PUHCA REPEAL A DOOR OPENS

Electric Perspectives, Jan/Feb 2006 by Silverstein, Evan

...but into what? A group of financial analysts looks at protecting the customer, consolidating generation, and dealing with higher prices-and discusses how companies will fare in a post-PUHCA world. * The repeal of the Public Utility Holding Company Act of 1935 (PUHCA), effective on February 8, 2006, has been heralded by the utility industry and many in the financial community as one of the most significant changes in electricity regulation in 70 years. Repeal will eliminate significant federal restrictions on the scope, structure, and ownership of electric companies. With PUHCA repeal, for example, a U.S. electric and gas distribution company on the East Coast could acquire a similar company on the West Coast-there won't be the requirement that utility operations be limited to a single, integrated system and that mergers be among companies with contiguous territories.

Many predict PUHCA repeal will have a substantial impact on the overall business structure of electric and gas utilities by permitting investment by new classes of nonutility investors, thus broadening the pool of capital available to companies, which they can use to enhance electric infrastructure. Some also predict greater efficiencies through consolidation among utilities across the country, and additional diversification by electric companies and their affiliates into core and related businesses. Potential (and as of this writing, theoretical) investors include foreign utilities, financial institutions, private equity groups, and other industrial groups.

With PUHCA repeal comes a transfer of significant new authority away from the securities and Exchange Commission (sec) to the Federal Energy Regulatory Commission (FERC). To address issues of consumer protection (one of PUHCA's original intentions), FERC and state regulatory commissions gain greater access to books and records of most holding companies and their affiliates. FERC authority over cost allocation is also enhanced to apply to allocation issues within holding company systems if requested by a utility or state commission. The Energy Policy Act of 2005 also grants FERC new authority to review the acquisition or merger of generating facilities along with the responsibility to more explicitly address cross-subsidization issues.

FERC issued a rule in December enacting PUHCA 2005. (Visit www.eei.org for more information.) Some members of Congress, state utility commissions, and consumer groups have raised concerns about the adequacy of consumer protection measures and the scope of FERC'S "books and records" requirements. They suggest ringfencing (putting up barriers on the state level between the regulated utility and the parent and its unregulated companies) or the adoption of statelevel "mini-PUHCAs" to safeguard the regulated utility and ultimately the consumer from bad decisions of the parent company.

PUHCA repeal, then, isn't as easy as everyone seems to think. Electric Perspectives hosted a round-table in November, inviting a range of Wall Street analysts-representatives from a rating agency, a fixed-income firm, a bond firm, and an equity research firm, moderated by a former hedge-fund manager-to discuss the industry's prospects in a post-PUHCA world.

Evan Silverstein: The last five or six years have been a tumultuous time for the electric utility industry. Passage of the Energy Policy Act of 2005-with PUHCA repeal-came partially in response to that. First, what are the broad impacts of the Energy Policy Act on the industry?

Greg Gordon: The two things that got most focus from investors were the repeal of PUHCA and the codification of electric reliability standards for transmission. A lot of other things were beneficial to the industry in terms of tax treatment for new capital spending. That's in the weeds, but it's also marginally bullish for the industry. The incentives for nuclear are helpful, but obviously nuclear has a long lead-time.

The real question is whether the repeal of PUHCA will result in increased consolidation in the industry. Are we going to see a lot more M&A? I'm not a big believer in that. The big impediment to companies consolidating has always been state regulation, not federal. Most public utility commission [PUC] mandates have a public interest standard in them, so state regulators will always demand some significant incremental benefit for the average retail consumer-that's a hurdle to approving a deal, and that usually means taking a big chunk of the merger synergies and steering them back to customers.

So, if you've got a big regulated entity merging with another big regulated entity, and you subtract a big chunk of the synergies-and if any premium at all is being paid from the acquisition-it's unlikely that you can recover that premium in a way that adds value for the shareholders. PUHCA repeal hasn't changed that.

Where PUHCA repeal does matter is, perversely, on the merchant side. It's what you're seeing with the Exelon/PSEG and Duke/Cinergy mergers. You've got a lot of holding-company structures that encompass regulated utilities and portfolios of merchant assets. The real juice for the shareholder is not the utilities consolidating, but the benefits created from consolidating the merchant assets. With PUHCA repeal, you have the option to pursue those transactions without worrying about having noncontiguous territories and other impediments. You'd be willing to give up the majority of the regulated synergies to get the deal done because you're really getting the benefit on the unregulated side.