November 2003

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2003/11/01)
 

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.

Here is one assessment:

• 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.
   
• 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.
   
• 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.

How could such a clear-cut signal as the Blackout  produce such uncertain and ambiguous results?

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:

• a capital investment deficiency in both transmission and distribution (estimated at $30-100 billion);
   
• an inadequate infrastructure system, incapable of carrying the amount of power that it is called on to bear, particularly under current usage patterns;
   
• reliance on outdated technology that is not responsive to the requirements imposed by deregulation; and
   
• absence of mandatory system reliability standards.

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.

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.

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.

The Blackout consequently has been characterized as justifying two polar opposite sets of policy con-clusions:

• One holds that deregulation is a flawed approach to the power industry, which has resulted not only in:

- power flows as a result of open access in ways and directions that cannot be accommodated by the existing grid; but also in

- "freeloading" on the use of the existing (and potentially enhanced) wires by non-regulated wholesale producers and beneficiaries of transmission improvement.

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.

• The other reminds us that traditional regulation is a flawed approach to the modern power industry that:

- balkanizes the oversight of operations and, by deferring excessively to locally regulated control areas, leads to blackouts;

- 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

- will not furnish the cost-of-service incentives necessary for transmission enhancement.

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.

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.

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:

(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.

(2) A limited form of regional grid management, with some voluntary elements and considerable regional variation, will be instituted.

(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.

(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.

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:

• Nonregulated generation will need to compete with utility generation, both for utility native load and on-the-spot and short-term capacity markets.
   
• Full, fixed-cost recovery by regulated units from native load will enable utility generation  to compete at purely marginal cost in competitive markets.
   
• 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.

Which leads to two non-intuitive conclusions:

• Existing valuation of asset valuations may (gasp) be no more accurate than prior models, due to the effect of regulation.
   
• 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.

A result that would certainly please Janus.

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.