United States: Investing in U.S. Utility Assets

Rapid changes in the electric utility industry in the United States present a host of opportunities for potential investors to enter the market. Prices for electric generating assets are depressed in the wake of recent distressed asset sales. While the market does present significant risks, including generation oversupply in some areas, these conditions also present unique opportunities that may rapidly disappear. Some new players have already entered the field. This White Paper will outline the major regulatory issues surrounding an investment in United States electric generation and transmission assets. What follows will introduce this complex area to non-U.S. investors or domestic investors who have no exposure to the electric utility industry.

The scope of this paper has an important limitation — it focuses only on the specified types of assets. The regulatory regime for individual assets, such as generating stations, is significantly different from that applicable to "vertically integrated" utility companies — that is, the traditional U.S. investor-owned public utility that serves a specified geographic area and provides integrated generation, transmission, and distribution service. For a full treatment of the issues involving transactions with vertically integrated utilities, see the 2003 Jones Day White Paper "Investing in U.S. Utility Operations."

Because changes to U.S. utility related laws and regulations have been made slowly and piecemeal since about 1978, there is a confusing array of entities that can be involved in power generation. These entities are subject to different rules and regulations. The status of the entity will determine whether an investment in it will have any immediate regulatory consequence to the buyer or its other businesses.

Before looking at the regulatory consequences of the different types of investment, it is necessary to say a word about the Public Utility Holding Company Act of 1935 ("PUHCA"). Under this Federal law, any person that owns or operates facilities used for generation, transmission, or distribution of electric energy for sale is an "electric utility company." Further, a person who owns 10 percent or more of the voting stock of an electric utility company is a "holding company" and is subject to PUHCA’s restrictions, unless it qualifies for an exemption. No exemption is likely to be available to non-U.S. investors or to conglomerates or others outside the "utility" field. The consequence of becoming subject to PUHCA can be severe, and great effort has been taken to avoid coming within its strictures. The development of "non-utility" generators, complex ownership structures, and other devices summarized in this paper has focused largely on ways to avoid the implications of PUHCA.

Congress has been considering repeal of PUHCA for years. As of this writing, however, recent efforts to adopt comprehensive energy legislation, including PUHCA repeal, have failed. For now, investors should plan for the future assuming PUHCA will remain the law of the land.

Qualifying Facilities. The earliest type of "non-utility" generator is known as a "qualifying facility" or "QF." QFs developed following enactment of a 1978 law, the Public Utility Regulatory Policies Act ("PURPA"). The goal of PURPA was to encourage energy efficiency. Accordingly, qualifying "co-generation" facilities and qualifying "small power production" facilities were given special treatment if they met energy efficiency criteria. A co-generation facility generates steam and/or electrical power for use in manufacturing, with excess electricity being sold to the local traditional utility. A small power production facility generates electrical power from renewable resources (e.g., wind, waste, biomass, geothermal energy, and sunlight). To be "qualified," these co-generation and small power production facilities must (1) satisfy certain operating criteria and (2) be owned by a person not primarily engaged in the generation or sale of electric power (i.e., the owner cannot be a traditional utility). A generator that meets these qualifications will become certified as a QF through a filing made with the Federal Energy Regulatory Commission ("FERC").

The benefit of "qualified" status is that qualified generators are not considered "public utility companies" under PUHCA. Therefore, ownership of a QF does not make the owner a "holding company." An investor may own up to 100 percent of any number of QFs located anywhere in the U.S. and not be subject to PUHCA. Furthermore, under the law creating QFs, to encourage their development, they have the ability to require the local traditional utility to purchase their excess output at a price attractive to the QF. In many cases, utilities are required to purchase this power under long-term contracts at prices significantly in excess of current market prices.

There is one limitation regarding QFs relevant to some investors. As mentioned above, to be qualified, the generator cannot be owned by a person "primarily engaged in the generation or sale of electric power." Ownership by a traditional utility will be disregarded, however, and the generator will nevertheless qualify as a QF, as long as the traditional utility, or any affiliate of a traditional utility, does not own more than 50 percent of the "equity interest" in a QF. The "equity interest" is not merely the percentage of voting control over the entity but also takes into account the investor’s share of the "stream of benefits" of the facility. Under these rules, "utility" has the meaning given the term in PUHCA.

An investor with no interests in "utility" operations anywhere in the world would not be concerned with the 50 percent limitation. A non-U.S. investor that has "utility" activities outside the U.S. should also be able to avoid this limitation. Under PUHCA, a "foreign utility company" ("FUCO") is a person that has no electric generation, transmission, or distribution facilities in the United States. A FUCO is not considered a "utility" as defined in PUHCA. Accordingly, as long as the QF investor has no U.S. "utility" as defined in PUHCA, it would not be limited to only a 50 percent equity interest in a QF. This investor could acquire up to 100 percent in any number of QFs located anywhere in the U.S.

This confusing interplay between the various laws points up the importance of definitions in this area. Owning a QF, as well as ownership of an exempt wholesale generator, discussed below, does not make a person a "utility" for purposes of the 50 percent ownership rule for QFs discussed in the preceding paragraphs. Only the "traditional" utility company is subject to that limitation.

However, if the owner of QFs later acquires a U.S. integrated utility, it then will be a "utility" for purposes of the investment limitation in QFs. This investor would be required to reduce its investment to 50 percent or less in each QF (or the QF would lose its qualifying status).

Exempt Wholesale Generator. In 1992, legislation was adopted creating a new type of non-utility generator, the exempt wholesale generator ("EWG"). An EWG is any entity that is exclusively engaged in the ownership of facilities used to generate electricity for sale at wholesale. Owners of EWGs must, therefore, sell their output to customers who will resell to end-use customers. EWG customers include traditional electric utilities that have retail load, power marketers or brokers, and other wholesale sellers. An EWG is not a "utility" for purposes of PUHCA. Furthermore, under the rules applicable to EWGs, there is no restriction on the type of operations, type of fuel, or the identity of the owners of an EWG. There is also no restriction on the number of EWGs an individual investor may own or the geographic location of the facilities.

Most of the activity in "non-utility" generators in the U.S. has involved EWGs. State legislation to deregulate traditional electric utilities has included incentives, or requirements, for these utilities to sell their generating plants. Accordingly, many generating stations across the country that were part of traditional utilities are now owned by EWGs and sell their output either to the former owner or into the wholesale power markets. In addition, a significant amount of newly constructed generation has been developed in the past 10 years or so and is owned by EWGs. Some of this generation has long-term sales contracts in place, but much of it was developed as speculative or "merchant" facilities. The inability of these merchant facilities to continue to sell their output at the prices assumed when they were built has led to the bankruptcy of several project developers and also contributes to the oversupply of generation in some areas.

The distinguishing features of the EWG segment of the electric utility industry is geographically disbursed assets consisting of only generating facilities since transmission or distribution facilities are not permitted.

QFs that are also EWGs. Many generating facilities are certified as both QFs and EWGs. However, even if a facility is an EWG, and therefore has no restriction on the identity of its owners, in order for that facility to retain its QF status, the ownership restriction would apply. An entity would want to retain its QF status in order to retain the authority to sell power to the local utility at the favorable prices mandated by law.

Independent Power Producers. Another category of generator is referred to as an independent power producer ("IPP"). This is a term sometimes used in a generic manner to refer to QFs and EWGs. There are some IPPs that are excluded from PUHCA constraints because they are structured in such a way that no one person owns 10 percent or more of the generator and thus no owner is classified as a holding company. As will be discussed under "Transmission Assets" below, the techniques used to allow investors to own "independent power" plants in the past, and avoid PUHCA restrictions, are now being put to use for investments in other utility facilities.

Fuel Cells/Micro-Turbines and Other Alternatives. There are no special laws applicable to fuel cells, micro-turbines, and similar technology. Under PUHCA, a person who owns or operates a "facility" for "generation" of electricity is an electric utility subject to regulation. Ownership of combustion turbines, for example, would raise a PUHCA issue. Likewise, fuel cells, mircoturbines, and other fossil generation, or any other technology that generates electricity will be subject to PUHCA issues. These technologies probably would not qualify for QF status and its exemption from PUHCA. However, there is no restriction on the technology used to achieve EWG status. As long as the fuel cells, mircoturbines, or other technology were used to make only wholesale sales, the generator would qualify for EWG status. Further, a person who generates electricity is not subject to PUHCA rules unless the electricity is sold. Generation for self-use by the person owning the facilities is not subject to regulation. Thus, for electricity generated by these technologies to be consumed directly by an end user, the end user would have to own the facilities. The owner of such facilities could not make sales to retail (end user) customers directly but would have to sell first to a wholesaler, who could be an affiliate, who could then sell to end users.

Modernization of laws in 1978 and 1992 led to the development of non-utility generators and a relatively unregulated market for electric generation. There have been no equivalent statutory changes applying to electric transmission assets. Nevertheless, "independent" transmission operators have been slowly developing in the United States. A significant impediment to an independent transmission operator with national scope is PUHCA. An owner of transmission assets is a "utility" under PUHCA and so any person who owns 10 percent or more of the voting control of such an owner is a holding company subject to PUHCA restraints. To date, investors in independent transmission have avoided a "holding company" structure, limited their operations to a single State, which helps avoid PUHCA limits, or used complicated ownership structures to avoid characterization as an "owner" of the operating assets. Each of these alternatives, discussed below, has advantages and disadvantages. An investor would have to evaluate its particular situation, and identify its priorities, when determining which of these alternatives would be suitable given its goals.

Investors with significant other business operations likely would want to invest in electric assets through a subsidiary to insulate their other businesses from the risks of the utility operation. However, as soon as the entity operating the assets is a subsidiary of the owner, PUHCA is implicated. PUHCA’s principal focus is regulating the "holding company." If there is no holding company, there is no PUHCA regulation. Thus, for example, if a single entity owned and operated transmission facilities in many different States throughout the U.S., and had no "utility" subsidiaries, it would not be regulated under PUHCA. The ownership of this entity would have to be disbursed so that no single owner held 10 percent or more of the voting control. This structure works if the objective is to develop a public company (or one with at least relatively disbursed ownership) with the single focus of owning transmission assets. However, it will not work for an investor who has other business interests and wants also to control a transmission company.

Another approach is to avoid owning transmission assets in more than one State. A holding company can be exempt under PUHCA if it operates predominantly in a single State. This company would be permitted to have a minor amount of utility operations in other States. The advantage of this approach is the benefit of being organized in a holding company structure. The trade-off is giving up the flexibility of operating geographically disbursed assets. The holding company in this case can also be engaged, through subsidiaries, in other lines of business, and these other businesses can operate anywhere; they are not limited to the State where the transmission assets are located, and the size of these non-utility operations (i.e., the amount of assets or revenues) is not limited. This alternative is only available to U.S.-based investors. The holding company must be organized in the State where the predominant transmission business is carried on. Thus, a non-U.S.-based investor would be ineligible for the exemption from PUHCA.

The last of the alternative methods of investing in transmission assets involves a complicated ownership structure that avoids PUHCA through technical avoidance of a holding company. In this structure, one or more interested investors will be able to have a significant economic interest in the entity owning and operating the transmission assets. However, none of these investors may have 10 percent or more of the voting control of the entity. A number of financial players such as Berkshire Hathaway, Kohlberg Kravis Roberts & Co., and General Electric Capital Corporation have used this technique to make utility investments.

Under PUHCA, a person becomes a holding company by owning 10 percent or more of the voting securities of a utility company. Power to control the subsidiary is presumed at that level. The law also allows the Securities and Exchange Commission ("SEC"), which administers PUHCA, to find that a person with a "controlling influence" over a utility should be deemed to be a holding company notwithstanding the level of ownership — above or below 10 percent — of voting securities.

The SEC has issued interpretative advice to a number of companies concluding that various ownership structures did not involve voting securities. In general, the workable structure requires one or more individuals to control the majority of the voting power of the utility. These controlling investors often have only a very small financial stake in the enterprise. Financial investors receive "preferred stock" or "non-voting member interests" in the utility entity. The preferred stock or member interests receive the majority of the economic return but do not have any vote in the general affairs of the utility. However, they generally do have "veto" powers over major actions — such as mergers, sales of all assets, changing line of business, expenditures above approved budgets, incurrence of extraordinary indebtedness, and so on. Thus, the "non-controlling" shareholders or members can have significant powers to safeguard their investment while not having technical control. In addition to ensuring technical compliance with the less than 10 percent voting control rule, these arrangements also are structured to avoid the financial investor being deemed to have a "controlling influence" over the utility.

The advantage of the non-controlling investment is that the investor can get the economic benefit of an investment in utility assets without the restrictions of PUHCA regulation. The disadvantage is that some other investors must have control of the utility. The controlling person must be someone who is indifferent to regulation under PUHCA. Individual management officers fill this role in some structures. Other alternatives would include relatively widely held ownership interests in the utility so that no person, or group that could be deemed a "holding company," would own more than 9.9 percent of the utility. These owners of less than 10 percent of the voting control would likewise be excluded from regulation as a holding company.

Although QFs and EWGs are not utilities for PUHCA purposes, they are public utilities under the Federal Power Act and subject to the jurisdiction of FERC with regard to rates charged for wholesale sales and other matters. Most QFs and EWGs have authority from FERC to sell wholesale power at market-based rates rather than traditional cost-of-service rates.

FERC is the agency principally responsible for enforcing competition, or antitrust, laws in the utility industry. If a potential investor has control of generating resources in the U.S., those resources would be considered by FERC in any competition analysis required in connection with further acquisitions. Obviously, to the extent the investor’s market share remains small, competition issues would not be a concern.

QFs, EWGs, IPPs, and other generators are subject to certain State utility regulation as well. In those States that have adopted utility restructuring legislation, non-utility generators are usually qualified to make wholesale and retail sales with minimal regulation. Most States require a competitive generation supplier to file notices with State officials and may impose certain financial requirements to ensure that these suppliers will live up to their obligations.

An owner of transmission assets is a "utility" subject to full regulation by FERC and also by most States. Transmission assets are subject to rules regarding "open access" that require the transmission system to be available to all on a nondiscriminatory basis. Rates for transmission service are subject to FERC regulation.

FERC does regulate some aspects of transactions between utilities and their affiliated companies. Most States also regulate affiliate transactions. However, unlike the SEC under PUHCA, FERC does not have jurisdiction over utility holding companies. A few States do have authority to regulate utility holding companies and may have jurisdiction over mergers, acquisitions, or changes in control involving utility companies or assets.

The regulatory framework surrounding investments in electric utility assets is complicated. In addition to overlapping national regulation by the SEC under PUHCA and the FERC under Federal utility regulation, each of the 50 States has jurisdiction over utility affairs. Investors already in the power or electric utility business elsewhere in the world have special factors to consider when making an investment in the U.S. Nevertheless, regulatory obstacles can be overcome with careful planing. Importantly, United States regulatory rules may be less onerous than other jurisdictions and the economic benefits of an investment in U.S. electric utility assets can be significant enough to outweigh the risks and the regulatory constraints.