FERC Proposes Changes to Its Merger Review Process — Will They Take Regulation “Back to the Future”?

January 22, 2015

On January 22, 2015, the Federal Energy Regulatory Commission (FERC) proposed significant changes to how it will review future electric utility merger applications. Specifically, FERC proposes to change its policy regarding the use of "hold harmless" commitments in applications for mergers or other transfers of electric utility assets under Federal Power Act (FPA) section 203.  Policy Statement on Hold Harmless Commitments, 150 FERC ¶ 61,031 (Jan. 22, 2015).  Among other things, FERC proposes to require that future hold harmless commitments no longer be limited in duration and to require applications to contain significant detail on how costs subject to the commitment will be tracked and managed.  Additionally, FERC sets forth a lengthy, but non-exclusive, list of costs that it proposes to fall within the scope of such commitments.  We do not believe that FERC intends to inhibit in any way efficiency-enhancing mergers but are concerned that the proposed policy statement, if adopted, could have unintended, adverse consequences.

For one, we believe that the proposed policy statement, if adopted, will significantly impact transactions involving entities subject to FERC cost-based rate making, particularly transmission owners, and may hinder merger activity by making future cost-recovery more difficult and subject to increased uncertainty.  Additionally, FERC’s proposed changes may put downward pressure on utility valuations as FERC makes it more difficult for utilities to recover transaction-related costs in rates.  Further, while FERC proposes to "clarify the scope and definition of the costs" subject to hold harmless commitments, these changes may, counter-intuitively, result in more disputes and litigation before FERC over what transaction-related costs are recoverable in rates. Finally, and perhaps unintentionally, FERC’s proposal may deter future infrastructure investments, especially in transmission facilities.

FERC’s proposal has the potential to take regulation "back to the future" to an era when FPA section 203 applicants regularly submitted "net benefits" analyses of a proposed transaction.  While FERC is not proposing to require such analyses in merger applications, its proposal may well result in post-merger requests to recover transaction-related costs supported by the old "net benefits" analysis.  Additionally, the proposal may result in merger applicants seeking pre-approval of transaction-related cost recovery or exemption from hold harmless commitments, also supported by "net benefits" analyses, along with their FPA section 203 application in order to gain greater regulatory and financial certainty before consummation.

These proposed changes coincide with a recent upswing in FERC audits of utilities’ conformance with merger commitments and obligations, including hold harmless commitments.  FERC states that any policy changes will be prospective only.  However, certain aspects of the issuance read more like clarifications of existing policy rather than new proposals, and it is possible that such interpretations may be applied by the FERC in ongoing matters.

Interested entities will have 60 days to comment on the proposed policy from the date it is published in the Federal Register.  (The publication has not yet occurred and therefore the exact date has not yet been established.)  We recommend that all market participants seriously consider weighing in on this important matter.

Historical Use of the Hold Harmless Commitment, Industry Uncertainty

FERC reviews applications for mergers or other transfers of electric utility assets under a multi-prong test that looks at, among other things, whether the proposed transaction will have an adverse effect on competition, rates, or regulation.  As far back as its 1996 Merger Policy Statement, FERC recognized that applicants could propose to "protect wholesale customers from any adverse rate effects resulting from the merger for a significant period of time following the merger"[1]–what came to be known as a "hold harmless" commitment.

FERC has never clearly established the specific requirements for hold harmless commitments, and applications to FERC have proposed hold harmless commitments of varying scope.  For the most part, applicants commit not to include transaction-related costs in rates for some period of time (most often five years) except to the extent such costs are matched by transaction-related savings. 

Applicants often also attempt to define the costs subject to their proposed harmless commitment, but FERC has tended not to commit one way or another to such specifics.  Rather, FERC has relied in its orders on standard language explaining how it interprets applicants’ hold harmless commitment, regardless of the specific language used in the commitment itself.  More recently, FERC has also included a requirement that any entity seeking to recover transaction-related costs subject to a hold harmless commitment must make a special FPA section 205 application to FERC, even if the costs are exceeded by transaction-related savings.

Indeed, FERC’s current approach to hold harmless commitments has led to some uncertainty in the industry as entities lack clear notice of what FERC considers to be "transaction-related" costs nor whether FERC will ultimately approve the recovery of such costs.  As a result, disputes have arisen between utilities and customers over what costs can be included in cost-based rates, including formula-based transmission rates that generally reset each year based on the prior year’s actual costs.  Additionally, hold harmless commitments have resulted in the need for utilities to track costs in great detail so that any costs subject to a commitment can be carved out of rates.

FERC’s Proposed Changes

FERC proposes several significant changes to hold harmless commitments, both in terms of what they must contain and how they will be applied.

First, FERC proposes to require that hold harmless commitments may not be of limited duration.  Historically, the "standard" hold harmless commitment was generally limited to a period of five years.  This occurred, in part, because the longer the time since a transaction was consummated the more difficult it was to continue to identify costs related to the transaction.  Additionally, it was believed that as time went on, any transaction-related costs tended to wane to the point where the burden of tracking them outweighed the benefit.  Without support, FERC now states that "time-limited hold harmless commitments may not adequately protect ratepayers from transaction-related costs,"[2] and thus proposes eliminating any such time limits.  FERC also asserts that time-limited hold harmless commitments may incentivize applicants to structure their cost-recovery efforts in order to recover transaction-related costs after the hold harmless commitment expires.[3]

Second, FERC proposes to clarify what costs are subject to hold harmless commitments.  Over the years, FERC has used a variety of terms to describe the transaction-related costs that it views as being subject to the commitment, but has not clearly delineated the scope of such costs beyond those general terms.  In its new proposal, FERC identifies a host of costs that it proposes should be subject to hold harmless commitments, including costs that may not necessarily be viewed by utilities as "transaction-related" such as internal labor costs of employees, severance payments, and certain refinancing costs.  That said, FERC emphasizes that even this proposed list is not exhaustive and that final determinations will be made on a case-by-case basis.  FERC also suggests that costs for transactions that are never consummated should not be recoverable.[4]

Third, FERC proposes to require applicants to describe "how they intend to protect ratepayers from transaction-related costs" including, among other things, "a detailed description of how they define, designate, accrue, and allocate transaction-related costs, and explain the criteria used to determine which costs are transaction-related."[5]  FERC notes that it has historically required entities to maintain a system for tracking transaction-related costs, but with this recent issuance, FERC proposes that applicants describe such a system in their section 203 application in what likely will require a great level of detail.

Fourth, while FERC proposes to increase the burden on applicants in some respects, it also proposes to clarify under what circumstances a hold harmless commitment is unnecessary.  Specifically, FERC proposes that applicants "undertaking certain transactions to fulfill documented utility service needs"[6] do not need to propose ratepayer protections such as hold harmless commitments.  FERC does not delineate fully the types of transactions that might qualify for this exemption, but identifies some examples such as acquisitions needed to satisfy resource adequacy requirements, to meet reliability standards, or to meet other regulatory requirements.[7]

Potential Impacts

FERC’s proposed policy, if adopted, will not only impact the burden of preparing section 203 applications but may also adversely impact the ability of utilities with cost-based rates to recover their transaction-related costs in the future.  Equally important, and perhaps unintentionally, FERC’s proposal may deter future infrastructure investments, especially in transmission facilities, as applicants face additional uncertainty over future cost recovery of acquired assets.

Mergers or other electric asset transactions subject to FERC section 203 approval, like any negotiated transaction, are priced based on anticipated value of the acquired or merging companies.  For entities subject to cost-based regulation–such as the vast majority of owners of electric transmission assets–such value depends in great part on forecasts of rates and rate recovery.  The proposed changes, if adopted, may put downward pressure on utility valuations as FERC makes it more difficult for utilities to recover transaction-related costs in rates.  Additionally, these changes may suppress merger activity by making future cost-recovery more difficult and subject to increased regulatory uncertainty.

In order to gain greater regulatory and financial certainty, entities may seek pre-approval of recovery of transaction-related costs from FERC as part of their FPA section 203 application before consummation of the transaction.  Whether FERC will entertain such applications is unclear, as FERC has historically been reluctant to approve cost recovery when the facts are not yet fully known.  That said, a certain level of pre-approval may be appropriate, or necessary, if merger activity by utilities with cost-based rates is not to be chilled.

Additionally, we believe that these changes will result in more disputes before FERC over what costs may be recoverable in rates.  Presently, hold harmless commitments generally tend to sunset after five years.  As a result, in full rate cases or in "mini rate cases" when entities update their formula-based charges, applicants, FERC staff, and intervenors are limited in their need or ability to challenge costs as contrary to a prior hold harmless commitment.  If FERC eliminates the ability to include time limits in hold harmless commitments, we expect full and "mini" rate cases to see more disputes as there will no longer be a date by which the commitments expire. In order to avoid inviting such litigation, FERC will likely need to impose some initial filing requirements on such protestors.

In sum, we believe that the proposed changes, if ultimately adopted, will significantly impact transactions involving entities subject to FERC cost-based rate making and may suppress merger activity, put downward pressure on utility valuations, and result in more disputes before FERC over what costs are recoverable in rates.  Moreover, the proposal will greatly increase regulatory uncertainty and deter infrastructure investment.

FERC’s issuance at this time is a proposed change in policy and it is unclear what policy changes, if any, will ultimately be adopted.  Still, with a few notable exceptions, FERC’s rulemakings and proposals tend to be adopted in largely the form proposed, absent significant criticism from multiple interest groups. 

We recommend that interested entities seriously consider commenting on the proposed policy statement.  Interested parties have 60 days to comment on the proposed policy from the date that it is published in the Federal Register.  (The publication in the Federal Register has not yet occurred and therefore the exact date is not yet known.)

   [1]   Inquiry Concerning the Commission’s Merger Policy Under the Federal Power Act: Policy Statement, Order No. 592, FERC Stats. & Regs. ¶ 31,044 at 30,124 (Dec. 18, 1996), reconsideration denied, Order No. 592-A, 79 FERC ¶ 61,321 (1997).

   [2]   Policy Statement on Hold Harmless Commitments, 150 FERC ¶ 61,031 at P 34 (Jan. 22, 2015).

   [3]   Id. at P 35.

   [4]   Id. at P 22.

   [5]   Id. at P 31.

   [6]   Id. at P 40.

   [7]   Id. at P 41.