Shifting Regulatory Oversight of Utility Mergers by Chris Trayhorn, Publisher of mThink Blue Book, May 15, 2006 Many in the energy industry are anticipating a wave of mergers that will fundamentally alter and concentrate the energy industry, both from utility consolidation and mergers between utilities and firms from other business sectors. Warren Buffett, for example, acquired MidAmerican Energy five years ago, announced the acquisition of PacifiCorp last year and recently declared, Well be looking for more.[1] The number of utilities has been shrinking for years, as those that remain have gotten larger, and the Energy Policy Act of 2005 (EPAct 2005) has removed one of the significant obstacles to further consolidation, largely through the repeal of the Public Utility Holding Company Act (PUHCA) of 1935. The Federal Energy Regulatory Commission (FERC) has taken on additional merger oversight responsibilities as a result of these changes and the role of the Securities and Exchange Commission has been greatly diminished. In addition, EPAct 2005 has also eased restrictions against ownership by firms that are foreign owned or involved in different industries. While PUHCA is gone, state legislatures and the various state commissions may step up to fill the void. The greatest uncertainties over the degree of consolidation relate to state-level activism. States actions will impose costs on the merging parties and as a result will play a major role in determining just how much consolidation takes Merger Incentives Under PUHCA, the geographic scope of businesses that could be owned by holding companies was limited to those that could be operated as a single integrated system. Companies were quite often restricted to either operations within a single state or to interconnected utilities across state lines. While there had been some success in pushing the geographic envelope AEPs Texas-to-Michigan and Exelons Illinois-to-Pennsylvania systems come to mind gaining regulatory approval of these kinds of mergers was a challenge. Actions taken to increase the interconnectedness of the merged entity (which might also be tied to increased efficiencies) could aggravate market power concerns. Thus, merging parties were caught between two contradictory regulatory objectives: They had to show they were part of an interconnected system while also demonstrating that market power was not an issue. While the number of publicly traded regulated electric utilities in the United States has dropped over the last 15 years, it is still remarkably large when considering maturity and capital intensity of the industry. Benefits from consolidation may include general scale economies from larger operations, reduced overhead costs, better access to capital, better access to technology and an ability to manage risk differently. Some smaller companies may be prime takeover targets due to higher costs, due to factors such as the requirements imposed under Sarbanes-Oxley, which disproportionately affect these smaller utilities. In theory, reduced restrictions on mergers may open up opportunities for risk management that previously had been limited. The combination of utilities in different geographic locations provides an opportunity to diversify weather risks (extreme temperatures and storms) as well as regulatory risk. Ownership affiliations with major oil, gas and coal firms could provide much more sophisticated risk management of fuel supplies and their costs. Increased scale may provide benefits in energy supply management and large-scale power plant ownership. Nevertheless, exploitable efficiency gains through merger are not necessarily clear with the repeal of PUHCA, especially with the associated regulatory burdens. The current structure of regulated utilities is a reflection of the balkanized state of regulation itself. The ultimate effect on the multitude and form of mergers depends upon the regulatory review of proposed combinations in the post-PUHCA environment compared to the environment prior to repeal. This comes down to the way in which FERC and the states will handle utility mergers. FERC seems poised to view utility mergers in a manner generally consistent with its rulings in the past. State legislatures and public service commissions, however, are re-evaluating their role and objectives in merger reviews. There are indications that states are concerned with the possibility of substantial consolidation, and may take actions in the interest of protecting consumers. FERCs Expanded Role FERC is preparing for the review of a larger number of mergers than it had in the past, expecting to receive eight in both FY 2006 and FY 2007, up from 4 in 2005.[2] EPAct 2005 amends Section 203(a) of the Federal Power Act to grant FERC the authority to approve public utility and holding company transactions involving a target (including generation facilities) with a value of more than $10 million. In doing so: After notice and opportunity for hearing, the Commission shall approve the proposed disposition, consolidation, acquisition, or change in control, if it finds that the proposed transaction will be consistent with the public interest, and will not result in crosssubsidization of a non-utility associate company or the pledge or encumbrance of utility assets for the benefit of an associate company, unless the Commission determines that the crosssubsidization, pledge, or encumbrance will be consistent with the public interest.[3] [emphasis added] The public interest standard is consistent with FERCs rules in the past regarding merger approval. In applying this standard, FERC has evaluated a transactions effect on competition, rates and regulation. In reviewing mergers, FERC follows the Department of Justice (DOJ) and Federal Trade Commission (FTC) Merger Guidelines, and has used an analytic tool of its own device (i.e., its Appendix A Analysis) to apply to utility mergers. In addition to the public interest standard, FERC must find that the acquisition will not result in a cross-subsidization to an associate company unless that cross-subsidization is in the public interest. Cross-subsidization can occur when a regulated company shares administrative, capital or operating costs with an unregulated company. FERC will be tasked with determining when cross-subsidies are in the public interest and when they are not. Presumably, merging companies will be pressed to demonstrate how efficiency gains from cross-subsidies will benefit consumers, or how these cross-subsidies otherwise are in the public interest. Under the new legislation, FERC is mandated to act within 180 days of a filed application, and is to adopt procedures for the expeditious consideration of applications.[4] While this review period is longer than the 60 days typically required of DOJ and FTC, specifying a time for review is a positive step to ensuring that merger applications are evaluated relatively quickly and companies are not left in limbo awaiting regulatory approval. In practice, FERC may receive additional time from the merging parties if the transaction is particularly large or troublesome, much as merging parties often grant the DOJ or FTC additional time if requested. While FERCs responsibilities have increased, recent changes build on a long history of merger oversight. That does not mean that everyone will be content with the scope of FERCs oversight or its judgment in applying the public interest standard. State Merger Activism The states have long been integral to any merger approval and the recent regulatory changes have, if anything, increased their role.[5] While each state has its own requirements, the state commissions role as the approver of retail rates ensures involvement in any merger involving state-regulated utilities. Merger announcements are often coupled with assertions of synergies and efficiencies. It does not take long for state commissions to ask, Whats in it for ratepayers? Many mergers have been approved once tied to a period of guaranteed rate reductions but this increases the cost of the merger. Rate reductions might be paid for out-of-operational cost savings, but predicted efficiency gains are uncertain. Merger benefits could arise from risk sharing between formerly separate entities but such benefits may be hard to capture when the entities are separately regulated. After all, some benefits are present only when unexpected losses in one area can be offset by gains from another. Only a very disciplined and optimistic state regulator would be willing to allow ratepayers in his state to bear financial burden from problems elsewhere (outside of his state) in the hopes that the favor would be returned some day if fortunes were reversed. Such hypothetical risk sharing is even more unlikely to be approved by state commissions if a merger is contemplated between regulated and unregulated affiliates, such as between an electric utility and a fuel company. State commissions have a long history of concern about the potential consequences arising from consolidation between utilities and unregulated companies. Commissions have focused concern on the possibility that the finances of the regulated utility would be jeopardized by an unregulated affiliate. Unregulated businesses are often riskier and in any event are largely outside of the state commissions control. In evaluating the risk management issues involved in a potential merger, commissions also may focus on issues such as transfer pricing, crosssubsidization and financial abuse arising post-merger. Transfer pricing involves the setting of prices for any good that passes between regulated and unregulated (or separately regulated) entities. Consumers can be harmed if transfer prices are higher than market rates and the utility attempts to capture these prices in the rate base. Crosssubsidization concerns may arise if companies share operating, administrative or capital costs. Limitations on cross-subsidies may mitigate potential efficiencies from size or scope, preventing a reduction in capital costs for the merger entity, for instance. The states are showing no indication of backing away from these issues. States are considering instituting increased authority in reviewing mergers and oversight of holding companies following the repeal of PUHCA. Laws to increase this state-level authority are being referred to as mini-PUHCAs, and it is possible that they could have a stifling effect on consolidation similar to that of the original PUHCA. While so-called mini-PUHCAs may give states additional access to holding companies, it is not clear the extent to which they will be employed or persist. In a recent conversation, Robert Burns of the National Regulatory Research Institute said Mini-PUHCAs essentially allow a state to reach into the holding company itself but potentially violate the intent of Congress to encourage investment in utilities and their infrastructure. States seem to be considering ring fencing as a viable tool to mitigate undesirable consequences from the combination of regulated and unregulated businesses. Ring fencing is designed to protect a regulated company from unregulated affiliates via certain restrictions such as capital structure requirements, independent boards and investment restrictions on the unregulated entity. Many states may not be able to require ring fencing of merging parties given their current laws and regulations. The National Regulatory Research Institute has identified only three states Wisconsin, Virginia and Oregon that have regulatory tools at their disposal sufficient to insulate regulated utilities from nonutility affiliate undertakings.[6] In the face of new complex mergers, many states may beef up their ringfencing authority. However, overly aggressive ring fencing could erase efficiencies contemplated by a merger. In a situation where there are no clear, large efficiency gains, merging entities may not be willing to promise large benefits to state commissions, especially when facing additional restrictions from states that may erode the very benefits in which states may seek to share. This combination of circumstances may dissuade a number of potential mergers. Looking Forward Industry Perspectives The prevailing view seems to be that repeal of PUHCA will increase the number of mergers and introduce additional regulatory complexities:. A decade from now, the total number of investor-owned utilities will be way down, the American marketplace will be far more internationalized, and there will almost certainly be more unbundling of assets to minimize negative impacts of the market power problems these large mergers will create, says Roger W. Gale, CEO of GF Energy.[7] The effect will likely be greater consolidation of the electric industry, greater concentration of ownership, more complex company structures, and more opportunities for the exercise of market power . Greater concentration in ownership of generating assets will only add to the structural problems, increasing the potential for market manipulation, the American Public Power Association has stated.[8] Due to the repeal of the PUHCA discussed above, FERC and state commissions can expect more mergers and acquisitions, many of which may involve diversified activities within holding company structures, The National Regulatory Research Institute has stated.[9] Some energy company executives expect further consolidation but largely as a result of other pressures in the industry, and not directly, as due to the repeal of PUHCA. And while some feel consolidation will occur within the regulated utility sector, they do not see a wider formation of conglomerate mergers, even within the energy industry. I believe that there will be further consolidation. I dont know that the repeal will have much to do with it. There will obviously be a positive impact. But I think many companies, if you look at Warren Buffett, Duke, and others, have been ignoring the holding company act already, says Warren Robinson, Executive VP and CFO of MDU Resources.[10] I dont think the problem was PUHCA. Running power plants is really not what oil companies do. And you also have even though you are allowed to do it you do have the rate regulation problem. Most oil companies dont like any more government regulation than they currently have, says Stephen I. Chazen, Senior Executive VP and CFO, Occidental Petroleum.[11] The impact on consolidation by the repeal of PUHCA, increased regulatory authority of FERC and potential for states to shift their focus is unclear. We might see some additional combinations designed to diversify geographically, and additional conglomerate mergers. Much of the impact will depend on the extent to which states step in to fill the perceived void left by the repeal of PUHCA. While it might be tempting for companies to wait and see to what extent states will be proactive in merger review, some more-daring companies might initiate mergers while state commissions themselves are unsure about what authority they possess. Of course, no company wants to be a test case resulting in a long drawn-out fight at the state level. Regardless, merging parties will likely be asked to provide assurances to states in which they operate, and states will carefully assess mergers that appear particularly complex. This alone will temper potential consolidations contemplated as a result of the repeal of PUHCA. This article does not represent the views of LECG or other experts at LECG. Endnotes Berkshire Hathaway Annual Report, Letter to Shareholders, February 28, 2006, p. 6. FY 2007 Congressional Performance Budget Request, Federal Energy Regulatory Commission, February 2006. Energy Policy Act of 2005, Section 1289, Merger Review Reform. Ibid. The EPAct 2005 has explicitly increased the authority of the states by explicitly permitting them to gain access to holding-company records, including associate companies and affiliates. Briefing Paper: Implications of EPAct 2005 for State Commission, The National Regulatory Research Institute, October 2005, p. 7. Gale, Roger W., What the New Mergers Will Mean, Energybiz Magazine, July/August 2005. The Electric Utility Industry After PUHCA Repeal: What Happens Next? American Public Power Association, October 2005, p. 1. Briefing Paper: Implications of EPAct 2005 for State Commission, The National Regulatory Research Institute, October 2005, p. 8. Stravos, Richard, CFOs Speak Out: Looking Beyond Power, Public Utility Fortnightly, October 2005. Ibid. Filed under: White Papers Tagged under: Utilities About the Author Chris Trayhorn, Publisher of mThink Blue Book Chris Trayhorn is the Chairman of the Performance Marketing Industry Blue Ribbon Panel and the CEO of mThink.com, a leading online and content marketing agency. He has founded four successful marketing companies in London and San Francisco in the last 15 years, and is currently the founder and publisher of Revenue+Performance magazine, the magazine of the performance marketing industry since 2002.