Stand-Alone Transmission: RTOs in the New Millennium
By Joshua Z. Rokach
Order No. 2000 (the RTO Rule) proclaims, at page 505, that the success of the FERC's efforts in restructuring the electric industry "depends on the feasibility and viability of transmission as a stand-alone business." Throughout its length, the RTO Rule outlines the means for establishing a profitable, independent, free-standing transmission industry. Choosing a voluntary approach, the FERC answered yes to the three questions prospective market entrants ask before committing money and effort to an enterprise. Does transmission afford the potential for reward? What business plan do I need to succeed? Can I design a corporate structure with which to create the company? This article answers those questions in greater detail.
Potential for Reward
Transmission pricing reform, under the category of innovative prices in Section 35.34(e)(2) of the new regulations, lists the following eight changes FERC will readily consider for RTOs:
- Rate moratoria that freeze prices (effective until Jan. 1, 2005);
- Rate moratoria that assume a static capital structure (effective until
- Jan. 1, 2005)) even if the company leverages toward more debt;
- Higher rate of return to reflect increased risk of stand-alone (no longer diversified) business;
- Rate of return that changes according to a pre-determined formula;
- Shorter depreciation, such as the life of the contract, for new plant;
- Favorable changes in depreciation " to straight line away from accelerated " for existing facilities integrated into an RTO;
- Incremental pricing in the form of a surcharge added to the access charge for customers that need new facilities;
- Performance-based rates with internal or external indexes.
Order No. 2000 encourages Regional Transmission Organizations (RTOs) to ask for other reforms. As long as the proponent shows a need for the change and, through a cost-benefit analysis, demonstrates that efficiency will result. The preamble discusses the possibility that transcos may seek a new method of calculating return and ask for acquisition adjustments. FERC would not use the RTO Rule as a vehicle for generic reform of the current discounted cash flow method for calculating return. On acquisition adjustments, Order No. 2000 restated current policy that allows revaluation of the rate base to match purchase price, rather than the original cost, if the utility shows a "demonstrable public benefit."
To me, investors in transcos should approach incentives as short-term, medium-term and long-term. The ultimate goal must remain performance-based rates. This constitutes the operating plan for the transco, akin to benchmarks companies adopt for their businesses. Ideally, the collaborative process provides the forum for investors, management, customers and consumers to establish the goals for the enterprise. (I distinguish customers, the generators that will connect to the grid or the marketers that will seek transmission service and consumers, the ultimate retail base.) While I find internal criteria preferable as direct inducements to good performance, the parties may want the simplicity of external, indirect indexes. With risk and reward, profit and loss, as well as periodic review, performance-based rates duplicate the free market as closely as any regulatory scheme can attempt.
In the meantime, the transco should seek an acquisition adjustment to enable the purchaser to finance the market price out of future earnings. Fulfilling the promise of the RTO Rule easily qualifies as a "measurable consumer benefit." Barring that incentive, passive ownership that allows the purchaser to buy on the installment plan should receive FERC approval as purely financial. Beyond that, the transco should seek rate moratoria. Whether in the form of a price freeze or a hypothetical capital structure, these immediate-term measures allow the enterprise to benefit from undertaking cost reductions right away.
Transcos should seek to change depreciation to the straight-line method for existing facilities. In Order No. 2000-A, FERC recognized the convenience of avoiding reconstructing depreciation tables for multiple facilities that operated under their own schedules. Higher rates of return or formula rates also make sense for the near and medium term. New construction requires incremental pricing. All these measures allow the RTO to capture the market value of its product.
These incentives will attract investment necessary to expand the network and increase the supply of generation to accommodate economic growth. Viewed as a form of economic development, transmission projects will gain more favor in the eyes of state regulators. Incremental pricing will soften opposition from existing consumers, whose rates would rise if the transco averaged the costs in everyone's bill.
The Business Plan
Order No. 2000 listed four characteristics and eight functions for RTOs. They boil down to two thoughts. RTOs must operate as independent going concerns and must take charge of the grid. Independence means looking after the transmission business, not that of selling electricity. Order No. 2000 (as FERC elaborated on rehearing) establishes periodic audits of ownership in for-profit entities and the governing boards in Independent System Operators (ISOs), the not-for-profit institutions that include the integrated utilities. Operating as a going concern means choosing the proper scope of the organization. Scope has all to do with encompassing a market and nothing to do with political boundaries.
Taking charge of the grid means managing the day-to-day operations, of course. It also means setting transmission rates. In a nonprofit ISO context, in which integrated utilities retain ownership of the grid, the integrated utilities may have a role in setting rates, but the RTO must retain the dominant position. Any rate reforms would come from the RTO process. Even when the owner proposes a higher rate of return, FERC will analyze it from the vantage of the RTO and its region. This approach shows that the RTO must take charge of the grid. RTOs must also ensure reliability, to the degree of having the authority to order construction when necessary.
Change takes time. How should entrepreneurs translate the words of the RTO Rule into reality? Use your imagination. The RTO road should lead to a transco. To get there, the company may need to engage the services of an ISO. For example, in Commonwealth Edison, et al., 90 FERC (2000), FERC approved, in concept, an arrangement under which a transco and an ISO split the 12 RTO functions. In places with an existing ISO, such as the Midwest, transcos may have to make that kind of accommodation. FERC required that the agreement clearly delineate the division of labor.
In addition, as Commissioner Hebert said, the agreement must assure that the "transition" lasts temporarily. The parties in Commonwealth chose to establish criteria for adding responsibilities to the transco. In other cases, the agreement could establish an expiration date for the ISO. Bitter experience with these entrenched institutions teaches the necessity for strict rules to limit the role of the ISO over time. The market, not politics, must govern.
As with innovative transmission pricing, FERC made flexibility the watchword. Order No. 2000 states, at page 204, "we reaffirm that it is the Commission’s policy to encourage all types of RTOs. In light of our evolving experience with the workability of certain RTO models, it would be inappropriate for us to mandate a[n] RTO model of ownership and operation." (Emphasis added). Investors may organize a transmission company that owns and operates the grid or one that operates the grid or one that owns parts and operates parts of its grid. Similarly, parties may form for-profit or not-for-profit entities, as corporations, partnerships, trusts or in any other combination.
FERC recognized that organizing a for-profit company requires flexibility. Integrated utilities selling their transmission must take into account tax law and corporate agreements, such as bond indentures. Public power must take into account legal restrictions in charters, laws and the like. Transfer may require allowing incumbent utilities, that otherwise qualify as market participants, to retain interests. Order No. 2000 accommodates that need, with unlimited passive (nonvoting) ownership. The RTO Rule has some restrictions on active ownership, but flexibility remains the order of the day.
Order No. 2000 states, at page 213, "we believe it would be acceptable for market participants to develop passive ownership arrangements that are purely financial." FERC placed no restrictions on these arrangements. "No restrictions" includes allowing passive owners to reserve rights necessary to "protect the integrity of their capital investment" (quoting from note 308.). FERC requires passive owners to file information; for purely financial arrangements, this presents a low hurdle, as we now see:
- The transmission company owes no fiduciary duty to the generation assets of the passive owner (of course not, the duty flows to the transmission business)
- The company can raise capital independently of the passive owners (of course, since for that reason companies have active owners)
- The extent to which the company makes investment decisions independently of thepassive owners (same answer and passive owners may protect their capital investment)
- The extent of control over board selection and removal (review to meet financial standards and removal for cause OK)
- The extent of control over rates, terms and conditions of transmission service (none, I expect that to fall under management answering to the board the active owners elect)
- Control over issuance of new memberships or equity (answered under board selection)
- Services passive owners will provide to the RTO (lending money)
- Extent of access to information (access to protect integrity of capital investment OK)
FERC put three ingredients into the active ownership rules: a safe harbor (5 percent by individuals with no questions asked, but transcos may justify more); a presumption (that lasts for five years, subject to extension) and a benchmark (15 percent for a class that can vary in individual cases).
On rehearing, FERC adopted an independent audit for a transcos passive owners and active owners and for ISO governing boards. Transcos should pass easily. Passive owners with purely financial arrangements may seek exemption from any auditing requirement.
The bottom line from FERC: Act boldly. Order No. 2000 provides the tools. RTOs should approach FERC with aggressive, well planned and thoroughly researched strategy to gain the commission’s approval. This will benefit the investors and the American people. Take the opportunities FERC offers and mold them to your requirements. Be flexible, but tough " like all thriving businesses that compete in the market. Get to it! "
Joshua Rokach acts as legal adviser to Commissioner Curt L. Hebert Jr. of the Federal Energy Regulatory Commission. This article presents Mr. Rokach's opinions, not the commissioner's or anyone else's.
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