A Q&A with White & Case's Earle O'Donnell, Donna M. Attanasio And Zori Ferkin
A series of changes to the regulations governing investment in the power sector provide opportunities to potentially raise returns and reduce risk for more investors. These reforms may go unnoticed, particularly by investors seeking smaller ownership interests and those who have not traditionally invested in utilities, such as many hedge funds. However, these changes warrant careful consideration by all types of potential investors. Furthermore, recent reforms in some regions should reduce price volatility and hopefully attract new investment.
In the following Q&A, veteran energy lawyers Earle O'Donnell, partner and head of White & Case's Energy Markets and Regulatory Group, Donna Attanasio, partner and Zori Ferkin, of counsel, each of whom recently joined White & Case, explain how regulatory changes create investment opportunities, and provide guidance on how to circumvent many pitfalls when contemplating acquisitions and making other investments in this sector.
Q: What are a few key changes to regulations governing investment in the power sector that may offer benefits to investors?
Earle: A key development was the repeal of the Public Utility Holding Company Act of 1935 (PUHCA). Prior to the repeal, the act generally prevented a company that owned five percent or more of a public utility company's voting securities from acquiring five percent or more of a second utility's voting securities – with limited exceptions – without time-consuming approval by the Securities and Exchange Commission (SEC). Even if the investor secured timely SEC approval, it was subjected to intrusive regulation by the SEC. PUHCA also prohibited combinations of electric and gas utilities that were in separate markets, while Federal Energy Regulatory Commission (FERC) policy, for competitive reasons, discouraged unions of electric utilities in the same regions. Together, these policies previously made it more challenging to acquire utilities.
Federal law also previously barred electric utilities from owning more than 50 percent of qualifying facilities (QFs), which refer to cogenerators or small power producers that under federal law have the right to sell their excess power output to public utilities. In 2005, Congress repealed the ownership limitation. At the same time, it allowed utilities to apply to be relieved of the federal obligation to buy power from QFs, but only if they can demonstrate that the QF has meaningful access to competitive energy and capacity markets. In addition, Congress revised sections of the Federal Power Act relating to mergers, acquisitions and dispositions of utilities that generally require FERC pre-approval for a broad range of such transactions. FERC's implementing regulations, however, granted various "blanket authorizations," which are essentially pre-granted authorizations for certain types of transactions with an after-the–fact notice. The law now generally requires holding companies acquiring 10 percent or more of certain utility securities and utilities disposing of assets (generally with a value more than $10 million) to obtain FERC's approval before proceeding with a transaction. FERC recently asked for public comments on whether to expand those blanket authorizations to more types of transactions.
The overall effect of these changes is to centralize federal energy regulation in one agency, FERC, and to streamline the regulatory process for some transactions.
Q: What's the importance of expanding these blanket authorizations?
Donna: Blanket authorizations can create a faster and less costly secondary market for trades of small shares of utility securities and facilitate transactions that do not raise regulatory concerns. For example, blanket authorizations permit acquisitions of voting securities by a holding company if, after the acquisition, the holding company owns less than 10 percent of the outstanding voting securities – subject to after-the-fact filing requirements. However, in many cases, "acquisitions" authorized by these blank authorizations are still subject to FERC review as "dispositions." FERC is considering proposals to expand these authorizations to further open the market for entities such as financial institutions and private equity funds that are not interested in owning and controlling the operations of a public utility, but are willing to invest in one and participate in the sector including, for example, by taking positions in distressed equities of utilities. We are currently involved in a proceeding in which we've been asked by clients to try to persuade FERC to loosen further some of the rules so that more types of transactions can proceed under these types of blanket authorizations.
Q: What actions has FERC taken to help ensure that there is a sufficient supply of electricity at "just and reasonable" prices, while still minimizing artificial price volatility and encourage investment?
Earle: To provide some background, demand in the PJM region – which extends from the coast of New Jersey, up to the New York border, to the Mid-Atlantic areas reaching out as far west as Illinois and as far south as parts of North Carolina – has been rising, while new entry has tapered off and many generation units have been retired. Although there are looming shortages in some areas of PJM, prices do not reflect these shortages because energy and capacity prices are tied to very near-term supply and demand conditions, as short as the next day or even the same day. This has contributed to volatility in prices and inadequate revenue to ensure needed investment to ensure long-term reliability. In organized markets that operate in PJM, New York and New England, FERC has been quietly supportive of efforts to facilitate cost-effective investment by assuring that the rates people receive for generation include a component for what is called the capacity value of generation – that is, that a generator gets paid for the power it is capable of delivering into the grid. In markets such as New England, New York and PJM, there has historically been a payment designed to allow generators to recover the capacity value – the cost of the steel in the ground if you will – that's ready to produce power. That system has not been very effective and FERC has been in the process of trying to come up with programs that achieve an overall price for generation that will induce investment when there is a need in the long term – even in situations where there might be a surplus at the present time. FERC has approved programs in these territories to try to establish somewhat more stable long-term price signals in hopes that people will avoid a boom or bust pricing cycle. This has happened in recent years where there would be too much capacity and nobody would build, then too little capacity, and suddenly prices would skyrocket, and by the time building would begin, we'd see a long-term price spike that was politically and economically destabilizing.
I participated actively in the settlement agreement that was filed by PJM Interconnection and many suppliers and purchasers of power to establish new market rules based on capacity auctions. While not perfect from anyone's perspective, the changes made by the settlement do provide longer-term price signals that are differentiated by location. This should address the core problem and help assure adequate electricity supply at just and reasonable prices over the long term. FERC recently approved the settlement which takes effect later this year.
Q: What types of issues should investors be attentive to on a state level?
Zori: There are many state incentives that can present substantial opportunities. If you're a supplier that wants to sell to a utility, you need (as with any potential purchaser) to understand that utility's power needs and the regulatory environment in which that utility operates. You must ask yourself questions such as, "Does the utility have a looming reliability need?" For example, California is requiring that load-serving entities, which have been granted the authority or have an obligation to sell electric energy to end users, be able to demonstrate that they have resources available to them to meet anticipated loads. If prices vary by location, it is important to know where the utility needs the capacity and to assess whether higher prices that may exist in one locality are likely to be mitigated over time by planned investment, for example, in additional transmission. Other questions to consider are, "Does the state have renewable portfolio standards?" and "Are there state tax incentives for certain investments and how do state tax incentives complement federal tax incentives?"
Q: What particular issues should investors – particularly non-traditional investors in this sector – consider when drafting language in documentation to form new funds or amend existing funds to allow them to invest in utilities?
Donna: When forming a fund, you should resist the urge to recycle language from past fund documents, such as restrictions on who may invest in the fund and the types of investments it may hold. As a result of the significant regulatory changes, a lot of that language may not make sense anymore. For example, many funds were created to invest in QFs and there used to be a restriction on utility ownership of them. Therefore, many of these funds had restrictions that said no public utility or public utility holding company could invest in that particular fund, and that it will not invest in anything other than qualifying facilities. Some of those restrictions are not relevant today as even a fund with utility participants is able to invest in a qualifying facility without any adverse consequences to the QF's status. Furthermore, you may also want to rewrite the fund documents to broaden the fund's investment parameters, such as by allowing it to invest in transmission companies, although doing so may expose the fund to some additional regulatory scrutiny (but far less so than in the past). That kind of advice is rooted in our regulatory experience, which is why clients turn to us to advise them how funds can be formed, what they can invest in and how capital can be deployed into the industry.
Q: In light of the recent regulations, are there any particular issues that utilities should consider when contemplating taking significant positions in qualifying facilities?
Earle: Utilities should consider whether it would make sense from an economic perspective to take a majority or sole ownership interest position in qualifying facilities, but careful attention needs to be paid in this regard to provisions in existing qualifying facility power sales contracts regarding maintenance of the qualifying facility‘s status.
Q: Do have you any final tips?
Earle: I think it's important to have a structured investment plan in place. There are a lot of little "gotcha" issues that you've got to pay attention to up front. They're not the types of things you want to be caught later having missed. They range from early consideration of timing and cost of obtaining interconnection to and transmission on the grid, to knowing when to have your business on line to take advantage of production tax credits. There are a myriad of complex regulations and issues to consider before making a business decision, and you have to wade through them very systematically. That's an area where someone who is approaching this with an eye of wanting to invest in the industry, and having a working knowledge of the rules, the short cuts, the ways in which you can most effectively and efficiently get your money working in this industry, the right commercial questions to address, can put you on a more prudent track toward maximizing the value of your invested dollars.
And that's really a very central part of what we do. We try to identify issues and then work with the client to solve them early in the process. There are pricing incentives. There are blanket authorizations and exemptions. We take all these factors into account when advising our clients and share our past experiences with them as doing so can save our clients significant money over the long term and position them to seize new potential opportunities faster and with more confidence than their competitors.