Electric Utility Industry After PUHCA Repeal ROBERT W

Electric Utility Industry After PUHCA Repeal ROBERT W. GEE PRESIDENT GEE STRATEGIES GROUP LLC NARUC STAFF SUBCOMMITTEE ON ACCOUNTING AND FINANCE APRIL 24, 2006 CORPUS CHRISTI, TEXAS

Overview • Background leading up to PUHCA repeal in the Energy Policy Act of 2005 • What the new law (PUHCA 2004) intended and what new authority it provides to FERC and the states • How some states are reacting to repeal to protect ratepayers • How investors regard the role of the states • Suggestions for how states should proceed under the new law 2

Background of Public Utility Holding Company Act of 1935 • No significant utility state regulation existed • PUHCA enacted to address financial abuses facilitated by complex holding company structures and interlocking directorates resulting in numerous utility insolvencies and little accountability • Required simplified, limited holding company system • Utility activities limited to a single, geographically integrated public utility system and to such other businesses as are “reasonably incidental, or economically necessary or appropriate” to the operations of the integrated system • Imposed significant recordkeeping and filing requirements before the Securities and Exchange Commission 3

The Case for PUHCA Repeal • Over time, PUHCA’s restrictions were deemed as not reflecting either the market structure or regulatory policy priorities affecting the modern electric power industry – Geographic integration requirement counterintuitive to blunt growth of market power – “PUHCA Pretzels” rendered certain legal requirements meaningless • Over 2 decades, SEC favored its repeal • Perception grew that repeal was necessary to eliminate arcane, duplicative, and unduly burdensome regulations that disserved the interest of the consuming public by hindering needed investment • Role of FERC and states in ratepayer protection had matured – Would be better equipped to protect ratepayers – SEC focused on investor protection 4

Basic Premises Reflected in Energy Policy Act Electricity Title • Congress concluded that the electric utility sector has been in dire need of significant capital investment to maintain affordable, reliable electric service for the future • This investment requirement could be met by making the sector more competitive from a capital-attraction standpoint, extending to a more diversified class of investors • Regulatory reform was required to spawn greater capital attractiveness 5

“PUHCA of 2005” • Under Energy Policy Act, FERC given expanded Section 203 authority to oversee mergers & acquisitions of electric and gas companies to include holding companies, and to prevent cross-subsidization by utility of non-utility affiliates • FERC given access to books and records of utility holding companies “relevant to costs incurred” by the public utility affiliated with a holding company and “necessary or appropriate” to protect utility customers • FERC authorized to determine certain non-power goods and services cost allocations among holding company members upon request • State commissions given a federally enforceable right to request access to utility holding company books and records, wherever located, with certain provisos • Act does not preempt states from exercising jurisdiction 6 under otherwise applicable law to protect utility customers

FERC’s Response to Repeal • Final rule takes incremental approach to exercising new authority • Streamlined filing requirements in contrast to prior SEC requirements • Chose not to mandate blanket filing of cost allocation agreements addressing costs of non-power goods and services purchased by jurisdictional utilities from affiliated companies • Deferred adopting additional rules regarding cross subsidization, encumbrances of utility assets, or diversification into non-utility businesses • Preferred to rely on existing ratemaking authority under Federal Power Act and Natural Gas Act and enhanced merger & acquisition authority 7 • Revisit need for expanded action in technical conference

Post-PUHCA State Inquiries • Some concerned about: – Prospect of increased merger & acquisition activity – Greater complexity in detecting utility’s cross-subsidization of its affiliates – Ability to address potential absorption of holding company diversification risks by regulated utility • Some have opened dockets to consider adoption of ex ante safeguards in anticipation of utility holding company diversification and potential crosssubsidization – Examining limits on degree and character of holding company diversification (New Jersey Board of Public Utilities Staff proposal to limit holding company diversification at 25 percent of aggregate asset value) – Requiring structural separation of utility and holding company, accompanied by ringfencing” safeguards (Kansas Corporation 8 Commission staff proposal)

Considerations to Factor • In PUHCA 2005 Congress gave states a vote of confidence to assume responsibility to protect ratepayer interests consistent with federal law • But will Congress’ intent to encourage investment be negated by state actions tilting too heavily in the name of ratepayer protection? – “Investors versus ratepayers” presents states with a false dichotomy – Both interests should be balanced in reaching a decision, consistent with state and federal laws • Outlook for new Merger & Acquisition activity – Pre-PUHCA repeal – accelerated activity (“land rush”) anticipated from more M & As and acquisitions by new investors – Post-PUHCA repeal – somewhat more sober, realistic 9

Investors’ Perspectives on PUHCA Repeal • While M & As will continue, as before, they still will be strategic in seeking value • Some new investors likely to be interested, but will be highly cautious given current regulatory risks, lack of familiarity with state or U. S. -style utility regulation (in the case of foreign investors), and books & records requirement of PUHCA 2005 • Recent J. M. Cannell, Inc. , survey indicated that many institutional investors deemed PUHCA repeal as benign, but a “non-event” – Respondents understood the need for effective state and federal regulation – Generally, they favorably regarded ringfencing to protect utility from affiliate or parent holding company risks 10 – But many unfavorably regarded proliferation of Wisconsin-

Recommended Steps for States Considering New Rules • If you can, take the time – don’t rush to judgment • Review existing authority to: – – – condition and approve mergers oversee issuance of debt impose restrictions on dividend payouts monitor affiliate transactions conduct audits • Examine precedent construing merger approval and ratemaking authority to determine if sufficient to protect ratepayers • Questions – Does the Commission require a broader scope of oversight? – Does the Commission have sufficient resources to escalate oversight? – Can objectives be met through voluntary or “safe harbor” alternatives? 11

Strategic Implications for States Contemplating Post-PUHCA Rules • State authority customarily at zenith during merger approvals even if express statutory authority unclear or ambiguous • Ambiguity allows commissions to condition outcome of requested approval to its favor where case resolved through settlement • But certainty of new rules could undercut authority if court finds that adopted rules exceed statutory authority • From a strategic standpoint, is ambiguity or uncertainty preferred? 12

Considerations for Seeking New Legislation • PUC's existing relationship with legislature – good, bad, or mixed? • Weigh likelihood of outcomes – Legislation adopted as requested – Legislation defeated – Requested legislation not adopted but alternative legislation adopted that PUC dislikes • Two out of three outcomes are negative 13

Post-PUHCA Closing Thoughts • PUHCA repeal represents a rare instance of Congress modifying federal regulation of energy sector and inviting states to “share the field” • How states respond to Congress’ invitation could strongly influence pace and degree of future mergers and acquisitions and volume of capital invested into the sector • How FERC exercises its new M & A authority in future cases, in tandem with new PUHCA authority, should provide states with guidance, and could conceivably lessen need for separate state safeguards • FERC and state commissions are “joined at the hip” 14 in implementing this legislation

Robert W. Gee President Gee Strategies Group LLC 7609 Brittany Parc Court Falls Church, VA 22304 U. S. A. 703. 593. 0116 703. 698. 2033 (fax) rwgee@geestrategies. com www. geestrategies. com 15