United States: Deregulation Done Right

This article originally appeared in the November/December edition of The Pennsylvania Lawyer.

Higher than average costs of electricity in both California and Pennsylvania, in part because of nuclear power, created the political pressures that put the two states among the first to legislate competition in the retail sale of electric power. Gov. Pete Wilson signed California’s public utility electrical restructuring statute on Sept. 23, 1996. Gov. Tom Ridge signed the Pennsylvania "Competition Act" restructuring its electric utility industry on Dec. 3, 1996.

Now, five years later, California’s privately owned electric utilities are in shambles, with the largest in bankruptcy. More than $13 billion in state money has been spent in stopgap efforts to purchase sufficient power to avoid rolling blackouts, with additional billions committed to long-term power purchase contracts at rates above the current market.

But Pennsylvania has thus far made the transition toward competition and lower retail prices without significant disruption, either to consumers or the commonwealth’s public utilities.

Are the different effects of restructuring in California and Pennsylvania merely happenstance or do the contrasts result from conscious choices that were made deliberately by the executive, legislative and judicial branches of each state’s government?

Only a longer test, perhaps over at least a decade, can give a definitive answer, but my opinion is that Pennsylvania made the correct choice on a single, but crucial, option in the creation of a deregulated electric-power industry, while California’s choice of the opposite option had disastrous consequences.

That single difference in the legal structure imposed on the competitive electric industry is the most significant among the multiple causes of the California crisis. Recent events in Pennsylvania demonstrate that if the commonwealth had taken the California option, our utilities might also be on the verge of financial collapse.

Moreover, Pennsylvania selected the right option for the right reasons. Although the California option was superficially more sophisticated and had been espoused by influential economists, Pennsylvania instead concluded that the California option might undermine the most fundamental principle of electric-power regulation: that certainty of an adequate supply of energy, both gas and electric, is a governmental objective to which other policies must yield, a proposition reaffirmed by the U.S. Supreme Court in 1997.

In 1992, federal regulatory initiatives created the legal framework for a national wholesale market in electric power, including requirements that utilities allow use of their transmission facilities to move electric power owned by others. By late 1995, a consensus had developed in California that the benefits of wholesale competition should be extended to the retail market for electric power.

In contrast to the adversarial and partisan deregulation process that played out in Pennsylvania in late 1996, California’s governmental leadership acted virtually without dissent to enact a comprehensive scheme, based on the best academic pronouncements, to create a legal structure for electric power that was confidently believed would assure Californians the benefits of lower-cost electricity.

The first step was the adoption of a comprehensive plan for deregulation by the California Public Utility Commission (PUC) in December 1995. Assembly Bill No. 1890, adopted unanimously in both houses of the legislature and signed by Gov. Wilson in September 1996, implemented that plan.

As in Pennsylvania, the California restructuring provided for payments to allow incumbent public utilities to recover so-called "stranded costs," especially the costs of building nuclear generating facilities. Following the near-meltdown at Three Mile Island in March 1979, the cost of completing nuclear facilities increased by many billions of dollars, as regulators imposed onerous safety requirements intended to prevent repetition of that disaster.

Under traditional regulation prior to restructuring, these costs would have been recoverable over time from the consumer-ratepayers in amounts approved by each state’s PUC. Part of the reason for high retail electric prices in both California and Pennsylvania was the regulated return on investment required to pay for nuclear facilities, such as Diablo Canyon built by Pacific Gas & Electric (PG&E) and the Limerick project of Philadelphia Electric Co. (later renamed PECO Energy Co.). Under the new competitive regime, in which the price for electric power would be set by a competitive national market, the full cost of such facilities could never be recovered, hence the concept of "stranded costs" — like a ship stranded when the tide goes out. Both in California and Pennsylvania, a portion of the stranded costs (also referred to as "transition costs") would be recoverable in an amount determined to be fair by the respective PUCs. They would be recoverable from the consumers in the geographical territory of a public utility through so-called "transition charges." These had to be paid even if consumers chose to purchase power from new suppliers.

In Pennsylvania, both the concept and the amounts of transition charges were vigorously contested. In California, legal provisions for transition charges to reimburse stranded costs were included as part of the unusual governmental consensus. Much of the text of Assembly Bill 1890 was devoted to assuring that the transition charges are "nonbypassable," meaning unavoidable by electric consumers in the territory served by the public utility, regardless of the identity of their new providers of electric power. The bill also made numerous amendments to the Uniform Commercial Code intended to immunize third-party purchasers of transition charges from a potential bankruptcy of the public utility.

The legislative intent in California was to create a stream of payments to float bonds, referred to as "rate-reduction bonds," that would be attractive financial instruments, saleable in the public markets with interest rates significantly below the cost of capital of the public utility itself. Through the sale of these rate-reduction bonds, funded by the future stream of transition charges (using a state financial intermediary, the California Infrastructure and Economic Development Bank), a utility could "securitize" transition payments—and obtain an immediate return of stranded costs. The savings would allow the utility to live within a legally mandated 10 percent reduction in electric rates to retail consumers and small industrial users of electricity.

In both California and Pennsylvania, the magic of securitization of transition payments worked exactly as the experts had predicted. The California bonds are still salable despite the bankruptcy of PG&E, exactly as the draftsmen of Assembly Bill 1890 provided. In 1997, when utility opponents awakened to the comprehensive enactments of 1995 and 1996, they organized a typical California proposition campaign to repeal much of the deregulation plan, but the effort failed at the polls by a wide margin.

Another part of the California plan mandated a central market place for electric power by creating a "power exchange" that would use an auction system to set the market price for power hour by hour. The exchange was supported by an "independent system operator" that would manage the transmission of power on the facilities owned by the utilities. Pennsylvania already had the "PJM interconnection," a privately initiated and highly effective system for sharing power within eastern Pennsylvania, New Jersey, and Maryland (which has now itself evolved into an independent system operator).

The final element in the California plan had been mandated by the California PUC in the deregulation plan adopted in December 1995. To assure that the payments received as transition charges by the existing utilities would not be used to stifle competition, economic and regulatory experts recommended that incumbent utilities divest themselves of most of their power-generating facilities. By requiring the sale of generating facilities to others, the power produced by those facilities would, the academic economists opined, be offered for sale at truly competitive prices. As a corollary to requiring divestiture, the academic economists also said that the incumbent utilities should be prohibited from entering into contracts to purchase power from the new owners of the divested facilities, lest pure competition be tainted by a holdover relationship with the original builder.

A key part of the California plan, therefore, was that the bulk of the generating facilities of PG&E and other investor-owned utilities were to be sold, "voluntarily" in legal theory. Some were sold to utilities in other states and some to non-utility "merchant" power producers, on terms that prohibited contracts by which the seller would have any right to receive power to be produced in the future. Although the utilities retained their nuclear generating facilities, the power thus generated was required to be offered for sale through the power exchange at prices set daily or hourly by the auction process and then bought back from the power exchange in order to distribute to retail consumers.

It was this divestiture of generating capacity, combined with the prohibition on long-term contracts, that led to the financial devastation of PG&E.

In Pennsylvania, strong political and economic forces supported electric deregulation, but they were up against a tenacious and partisan opposition that fought the Ridge administration in the Legislature, before the Public Utility Commission and later in the courts. Gov. Ridge, at the height of his political power in the second year of his first term, pressed for deregulation in a lame-duck session of the Legislature in November 1996. Major industrial users of electric power, which had also been consistent supporters of the governor, had rebelled at Pennsylvania’s high electric costs. The incumbent pubic utilities joined the governor’s initiative in order to secure a deregulation plan that protected their right to be compensated for stranded costs. The Democratic legislative leadership in the state Senate, led by state Sen. Vincent J. Fumo, fought many of the Ridge proposals.

The repeated clashes between the Ridge proponents and the Fumo-led opponents may have contributed to a better deregulation plan than was adopted by consensus in California. The Ridge plan emerged near the end of the 1996 lame-duck session in a series of last-minute maneuvers that strained the state constitutional requirements for legislative due process. It omitted any requirement of divestiture of generating capacity and the corollary prohibition on long-term contracts for the purchase of power.

Two of the three branches of the Pennsylvania government — the executive and the legislative — had eschewed divestiture, but the issue suddenly surfaced, from an unusual source, before the judicial branch in late 1997.

An Indiana public utility, Indianapolis Power & Light Company (IPL) had participated in the first regulatory proceeding before the Pennsylvania PUC in which PECO Energy Co. had obtained approval to securitize part of its stranded costs. In filings before the PUC, the IPL lawyers carefully laid the foundation for a federal constitutional challenge to Pennsylvania’s omission of a divestiture requirement. IPL’s stated motivation was to be able to compete effectively with PECO in offering power to PECO customers. IPL relied on the "dormant" Commerce Clause. This refers to the effect of the U.S. Constitution’s Commerce Clause when Congress does not take action to regulate commerce in a particular respect - "dormant," referring to an absence of Congressional action. Precedent involving the dormant Commerce Clause holds that state legislative action is unconstitutional if it burdens interstate commerce and has not been permitted by Congress. For example, New Jersey’s elaborate legislative scheme regulating the transportation and handling of trash is among the state regulations struck down by the U.S. Supreme Court pursuant to the dormant Commerce Clause. [C & A Carbone, Inc. v. Town of Clarkstown, 511 U.S. 393 (1994)].

IPL argued before the PUC that competition in the sale of electric power into Pennsylvania would be hampered by the imposition of transition charges payable to PECO for its stranded costs and that the transition charges would burden interstate commerce unless PECO and other incumbent utilities were required to divest their generation capacity. IPL relied on a Supreme Court precedent that, at first blush, seemed squarely on point. In West Lynn Creamery, Inc. v. Healy, 512 U.S. 186 (1994), a Massachusetts tax on all wholesale transactions in milk produced both out-of-state and in-state had been struck down pursuant to the dormant Commerce Clause, because the fund created by the tax was distributed only to in-state dairies as part of a plan to protect higher-cost in-state dairies from being overwhelmed by lower-cost out-of-state competitors. IPL argued that the transition charge imposed on all electricity sold into a territory formerly served by a Pennsylvania public utility, regardless of the identity and location of the seller of that electricity, was indistinguishable from the tax struck down in the West Lynn Creamery case and was equally a burden on interstate commerce.

When the Pennsylvania PUC declined this argument and upheld the constitutionality of the Competition Act, IPL appealed to Commonwealth Court, and the stage was set for a monumental legal battle. Although litigating in the Pennsylvania state court system against Pennsylvania’s state government and its largest utility was obviously an uphill fight, IPL hoped to frame and preserve a constitutional issue of enormous public importance in every state contemplating a competitive electric market. Such an issue offers a reasonable chance of success on a petition for certiorari and eventual reversal in the U.S. Supreme Court.

PECO, with $5 billion in transition charges at stake, used its traditional regulatory counsel, Morgan, Lewis & Bockius L.L.P., led by Thomas P. Gadsden, a leading utility advocate, and Joseph B.G. Fay, a veteran of many antitrust battles. I made the oral argument before Commonwealth Court. The Morgan, Lewis team reported to PECO general counsel James W. Durham, who had been deeply involved in the legislative battles over the Competition Act, and his colleagues Paul R. Bonney and Ward L. Smith. IPL engaged Walter W. Cohen, a former acting state attorney general and former state consumer advocate, who had fought PECO at various stages of the Limerick project, working with IPL’s Indianapolis counsel, Barnes & Thornburg.

IPL’s lawyers were blunt in pressing their position that allowing incumbent utilities to recover their transition costs could only be constitutional if the incumbent utilities were required to divest their generating facilities. Counsel for PECO and the PUC argued that the Legislature had "legitimate local concerns" for determining not to require divestiture, especially an interest in "assuring the reliability of electric service throughout the commonwealth." This argument relied on a long line of Supreme Court cases sustaining state power to regulate public utilities, including a 1997 decision that upheld Ohio’s disparate levels of taxation on sales of natural gas through local distribution companies, which were not taxed, and directly from pipelines to industrial customers, which were taxed. [General Motors Corp. v. Tracy, 519 U.S. 278 (1997)] Justice David H. Souter’s opinion for the court had concluded that the interest in "dependable supply" of energy sources was a critical local interest that justified differential treatment of regulated utilities in a manner that might otherwise create an issue under the Commerce Clause. [Tracey, 519 U.S. at 306-07] Justice Antonin Scalia, dissenting in another case, referred to this holding as "the ‘public utility’ exception" to "the negative Commerce Clause." [Camps Newfoud/Owatonna, Inc. v. Town of Harrison, 520 U.S. 564, 607 (1997)]

IPL attempted to avoid the pivotal argument that the state’s interest in a "dependable supply" of energy justified Pennsylvania’s choice to refrain from requiring divestiture of generating capacity. Instead, IPL argued that the financial health of Pennsylvania utilities was irrelevant under the constitutional requirements of the Commerce Clause. In candid language that was remarkably prescient of what would later happen in California, IPL argued in its reply brief in Commonwealth Court that the financial condition of Pennsylvania utilities was not a legitimate local concern because, argued IPL, "even insolvent utilities continue to provide service without interruption as debtors in possession under Chapter 11 of the Bankruptcy Act. ..." [IPL Reply Brief at 16].

In the en banc session before seven judges of Commonwealth Court, counsel for the PUC and counsel for PECO divided 20 minutes of oral argument defending the constitutionality of the Competition Act. President Judge James Gardner Colins, reflecting the importance of the issues, extended by three minutes the 10 allotted to PECO. IPL, controlling 20 minutes as sole appellant, somewhat unconventionally split its opening argument into three segments with Walter Cohen starting and finishing and Stanley C. Fickle of Barnes & Thornburg sandwiched in between.

The unanimous opinion of Commonwealth Court, written by Colins, not only dealt with every objection to the Competition Act but also concluded that the transition charges were so central to the legislative intent that a decision invalidating the transition charges would require invalidation of the entire statute. In rejecting the IPL arguments based on the West Lynn Creamery wholesale milk levy, Colins stated:

After thoroughly reviewing Supreme Court Commerce Clause precedent, we conclude that the Competition Act does not implicate the Commerce Clause for three reasons. First, the Competition Act does not discriminate against interstate commerce and is unlike the state statutes that have been previously examined under the Commerce Clause by the Supreme Court. Second, the provisions of the Competition Act that are questioned as discriminatory (those that allow for the recovery of stranded-costs) are consistent with the traditional ability of states to regulate the retail sales of electricity and do not trigger the dormant aspects of the Commerce Clause. Third, the need for stranded-cost recovery is evidenced by their acceptance in other forums moving toward competition and the Commerce Clause should not be used as an impediment to Pennsylvania’s experiment with competition.

[Indianapolis Power & Light Co. v. Pennsylvania Public Utility Comm’n, 711 A.2d 1071 (Pa. Cmwlth. May 7, 1998), appeal denied, 556 Pa. 698, 727 A.2d 1124 (Sept. 29, 1998), cert. denied, 526 U.S.1005 (March 8, 1999)].

The Supreme Court of Pennsylvania promptly declined review. IPL then went all out in a petition for certiorari keyed to the West Lynn Creamery precedent and argued that the Competition Act could be constitutional only if divestiture of generating facilities was compelled. Not surprisingly, the pendency of the petition had the effect of preventing PECO and other utilities from moving forward to securitize the initial amount of transition charges as authorized by the PUC. As long as the possibility existed that the Supreme Court might take the case, the transition securities could not be sold to the public. Because the reduction in retail customer rates was intertwined with the sale of the transition securities, the entire deregulation process was temporarily stalled until the U.S. Supreme Court, acting within a few days of the close of the certiorari briefing schedule, denied certiorari in March 1999.

The California experience demonstrates that the divestiture requirement and the corollary prohibition on long-term contracts are fatal flaws in that state’s deregulation plan. Some causes of the California crisis are not directly related to its deregulation plan, such as a shortage of hydroelectric power "due to dryer than usual conditions" and a substantial increase nationally in natural gas prices. Other causes - some alleged to be sinister (collusion among out-of-state power suppliers and manipulation of natural gas supplies) - remain under investigation. But as power became in short supply and wholesale prices increased dramatically, the California public utilities, stripped of their own generating capacity, were trapped between an increasingly dysfunctional wholesale market and the rigid retail price cap created under the deregulation plan.

The Pennsylvania experience during the same time period demonstrates that compelled divestiture would have seriously damaged Pennsylvania’s utilities. One New Jersey utility holding company, GPU, parent of Metropolitan Edison, the utility that built Three Mile Island, and parent of Pennelec, which serves Western Pennsylvania, voluntarily divested itself of generating capacity and did not enter into long-term power purchase contracts with the new owners. As wholesale prices increased nationally, GPU’s Pennsylvania subsidiaries were similarly trapped between a higher wholesale price and the retail price cap imposed under the Pennsylvania Competition Act. Unable to get PUC permission to exceed the retail price cap, GPU was forced into being acquired by an Ohio utility company that had its own generation capacity. In contrast to GPU’s voluntary replication of the California divestiture model, PECO Energy choose to keep its own generating capacity and purchase additional capacity from others, including the remaining active reactor at Three Mile Island (purchased by PECO from GPU), all at very favorable prices in what was, in 1999, a buyers’ market for second-hand electric facilities. In a strong financial condition, PECO went on to merge with Commonwealth Edison of Illinois to create Exelon.

In California, the only favorable news for the shareholders of PG&E is the financial success of the PG&E subsidiary formed to purchase generating capacity in New England, which incumbent New England utilities were required to divest as part of state deregulation plans modeled after the 1995-96 California experiment. Whether the creation of elaborate legal "ring fencing" (PG&E’s own phrase) will successfully insulate these assets from California creditors is still undecided. The California Power Exchange, which was central to the concept of pure and "transparent" competition, also filed for bankruptcy earlier this year. Most of what remains of the statutory deregulation structure is now totally, and rather secretively, under the control of the new California governor. Many lawyers - but perhaps fewer academic economists -will be employed for years to come in allocating the liabilities created by the California plan.

Gregory M. Harvey is a partner in the litigation department of Montgomery, McCracken, Walker & Rhoads, L.L.P. While a partner at Morgan, Lewis & Bockius L.L.P., he delivered the winning oral argument for PECO Energy Co. and was counsel of record for PECO in the subsequent proceedings leading to the denial of certiorari by the U.S. Supreme Court. He last wrote for The Pennsylvania Lawyer on Pennsylvania election law and what might have happened had Pennsylvania, rather than Florida, been faced with a recount in the presidential election.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances