The Energy Policy Act of 2005

On August 8, 2005, President George W. Bush signed the Energy Policy Act of
2005 into law, following four long years of congressional debates, negotiations
and revisions. The act is the first major federal energy policy legislation
since the Energy Policy Act of 1992. Since it institutes tax incentives and
regulatory changes that will substantially affect U.S. energy markets over the
next few decades, utilities should consider it carefully when developing and
implementing their business strategies and tactics for 2006 and beyond.

Important Areas for Utilities

The Energy Policy Act of 2005 (the act) includes numerous provisions that affect
a range of industries. This article focuses on the following three key areas
that are most important for utilities:

  • Less-restricted utility ownership;
  • Improved infrastructure and reliability; and
  • Increased diversity of fuel supplies.

These areas reflect the primary U.S. energy policy goals of reducing dependence
on foreign energy sources and increasing the competitiveness, efficiency and
reliability of U.S. energy markets. We think that these are important and worthwhile
goals and that the act represents real progress toward achieving them.

Less-Restricted Utility Ownership

The act repeals the Public Utility Holding Company Act (PUHCA) of 1935 as of
February 2006, reducing restrictions on utility ownership, expanding FERC’s
(Federal Energy Regulatory Commission) merger approval authority and removing
some hurdles to mergers. The act shifts federal merger approval authority from
the SEC to FERC and no longer requires utilities considering a merger to have
a network interconnection, so the geographic diversity of utility holdings can
be greatly increased. Related to the shift in regulatory jurisdiction, utilities
will now be required to open their books to both FERC and state utility commissions
during the merger review process.

PUHCA repeal will likely result in increased utility merger and acquisition
activity, and nationwide utility holding companies are likely to emerge over
the next few years. The act also lifts restrictions that had made it difficult
for private equity, foreign and nonutility investors to own utilities. However,
these potential investors will continue to face significant state regulatory
hurdles, and the state regulatory approval process itself will remain onerous.
In fact, state regulatory approval may become more complicated with the increased
powers granted to state regulators. And the shift to FERC approval authority
for mergers, while likely to be a positive development for acquiring utilities,
introduces some new uncertainty into the merger process.

Utility merger and acquisition activity is also likely to increase as a result
of other provisions in the act. Meeting the standards for transmission reliability
and developing new nuclear plants will require substantial capital and deep
expertise, driving utilities to consolidate into larger corporations that have
access to the necessary financial and human capital.

Improved Infrastructure and Reliability

The act establishes mandatory electricity transmission reliability standards,
provides incentives for electric grid and gas distribution system improvements,
increases open transmission access and calls for state consideration of demand-response
programs and timedifferentiated rate structures.

Transmission Reliability Standards and Monitoring

The act calls for common nationwide standards for system reliability to which
utilities must conform and it establishes a national authority – the Electric
Reliability Organization (ERO) – to provide unprecedented monitoring of transmission
grid status. To help the industry meet these reliability standards, the act
provides incentives to attract new transmission infrastructure investment. These
incentives:

  • Allow for increased rates of return on equity for interstate transmission
    systems;
  • Allow accelerated depreciation of qualified transmission facilities;
  • Permit recovery of costs incurred to comply with new reliability standards;
    and
  • Allow deferred gains on the sale of transmission assets through 2007 to
    FERC-approved transmission organizations.

FERC
also gains the authority to site new transmission facilities in transmission
corridors of national interest if state authorities cannot or will not take
action. Although this will not entirely eliminate the often-difficult struggles
required to overcome public and municipal resistance to new transmission lines,
we expect that this new authority will lead to needed investments in the country’s
most supply-constrained regions.

All of these provisions substantially increase the already considerable control
of the transmission grid by the federal government. The creation of the ERO
is likely to result in increased penalties for violations of reliability standards,
increasing the incentives for major new transmission investments where the transmission
grid is constrained. But the new reliability standards will be met through more
than simply investments in new transmission lines. We also expect increased
investments in what we call the intelligent network: the automated metering,
monitoring and switching hardware and software needed to extract more capacity
from existing lines and rights of way.

Real-time Pricing, Smart Metering and Net Metering

The act calls for state regulators to consider adopting the following:

  • Interconnection service – Make interconnection to distributed generation
    facilities a standard service available to all customers;
  • Smart meters – Make time-based meters widely available to allow for time-of-use
    rates;
  • Time-of-use rates – Offer all customer classes a time-based rate schedule;
    and
  • Net metering – Provide customers with the option of netting the electricity
    they provide to the grid from on-site distributed generation facilities from
    the electricity they consume from the grid.

State regulators must begin considering these standards within the next one
to two years and decide on whether to adopt them within two to three years.
These provisions will further encourage state regulators that are already pushing
for smart metering and time-of-use pricing (e.g., California) and will quickly
begin to drive other states in this direction, even if they have not yet been
active in these areas. Within a few years, we expect that regulators nationwide
will regard time-of-use rates and the supporting infrastructure as utility service
obligations rather than optionally available programs.

Natural Gas Storage and Transmission Incentives

The act provides that the FERC allow natural gas companies to charge market-based
rates for new gas storage capacity, even in cases where the company is perceived
to have market power. It also allows for accelerated depreciation of new natural
gas distribution lines and provides relief from royalties on gas production
from new wells in the Gulf of Mexico. Utilities that build or expand natural
gas storage facilities clearly stand to benefit, and large investors in natural
gas pipeline construction are likely to see increased cash flows resulting from
the accelerated depreciation.

Increased Diversity of Fuel Supplies

The act provides incentives for new nuclear plant development and for gas utilities
to develop distribution pipelines and gas storage facilities; reauthorizes incentives
for clean coal technology and renewable energy sources; and clarifies liquefied
natural gas (LNG) facility siting authority.

Nuclear Plant Investment Incentives

The act provides for a tax credit of 1.8 cents per kWh for electricity produced
at new nuclear facilities over the first eight years of production and creates
insurance for nuclear plant owners/builders to protect them against losses caused
by litigation and/or regulatory approval delays. Liability protection for nuclear
plants is extended to 2025, continuing the limitation on the exposure of plant
owners to financial risk in the case of an accident. Loans for up to 80 percent
of the project cost of advanced nuclear facilities will be guaranteed (contingent
upon Congress appropriating funds for this purpose), and the tax treatment of
funds required to be set aside for safe nuclear plant decommissioning is improved.

The act could dramatically improve the financial viability of new nuclear plants
and at least partially mitigate several major risks to investors. As a result
of these changes, in combination with the continued pressure to reduce greenhouse
gas emissions and the increasing price of natural gas, we expect to see the
start of substantial new nuclear plant development in the United States over
the next few years. We recognize that considerable hurdles to new nuclear plants
remain, as public distrust of nuclear power is still very high, homeland security
concerns will need to be addressed and facilities for long-term storage of nuclear
waste (at Yucca Mountain or elsewhere) are yet to be established. But overall,
we expect nuclear power to be a primary contributor in moving the United States
toward a more diversified energy base, and we suggest that power generators
consider nuclear generation as they plan for increasing their capacity.

Clean Coal and Renewables Incentives

The act provides for federal investment tax credits for clean coal and integrated
gasification combined cycle (IGCC) generation projects and reduces the cost
recovery period for pollution control equipment on older coal plants from 20
years to seven years. The placed-in-service date to qualify for the tax credit
on renewable energy production is extended through 2007 and covers qualifying
production from wind, biomass, geothermal, small irrigation, landfill gas and
trash combustion facilities.

The act also pushes state regulators to influence fuel diversity by calling
for them to consider standards for:

  • Fuel sources; and
  • Fossil fuel generation efficiency.

Utilities should develop plans to significantly reduce their dependence on
any one fuel source. In addition, utilities should develop plans to increase
the efficiency of their fossil generation.

Other Fuel Diversity Provisions

Provisions in a couple of other areas should help increase fuel diversity:

  • LNG siting authority – The act grants FERC the exclusive authority on siting
    LNG facilities, effectively ending the challenge to this authority set forth
    by the California Public Utilities Commission. Assuming that FERC allows for
    more flexibility for LNG facilities, this should provide the United States
    with an increasing supply of natural gas from international markets, reducing
    dependence on domestic sources.
  • Alternative generation tax credits – The act provides for tax credits for
    solar energy, fuel cells and distributed generation equipment.

LNG facility investors should note that while the FERC has the exclusive authority
on siting LNG facilities, the states will continue to have considerable control
over siting decisions through such vehicles as the Coastal Zone Management Act,
the Clean Air Act and the Clean Water Act.

What It All Means

Overall, we expect that the act will help drive continued utility consolidation,
although the challenges of successfully integrating two utility operations and
realizing merger benefits will remain. We believe that utilities need to consider
mergers and acquisitions in their strategic plans. To this end, utilities should
answer a fundamental question: Are we going to grow through acquisitions, or
are we prepared to be acquired?

The act also should spur investment. In addition, it should help the United
States gain a more diversified and reliable network for natural gas storage
and delivery. We expect the act’s incentives and potential standards to at least
sustain the current rate of investment in renewable energy sources and continue
to help the United States diversify its energy fuel supplies. The new and extended
production incentives may also result in an increased role for private equity
in the industry as private equity groups look at investments in large utilities
as a means to take advantage of the variety of production tax credits.

With the act’s alternative generation tax credit incentives and the continued
advancements in fuel cells, we expect micro-generation activity to increase,
with some combination of central generation farms, substation-located generation
and distributed generation at customer locations.

Conclusion

We believe that the Energy Policy Act of 2005 will have substantial and lasting
impacts that will benefit U.S. energy markets and that utilities will need to
carefully consider the act as they conduct both short-term and long-term planning
activities. In particular, we recommend a careful focus on growth strategies
through acquisitions, consideration of new nuclear generation, targeted investments
in transmission capacity and the technology to manage it and development of
more sophisticated electricity pricing options to meet both customer and regulatory
requirements.

Utilities and investors in utilities are responsible for obtaining appropriate
legal, accounting and tax advice in connection with the Energy Policy Act of
2005 and other relevant laws and regulations.