Money, Power, Gas And The Law: The 'Big' Convergence

Sheila Slocum Hollis
Duane, Morris & Heckscher LLP
Washington, D.C.

• Competitiveness of U.S. gas-fired power generation [137,953 bytes]
• North America gas producing region differentials vs. Henry Hub [131,847 bytes]
• U.S. natural gas trends [93,080 bytes]

Nothing ever endures but change ¹, and in the ever-whirling wheel of change that is the energy economy and its regulation, massive flux is under way.

The key ingredients in this mix-the gas and electric industries, the financial instruments and entities that back them, and the laws and regulations that control and guide them-are in a confluence moving at warp speed. The signs of a revolution in progress are many.

(Some of the trends in the gas and power industries underlying this change are illustrated by figures accompanying this article that were extracted from a study on North American natural gas trends by Arthur Andersen and Cambridge Energy Research Associates.)

Assets are being divested or monetized. Financial products-not only reserves-are the answer to managing supply risks. "Spark spreads"²-the financial differential between the price of gas as a commodity and gas that has been transformed into electrons-are being traded. Electric restructuring is being patterned on the template of the gas experience. Electronic bulletin boards and trading systems are linking the industries in cyberspace. And the consolidation of these industries has led to the biggest mating game in the energy industries' history, all at a fast-forward pace.

Federal and state legislators and regulators swim in the same tank as the voracious entities this article discusses. Faced with unimagined combinations of players, complicated market power questions swirl around the merger and acquisition marriages. And, as the markets push ahead with new ideas, the regulators attempt to shape the process with their own proposals to influence the market of the next millennium. This article discusses some of the major moves and certain key regulatory decisions regarding these landscape-altering initiatives.

Big convergence

The worlds of gas, electric, and finance are converging through domestic and international mergers, acquisitions, strategic alliances and joint ventures, electronic trading and bulletin board systems, the creation of new multi-fuel, multi-product marketing entities, and international investments.

Law, politics, greed, and fear mingle in this volatile mix. And, although life is short-particularly in the turbocharged world of energy industry restructuring-and although the art of achieving success in the new millennium will be hard to master, many of the largest domestic and international players in money and energy are stepping forward to meet their destinies.

Immense financial commitments and vast structural changes are occurring in:

• the way producers sell their energy and associated services.
• the way consumers buy their energy and related services.
• the cast of entities that are emerging as the suppliers, transporters, and organizers of energy products and services in these markets.
• the financial underpinnings of these structures.
• the manner in which all of these transactions and players are regulated.

Ultimately, consumers will be free to buy a variety of products and services from suppliers that offer combined electric, gas, environmental, telecommunications, and financial services. These suppliers are unlikely to be traditional utility suppliers. Instead, the utility will be a "wires and pipes" business (albeit a huge one), providing access for other suppliers (including their own marketing affiliates). The marketing affiliates will be knocking on consumers' doors, selling energy services, supplies and other products beyond the utility's traditional service territory.

About 200 power marketers have received the necessary Federal Energy Regulatory Commission approval, including brokers and financial industry players, gas and electric utility affiliates, independent entrepreneurs, manufacturers, independent power producers, and natural gas marketers. FERC grants power market certificates to allow the sale for resale in interstate commerce of electric power without being fully regulated as utility-type sales. Few companies are truly active, with the large players including Enron Power Marketing, PGE Energy Services, Morgan Stanley, Natural Gas Clearinghouse (NGC), and Louisville Gas & Electric Co. But these entities trade it all-gas, electricity, and other commodities-and they have a highly sophisticated integration of financial products, including options, futures, forwards, collars, hedges, and other instruments to back their activities in the physical markets.

All the while, the transactions of and communications between regulated and non-regulated corporate family members will continue to be closely monitored by the regulators.

Gas, electricity markets converge

The increased blurring of what used to be distinct markets for electric power and natural gas is now accepted fact, and the trend can be expected to accelerate, not abate.

The first phase of this convergence is now entering its fourth year, as major gas companies such as Enron and CNG formed affiliates to engage in marketing both natural gas and electric power in both U.S. and international markets.

NGC formed Electric Clearinghouse Inc. to capitalize on its strengths as a gas marketer. This trend continued in 1997, as NGC formed interregional alliances with power marketers such as Nicor in the U.S. Midwest, Consumersfirst in Canada, and AllEnergy (now owned by the New England Electric System) in the U.S. Northeast.

On both a small and a large scale, energy marketers can profit from the synergism of selling gas to a power generator and buying back part of the power for resale. These activities create more interdependence between the two commodities and more opportunities to trade in and out of both commodities.

A new symbiosis between the natural gas and electricity industries has developed, based upon the widely perceived acceptability of-and heavy reliance on-natural gas by those involved in new generation projects. As gas marketers evolve into power marketers, and gas market centers and market hubs are replicated in electric RTGs (regional transmission groups), history is repeating itself and mutating to meet the needs of the market.

The electronic marketplace for natural gas, the electronic bulletin boards (EBBs) and trading systems, are replicated in the creation of the electric industry's FERC-mandated Oasis systems. The natural gas futures contract was the precursor to the electricity futures contract, which began trading on the New York Mercantile Exchange (Nymex) on Mar. 29, 1996. Electricity futures contracts cleared a major regulatory hurdle when FERC declared that the Nymex contract is not subject to its jurisdiction.³

Thus, the worlds of gas and electricity meet on the computer, and the time is at hand when transmission and generation, as well as the commodity and transportation, will be fungible through computer technology.

In another major bellwether of market developments, Shell Oil Co., the leading U.S. gasoline marketer, established a new company to sell electricity and natural gas directly to homes and businesses. Shell Energy Services Co. LLC expects to begin retail sales within the year in selected deregulated markets. Shell began building the new marketing company in late 1997, following an extensive analysis of the emerging retail energy market. Shell already had a major presence in the wholesale electricity and natural gas market through its ownership of Coral Energy LP, one of the largest energy marketers in North America. Coral will continue to be Shell's interface for energy sales and services to industrial and large commercial customers. Shell is also developing a strategy for entering the power generation market through its affiliate Tejas Gas LLC.

In short, the biggest and bravest players, with the clearest vision of the profit and peril ahead, are girding for immense challenges. Competition for electric and gas customers, along with competition among suppliers, producers, and aggregators of energy, is supercharging an already tumultuous environment. The development of power marketers clearly signals the commoditization of electricity. Indices of the commodity nature of electricity, as in petroleum, gas, and other commodities, are daily price publications, market center and hub trading, the existence of a futures market, and sophisticated EBBs that permit price discovery.

A short list of the U.S. convergence deals that are shaping the future include: Duke Power and PanEnergy; LG&E and Morgan Stanley/Oglethorpe

Power; Houston Industries/NorAm Energy Services; Enova Corp./Pacific Enterprises; Enron Corp./Portland General Electric (PGE); Public Service Co. of Colorado/Southwest Public Service; NGC/Destec Energy; and Atlantic Energy/Delmarva Power & Light.

What are some of the signs of change? For one thing, the Dow Jones Utility Average experienced the biggest change in its 68-year history, which resulted in six utilities being dropped from the average and six being added. Entities in the low-growth areas of the U.S. were dropped, whereas the newly added entities generally reflect the increased role of natural gas as a source of energy, including Enron, Williams Cos., Duke (now including PanEnergy), and Columbia Gas.

Forces for change

What forces have sent these giants into mating dances that reverberate around the world? Some factors precipitating the stampede are barely remembered through the mists of regulatory times past. Competitive dynamics in the energy and financial markets impel some moves.

How big is the change? In a survey of over 500 utility executives conducted last year, 86% believe that virtually all electric customers will be able to choose their own electric suppliers within the next few years.⁴ Fifty percent believe that most companies will not survive intact, and 45% of their companies are engaged in some form of merger or acquisition activities. The utility area accounts for a large portion of merger and acquisition transactions. Fifty-two mergers or acquisitions together valued at more than $35.5 billion occurred in 1996, doubling 1995 activity.⁵ And 1997 surpassed 1996 's extraordinary level.

What are the basic legal and structural change agents at work?

FERC, mandated to administer and enforce the Federal Power Act of 1935, the Public Utility Regulatory Policies Act (Purpa) of 1978, and the Energy Policy Act of 1992, opened the interstate electricity transmission grid to open access and is the father of both Order Nos. 636 (gas restructuring) and 888 (electric restructuring). Thus, a single agency regulates both industries in a highly symbiotic warp.

Successful natural gas marketers morphed into energy marketers or power marketers and financial arbitrageurs.

Large, restless, and innovative state regulatory agencies in key states-California, New York, Massachusetts, and Pennsylvania-are in the process of opening up markets through unbundling and retail access initiatives. These steps are accelerated where stranded costs (a similar phenomenon to take-or-pay in the gas business) are a threat.

Large consumers discovered their ability to demand lower energy costs.

Major financial players, including Nymex, developed trading instruments and structures for natural gas and electric power, thus allowing for the arbitrage between and among sources of fuel for electric power generation through the use of hedges, options, collars and a variety of other tools. Already a real trade in electrons exists throughout the U.S., and more comprehensive trading is rapidly emerging. Just as markets developed for a futures and a spot market for natural gas, the electricity industry is evolving.

Independent power producers reliant on natural gas became pioneers in the spark-spread arbitrage game, setting the stage for greater sophistication in buying and producing energy.

Intellectual capital developed during the gas restructuring of the 1980s is being transferred wholesale to electric restructuring. Regulators, economists, lawyers, and consultants are making an easy transition from one world to the next.

FERC's role as ringmaster

A primary forum for observing the convergence phenomena is FERC, whose decisions mirror market trends.

In a spate of important recent orders, FERC clarified the extent of its jurisdiction over some huge corporate realignments, asserting jurisdiction in a series of large merger proceedings. In each, FERC distinguished between jurisdiction over mergers of public utility holding companies (over which the Securities and Exchange Commission, not FERC, has jurisdiction ) and jurisdiction over transfers of control of public utility facilities that result from such mergers (over which the FERC does claim jurisdiction). Some of the mergers are "gas to gas," some are "gas to electric," and many are "electric to electric." With respect to large gas/electric mergers, FERC bifurcated its process: first, staking out a broad jurisdictional base for itself and second, ruling on the merger.⁶

The visibility of convergence was intensified in 1997 and this year by FERC's approval of mergers of several large energy companies. In February, it approved the merger of PGE, an owner of substantial electric generation, distribution and transmission facilities in the Pacific Northwest, with Enron, the parent company of a marketer of natural gas and electric power, as well as several interstate pipelines.⁷ In the commission's first application of its revised merger policy criteria under Order No. 592,⁸ it established a template for determining whether a proposed merger is in the "public interest," focusing on its impact upon regulation, rates, and competition. Key factors in the Enron/PGE merger were the agreement not to raise wholesale rates for at least 4 years and not to pass on merger costs to customers. With respect to competition, FERC relied on the facts that the merger would not consolidate power generation and that generators' access to other gas pipelines within Enron's service territory would mitigate the ability of the merged company to restrict gas services to competitors.

Last May, FERC approved the merger of Duke Power Co. and PanEnergy Corp., thereby creating one of the largest utilities in the U.S., with assets of over $10 billion.⁹ Duke owns 17,346 MW of installed generating capacity and provides retail and wholesale electric service in the Carolinas, while PanEnergy has subsidiaries that operate over 37,500 miles of natural gas pipelines that deliver gas to markets in the Midwest, Mid-Atlantic, and New England. In addition, both companies have marketing subsidiaries. One Duke subsidiary also sells natural gas, and PanEnergy and its affiliates have interests in various "qualifying facilities" that generate and sell power pursuant to Purpa.

FERC was persuaded that Duke and PanEnergy operate in distinct market areas and that the merger will not increase the market power or generating capability of either by any measurable amount. By contrast, a proposed Primergy merger¹⁰, which was withdrawn after the commission sent the applicants back to the drawing board just 2 weeks before it acted on the Duke/PanEnergy merger, was between geographically contiguous, vertically integrated utilities (Wisconsin Electric and Northern States), each of which has significant generating capacity. As did Enron/PGE, Duke and PanEnergy agreed to a 4-year rate freeze on non-market-based wholesale rates. FERC warned, however, that it would revisit rate issues if the need to do so arises. In approving the merger, the commissioners pointed out that such combinations may actually be pro-competition, in terms of economies of scale and opportunities for innovation and synergistic sharing of talent.

In a major final order, issued in late May of this year and acting on the Enova application, the commission denied rehearing of its June 1997 order and approved the merger of Enova and Pacific Enterprises. The order adopts the market power mitigation measures approved by the California Public Utilities Commission in March and imposes additional conditions concerning affiliate conduct. This convergent merger unites local distribution company Southern California Gas Co. and the combination utility San Diego Gas & Electric Co.

Mitigation measures

In the June 1997 order, FERC recognized the potential for the merged company to exercise market power and suggested mitigation measures that the parties and CPUC might want to consider.

The order includes all of the mitigation measures approved by the CPUC. These measures involve codes of conduct (to regulate the sharing of market information); application to SoCalGas of the requirements of Order No. 497 (which is designed to prevent abuses of the affiliated relationship between jurisdictional pipelines and marketers); and a requirement that SoCalGas operate its GasSelect EBB as an interactive same-time reservation and information system.

FERC stated in the June 1997 order that another way to eliminate vertical market power problems would be for SDG&E to divest its gas-fired plants. A stipulation with the Department of Justice provides that SDG&E will divest almost all of its gas-fired generation within 18 months and limits Enova's ability to acquire new generation capacity. CPUC also required SoCalGas to divest its options to purchase the Kern River and Mojave pipelines, which provide SoCalGas's only natural gas transportation competition. The FERC concluded that these mitigation measures, along with the establishment of an information "firewall" between SoCalGas and downstream power merchant affiliates, adequately responds to concerns that combining the gas procurement functions of the companies could enhance the merged company's detrimental competitive effect in the downstream electricity market.

The Imperial Irrigation District contended that the mitigation measures adopted by CPUC fail to fully implement the remedies in the June 1997 order because four of those measures apply only to marketing affiliates. FERC agreed, and is requiring the applicants to apply these conditions to any affiliate in the corporate family with an electric power merchant function. A very significant footnote explains that FERC has previously held that public utilities that are not exempt wholesale generators must define an "affiliate" for rate purposes under SS2(a)(11) of Puhca rather than under the FERC regulations.

The Puhca provision is the broader of the two and includes: "any person or class of persons that the commission determines, after appropriate notice and opportunity for hearing, to stand in such relation to such specified company that there is liable to be such an absence of arm's-length bargaining in transactions between them as to make it necessary or appropriate in the public interest or for the protection of investors or consumers that such person be subject to the obligations, duties, and liabilities imposed in this title upon affiliates of a company."

The meeting discussion indicated the commissioners' lack of unanimity as to what this all means, but the aforementioned footnote invites anyone who is confused to seek a declaratory order as to whether an ownership interest falls within the definition of "affiliate." However, during discussion, specific mention was made of joint ventures, and Commissioner Hebert pointed out that this is FERC's first extension of the "affiliate" definition to joint ventures. Reference was also made to a joint venture between Enova and Houston Industries-most likely a plan to build a $280 million combined-cycle gas turbine power plant southeast of Las Vegas. Construction of this 480-MW facility, called El Dorado Energy, began in April 1998.

FERC has also approved the merger of a power marketer and a natural gas marketer.¹¹ That the commission had jurisdiction at all over this type of transaction had been established less than 2 months earlier. FERC asserted its jurisdiction over the transfer of control over public utility facilities, as distinguished from its absence of jurisdiction over mergers of public utility holding companies.¹² But it was readily apparent that the Commission has no intention of using its jurisdiction as a vehicle to block mergers, convergent or otherwise.

In July 1997, FERC approved the megamerger of NorAm and Houston Industries, the companies who had initially contended that the FERC lacked jurisdiction over the transfer of facilities between unregulated entities.¹³

The commission was persuaded by NorAm's representation that it does not own or control generation resources by virtue of its purchase power contracts or its interconnection agreements with entities from which it buys power. Thus, the merger would not enhance generation market power. With respect to vertical market power issues, specifically upstream market competitive conditions, NorAm pointed out that a number of non-affiliated gas pipelines within the same geographic area have excess capacity. NorAm companies could not profitably deny access to new generators that compete with the merged company, because those generators would have significant alternatives for delivered gas. FERC concluded that any attempt by NorAm companies to restrict delivered gas to wholesale market generators that could compete with Houston Industries subsidiary Houston Lighting & Power Company (HL&P) would be unsuccessful. Because NorAm cannot exercise market power in the upstream market, the Commission concluded that the merger will not affect the merged company's ability to exercise market power in the downstream market. In addition, FERC took comfort in HL&P's commitment not to increase its firm transmission rates for 4 years after completion of the merger.

During this same period, the FERC approved convergent mergers between Brooklyn Union Gas Co and Long Island Lighting Co.¹⁴ and between PG&E Corp. and Valero Energy Corp.¹⁵ At the same time, however, FERC's blessing did not ensure a merger's successful completion. For example, the commission unconditionally approved the merger of Baltimore Gas & Electric Co. and Potomac Electric Power Co. in April 1997,¹⁶ but at year's end the utilities called the merger off, due to unfavorable conditions imposed by state regulators.

Outlook

Relentless and brutal competition will make the utility industry more economically efficient overall by increasing consolidation and by remaking the roles of regulators.

But mergers are only one part of the convergence story. With prospects of multibillion-dollar deals, Wall Street has visions of sugar plums dancing in its head.

Thus, we can expect to see financial markets interacting dangerously with energy markets in yet another year of convergence.

From the trading level to the physical use of gas in electric generation to the reliance on computers rather than lawyers to do the deals-all the way up to the lofty climes of think tanks and regulatory agencies-gas, electricity, money, and the law are meeting at the crossroads of history.

References

1. Heraclitus.
2. A spark spread depicts the relative value of natural gas as BTUs and as converted to electrons. The principal variables in a spark spread determination are: (1) heat rate efficiency; (2) the spot market price of natural gas; and (3) the spot market price of electricity. The heat rate of a generator denotes the number of BTUs required to generate a MW-hr of electricity. The lower the heat rate, the more efficient the generator.
3. New York Mercantile Exchange, 74 FERC paragraph61,311 (Mar. 27, 1996).
4. Survey by Washington International Energy Group, as reported in Utility Spotlight, Jan. 13, 1997.
5. New York Times, Dec. 10, 1996.
6. Enova Corp. and Pacific Enterprises, 79 FERC paragraph61,107 (1997) ("Enova"); and NorAm Energy Services Inc., 79 FERC paragraph61,108 (1997) ("NorAm").
7. Enron Corp., et al., 78 FERC paragraph61,179 (1997).
8. Inquiry Concerning the Commission's Merger Policy under the Federal Power Act, III FERC Stats. & Regs. paragraph31,044 (1996).
9. Duke Power Co. and PanEnergy Corp., 79 FERC paragraph61,236 (1997).
10. Wisconsin Electric Power Co., et al., 79 FERC paragraph61,158 (1997).
11. Destec Energy Inc. and NGC Corp., 79 FERC paragraph61,373 (19 97).
12. Enova Corp. and Pacific Enterprises, 79 FERC paragraph61,107; NorAm Energy Services Inc., 79 FERC paragraph61,108; Morgan Stanley Capital Group, Inc., 79 FERC paragraph61,109 (Apr. 30, 1997).
13. NorAm Energy Services, Inc., 80 FERC paragraph6 1,120 (1997).
14. Long Island Lighting Co., 80 FERC paragraph61,035 (1997).
15. PG&E Corp., et al., 80 FERC paragraph61,041 (1997).
16. Baltimore Gas & Electric Co. and Potomac Electric Power Co., 79 FERC paragraph61,027 (1997).

The Author