiguous results?</p>
<p>With respect to the impact of the Blackout itself, there is no lack of
consensus as to necessary technical fixes. To one degree or another,
virtually all observers have identified the existence of:</p>
<ul>
<li>a capital investment deficiency in both transmission and distribution
(estimated at $30-100 billion); <br>
</li>
<li>an inadequate infrastructure system, incapable of carrying the amount
of power that it is called on to bear, particularly under current usage
patterns;<br>
</li>
<li>reliance on outdated technology that is not responsive to the
requirements imposed by deregulation; and<br>
</li>
<li>absence of mandatory system reliability standards.</li>
</ul>
<p>General issues, such as whether a unified national transmission grid is
the optimal configuration for power transportation and whether as much
transmission capacity should be developed as generators consider optimal
regardless of cost, remain but they are not now impeding needed progress.</p>
<p>However, the basic problem is that, notwithstanding the Blackout, no
definitive reform of grid management and future systems requirements
identification has emerged. The occurrence of the Blackout cannot be counted
on to revise the regulatory environment. Of course, underlying this veneer
of political and policy issues are competing corporate economic interests.
</p>
<p>The future value of many assets depends on the determination whether the
United States technically can and should continue a hybrid provision of
system of service by the power industry, part by integrated firms that
produce and transmit power and partially by firms (or organizations)
specializing in one of these activities, which rely upon innovative federal
(or regional) governance to protect the competitive economics of their
business strategies.</p>
<p>The Blackout consequently has been characterized as justifying two polar
opposite sets of policy con-clusions: </p>
<ul>
<li>One holds that deregulation is a flawed approach to the power
industry, which has resulted not only in:</li>
</ul>
<blockquote>
<blockquote>
<p>- power flows as a result of open access in ways and directions that
cannot be accommodated by the existing grid; but also in </p>
<p>- "freeloading" on the use of the existing (and potentially enhanced)
wires by non-regulated wholesale producers and beneficiaries of
transmission improvement.</p>
</blockquote>
</blockquote>
<p>This is the argument behind support for measures that would defer any
FERC implementation of FERC’s Standard Market Design as a condition of
making Congressional progress on other issues related to prevention of
future blackouts. </p>
<ul>
<li>The other reminds us that traditional regulation is a flawed approach
to the modern power industry that:</li>
</ul>
<blockquote>
<blockquote>
<p>- balkanizes the oversight of operations and, by deferring
excessively to locally regulated control areas, leads to blackouts; </p>
<p>- stifles healthy open access competition via such as that which
already has been unleashed in the generation sector and overturned the
impact of developments; and </p>
<p>- will not furnish the cost-of-service incentives necessary for
transmission enhancement. </p>
</blockquote>
</blockquote>
<p>The Blackout debate is, of course, actually an extension of a "seven-year
war" regarding the introduction by FERC of competitive markets to replace
the existing regulated monopoly model. An ancillary thrust of its Standard
Market Design proposal (even as scaled back to make it more politically
acceptable) was, among other matters, to assure the framework for the
economics of both generation and transmission in a deregulated environment a
commercially viable tool on an ongoing basis. Currently, of course, the
somewhat perilous future of this approach is before Congress.</p>
<p>In sum, because the Blackout crisis and ensuing debate was one not only
of management of the power transportation system but of the future of
deregulation, its future impacts (for good or ill) will fall both on the
value of generation and transmission. It was through modification of
access to the transportation system that competitive generation markets were
created. The resolution of the transportation crisis, therefore, has the
potential to protect existing leverageable cash flow streams – thereby
enhancing or modifying the value of many assets – or simply to
reestablish a model in which corporate finance of returns increased by
regulators locks in traditional utility structure and affects valuation
accordingly.</p>
<p>Accordingly, here is a Janus-like, reasonable hypothetical construct of
how events may respond to the Blackout. Its implications can be modified
over time, if prognostications prove inaccurate:</p>
<p>(1) The operation of the grid will be improved introduction of needed
control techniques, such as improved overall mandatory reliability
management, national operating standards and Federal eminent domain for
transmission lines. </p>
<p>(2) A limited form of regional grid management, with some voluntary
elements and considerable regional variation, will be instituted. </p>
<p>(3) There will be declining regulatory support for IPPs labeled as
transmission system troublemakers, and utilities will continue to move
assets into rate-based or self-service facilities; merchants will continue
to risk manage hedged investments for selected players.</p>
<p>(4) Recognition of the difficulty and associated probable time delay of
developing any new transmission, notwithstanding piecemeal reform,
particularly in a regulatory environment where siting issues continue and
there are regulatory ambiguities in development of markets, will contribute
to some increased focus on use of distributed generation as reliability
backstop and also as a technique for reducing transmission system strain
through distribution system improvement.</p>
<p>Accordingly, we are increasing likely to see hybrid regulated/nonregulated
markets, particularly in generation, and competition between regulated and
unregulated assets. Key trends during the three- to five-year period while
the state/FERC regulated-unregulated environment continues in both
transmission and generation are: </p>
<ul>
<li>Nonregulated generation will need to compete with utility generation,
both for utility native load and on-the-spot and short-term capacity
markets.<br>
</li>
<li>Full, fixed-cost recovery by regulated units from native load will
enable utility generation to compete at purely marginal cost in
competitive markets.<br>
</li>
<li>If this is the case, a higher premium to be required on non-regulated
investments; regulatory commissions may then allow higher achievable
returns on equity for regulated utilities. </li>
</ul>
<p>Which leads to two non-intuitive conclusions:</p>
<ul>
<li>Existing valuation of asset valuations may (gasp) be no more accurate
than prior models, due to the effect of regulation. <br>
</li>
<li>Opportunities created by differing perceptions of buyers and sellers
of how changing regulation will affect them may be created, which could
serve to bridge some of the current market pricing gaps and attract new
buyers of regulated assets and companies into the market.</li>
</ul>
<p>A result that would certainly please Janus. </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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