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REGULATORY RISKS ON THE RISE
The electric utility industry is entering a
period of exceptional regulatory risk due
to the rising cost of producing electricity.
When the cost of providing electric service
increases, so does the risk of regulatory
disallowances. The most successful
companies will avoid overreaching, manage
the regulatory process well and maintain
positive relationships with the regulatory
and political community.
The cost to produce electricity has already
jumped in the last few years as a result
of large increases in fossil fuel prices, and
this trend is expected to continue. In
addition, the industry will need to invest
hundreds of billions of dollars over the
next few decades to meet increasing
demand for electricity and replace aging
facilities, and recovery of this investment
will put enormous additional upward
pressure on electric rates. The industry
must also reduce its reliance on generation
sources that produce greenhouse gas
emissions, such as the approximately
50 percent of U.S. electric energy that is
currently produced by burning coal.
This will put additional upward pressure
on rates.
Examples of regulatory risks include the
recent standoffs in Maryland and Illinois,
where politicians have intervened to limit
cost recovery in response to substantial
rate increases. The risk of disallowances
will not be limited to so-called regulated
services. The same political and regulatory
forces will affect the recovery of investment
costs by unregulated “merchant” generators
who operate in a mixed regulatory and
competitive environment. For example,
rising prices are already producing
disenchantment with deregulated markets,
and this trend is likely to accelerate as
prices continue to rise.
David B. Raskin
Partner
draskin@steptoe.com
Peer Review Rated
Steptoe & Johnson LLP
STATE UTILITY CONSTRUCTION
INCENTIVES
Evolving state electricity deregulation led
many utilities to acquire power plants
rather than build new ones. Since 2003-
2004, with the effects of California’s power
marketing crisis, Enron’s collapse, the
2003 Northeast blackout and rising natural
gas prices, however, state deregulation
has slowed. Power demand is growing, but
utilities find it unprofitable to build in
deregulated states. The 50-year lifetime of
generating plants requires rate assurance for
cost recovery, and several states are seeking
to provide it by creating new regulatory
structures that combine modified competitive
rate review with capacity construction
incentives.
In Virginia, state legislation approved in
2007 ends deregulation and capped rates on
December 31, 2007. The Virginia State
Corporation Commission will set base rates
of investor-owned electric utilities under a
modified cost-of-service model based on
adjusted return on equity (ROE) of a group
of Southeastern U.S. utilities. The new
structure authorizes stand-alone rate adjustments
to recover costs of new generation
projects, major generating unit modifications
and energy efficiency and conservation
programs. Utilities are granted enhanced
ROE on new capital expenditures as
incentive to build major generation projects.
States that re-regulate with a modified
regulatory scheme that ensures relative
financial certainty will likely receive most
new energy infrastructure development,
while those that stay deregulated or are
slower to regulate may experience less
development. While any investment in this
area would seem sound, it is important
to understand your market and legislative
and regulatory trends to protect your
shareholders by knowing what equity
returns can be expected.
Joanne Katsantonis
Partner and Chair, Energy and Utilities
jkatsantonis@mcguirewoods.com
Peer Review Rated
Edward L. Flippen
Partner, Energy and Utilities
eflippen@mcguirewoods.com
Peer Review Rated
McGuireWoods LLP
THE GOING-PRIVATE
BRIAR PATCH
The power sector is seen as “hungry for
capital,” much of which will come from
private equity sources, according to the
February 20, 2007 edition of Platts Electric
Power Daily. An example of this trend is
the proposed buyout of TXU Corp., a
publicly traded utility company regulated
by the State of Texas, by private equity firm
Kohlberg Kravis Roberts & Co. (KKR).
KKR may have assumed that a relatively
benign regulatory environment in Texas
would prevail. TXU’s assets and operations
are within the Electric Reliability Council
of Texas (ERCOT), which is within Texas’
geographic boundaries, and largely
outside the purview of the Federal Energy
Regulatory Commission (FERC). This
would mean only the regulatory scrutiny of
the Public Utility Commission of Texas
(PUCT), whose rules require only notice of
the transaction to PUCT within 30 days
after closing of the sale. FERC approval
was not necessary.
However, PUCT is working to change its
rules to give it power to review the
KKR/TXU transaction. Moreover, Electric
Power Daily reported on March 30 that
Rep. Joe Barton, congressman from Texas,
has pressed for FERC regulation of
ERCOT.
Whether the efforts of PUCT, Rep. Barton
or FERC result in control over the
KKR/TXU transaction is not the real story.
The real story is that the hard and soft
costs of this transaction just skyrocketed.
As counsel in such a transaction, plan
ahead, count on opposition, devise a war
plan and count on exponential increases in
transaction costs. Whether the costs are
worth it will remain to be seen.
Douglas F. Pedigo
Partner, Corporate and Securities
doug.pedigo@tklaw.com
Peer Review Rated
Thompson & Knight LLP
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JULY 2007
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