Briefing Paper

Briefing Paper REPEAL OF THE PUBLIC UTILITY HOLDING COMPANY ACT OF 1935: IMPLICATIONS AND OPTIONS FOR STATE COMMISSIONS The National Regulatory Research Institute August 2006 Robert Burns, Esq. Michael Murphy, Esq. Senior Institute Attorney Graduate Research Associate EXECUTIVE SUMMARY Repeal of the federal Public Utility Holding Company Act of 1935 (PUHCA 1935) is perhaps the most far-reaching provision in the Energy Policy Act of 2005 (EPAct 2005) regarding the future structure of the electricity industry and its markets. The repeal removes statutory and regulatory barriers to industry consolidation, conglomeration, and diversification. The PUHCA of 2005 (PUHCA 2005) replaces comprehensive regulation by the Securi- ties and Exchange Commission (SEC) with much narrower authority for federal and state access to books and records. It allows both the Federal Ener- gy Regulatory Commission (FERC) and state utility commissions to review affiliate transactions and to deal with cost allocations and cross subsidies. Repeal is expected to encourage investment in electric utility infrastructure, but it may open up potential abuses where utilities under state jurisdiction are part of larger holding companies. Most state commissions have authority to deal with affiliate transactions, cost allocation, and cross-subsidy issues. Many state commissions are reviewing their authority to regulate holding company affiliates to decide whether existing protections are sufficient or whether ad- ditional state legislation or commission regulation is needed to fill the void. In particular, ring-fencing provisions are desirable to prevent potential corporate abuse, whether the abuse is easily definable or subtle. This paper reviews approaches for providing more expansive state authority for commission access to books and records, as well as requirements that might be incorporated in statutes, commission regulations, or merger orders to insulate public utilities from holding company abuses. State commissions have what might be viewed as a continuum of options. For the sake of exposition, this report identifies three approaches once a state has carefully reviewed its statute(s), existing authority, and existing merger conditions. First, a state commission may find that it can address ring-fencing to insulate a company from the holding company on a case-by-case basis relying on existing commission authority. The second approach calls for ring- fencing statutes or rulemakings but does not include limits on utility diversification. The third approach attempts to re-create the PUHCA 1935, includ- ing strictures on diversification, which might be the most problematic from the viewpoint of encouraging investment in electric utility infrastructure. Contents Introduction 2 Three General State Approaches to Ring-Fencing 14 Background 2 Summary and Conclusions 26 Implications of 7 Appendix A - Key Provisions of The Public Util- 28 Repeal ity Holding Company Act of 2005 Traditional State 10 06-12 Authority — The Starting Point INTRODUCTION BACKGROUND Repeal of the federal Public Util- PUHCA 1935 The PUHCA 1935 was ity Holding Company Act of 1935 repealed by the EPAct (PUHCA 1935) is perhaps the most Congress enacted PUHCA 1935 to 2005. far-reaching provision in the Energy combat market imperfections inher- Policy Act of 2005 (EPAct 2005) re- ent in holding company structure garding the future structure of the elec- and operations.1 Congress found tricity industry and its markets. The investors and energy consumers repeal removes statutory and regula- may be adversely affected when any tory barriers to industry consolidation, of 11 enumerated evils emerged.2 conglomeration, and diversification They are: at the possible expense of consumers and investors. Repeal is expected to • investors cannot obtain adequate in- encourage investment in electric util- formation to appraise the f i n a n - ity infrastructure, but it may open up cial position or earning power of the potential abuses where utilities under issuers because of the absence of state jurisdiction are part of larger uniform standard accounts holding companies. Many state com- • securities are issued without the con- missions are reviewing their author- sent of the states ity to regulate holding company af- • securities are issued on the basis of filiates to decide whether existing fictitious or unsound asset v a l u e s protections are sufficient or wheth- bearing no fair relationship to the er state legislation or commission amount invested or earning power rulemaking is needed to fill the void. of the properties, and on the basis of paper profits from inter-com- This research report lays out broad pany transactions or in anticipation options for state commissions, includ- of excessive revenues from utility ing extended examples of three quite subsidiaries different approaches that represent • securities that require the utility to alternatives that range from highly support an overcapitalized s t r u c - restrictive on holding company op- ture and tend to prevent voluntary erations to less comprehensive and rate reductions are issued anticipatory. It begins with a brief • utility subsidiaries are subject to ex- history of PUHCA and the new stat- cessive charges for services, ute and federal framework, discusses construction work, equipment, and the implications of repeal, gives an materials, or enter into transac- overview of where states are starting tions where arm’s length bargaining from and what to look for in their ex- is absent and free competition is isting statutes and rules, and provides restrained the three examples. The report ends • service, management, construction, with a summary and conclusions. and other contracts involve the �� Section 1(a) of PUHCA, 15 U.S.C. �79(a). �� Section 1(b) of PUHCA, 15 U.S.C. �79(b) The National Regulatory Research Institute allocation of charges among utility needed for the ratemaking process and subsidiaries in different states so as for other regulatory needs. It also al- to make effective state regulation lows separation of utility property and difficult activities from non-utility operations. • control of utility subsidiaries affects Most states require approval before the accounting practices, r a t e s , utilities are allowed to issue major dividends, and other policies of such securities. States tend to monitor the companies so as to complicate and issuance of securities so that the util- obstruct state regulation ity does not become overcapitalized • control of utility subsidiaries is ex- given its assets, and now bond cov- Repeal of PUHCA 1935 erted through disproportionate in- enants also prevent overcapitalization. was urged to encourage vestment the infusion of capital, • the growth and extension of holding PUHCA 2005 a central goal of EPAct companies bear no relation to econ- 2005. omy of management and operation Repeal of PUHCA 1935 was urged to or coordination of related operating encourage the infusion of capital into properties the electric and gas industries, a cen- • there is a lack of [economy of] effec- tral goal of EPAct 2005. It is hoped tive public regulation that PUHCA 1935 repeal will lead • there is a lack of economies in rais- to economically efficient consolida- ing capital.3 tion of the electric and gas industries. Without geographic limitations on The main thrust of PUHCA 1935 to holding companies, cross-commodity eliminate the 11 evils was limits on constraints, the requirement of vertical holding company ownership of geo- integration, and barriers that limited graphically remote utilities and re- diversification to related industries, strictions on diversification beyond the the industry will be free to take advan- electric and gas utility industries. Sev- tage of economies of both scope and enty years later, it is fair to say many scale, and new investment opportuni- of the evils identified by Congress no ties will be created. Market consoli- longer exist or are controlled through dation and investment by new diver- other forms of regulation. The Sar- sified entities are expected to lead to banes-Oxley Act addresses the issues portfolio diversity and vertical as well of corporate responsibility, account- as horizontal diversification. Scale ing oversight, financial disclosure, and economies, to the extent they exist, auditing requirements.4 There are Uni- can lead to unit cost reduction, leading form Systems of Accounts that provide to more competitive costs. Portfolio for the reporting of regulated utility diversity can lower risk or, by creat- accounting information on a uniform ing options, make risk more manage- and consistent basis. Use of a Uniform able. Greater diversification can also System of Accounts provides regula- create market position opportunities. tors and other parties with information Technically, in repealing PUHCA 1935, Congress in Section 1263 of �� Section 1(b) of PUHCA, 15 U.S.C. ��§�� 79(b). EPAct 2005 substituted a new Public �� The Sarbanes-Oxley Act of 2002, Public �aw Utility Holding Company Act of 2005 107-204, 116 Stat. 745 (30 July 2002). The National Regulatory Research Institute (PUHCA 2005).5 PUHCA 2005 is is subject to terms and conditions as much more limited than the original, may be necessary and appropriate to however. The broad authority of

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