Proposed Rules and Request
for Comments on Registered
Public-Utility Holding Companies


File No. S7-05-01
Release No. 35-27342


On January 31, 2001, the Commission issued proposed rule changes under Rules 55, 56 and 87 and a request for comments on the legality and desirability of acquisitions of U.S. utilities by foreign entities and of acquisitions of foreign utility companies by U.S. utility holding companies. The Consumer Intervenors1 hereby submit their response. Persons on whom communications concerning this proceeding should be served are:

Scott Hempling, Esq.
David Lapp, Esq.
417 St. Lawrence Dr.
Silver Spring MD 20901
(301) 681-4669 (tel.)
(301) 681-7211 (fax)

Larry Frimerman
Chairman, NASUCA Electricity Committee
Federal Liaison, Ohio Consumers' Counsel
10 W. Broad Street, Suite 1800
Columbus, Ohio 43215-3485

Our comments are divided into two main parts. In Part I, we respond to the Commission's proposed rules governing U.S. utility holding company acquisitions of foreign utility companies (FUCOs). In Part II, we respond to the Commission's request for comment on the ability of a foreign holding company to acquire a U.S. utility by qualifying its foreign operations as a FUCO.

Part I: Comments on U.S. Utility Holding
Company Acquisitions of Foreign Utility Companies (FUCOs)

A. Introduction

When Congress decided to facilitate foreign investment by U.S. utility companies, Congress did not intend to create a conflict between globalization and consumer protection. There is no inherent conflict. Trade among nations, of expertise, resources and technology, can benefit all parties to a transaction. If the markets in which this trade occurs are unsubsidized and evenhanded, there should be gains available.

Congress recognized, however, that electricity was different. Electricity markets in the United States are neither unsubsidized nor evenhanded. U.S. utility companies enter the globalization effort substantially aided by a century of government protection from competition, and government assurance that ratepayers will pay enough to keep the companies profitable. This long-term government policy has had two effects of direct relevance to globalization: it gives U.S. utilities competitive advantages not enjoyed by many of their U.S. competitors, and it places U.S. ratepayers, who have little choice but to continue buying electricity as an essential good from their local utility, in a position of vulnerability as utility managers use their ratepayer-furnished revenue stream to finance the globalization effort. Efficient globalization is not assisted if some companies have unearned advantages, in the form of ratepayer-financed plant and ratepayer-financed employees, who can use these advantages to beat out more efficient competitors.

Congress recognized this tension between the goal of globalization and the vulnerability of consumers and made its priorities clear by directing the SEC to promulgate rules to protect consumers. Thus, while wishing to facilitate foreign expansion by U.S. utilities, Congress sought to resolve the tension between the goal globalization and the risk to consumers by eliminating that tension.

In contrast, the SEC rules recreate the tension that Congress intended to eliminate. By making the globalization goal primary and the consumer protection goal secondary, the proposed rules create rather than eliminate opportunities for conflict. Under the proposed rules, the U.S. utility can test the limits of ratepayer risk, rather than accept the Congressional requirement that there be no risk.

Our comments below address how the SEC's rules, in five ways, fail the test of efficiency and evenhandedness established by Congress. As should be clear from these comments, our goal is not to oppose or eliminate globalization, but merely to assure that global competition is won on the merits, without risk-taking or subsidization by U.S. electricity consumers.

Our comments provide several examples where the Commission's proposed rules place the interests of registered holding companies (RHCs) over the interests of consumers. We cover the following five topics:

  1. The proposed rule would rely on the Board of Directors of a registered holding company to self-certify that consumers are not at risk from the FUCO investment. This aspect of the rule is structurally flawed, since the Board is legally obligated to promote the interests of shareholder and not ratepayers. The Commission should not delegate its regulatory responsibilities to the regulated entity. In the final rule, the SEC should replace self-certification with case-by-case review of specific evidence in the form of systematic studies, executive affidavits, and third party appraisals.

  2. The proposed rule adopts a "safe harbor" for FUCO and EWG investments that are less than 51% of the holding company's consolidated retained earnings. This proposal is flawed because retained earnings are not an accurate measurement of risk to utility ratepayers of the RHC's diversification efforts. If in the final rule, the Commission still wishes to establish a safe harbor based on a single financial indicator, that indicator should not be retained earnings, but a ratio based on the total assets at risk from diversification and investment in FUCOs relative to the assets used to serve domestic public utility customers.

  3. The proposed rules establish a general rule that interaffiliate transactions will be priced "at cost." The proposed rule conflicts with well-established regulatory principles. Ratepayers who have borne the cost and risk of assets in the rate base should receive nothing less than the full market value of those assets when they are provided to the utility's competitive affiliate. The "at-cost" standard causes ratepayers to subsidize the holding company's competitive efforts; it should be corrected in the final rule through the adoption of the uniform pricing standards used by most other regulatory agencies.

  4. The proposed rule allows utility affiliates to provide employees to serve affiliated FUCOs and EWGs, up to a total of two percent of the employees of the domestic utilities. This aspect of the proposed rules is flawed because it endorses ratepayer subsidization of RHC FUCO efforts, particularly if the final rule retains the "at-cost" standard. RHCs would be free to use their most qualified employees to further their FUCO efforts rather than to provide efficient, low-cost service to captive ratepayers. Further, without more definition, the two-percent test could encourage inefficient utility staffing levels and could be subject to gaming by the utility. If the Commission retains the two-percent rule, the calculation of the two percent should defined narrowly so that it does not encourage utility inefficiency and allow gaming.

  5. The proposed rules and changes to Commission reporting requirements send an inconsistent message to holding companies regarding their ability to compensate for FUCO losses or inadequate returns through rate increases to domestic utility ratepayers. Utilities must report whether they have obtained rate increases to recover FUCO losses, and if they have, they must receive prior approval before investing in more FUCOs. The Commission should clarify that RHCs may not recover any FUCO losses from captive domestic retail ratepayers; if losses are recovered from ratepayers, that fact should bar any future FUCO acquisitions for a time period that reflects the amount of losses recovered.

We cover each of these topics in more detail next.

I. Self-Certification is not Sufficient; the Commission Should Require Reliable Evidence that Ratepayers Will Not Be Harmed

A. Introduction

Proposed Rule 55(a)(1) would require the board of directors (board) of the registered holding company to adopt procedures ("FUCO Investment Procedures") "designed to analyze the risks of investing in foreign jurisdictions, including, for example, operational risks, construction risks, commercial risks, management risks, political risks, legal risks, financing risks and foreign currency risks."

Proposed Rule 55(a)(2) would prohibit a registered holding company investment in a FUCO unless the holding company's board has complied with its "FUCO Investment Procedures" and has taken actions to mitigate risks to the holding company system and structured the transaction "so that ratepayers of the system's public-utility companies are adequately insulated from any adverse effects of the FUCO Investment."

The Commission seeks comment on whether the rule should require RHC boards to make additional findings concerning specific issues, require certain legal and other expert opinions to serve as the basis of the findings, or specify additional procedures.

There are two main problems with the proposal. First, ratepayer protection is largely left to the boards of the registered holding company, whose obligation is to shareholders, not ratepayers. Second, the evidentiary requirements are too few and too ambiguous. We next discuss each of these two problems and recommend solutions.

B. Self-Certification Cannot Substitute for Objective Analysis

The Commission's proposed Rule 55(a) allows all FUCO transactions meeting the safe harbor of subsection (b) to proceed based solely on actions taken by the Board of Directors (Board) of the registered holding company. The Board must "analyze" the risks of the foreign investment, mitigate risks to the holding company system, and structure the arrangement to "adequately insulate[]" ratepayers from adverse affects of the investment.

The reliance on Board certification amounts to delegating regulation to the regulated entity, a principle not consistent with either the Act or with a century of regulatory practice. Self-policing too easily becomes self-protection, thereby undermining the goal of independent Commission review. The RHC Board's legal obligation to comply with the regulation would come into direct conflict with its legal obligation to maximize profits. The same Board cannot protect shareholders and ratepayers at the same time. Regulation does not work when built upon a conflict of interest.

Compounding the rule's structural defect is its failure to reference specific, objective criteria for analyzing risks. This failure permits substantial subjectivity when the Board evaluates ratepayer risks. Risk analysis is inherently subject to multiple interpretations of competing sets of data. The analyst favoring a certain outcome, such as the outcome most likely to produce the largest benefit to shareholders, will be biased in its determination of what "adequately insulate[s]" ratepayers from the adverse effects of the FUCO investment. Self-certification may sometimes work when the standards are objective (e.g., self-certification of an "exempt wholesale generator" where "wholesale" is an unambiguous concept). But for risk analysis, self-certification only invites bias. .

Similarly, the procedures to be adopted by the Board (i.e., the "FUCO Investment Procedures") demand only minimal analysis of the various risks of investment. The proposed rule states that the Board's procedures must provide for "analysis" of risks in general categories. What constitutes such "analysis" is left to the companies to decide. In practice, the requirement for "investment procedures" demands no more than what any prudently operated company would have in place, to protect its investors, before investing in a foreign utility. The procedures will confer no real protections for ratepayers, because they provide only for a Board analysis of what is good for the holding company and then assume that what is good for shareholders is also good for the ratepayers.

Suggested Modification -- The proposed rule should be modified to provide for an objective framework for analyzing the risks of foreign utility investment. The best solution is to place the regulatory responsibility for monitoring RHC FUCO investments with the Commission, where it more appropriately (and statutorily) resides. Relative to the holding companies, the Commission is better positioned to make an objective analysis of whether the investment is too risky or sufficiently safe.

C. Self-Certification Cannot Substitute for Actual Evidence

With respect to evaluating the risks to the holding company and its public utility subsidiaries of investing in foreign utilities, the proposed rule establishes a very low evidentiary threshold. The low threshold is the result of the lack of detail in the terms of proposed rule 55. The rule would simply require RHCs to (a) adopt "procedures designed to analyze" the various risks of the investment, (b) adopt "measures" to mitigate those risks, and (c) structure the deal so that ratepayers are "adequately insulated." The proposed regulation provides no detail on the type or extent of the required risk analysis, what measures might be appropriate for mitigation, or what sorts of structures adequately insulate ratepayers. The rule therefore would seem to permit boilerplate affirmations by company boards of utility management decisions. These boilerplate affirmations then would become, by operation of the regulation, boilerplate affirmations of the Commission.

Suggested Modification -- Rather than RHC certification of a general obligation to analyze risks, the Commission should adopt a rule that requires risk assessments backed by systematic studies, executive affidavits, and third party appraisals. These requirements for actual evidence will promote public and legal accountability and ensure that there is actual evidence in the public record that ratepayers will not be harmed as the result of an RHC's FUCO investments. The evidence should be filed with the Commission for evaluation and approval prior to consummation of the FUCO investment. Specific evidence should be filed analyzing, among other things,

  1. operational risks

  2. construction risks

  3. commercial risks

  4. environmental risks

  5. management risks

  6. political risks

  7. legal risks

  8. financing risks

  9. foreign currency risks and

  10. any other relevant risks.

With respect to all these risks, the evidentiary filing should --

  1. provide a description of all the information considered in evaluating each of risks;

  2. explain the techniques used to analyze the information and to determine the risks in each of the categories;

  3. quantify the risks posed by the investment;

  4. identify who was responsible for doing the risk analysis in each of the potential areas of risk, and their actual or potential conflicts of interest; and

  5. include affidavits from those preparing the analysis and the filings, which attests to their accuracy.

D. The Commission Can Independently Review FUCO Acquisitions and Still Have a Safe Harbor

We do not oppose the concept of a safe harbor. A safe harbor is appropriate where the RHC has submitted to the Commission evidentiary materials showing that the risk level is satisfactory and that captive ratepayers are protected from any adverse effects.

Adoption of a safe harbor, however, should not mean eliminating the Commission's policing role altogether, as under the proposed rule. If the evidence submitted indicates that the acquisition will not pose risks to the utility subsidiaries, the Commission should be able to approve the acquisition without a hearing. That result is "safe harbor" enough. If the evidence raises questions about the risk levels or the ability of the RHC to insulate ratepayers from risks of the investment, then further inquiry and a hearing will be necessary.

Suggested Modification -- The Commission should adopt a FUCO review process resembling FERC's merger review process, where merger applicants file an initial market analysis to "screen" mergers with potential anti-competitive effects from those posing no threat to competition; if the screen indicates no threat, then the merger may proceed without a hearing. Similarly, for FUCO acquisitions, the Commission should conduct a preliminary review, on a case-by-case basis, of the evidence (in the form of risk assessments backed by systematic studies, executive affidavits, and third party appraisals described above) to determine whether the acquisition should be subject to a full evidentiary hearing or meets a safe-harbor threshold for which no hearing is required. Such a case-by-case application of a safe harbor test - which would allow RHCs to proceed with FUCO acquisitions without a full evidentiary hearing - should replace the 50% of consolidated retained earnings safe-harbor test proposed by the Commission. We describe the flaws with that test next.

II. The Commission Should Replace the 50% Consolidated Retained Earnings Test With a Case-by-Case Review

Proposed rule 55 requires the SEC's prior review of a FUCO acquisition in only two circumstances: (a) if certain financial indicators are present or (b) if "the registered holding company's investment in FUCOs and EWGs exceeds 50% of consolidated retained earnings (or such greater amount as may be authorized by Commission order)...." The latter provision creates a safe harbor for most FUCO (and EWG) acquisitions representing less than 51% of the RHC's consolidated retained earnings. We next explain three serious problems with the proposed rule's test of 50% of retained earnings.

A. Retained Earnings Is Not the Correct Measure of Risk Exposure

The amount of an RHC's retained earnings bears no logical relation to the risk presented by an RHC's FUCO investments. While no single financial indicator is dispositive of risk, the focus should be on assets, not retained earnings.

The calculation which would most accurately present the risk of the FUCO investments would be one which compares the level of all the RHC's nonutility activities before the acquisition to the level after the acquisition. Thus, the denominator in the equation should be the total capital prudently invested for the purpose of selling electricity within the service territory of the utility at issue. The numerator should not be limited to investments in FUCOs and EWGs, but also should include investment in all activities not devoted to captive customers of the utility subsidiaries.

Suggested Modification -- If the Commission wants to use a single indicator (as opposed to the case-by-case evaluation we recommend) for the total level of risk of an RHC's FUCO and EWG investments, it should focus on the ratio between:

  1. assets used for domestic public utility service; and

  2. assets used to further all competitive businesses of the RHC.

B. Retained Earnings Is Subject to Gaming by the RHC, Which Controls the Timing of Its Expenditures

A utility can inflate its retained earnings by withholding funds from utility maintenance and construction expenditures. Moreover, while substantial retained earnings demonstrate past profitability, the company may be experiencing present or imminent losses.

Suggested Modification -- If the Commission adopts a retained earnings test in the final rule, it should amend the rule to require that the RHC demonstrate that the current level of earnings is comparable to what it has been over the past five years. Also, the Commission should not permit the system to reduce the level of retained earnings substantially, from the level existing at the time the FUCO transaction occurred, without its express permission.

C. The 50% Figure is Unsupported by any Facts

The proposed rulemaking provides no factual basis or explanation for its choice of 50% figure. The Commission refers to its use of the same 50% figure in rule 53. But the choice of 50% was not explained in that proceeding either. There is no record anywhere of why 50% is more appropriate than 0% or 100%. Indeed, rather than explaining why 50% is the appropriate level by which to establish a safe harbor, the discussion in the NOPR emphasizes cases in which it allowed RHCs to invest in FUCOs and EWGs 100% of consolidated retained earnings.

Suggested Modification -- The best solution to the problems of the consolidated retained earnings test is to replace it with case-by-case review of FUCO acquisitions with a safe harbor for proposed acquisitions meeting a minimum evidentiary threshold, as described above. As part of the filing and review process described above, the Commission should examine the full range of financial indicators to determine whether the RHC is placing ratepayers at risk from its FUCO investments in combination with its other nonutility activities. Case-by-case review will make it more difficult for the RHC to game retained earnings, permit evaluation of more than one single financial indicator, and allow for full consideration of all of the RHC's nonutility activities.

III. The Commission Should Revise its Interaffiliate Pricing Rules and Retain Advance Review

A. Introduction: The Problem of Interaffiliate Relations

A holding company with both competitive and noncompetitive subsidiaries has an incentive to use its noncompetitive business resources, the costs of which it recovers (or has recovered) from captive customers through the ratemaking process, to subsidize the competitive business efforts. If an RHC can subsidize its competitive efforts (such as FUCO acquisitions) with ratepayer money, two problems arise: the affiliated competitive efforts gain an unearned cost advantage relative to unsubsidized competitors, and the captive customers of the noncompetitive utility affiliates will have higher rates.

The opportunities for cross subsidization are vast, in both number of dollars and types of transactions. They involve both the use and sale, of both tangible and intangible assets, between utilities and their competitive affiliates. Assets available for exploitation include:

  1. customer and marketing information

  2. "name brand" recognition

  3. equipment and tools

  4. shared employees such as lawyers, accountants, human resource managers, researchers, customer representatives and technicians

  5. the ability to borrow money at lower rates because of the holding company's line of credit

  6. customer lists and data

  7. purchasing discounts

  8. customer referrals.

Ratepayer cross-subsidization of an RHC's competitive efforts harms consumers because the resources and advantages are usually built and paid for out of the rate base. The problem of cross-subsidization implicates two key aspects of the Commission's proposed rules:

Advance Review. The proposed rules appropriately require advance regulatory review of interaffiliate relations. Advance review is necessary to prevent the various species and subspecies of cross-subsidization. Advance review allows interested parties to consider the merits of each contract that makes use of ratepayer-financed assets and services, in order to be sure that ratepayers are not subsidizing the RHC's FUCO efforts. It is more costly and difficult to address cross-subsidies after they have already occurred. Advance review should be preserved in the final rule.

Pricing Standards. Cross-subsidization cannot be prevented without appropriate pricing rules for transactions between the utility and its competitive affiliates. Unfortunately, the proposed rule would apply its "at cost" pricing standard unless the Commission makes a case-specific exception. The next two subparts explain why the "at-cost" standard is flawed and how it should be changed in the final rule.

B. The Commission Should Adopt Pricing Rules Based on Consistent Regulatory Principles

The Commission should adopt uniform pricing standards for all transactions between a FUCO or EWG and its utility affiliates rather than relying on case-by-case exceptions to protect ratepayers. Two general pricing principles should be applied to all transactions between utilities and FUCO affiliates:

  1. When the utility sells to the FUCO, the price should be the higher of book or market.

  2. When the utility buys from FUCO, the price should be the lower of book or market.

These pricing standards are based on the longstanding regulatory principle that the gain on an asset goes flows to the party who took the risk of loss on the asset.2 In utility regulation, the act of entering an asset into ratebase guarantees that utility customers will pay the utility for the costs of the asset, regardless of its market value. Where the asset has a lower market value than anticipated, customer rates nevertheless do not change because customers have assumed the risk of loss. Since ratepayers assume the risk of a lower market value, they should receive the benefit of a market value above book value.

For affiliate transactions between FUCOs and affiliated utilities, the principle that the gain follows the risk of loss has two ramifications, depending on the type of transaction:

  1. Where the utility sells products or services to the FUCO, a higher of market or book cost standard ensures that the utility and its ratepayers receive maximum value for the assets they have paid for. Fair market value reflects the utility's obligation to minimize ratepayer costs. Further, market value is the same price that the utility's competitors must pay and therefore ensures a level playing field between the affiliate and its competitors.

  2. Where a FUCO sells products or services to the utility, the lower of market or book standard should apply.3 The utility should never buy products or services from a FUCO at a price above the market; rather it should purchase the product or service from a nonaffiliate at the lower market price. Further, where the FUCO's book costs are lower than market costs, charging the utility book price ensures that ratepayers, rather than shareholders, receive the benefit of the corporate affiliation. If the FUCO wants more than book cost for the good or service, it may sell into the competitive market rather than to its utility affiliate.

Consistent with these principles, state regulators, through NARUC, have endorsed the following cost allocation guidelines for affiliate transactions:

  1. Generally, the price for services, products and the use of assets provided by a regulated entity to its non-regulated affiliates should be at the higher of fully allocated costs or prevailing market prices. Under appropriate circumstances, prices could be based on incremental cost, or other pricing mechanisms as determined by the regulator.

  2. Generally, the price for services, products and the use of assets provided by a non-regulated affiliate to a regulated affiliate should be at the lower of fully allocated cost or prevailing market prices. Under appropriate circumstances, prices could be based on incremental cost, or other pricing mechanisms as determined by the regulator.

  3. Generally, transfer of a capital asset from the utility to its non-regulated affiliate should be at the greater of prevailing market price or net book value, except as otherwise required by law or regulation. Generally, transfer of assets from an affiliate to the utility should be at the lower of prevailing market price or net book value, except as otherwise required by law or regulation. To determine prevailing market value, an appraisal should be required at certain value thresholds as determined by regulators.4

The proposed rule's "at cost" standard deviates significantly from the standards adopted by NARUC and the principles articulated above. The cost rule would deny ratepayers the full value of what they have paid for by permitting transactions "at-cost" when the market price should prevail.

C. The Commission Should Reconcile Its Pricing Policies with Those of Other Ratemaking Agencies and Defer to State Regulators

The Commission should recognize that its "at cost" standard deviates from the interaffiliate transaction pricing rules, described above, which are employed by the majority of ratemaking agencies, both federal and state and are reflected widely in state and federal statutory and case law. The Commission's unwillingness to revisit the "at-cost" standard is a constant thorn in the side of state and federal policymakers who are trying to apply well-established, consistent regulatory policy. The FERC, for example, has sought to avoid application of the Commission's "at-cost" rule by making compliance with its higher of market or book cost rule a condition of approval for a merger resulting in a registered holding company.5

The Commission also should take action consistent with its frequent statements about deferring to state regulators, and give appropriate consideration to the fact that NARUC has endorsed the uniform pricing principles described in this section.

To summarize, the Commission's pricing standard should be reconciled with those of FERC and the states, so that its general standard is consistent with ratepayer interests and the inherent logic of the benefits-follows-the-burdens principle. Such consistency requires that the SEC forgo its "at-cost" rule for a rule that requires the higher of market or book for sales from the utility to the affiliate and the lower of market or book for transactions in the opposite direction.

IV. The SEC Should Not Tolerate Ratepayer Subsidy of FUCO Employees

The proposed rule allows utilities to devote utility personnel to serve FUCOs and EWGs. The rule states that "[n]o more than two percent of the system's domestic public-utility employees [may] render services at any one time, directly or indirectly." Proposed Rule 55(a)(3). As the Commission acknowledges, this proposal implicates the "basic concern of the Act" that diversified holding companies will divert expertise from the system's core utility business to competitive businesses.

The two-percent rule has several problems. First, the rule does not preclude RHCs from diverting top utility personnel to serve FUCOs and EWGs; rather, the proposed rule actually facilitates the diversion of utility personnel, at least until the two-percent level is reached. Nothing precludes an RHC from including in that two percent the most effective employees of the RHC's domestic utilities. Such employee diversion could adversely affect domestic utility operations, exactly the concern of the Act noted by the Commission. The diversion of expertise away from the utility to competitive operations does not stop being problematic simply because it is limited by a percentage.

Second, the two-percent limit on domestic utility employees is illogical because the denominator is all employees rather than the employees necessary for the efficient operation of the domestic utilities. Because the denominator is simply all employees, the proposed rule would provide greater flexibility to an inefficient RHC to divert employees than to an efficient RHC. Moreover, the rule actually creates a perverse incentive for RHCs that want to maximize the domestic utility employees serving FUCOs and EWGs: by inflating the number of domestic employees to inefficient levels (or not reducing the number of employees to an efficient level), a higher number of utility employees may serve FUCOs and EWGs. Unneeded increases in the staffing levels of domestic utility employees (or the failure to reduce utility staffing inefficiencies) harms captive ratepayers.

Third, the rule applies the two-percent limit "at any one time," thereby allowing the use of a much larger percentage of employees over a period of time. A company may calculate its employees at a time when the number of employees is inflated, enter into contracts in which two percent of employees provide services to EWGs and FUCOs, and later reduce the total number of domestic employees without reducing the number of employees serving EWGs and FUCOs. In other words, the rule makes the two-percent limit a moving target, subject to gaming by the registered holding company.

Fourth, the two-percent limitation does not prevent the utility employees from providing services to FUCOs and EWGs on a subsidized basis. Because of the Commission's "at-cost" rule for interaffiliate transactions, a FUCO could make use of a valuable utility employee by paying only the utility's costs, in violation of the pricing principles discussed above. The employee's services likely will have a greater market value than the utility's cost. If the services were provided to a non-affiliated company, the utility would be compensated at a market rate. The proposed rule would deny ratepayers the benefit, which is properly theirs under standard regulatory principles, of any market value of the services that exceed the utility's cost.

Suggested Modification -- The most effective way to ensure the "protection of the customers of a public utility company" affiliated with a FUCO as required by Section 33(c)(1) of the Act would be to preclude utility employees from providing any services to the FUCO. Assuming, however, that the Commission retains some version of the two-percent rule, it should clarify its terms to reduce the chances that ratepayers will subsidize FUCO efforts. Specifically, the two-percent limitation should be defined as two percent of the employees necessary for the efficient operation of the company, and the limitation should be ongoing so as to preclude services by more than two percent of domestic employee levels at all times. Finally, any use of domestic employees for FUCO or EWG operations should be subject to the interaffiliate pricing rules described in Part One, III.

V. The Proposed Rule Should Clarify that Retail Utility Rates Should Never be Raised to Compensate for FUCO Losses or Risks

The Commission should clarify that holding companies are prohibited from recovering FUCO or EWG losses through rate increases by its public utility subsidiaries. The proposed rule sends a mixed message that some subsidization may be permitted.

The Commission implicitly acknowledges in the proposed rule that ratepayers should not pay for the holding company's miscalculations in competitive markets. In prior FUCO cases, the Commission explains in the NOPR, the registered holding company

specifically undert[ook] that it will not seek recovery through higher rates to its utility subsidiaries' customers to compensate it for any possible losses that it may sustain on investments in EWGs and FUCOs or for any inadequate returns on these investments. We believe that it is appropriate to include similar requirements in proposed rule 55.

Despite this "belief" that RHCs should not seek from ratepayers recovery of FUCO losses, the proposed rule actually anticipates that RHCs may seek compensation for FUCO losses or inadequate returns from retail ratepayers:

In order to provide greater assurance that losses, if any, are not passed on to ratepayers, we are proposing to amend Item 9 of Form U5S, the form for annual reports that registered holding companies are required to file under section 5(c) of the Act, to require disclosure of whether any rate increases to retail customers have been obtained in order to recover these losses. If, during the preceding three years, the holding company has responded to this item in the affirmative, the proposed rule would require our approval of additional acquisitions." (footnote omitted)(emphasis added).

The Commission's message is to RHCs is this: "If you have troubles with your FUCO investment, try not to recover losses through rate increases to utility customers. But if you do have to increase retail rates, you must tell us and ask us for permission to invest in more FUCOs." The Commission's proposed policy is, in effect, a concession that such rate increases may occur. The Commission should not send such a mixed message regarding the propriety of increasing rates to retail utility customers for FUCO losses.

Suggested Modification -- The proposed rule should be modified to ensure that registered holding companies are barred from raising retail rates to compensate for their poor earnings or losses from FUCO investments. The principle endorsed by the Commission is that retail ratepayers should not suffer rate increases due to FUCO losses or inadequate returns. Without jurisdiction over retail rates to bar such rate increases, the Commission proposes to require RHCs to report to the Commission any recovery from ratepayers and seek prior approval for future FUC acquisitions. The Commission's proposal does not serve its principle. The Commission should abide by its principle by making the prohibition on retail ratepayer recovery of FUCO losses a condition of approval of the FUCO investment. If the condition is violated, the Commission should require the RHC to divest the FUCO and bar the RHC from making any future FUCO acquisitions.

Part Two: Comments on the Ability of a Foreign
Holding Company to Acquire a U.S. Utility by Qualifying
its Foreign Operations as a FUCO

The Commission also seeks comment on the "the advisability of possible limitations upon the ability of a holding company to qualify its foreign operations as a FUCO." This issue of foreign holding company acquisition of domestic utilities was the subject of the Commission's "Concept Release" issued on Dec. 14, 1999. See "Registered Public-Utility Holding Companies and Internationalization," Release No. 35-27110, File No. S7-30-99. Many of the signatories to this document jointly filed comments on the Commission's Concept Release, also as "Consumer Intervenors" (filed on February 4, 2000). Those comments stated:

Entry of foreign owners can play a positive role in increasing the diversity and accountability of the U.S. electric industry. Diversity of ownership has marked the industry from its beginnings: a mix of investor-owned utilities, private consumer-owned utilities (i.e. cooperatives), and municipal, state and federal utilities. This diversity has allowed experimentation, franchise and benchmark competition, citizen choice, and service to consumers who, to this day, might otherwise be without electricity. More diversity in ownership can continue these benefits, provided that this ownership is accountable.


While being welcoming of new investors, we also must be realistic. Acquisition by foreign entities does raise a set of concerns warranting special attention. While foreign and domestic acquirers are subject to the same statutory standards, the application of those standards must take into account real factual differences. To the extent facts relating to foreign acquirers differ from those of domestic acquirers, the application of the statutory standards may vary.

The comments explored seven features or possible effects of foreign ownership that require special methods of accountability and review. The seven topics included:

  1. National Security Concerns

  2. Control of the Physical Infrastructure

  3. Access to Books and Records

  4. Interaffiliate Transactions

  5. Determination of Cost of Capital

  6. Protection Against Diminution of Competition

  7. Gaps Between Regulatory Jurisdictions

The comments further explained that the limitations of the statute's "economic and efficient development" and "integrated public-utility system" tests apply to foreign acquisitions just as they do to domestic acquisitions.

The signatories to this filing incorporate in full the comments filed by the Consumer Intervenors on February 4, 2000 on Release No. 35-27110. Those comments are attached as Appendix A.

A related question has arisen concerning the application of the Act's limits on utility diversification to foreign acquirers of U.S. registered holding companies. This concern also applies to foreign sovereign entities owning a direct or indirect interest in a U.S. public-utility system or public-utility company. Specifically, the possible scenario is one in which a foreign holding company is a conglomerate, owning utility and nonutility businesses abroad, and nonutility businesses in the U.S. Could and should such a company acquire a U.S. registered holding company?

The result of such an acquisition would be a U.S. registered holding company that had, as affiliates, a foreign holding company, foreign utility companies, foreign nonutility companies and U.S. nonutility companies. We see no reason why the risk to ratepayers from the presence of nonutility businesses in the corporate holding company system is any less merely because the ultimate owner of the system is a foreign company. Consequently the existing limits of Section 11(b)(1) should apply: only energy-related nonutility businesses should be permitted in the post-acquisition holding company structure.
April 9, 2001 Respectfully submitted,


Scott Hempling
David Lapp
Attorneys for Consumer Intervenors



Request for Comments on
Registered Public-Utility
Holding Companies


File No. S7-30-99
Release No. 35-27110


The Commission has issued a Concept Release seeking comments on the legality and desirability of acquisitions of U.S. utilities by foreign entities. The Consumer Intervenors6 hereby submit their response.

Persons on whom communications concerning this proceeding should be served are:

Scott Hempling, Esq.
David Lapp, Esq.
417 St. Lawrence Dr.
Silver Spring MD 20901
(301) 681-4669 (tel.)
(301) 681-7211 (fax)

Larry Frimerman
Chairman, NASUCA Electricity Committee
Federal Liaison, Ohio Consumers' Counsel
77 S. High Street, 15th Floor
Columbus, Ohio 43266-0550

David W. Penn
Deputy Executive Director
American Public Power Association
2301 M. Street NW 32d Floor
Washington, D.C. 20037-1484


Entry of foreign owners can play a positive role in increasing the diversity and accountability of the U.S. electric industry. Diversity of ownership has marked the industry from its beginnings: a mix of investor-owned utilities, private consumer-owned utilities (i.e., cooperatives), and municipal, state and federal utilities. This diversity has allowed experimentation, franchise and benchmark competition, citizen choice, and service to consumers who, to this day, might otherwise be without electricity. More diversity in ownership can continue these benefits, provided that this ownership is accountable.

In the Public Utility Holding Company Act ("PUHCA" or "Act"), foreign acquirers are subject to the same requirements of economic and efficient integration, prohibition against undue complexity and concentration of control, and other statutory criteria as domestic acquirers. The Commission should resist calls for excluding "foreigners," particularly from domestic utilities who would prefer to limit entry into their markets.

Acquisition by foreign entities does raise a set of concerns warranting special attention. While foreign and domestic acquirers are subject to the same statutory standards, the application of those standards must take into account real factual differences. To the extent facts relating to foreign acquirers differ from those of domestic acquirers, the application of the statutory standards may vary. We address this possibility in Part I. Part II explains that the limitations in the statute's "integrated public-utility system" tests apply to foreign acquirors just as they do to domestic acquisitions.

Under no circumstances should our comments be construed as unwelcoming. As consumers and competitors of U.S. utilities, the signatories know well the dangers of insufficient diversity and accountability in our industry. Change, including change in ownership, can benefit all.

I. Acquisitions of U.S. Utilities by Foreign Companies, Where Legally Permissible, Require Special Regulatory Attention

The electric industry is part of our nation's infrastructure. Its control must be in hands that are capable and accountable. Seven features or possible effects of foreign ownership will require special methods of accountability and review. These seven features are:

  1. National Security Concerns

  2. Control of the Physical Infrastructure

  3. Access to Books and Records

  4. Interaffiliate Transactions

  5. Determination of Cost of Capital

  6. Protection Against Diminution of Competition

  7. Gaps Between Regulatory Jurisdictions

Each feature is discussed in turn.

A. National Security Concerns

Ownership of a U.S. utility means ultimate control of all or part of a transmission network, generation and distribution resources. This control must be in the hands of entities whose loyalty and accountability to this nation, its economy and the health and safety of its citizens, is unquestioned. A foreign company is likely to have its Board of Directors comprised of members whose loyalty and accountability reside elsewhere.

Nations' loyalties change. The prospect of foreign ownership means that control of essential infrastructure is in the hands of an entity that can change from friend to foe. This possibility warrants special attention. Clearly, all steps must be taken to assure the reliability of the utility networks from possible actions that are counter to the interests of this country.

The risk of divided loyalty arising from international political differences may also be manifested through behaviors similar to those contemplated from "functional diversification." In the functional diversification situation, the utility customer faces financial risk because those responsible for utility operations face incentives, created by the utility's other investments, to sacrifice the customer's welfare for some other purpose. In this situation, we have traditional protections intended to insulate the utility business from these risks. The foregoing concepts can serve the same function in the context of ownership diversification represented by foreign acquisition.

We do not profess any special understanding of national security policy, international trade or foreign relations generally. Moreover, we wish not to take positions that, while reasonable as protections of the nation's electric and natural gas infrastructure, might be seen as unreasonable from these other perspectives. Consequently we offer the suggestions below for discussion, with the hope that those with more knowledge in these other areas can adapt our views as necessary to achieve ends which are compatible both with our electric and gas industry goals and our nation's other goals.

Specifically, the Commission should consider adopting one or more of the following conditions applicable to acquisitions by foreign entities:

  1. The acquirer must identify a local management team, with full authority to commit the company on matters otherwise considered jurisdictional to state commissions and FERC.

  2. The aquirer must specify all types of management decisions, potentially affecting the local utility, that would be made by people other than the local management team.

  3. The acquirer must enter into a relationship with a trustee, approved by the state regulators and FERC, which trustee would have the authority and obligation to take control of assets critical to reliability upon a finding by the state regulators or FERC that such a change in control is warranted by a lapse in performance or loyalty.

  4. There should be certification by state regulators, FERC and the relevant reliability councils that the acquirer and the local management team have the experience and ability to operate the assets to be acquired.

  5. There should be certification of membership in all required reliability councils.

  6. There should be certification of membership in and transfer of control to a regional transmission organization (for more on this topic, see Part I.B below).

  7. There should be a certification that neither the acquirer nor any of its headquarters management team has any record of violating laws or regulations.

  8. There should be firewalls assuring that employees with operational responsibility for key infrastructural assets are independent of other parts of the organization to the extent deemed satisfactory by state regulators and FERC.

B. Control of the Physical Infrastructure

The nation's transmission grid, while physically interconnected, historically has been owned piecemeal by individual utilities. FERC's Order 20007 correctly recognizes that the planning, construction, operation, maintenance and pricing of transmission facilities should occur on a regional basis, even if ownership remains dispersed.

This new policy should apply to foreign acquirers. The unification of transmission policy within a region will lend predictability and stability during a time of rapid ownership change. Participation by foreign acquirers in a FERC-approved regional transmission organization or and/or natural gas pipeline should be a condition of any Commission finding that the acquisition satisfies the "economical and efficient development" test of Section 10(c)(2).

C. Access to Books and Records

The mantra "competition is here" is not reality. For many product and geographic markets, competition is not here. The physical services of distribution and transmission remain subject to franchises which, for the most part, are legally exclusive. In at least half the states, moreover, the political process has not produced a consensus to substitute competition in generation supply for monopoly regulation. In these states, electricity still is provided primarily by vertically integrated monopolies.

Most states that have enacted competition statutes still permit a continuing and prominent role for the incumbent electric utility. In addition to continuing to control the physical infrastructure of distribution and transmission facilities, the incumbent utility is generally permitted, directly or through an affiliate, to provide competitive services, "default" service, or both. As the lone entity in the market providing both competitive and noncompetitive services, the incumbent utility has an incentive and opportunity to grant its competitive affiliate favorable access to resources used for the noncompetitive businesses, to the detriment of competition and the captive customers of the noncompetitive businesses.

To reduce these risks, regulators need access to books and records. As long as some markets remain noncompetitive, consumer protection depends on regulation. Regulation in turn depends on data. Data -- in the form of financial books and records -- will not be useful if they are not accessible.

Foreign ownership of domestic utilities raises at least four distinct issues of data access. These four issues suggest four possible conditions on acquisition by foreign companies. Specifically:

  1. Physical availability of records: Records deemed necessary by the state regulator or FERC must be located physically in the United States and available during normal business hours. If a particular state jurisdiction wishes to require a copy of such records, or any part thereof, be available within the state, the SEC's approval of the acquisition should be conditioned on compliance.

  2. Physical availability of personnel: Records alone do not inform unless explanation is available. The acquirer should therefore be required to comply with any state or FERC requirements that personnel familiar with the records be reasonably available.

  3. Currency clarity: Books of foreign companies will not necessarily be kept in U.S. currency. Some means of translation will be necessarily

  4. Language issues: For reasons similar to those described above, books must be maintained in English.

D. Interaffiliate Transactions

Acquisition of a U.S. utility by a foreign holding company is likely to result in a corporate structure in which interaffiliate transactions take place. Interaffiliate transactions will create risks as long as two current features of the utility, presently prevalent, remain: (1) certain utility services remain noncompetitive services; and (2) entities that provide noncompetitive services are permitted to provide competitive services, directly or through an affiliate.

The two main risks are: (a) customers of noncompetitive services bear the cost of subsidizing competitive services; and (b) certain providers of competitive services have unearned advantages because of their affiliation with a provider of noncompetitive services. A policy on interaffiliate transactions therefore must have two goals: prevent cross subsidies by customers of noncompetitive services, and prevent unearned competitive advantages for competitive affiliates of the providers of noncompetitive services.

The general policy on interaffiliate transactions consistent with the foregoing goals is:

  1. where the regulated utility buys from an affiliate, the price should be the lower of book cost or market.

  2. where the regulated utility sells to an affiliate, the price should be the higher of book or market price.

Among economic regulators, these pricing principles have been long held and widely applied. Yet the Commission's present practices fail to reflect them. The Commission remains tied to a so-called "at cost" principle that is consistent with neither ratepayer protection nor effective competition, because it both fails to garner for ratepayers the market rewards commensurate with their historic contribution to utility costs, while allowing the utility's competitive affiliate to receive advantages not available to unaffiliated competitors. Until the Commission re-orients its policies on interaffiliate pricing, the undersigned organizations will be concerned about any acquisition trend that increases the number of transactions between competitive and noncompetitive affiliates of the same corporate family.

A holding company's foreign status complicates these problems of interaffiliate transactions in at least three ways:

  1. Key to the appropriateness of the transaction is the transaction price. Currency differences and changing exchange rates will make that price will be hard to determine.

  2. There may be nonprice benefits or costs which enter into the transaction. Distance, language and communication complexities will make such benefits and costs difficult to detect and evaluate.

  3. Parties might gain the timing of inter-affiliate transactions to gain exchange rate advantages.

These concerns suggest the following conditions:

  1. The Commission should limit interaffiliate transactions to which the U.S. utility is a party to those which the state regulators and FERC have verified (a) will be at prices reflecting the appropriate interaffiliate pricing rules stated above; and (b) do not have nonprice terms or conditions inconsistent with such rules.

  2. All such transactions should be reported in U.S. dollars.

E. Determination of Cost of Capital

A utility's cost of capital is affected by risk. There are many types of risks. One is the risk that management's technical performance will fall below regulatory expectations and provoke penalties. Another is that the utility's financial performance falls below expectations. In either case, investors concerned about performance will demand a higher return on their capital to compensate for their concerns about the future.

A foreign acquirer brings this set of risks to its acquired U.S. utility. While an investor in a U.S. utility is familiar with these risks generically, he or she is less familiar with how to analyze them in an international context. For example, the U.S. investor will be unfamiliar with the types of foreign government regulation, including what types of performance lapses produce what types of regulatory response. Moreover, like any business entity, the foreign entity will be subject to political risks -- including the risk that the company's product or its mode of production will become a source of controversy. The typical U.S. investor is less familiar with foreign political risks than U.S. political risks. This difference in familiarity will cause the U.S. investor to demand a higher return to compensate for the unknown risk.

The foregoing risks are traditional risks whose foreign applications are unfamiliar to the investor. Foreign acquisitions also bring nontraditional risks. Currency risk is one. Another is the risk that the general political and trade relationships between the U.S. government and the foreign government, friendly at the time of the acquisition, become unfriendly.

Where the acquired U.S. utility provides a noncompetitive, regulated service, this determination is a task for a state regulator (unless the noncompetitive service is unbundled transmission service, in which case the rate regulator is the Federal Energy Regulatory Commission). Traditional techniques available to rate regulators allow them to determine the cost of capital associated with the regulated business only, insulating the customer from risks associated with unrelated business from which he or she does not benefit.

The foregoing considerations all complicate the determination of the cost of capital for ratemaking purposes. The new types of foreign risks, and the potential complexity of the corporate and capital structures used by foreign acquirer, will be unfamiliar to the state and FERC rate regulator. The Commission therefore must condition any acquisition, assuming it otherwise satisfies the statutory tests, on a certification by the affected state regulators and FERC that they have in place the techniques and resources necessary to determine the regulated cost of capital accurately. This certification should be required annually.

In addition to taking into account these special considerations applicable to state and FERC rate regulators, the Commission must consider its direct jurisdictional obligations. The foregoing risks boil down to a new type of diversification risk. Even where the acquirer is primarily an electric or gas company, its non-U.S. business activities will have little relationship to the U.S. utility activities. In this context, the Commission should apply the "functional relationship" test of Section 11(b)(1) (where it applies due to the post-acquisition holding company's "registered" status), and permit the affiliation only where the foreign activities are not so unrelated to the U.S. activities as to cause management distraction, or investor or customer confusion.

F. Protection Against Diminution of Competition

PUHCA Section 10(b)(1) requires rejection of an acquisition that "tend[s] towards interlocking relations or the concentration of control of public-utility companies, of a kind or to an extent detrimental to the public interest or the interest of investors or consumers...."

An acquisition of competing or potentially competing electric companies raises concerns under this section. One might argue that the first acquisition by a foreign company, of a single vertically integrated utility in the U.S., does not raise competition concerns because the acquirer and acquiree do not compete in the same market. That reasoning is incorrect. Given the prospect and potential for retail competition, foreign company entry into our markets -- as new retail players rather than as acquirers of existing players -- is a possibility. Thus an acquirer can be a potential competitor, even if the acquirer is foreign.

While there may be benefits to changing the leadership of certain U.S. electric companies through foreign acquisition, there also are benefits to introducing new players into retail markets that are at risk of becoming concentrated before they even have become competitive. If foreign investors find the U.S. electricity and natural gas market attractive, they should find it attractive because of the possibility of competing on the merits and winning new customers, not because of the possibility of "buying customers" through the acquisition of an existing vertically integrated monopoly. The Commission should take these factors into account in assessing whether a foreign acquisition "tends towards ... concentration of control."

In any event, a foreign entity's first acquisition is not necessarily its last. The prospect of future foreign acquisitions is made more worrisome by the Commission's historic inaction on acquisitions. In the past few years, the "second generation" of U.S. mergers has begun, where the merging companies are themselves the product of mergers occurring in the past ten years. After 40 years of relative stability, a consolidation process has begun whose end state is unknown. However, until now, the Commission has not availed itself of the opportunity to use the unique jurisdiction Congress has vested in it: the jurisdiction to prevent acquisitions that "tend towards interlocking relations or the concentration of control of public-utility companies, of a kind or to an extent detrimental to the public interest or the interest of investors or consumers...." In not a single acquisition in the past 15 years has the Commission exercised serious independent review.

We think it would be incorrect for the Commission suddenly to apply seriously Section 10(b)(1) to acquisitions by foreign companies but not U.S. companies. The best way to assure that acquisitions by foreign companies do not tend toward a concentration of control is to apply this standard to all acquisitions. In doing so, the Commission must look at each acquisition not in isolation. It must consider not only whether the particular acquisition concentrates markets, but whether it precludes other forms of entry that would de-concentrate markets. It must consider the long-term effects, including whether one acquisition will lead to other acquisitions. Only in this way can the Commission pursue a policy, described in the Introduction, of welcoming diversity to our industry while ensuring that this diversity plays a positive role.

Finally, the Commission should not continue to avoid its responsibilities under Section 10(b)(1) by citing the "increasing internationalization of the energy business," as it does in its Concept Release. This vague phrase fails to explain or address the technical analysis of markets necessary to determine the effect of an acquisition on competition. Whether an acquisition concentrates a market requires a determination of the geographic and product boundaries of the market, a measurement of market shares and an examination of entry barriers. The analysis is fact-based and specific. References to the "internationalization of the energy business" describe investment strategies, not customer options.

G. Gaps Between Regulatory Jurisdictions

In the present U.S. electric industry, major jurisdictional responsibility for reliability and adequacy of electric service rests with state commissions. State statutes requiring review of changes in control are the chief means by which states assess the appropriateness of these changes and the fitness of new franchisees. The states' responsibility is not exclusive. FERC indirectly acts in these areas through its jurisdiction over transmission. FERC acts on changes in control when the transaction constitutes, under Section 203 of the Federal Power Act, a disposition of facilities subject to the jurisdiction of that Act.

The state statutes and the Federal Power Act were enacted many years ago, without full knowledge of the different types of transactional structures. In recent years, a number of acquisitions have used corporate structures that are not subject to review by state commissions; others have avoided FERC review. In still other situations, multiple jurisdictions have had authority to review but have not addressed particular issues. For example, the FERC frequently asserts it will not review the effect of a merger on retail competition unless requested by a state commission. On more than one occasion, the state commission with jurisdiction over the merger has neither asked FERC to review the effects on retail competition nor undertaken such review itself. Thus there are gaps in either jurisdiction, actual review, or both.

These gaps are of increased concern where the acquirer is foreign. For some foreign acquirers, there is no track record, easily accessible to state regulators, concerning past performance, including responsiveness to customers and regulators. For example, state regulators frequently approve mergers without specific findings on the merger's effect on retail competition. In this context, certain Commissions have stated that if a market power problem arises after a merger, they can address the problems at that time rather than impose protective conditions on the merger approval. Without necessarily agreeing with this approach to regulation, we think the confidence level a state commission can have, as to its ability to "undo" a merger years after its consummation, is lower when the initial acquirer is foreign. For a state commission to order a foreign company to divest certain business or assets in the U.S. is well beyond present practices, and the consequences of such an action are not easy to predict.

Under these circumstances, special review is necessary to assure a record of past accountability and a likelihood of future accountability. This Commission therefore should require certification by the regulators in each affected state that the statutory authority, resources and ability exists to address all issues of consumer protection, reliability and competition.

II. The Limitations of the Statute's "Economic and Efficient Development" and "Integrated Public-Utility System" Tests Apply to Foreign Acquisitions Just As They Do to Domestic Acquisitions

Part I explained that acquisitions of U.S. utilities by foreign companies, where legally permissible, require special regulatory attention. This Part II addresses whether these acquisitions will be legally permissible to begin with.

The legal difficulties faced by foreign acquirers flow from the Act's central tests:

  1. Section 10(c)(2) states that the Commission shall not approve acquisition "unless the Commission finds that such acquisition will serve the public interest by tending towards the economical and efficient development of an integrated public-utility system."

  2. Section 11(b)(1) requires the Commission to "limit the operations of the holding company system ... to a single, integrated public-utility system, and to such other businesses as are reasonably incidental, or economically necessary or appropriate to the operations of such integrated public-utility system...."

  3. Section 2(a)(29)(A) defines "single integrated public-utility system," as applied to an electric utility company, as

    a system consisting of one or more units of generating plants and/or transmission lines and/or distributing facilities, whose utility assets, whether owned by one or more electric utility companies, are physically interconnected or capable of physical interconnection and which under normal conditions may be economically operated as a single interconnected and coordinated system confined in its operations to a single area or region, in one or more States, not so large as to impair (considering the state of the art and the area or region affected) the advantages of localized management, efficient operation, and the effectiveness of regulation....

In this Part II, we explain how these tests should apply to acquisitions of U.S. utilities by foreign entities. We offer three interrelated conclusions:

  1. The "Economic and Efficient Development" Test of Section 10(c)(2) Will Preclude Most Foreign Acquisitions Where There are Two or More Utility Affiliates in the Post-Acquisition Holding Company Structure

  2. The "Single Area or Region" Test of Section 2(a)(29)(A) Will Preclude or Limit Many Acquisitions by Foreign Companies Using the Holding Company Form

  3. Foreign Holding Companies Will Be Unlikely to Qualify For Any of the Section 3(a) Exemptions, Thereby Requiring "Registered" Status Which Precludes Owners Who are Diversified

A. The "Economic and Efficient Development" Test of Section 10(c)(2) Will Preclude Most Foreign Acquisitions Where There are Two or More Utility Affiliates in the Post-Acquisition Holding Company Structure

1. Through Section 9, Section 10(c)(2) Applies to Acquisitions, the Result of Which is Two or More Public Utilities in the Corporate Family

Section 10(c)(2) applies to acquisitions of public utility securities and assets when the acquisition falls within the criteria of Section 9(a). Section 9(a)(2) applies where a person other than a registered holding company makes an acquisition, and the result of the acquisition is that the acquirer is an affiliate of two or more public utilities. Section 9(a)(2) is known as the "two bite" rule.8

In the context of foreign acquisitions, the application of the Section 10(c)(2) "economical and efficient development" test applies when the foreign holding company will, after the acquisition, own more than one U.S. public utility company. Review under Section 10(c)(2) is not required if the foreign owner, after the acquisition, controls only one public utility (its "one bite").

2. The "Economical and Efficient Development" Test of Section 10(c)(2) Requires Integration of Physical Operations

Section 10(c)(2) requires the Commission to disapprove an acquisition "unless" it finds, "affirmatively," Electric Energy, Inc., 38 S.E.C. 658, 668 (1958), that the acquisition will "serve the public interest by tending toward the economical and efficient development of an integrated public-utility system." The Section 10(c)(2) review requirement can be separated into two components. First, the acquisition must lead to a "single integrated public utility system," as defined under Section 2(a)(29)(A). Second, it must enhance the physical operations of the integrated public-utility system, by making the system "more economical and efficient."

Under the first part of the test, the assets of the post-acquisition company should be "physically interconnected or capable of physical interconnection," and "under normal conditions" the companies should be "economically operated as a single interconnected and coordinated system confined in its operations to a single area or region." Section 2(a)(29)(A). The "normal conditions" under which the system will be economically operated must be demonstrated by "facts shown in the record." General Public Utilities Corporation, 32 S.E.C. 807, 825 (1951).

The second part of the Section 10(c)(2) test requires that the Commission find that the acquisition will create operational gains in utility service. It is a physical test of operational improvements, requiring more than "a showing of efficiencies and economies by virtue of the affiliation" to give "meaning to the language of section 10(c)(2)." Union Electric Co., 45 S.E.C. 489, 494 (1974). Even if savings are not "precisely quantifiable," there still must be "a demonstrated potential for economies." Centerior Energy Corp., HCAR No. 24073, 35 S.E.C. 769, 775 (Apr. 29, 1986).

Evidence of integration would include, for example, economic savings from the deferral of new plant construction, joint economic coordination of power dispatch, improved coordination of off-peak power generation and rationalization of generating capacity. Centerior Energy Corp., HCAR No. 24073, 35 S.E.C. 769 (Apr. 29, 1986)

Centerior Energy continued an emphasis on physical integration that has existed from the early days of the Act. In North American Co., 11 S.E.C. 194, 242 (1942), the Commission has stated that in an integrated system,

"the generation and/or flow of current within the system may be centrally controlled and allocated as need or economy directs, and [the system] is operated as a unit. Thus, even though we find physical interconnection exists or may be effected, evidence is necessary that in fact the isolated territories are or can be so operated in conjunction with the remainder of the system that central control is available for the routing of power within the system."

See also Federal Light & Traction Co., 15 S.E.C. 675, 680 (1940) (single system did not exist where the transmission line connecting the two corporate entities "will not coordinate -- in the normal operational sense -- the [company's] properties, but will provide for certain of its properties additional sources of purchased power").

3. The Commission's Recent Approvals of Acquisitions That Do Not Integrate Physical Operations Should Not Apply Prospectively

In recent cases, the Commission has concluded that geographically distant utilities constitute an integrated system even though there are few apparent operational efficiencies. These recent decisions have required few, if any, operational efficiencies as a result of the affiliation between the public utility companies.

One example is NIPSCO Industries, Release Nos. 35-26975, 70-9197 (Feb. 10, 1999). The Commission there permitted a gas-electric utility operating exclusively in Indiana to acquire a gas public utility operating in Maine and New Hampshire. Despite the vast distance between the utilities, the Commission found the combined operations were integrated, based primarily on the companies' anticipated common source of gas supply from sources in Texas and Louisiana and their proposed combination of gas supply departments. See also Sempra Energy, Release Nos. 35-26971. 70-9333 (Feb. 1, 1999)(authorizing acquisition combining separate utility operations in California and North Carolina based on common source of gas supply).

These recent decisions misapply Congress' requirement of physical integration, approving cross-continental acquisitions of the very type Congress intended to ban. The Commission should not apply these decisions to prospective acquisitions, whether or not they involve foreign utility companies.

4. The Requirement of Integrated Physical Operations Precludes Most Acquisitions by Foreign Companies Where Section 9 Applies

Correctly interpreted, the integration test requires operational, physical integration. There cannot be operational, physical integration across continents or across oceans. Where Section 9 requires approval under Section 10(c)(2)'s economical and efficient operations test (i.e., when the result of the acquisition will be to make the acquirer an affiliate of two or more public utility companies -- see Section 9(a)(2)), such acquisitions are impermissible.

B. The "Single Area or Region" Test of Section 2(a)(29)(A) Will Preclude or Limit Many Acquisitions by Foreign Companies Using the Holding Company Form

An integrated public utility system is a system which, among other things, is "confined in its operations to a single area or region." This "single area or region" standard is a distinct criterion of an integrated public-utility system "that must be met before the Commission can find that an integrated public-utility system will result from a proposed acquisition." Environmental Action, Inc. v. S.E.C., 895 F.2d 1255, 1263 (D.C. Cir. 1990) (citing In re Electric Energy, Inc., 38 S.E.C. 658, 668 (1958)).

Size alone can be determinative of whether the "single area or region" standard is met. The Commission has observed that "when extremely large sections are considered .... distance alone may be definitive." Middle West Corp., Release No. 4846 (Jan. 25, 1944). See also Cities Service Power & Light, Release No. 4489 (Aug. 18, 1943) ("[T]erritory as vast as that covered by the States of Wyoming, Colorado, New Mexico and Arizona," spanning 900 miles from north to south, is not a single area or region under Section 2(a)(29)).

When size has not been determinative, the Commission has considered various other economic and business factors in the assessment of what constitutes a single area or region. Some factors considered include: industrial and business activity in the territories, marketing, transportation facilities, and basic geographical characteristics. Middle West Corp., supra (finding integration based on similar geographical characteristics and similar economic subsistence).

A "single area or region" makes most foreign acquisitions, where the acquirer owns utility properties, legally impossible. Unless the foreign acquirer's utility properties are located adjacent to the to-be-acquired U.S. utility properties (such as acquisitions by a Canadian company of utilities in the northern U.S.), the resulting system will not be "confined in its operations to a single area or region." In particular, the test cannot be met when the post-acquisition system consists of parts separated by an ocean.

C. Foreign Holding Companies Will Be Unlikely to Qualify For Any of the Section 3(a) Exemptions, Thereby Requiring "Registered" Status Which Precludes Owners Who are Diversified

Section 3(a) permits the SEC to exempt holding companies from the provisions of the Act if they meet the criteria of one of five exemptions. These exemptions largely will be unavailable to a foreign acquirers.

The first exemption is for holding companies in which all the utility operations are "predominantly intrastate in character" and which "carry on their business substantially within one state." Section 3(a)(1). The second exemption is available to holding companies that are predominantly public utilities with operations that "do not extend beyond the state in which it is organized and States contiguous thereto." Section 3(a)(2). Neither of these two exemptions will be available to foreign acquirers which, by definition, will not be organized in the state of the U.S. utility operations.

The other three exemptions similarly will be unavailable for most acquisitions of U.S. utilities by foreign entities. Under the third exemption of Section 3(a)(3), the holding company must only be "incidentally" a holding company, not primarily engaged in utility operations, and the holding company and its affiliates cannot derive a material amount of their income from U.S. utility operations. The fourth exemption is for temporary holding companies. The final exemption of Section 3(a)(5) will not be available for any significant acquisitions of U.S. utilities by foreign entities because a qualifying holding company cannot derive a material part of its income from its U.S. utility operations.

The absence of exemption means that a foreign acquirer with substantial non-utility business interests would have to divest them before acquiring a U.S. utility. The reason is as follows: Because the foreign acquirer will not qualify for an exemption under Section 3(a), it will be a registered holding company. This registered status will require the acquirer to comply with, among other provisions, the prohibition on diversification erected in Section 11(b)(1) (limiting "the operations of the holding company system ... to a single, integrated public-utility system, and to such other businesses as are reasonably incidental, or economically necessary or appropriate to the operations of such integrated public-utility system....").

* * *

The Concept Release acknowledges that the integration requirements establish a formidable barrier to the ownership of U.S. utilities by foreign utility holding companies. The Commission suggests, however:

Section 33 is neutral on its face with respect to the ownership of a FUCO by a foreign holding company. [foonote omitted]. It is thus possible to construe section 33(c)(1) to allow a foreign holding company to qualify its foreign utility operations as a FUCO, and the foreign holding company to acquire a U.S. utility without regard to the integration of the foreign and domestic operations.

The Commission's reasoning, if correct, does not alter the importance of PUHCA's provisions where they apply. Where the acquisitions by a foreign company trigger provisions of PUHCA, the Commission should apply the statute faithfully, according to the conditions and standards discussed above.

February 4, 2000

Respectfully submitted,

Scott Hempling
David Lapp
Attorneys for Consumer Intervenors


1 Consumer Intervenors consists of the following organizations: Air Conditioning Contractors of America, Alliance Against Utility Competition in Orleans Parish, American Public Power Association, Citizen Action Coalition of Indiana, Consumer Federation of America, Environmental Law and Policy Center, Industrial Energy Users - Ohio, National Alliance for Fair Competition, National Association of State Utility Consumer Advocates, Public Citizen, and Small Business Alliance.
2 Democratic Central Committee of the Dist. of Columbia v. Washington Metropolitan Area Transit Comm'n, 485 F.2d 786, 810-11 (1973), cert. denied, 415 U.S. 935 (1975) ("Democratic Central Committee") ("[I]t is eminently just that consumers, whose payments for service reimburse investors..., should benefit in instances where gain eventuates -- to the full extent of the gain."). Democratic Central Committee's principle that "those who shouldered the risk of loss are entitled to the benefit from the gain" has been widely cited and accepted by courts and regulatory agencies.
3 See, e.g., Tucson Electric Power Co., Decision No. 59224 (Ariz. Corp. Comm'n 1995) (applying higher of market or cost pricing standard for affiliate transactions); San Diego Gas and Elec. Co., 166 P.U.R.4th 257 (Ca. Pub. Util. Comm'n 1995) (same); Pacific Bell, 135 P.U.R.4th 276 (Ca. Pub. Util. Comm'n 1992) (same); Duke/Louis Dreyfus L.L.C., 73 F.E.R.C. para. 61,309 at 61,868-69 (1995) (discussing FERC's interaffiliate transaction rules).
4 "Guidelines for Cost Allocations and Affiliate Transactions", adopted Summer 1999, available at http://www.naruc.org/Resolutions/summer99.htm#Resolution.
5 See Public Serv. Co. of Colorado and Southwestern Pub. Serv. Co., 75 F.E.R.C. para. 61,325 n.23 (June 26, 1996) (order establishing hearing procedures) (requiring that sales of non-power goods and services by a utility to its affiliates be priced at the higher of the utility's cost or market value).
6 Consumer Intervenors consists of the following organizations: Air Conditioning Contractors of America; Alliance Against Utility Competition in Orleans Parish; American Public Power Association; Consumer Federation of America; National Association of State Utility Consumer Advocates; National Alliance for Fair Competition; National Association of Plumbing, Heating and Cooling Contractors; National Electrical Contractors Association; Public Citizen; and Small Business Alliance.
7 Regional Transmission Organizations, 89 F.E.R.C. para. 61,285, Docket No. RM99-2-000; Order No. 2000 (Dec. 20, 1999)(final rule).
8 Specifically, Section 9(a)(2) prohibits, unless they have been approved by the Commission under Section 10, direct or indirect acquisitions of any securities of a public utility company, if the acquiror is an affiliate, or will be an affiliate as a result of the acquisition, of any other public utility, as defined in Section 2(a)(11)(A). Subsection 2(a)(11)(A) defines an affiliate as "any person that directly or indirectly owns, controls, or holds with power to vote, 5 per centum or more of the outstanding voting securities" of the utility company.