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With an energy industry weakened by the stunning collapse of Enron and by the bankruptcy and near-bankruptcy of numerous industry giants, the golden days of the power markets seem all too distant. But it was only two years ago that new merchant trading affiliates were turning enormous profits, outstripping in a year’s time the long-term profits of their regulated parents. Now the Federal Energy Regulatory Commission struggles to reshape its so-called Standard Market Design for electricity in order to mollify its critics and provide a framework for a more secure energy future. Congress, too, seeks to provide remedies for the woes of the power industry. Lawmakers hope to pass a comprehensive energy bill this year. And energy firms themselves have taken steps toward reform. A stronger energy industry remains a work in progress. But with the efforts of FERC, Congress, and business, a more viable market may be on the horizon. Let’s survey the landscape. INDUSTRY EFFORTS Once the symbol of corporate power, the Enron logo and other industry memorabilia are now traded on eBay. Even the merchant traders that escaped bankruptcy have teetered close to the edge and seen their credit ratings slashed. A sharp decrease in power prices has stifled cash flows, while the cost of loans has soared. The market dysfunctions in California still reverberate as FERC demands answers and orders refunds. A white paper on “Price Manipulation in Western Markets,” prepared by the FERC staff and issued March 26, finds that markets for natural gas and electricity in California are inextricably linked and that dysfunctions in one market fed off the other. According to the report, the dysfunctions occurred, in part, from attempts to manipulate prices. Also on March 26, FERC issued show cause orders aimed at revoking the authority of four power marketers to charge market-based rates. Indications are that similar orders are on the launching pad for other marketers. The potential for financial instability remains high as companies face the maturation of long-term debt that must be renegotiated in the near future. FERC estimates that almost one-third of long-term debt will mature for energy companies over the next five years. To survive, many companies — including several industry giants — have withdrawn from or announced that they will no longer participate in the merchant trading market. Others have indicated privately that they won’t be playing either. At a Feb. 5 joint meeting of FERC and the Commodity Futures Trading Commission, most speakers advocated a centralized clearing facility for energy transactions as one way to tackle credit and other liquidity problems. While the idea appeals to some at FERC, credit solutions are but one piece of the market puzzle. As Commissioner William Massey asked, “[I]f you build it, will they come?” Some new market entrants have answered Massey’s question in the affirmative. Over the past year, banks and brokerage firms have become power trading players. FERC’s recent assessment of the natural gas market lists such new participants as Bank of America, Credit Lyonnais, Goldman Sachs, and Morgan Stanley. These new players bring financial stability, cash, good credit ratings, and commodity trading experience. A leading oracle of the financial world, Warren Buffet, entered the energy market in a big way — by purchasing a controlling stake in MidAmerican Energy and buying Northern Natural Gas Pipeline from Dynegy. With his usual business acumen and taste for undervalued properties with dependable cash flows, Buffet paid $600 million less for Northern Natural than Dynegy had paid just a few months earlier. Other companies have taken measures to stem the tide. Gas and electric companies are selling assets and renegotiating debt. The Securities and Exchange Commission has recommended, among other things, that companies abandon “mark to market” accounting (a practice apparently misused by Enron to maximize reported profits). While the energy industry has not embraced all the SEC’s recommendations, it has heard the message that it must heal itself and is moving to establish standardized accounting practices and to provide transparency in pricing. Executives from more than 30 energy companies have formed the Committee of Chief Risk Officers to establish best practices for risk management and financial reporting practices. The group published a white paper in February. Its recommendations include more detailed financial disclosures than the minimum now required by the SEC, new rules for managing credit among traders, and the use of strict governance and control procedures. In addition, last year the Electric Power Supply Association, a national trade group for competitive power suppliers, launched an initiative to write a code of conduct for power traders. The group’s president, Lynne Church, said that the initiative, comprising CEOs from top energy companies, will address head-on the existing crisis of confidence. FERC INITIATIVES While industry has been facing the music, last year FERC attempted to set the course for a new and improved energy market through its Standard Market Design notice of proposed rule making. FERC’s stated purpose is to set forth a structure for a standardized transmission and wholesale electric market that will provide a level playing field for all participants in wholesale electricity sales. To reach that goal, FERC wants to establish a single flexible transmission service that applies consistent rules for all customers. Chairman Pat Wood III has envisioned a bulk electric power market that basically mirrors the deregulated natural gas market. Once issued, the Standard Market Design was hotly debated and criticized. States resisted the one-size-fits-all approach to what they regard as their unique regional problems. Comments filed jointly by regulators and consumer groups from 22 states argued that FERC’s universal plan would intrude on the states’ authority to oversee retail electricity markets. States argued that FERC has not shown that the benefits of a single regulatory treatment will outweigh the costs. So the Standard Market Design was reworked. The new vision includes a distilled core of features based on, in Chairman Wood’s words, “what really works, not just what sounds like a good idea.” The principal features include independent transmission grid operation, regional transmission planning, a long-term bilateral contract market, and a voluntary short-term spot market with transparent prices. Last week, FERC issued a white paper on “Wholesale Power Market Platform.” The April 28 white paper further addresses concerns expressed by Standard Market Design critics and again invites comments before issuance of a final rule. It offers several clarifications that will shape the final rule, including the following: (1) FERC will eliminate the proposed requirement that public utilities create an independent transmission provider and, instead, will require public utilities to join a regional transmission organization or create an independent system operator. (2) FERC will not assert jurisdiction over the transmission rate component of bundled retail service (leaving retail service regulation the province of the states). (3) The final rule will not set a minimum level of adequate industry resources. (4) The final rule will allow for phased-in implementation and sequencing tailored to each region. FERC’s efforts to heal the energy markets do not stop with the Standard Market Design. Following the Enron debacle, the commission became more sensitive to the need for changes in accounting and financial reporting and late last year issued Order No. 627. The order establishes uniform accounting requirements for the recognition of changes in the fair value of security investments, derivative instruments, and hedging activities — activities heretofore unaddressed by FERC’s Uniform System of Accounts. FERC further revised its accounting rules in April under Order No. 631 to provide even greater financial transparency. FERC is also proposing new incentives to attract capital for sorely needed investment in the electric transmission infrastructure. A proposed pricing policy would create rate incentives that reward formation of regional transmission organizations and independent transmission providers, and investment in the transmission grid. TOMORROW AND TOMORROW Meanwhile, major energy legislation is now being considered by both houses of Congress — although it is still too early to know what will be in the final bill. The House Commerce Committee passed a comprehensive package on April 11 that would give FERC authority over the transmission of currently unregulated utilities and repeal the Public Utility Holding Company Act of 1935, which imposes strict requirements on a utility holding company’s unregulated and regulated business activities. The bill also would permit FERC to authorize construction of interstate transmission facilities where states lack siting authority. The bill would ask FERC to use incentive rates to encourage transmission investment and more effective use of existing assets. It would put interstate transmission facilities owned by municipal utilities, cooperatives, and federal power agencies under FERC’s jurisdiction. The House rejected Rep. John Dingell’s proposal to give FERC broad authority to deal with fraud and price manipulation in the electricity and natural gas markets. On the other side of the Hill, the Senate Energy and Natural Resources Committee voted out its bill last week. The Senate bill also offers numerous tax incentives, including a 10 percent credit for cogenerators and expanded credits for renewable generation. While the shocks and jolts of the past two years have left a rough imprint on the energy industry, not all is as bleak as it may appear. The combined efforts of industry, regulators, and Congress will eventually produce workable solutions for everybody. The newly issued FERC white paper, for instance, indicates that the final rule on Standard Market Design will be responsive to critics’ concerns. And supporters of the new energy legislation are optimistic that it will be signed by year’s end. In the short term, consumers will not be left without needed electricity or gas. In the long term, the industry will be healthier for the pruning and weeding of the past two years. The demand for natural gas and electricity continues to grow. The introduction of new players, armed with capital and expertise, together with FERC’s new market design and a new dedication on the part of industry to find better practices, will bring new growth to the power industry. Michael A. Stosser is a shareholder and Jane E. Stelck is special counsel in the D.C. office of Heller Ehrman White & McAuliffe. He co-chairs and she practices with the firm’s energy national practice group. Stosser and Stelck can be reached at [email protected]and [email protected], respectively.

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