March 2001

California Dreaming

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2001/03)

Recently, I had occasion to refer to the Dictionary of Project Finance for a definition of "regulatory risk." This one-way mirror on the power industry wall provided the following cryptic blurb: 

A circumstance subject to public governance affecting supplier revenue volatility adversely, generally characterized by one or more of the following: competing economic theories as purported basis for problem resolution, inadequately defined authority of regulatory bodies, political interests not directly related to problem resolution, and severe fractionalization of economic interests of consumers affected by the circumstance. 

See California Energy Regulation. 
Synonyms Three Ring Circus or formula for apocalypse. 

The Dictionary goes on to explain that "regulatory risk" represents a deterrent to means of finance dependent all or in part on projected future cash flow in the absence of third party credit support arrangements.

Well, Houston, I think we have a power finance "regulatory risk" situation shaping up. It springs from the non-pragmatic, wacky form of public policy dialogue that seems to be endemic to the contemporary Washington scene. To judge from the public debate, what we have is an Armageddon for the economic theory of deregulation: one of those issues that these days red-blooded Americans send to the courts. Some players purport to believe that once this intellectual issue is resolved, the policy questions will fall away. Always a naïve viewpoint. Here’s the state of matters today.

First, there are those who assert that the California experience proves that power deregulation does not work, and that we should return to regulation, i.e., re-regulation. Certainly in California the popularly held view is that deregulation was a portal to sharp dealing on the trading exchanges and price spike manipulation. A key feature of re-regulation in this view seems to be price controls of one type or another as well. Ratepayers, after all vote. Enlightened re-regulationists are prepared to recognize that the laws of supply and demand have something to do with prices too. Apparently, more in response to emergency than ideology, re-regulation at the California state level has morphed into a statist doctrine as well: State purchase of transmission; state expedition of new plant development; state financing and equity kicker ownership in utilities; state development. It worked in the USSR didn’t it?

Confronting the re-regulationists, from an intellectual standpoint, are the true believers in free market economics. For them, the California debacle is the moment of truth for proponents of the mixed economic model of private sector and government imposed regulatory mechanisms. California was not deregulation after all; there were still quite a number of regulations left standing-not counting the ISO public participants queued all the way into the hall. Now, they assert these muddle-headed quasi socialists must give way to the recognition that a free and unfettered competitive marketplace is the best and only resource allocation mechanisms.

Sometimes, however, this line of argument has led, to more pragmatic analysis of where California went wrong- which analysis does not by itself, unhappily, reveal all that California must now do to get it right. Noted repeatedly by analysts of this agnostic persuasion are the following facts: the California utilities pushed for system reform to deregulate wholesale prices but leave retail prices capped (at what they thought would be a high enough level for them to benefit); the unregulated out-of-state generators blocked the utilities’ efforts to have a right to enter long term contracts in order to hedge power supply risk; the consumers refused (and still refuse!) to be exposed to the market prices which might have resulted in some conservation, as well as stimulating new plant development; the actual configuration of the power grid (and the still incomplete Federal open access rules) do not permit the wholesale power suppliers to respond to opportunities actually presented; the environmentalists, through the State, blocked the needed necessary construction of new plants (pitching a 10 year shutout, albeit against little utility resistance); the utilities dropped their conservation plans, with State blessing, (because deregulation was supposed to solve all problems, per the utilities). Thus, flawed deregulation, rather than the concept of deregulation is the villain for these moderate deregulationists.

Lurking in the chasin between the re-regulationists and deregulators lies the cynical political center. For its denizens, the problem is even simpler than those polar ideologues recognize: it’s a supply and demand gap. So far, so good. But for these purported realists, energy supply covers a pretty wide ambit since, for political reasons the cynical political center wants it to. As The Wall Street Journal reports on the new Administration’s response to the Western states’ energy crisis: "It was not lost on anyone (at a White House staff meeting) that the energy crisis in the West may also be an opportunity to build support to a sense of urgency for their national energy agenda." In other words, drilling in the Arctic National Wildlife Reserve is to be touted by the Administration as translating into lower power prices in California. A new national energy act is being scripted in reliance on this viewpoint. (They’re even bringing back the old Federal Energy Administration head as an advisor – his other hat is heading NASDAQ, strangely pertinent experience, that…).

Meanwhile on Valentine’s Day the FERC, left to retain operating market order built on this shifting ideological sand, came up with a two part mock Solomonic order allowing the California utilities to schedule and transmit their own generation over their own lines, but denying Cal ISO efforts to schedule third-party transactions in the absence of adequate assurance of payment from third party sources. And where would that credit support come from: perhaps, suggests FERC, a creditworthy state agency or specific state bond issue. Thus do the adherents of free markets redirect the heavy lifting to others (of other political parties) if deregulation is to be made to work. The dream lives on at FERC that if the price goes to $100,000 a megawatt, the speed with which new plants will go up in California is increased.

Slowly out of the rubble produced by the re-regulation/deregulation demolition derby is emerging recognition of the potential of demand management as a result of price responsiveness by large customers. It is an approach utilities in Georgia, Illinois and PJM have followed with some success. It is an approach new information technology can abet. It is even an approach which Mr. Greenspan seems to have implicitly endorsed in his characteristically cryptic observation to the Congress that "The sharp increase in energy prices in the US does not appear to have a broad economic affect other than to depress aggregate demand." Demand Resource Management, while no panacea, also represents a potential bridge between the re-regulation and deregulation forces, since it entails applying market principles in a manner, which benefits consumers as well as producers.

Moreover, through its application, however, a degree of regulatory uncertainty otherwise present for new generation facilities (i.e. the extent of spikes) can be reduced. That is not a claim parties to either side of the polarizing re-regulation-deregulation debate can make convincingly to the capital markets. Or, as the Project Finance Dictionary defines "compromise" "A means of stabilizing projected cash flow on a probabilistic basis by addressing the supply and demand aspects of regulatory uncertainty in a comprehensible manner." Synonyms: "Deregulation Preservation" or "California Dreaming (on a sunny day)."

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.