ENDESA, INC.

NEA Acquisition Regulatory Risk Review

Maxwell, John P 12/12/2012

John P Maxwell Energy Law Final Problem 12/12/12

This memo will review the proposed merger with National Energy Corp. (NEA) will highlight some of the main issues that permeate the energy industry. The main methodology that should be stated first is that regulation seeks to strike a balance between the profit motive and the public interest. This policy argument views both free competition and environmental regulation through the lens of providing an updated definition of where the fulcrum between the two perspectives should lie. The landmark US Supreme Court case, Charles River Bridge, underlies much of the legal theory to what role the state has in regulating the public interest. In this case, the Court set the precedent for the intervention of the government into those areas where it deems to have a stake in protecting the public interest even at the expense of a private business. The next regulatory consideration for Endesa is the legal framework between the two levels of government: federal and state. Federalism creates some difficulty in the way laws and regulations are enacted as regulating powers that stretch both vertically and horizontally. There are important constitutional aspects that are relevant to the way the equilibrium between the levels is reached. The first item the Commerce clause and dormant commerce clause deal with the fact that Congress has the right to regulate commerce when it occurs between states. In addition, there is the dormant commerce clause which is related to the commerce clause in that no state can make a law that abridges the commerce that would otherwise occur between states. See Munn v. Illinois and Alliance for Clean Coal v. Miller for the case law as it relates to common carriers and the way states cannot favor one source of coal at the expense of another. The next element to be aware of is the supremacy clause which dictate that when state and federal law come into conflict, federal law will trump state law. This is important in environmental law which dictates the minimum regulations which may affect any electric plant in the country. Though it has a relatively short legal life, this regulatory framework has produced 3 main statutes that one should be aware of when operating in the US: Clean Air Act (1963 w/ amendments in 1970, 1977 and 1990), Clean Water Act (1972) and Endangered Species Act (1973). The next section will cover the important aspects of electricity legislation in the U.S. The initial statue that regulated the electric power industry was the Federal Power Act (FPA) which initially dealt with the development of hydroelectric dam construction, but was expanded to the entire power utility industry. This statue also established the Federal Power Commission (FPC) which eventually has evolved into the Federal Energy Regulatory Commission (FERC). The 1935 expansion of the FPA allowed for the passage of the Public Utility Holding Company Act (PUCHA) which helped to create the vertically integrated utility which operated as a natural monopoly in a designated geographically area. The state that MaPL operates in is still under this regulated utility framework. Some changes that have occurred at the federal level which has changed the regulated monopoly outside of specific state deregulation. The first important regulation to be aware of is the Public Utilities Regulatory Policies Act (PURPA) which helped to encourage renewable projects and their connection to the grid. The other important development was FERC orders 888 & 889 which pushed states to put in place more market fundamentals into the electric power generation area. Order 888 opened the wholesale market to allow for a greater regional operation of sales and to make sure that there were not discriminatory rates charged by the operator of the transmission lines. Additionally, it set-up regional transmission organizations (RTOs) to coordinate wholesale electric sales. Order 889 ensured that the market operated efficiently by separating the sales and trading from the actual generation part of the business. As the
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John P Maxwell Energy Law Final Problem 12/12/12

state which MaPL is located considers moving from regulated to a deregulated market, the state should review the lessons learned from Californias deregulation and not do much too quickly. After covering the broader regulatory outline, the memo will next discuss the specific assets owned by Midatlantic Power and Light (MaPL) and the other NEA subsidiary Utica GasCo (UGC) and highlight the regulatory risks Endesa could be exposed to by participating in the retail and power generation within this mid-Atlantic state. To lessen the impacts from regulation on the generating facilities, the analysis will cover each generation type and some of the regulations which could influence the appraisal of the NEA properties. Although trying to predict the future of US regulatory changes is a difficult exercise, it is useful to highlight major regulatory risks which provides due diligence for management to detail the risks to consider when evaluating the particulars of the transaction and downside risk to the future value of these assets. The major regulation change that could adjust the future value of the assets is the introduction of a broadbased carbon reduction statute. Currently, the CAA regulates SO2, NOx, Hg, particulates, and others. There is no legislation that directs the Environmental Protection Agency (EPA) to regulate CO2, though it has been approved by the Supreme Court as the EPA has designated CO2 a pollutant and has put in place rules which would limit CO2 emissions on newly constructed plants. Coal Plants: Rogers Station (RS) (1966) & Pendleton Station (PS) (1992). Since RS was built after the first CAA, some of the more restrictive later amendments may not apply. PS was built after all the amendments to the CAA. Both of the plants need to be cognizant of any changes to the CAA that may affect the National Ambient Air Quality Standards (NAAQS), New Source Performance Standards (NSPS), or State Implementation Plans (SIPs). The state where MaPLs plants are located in must conform to the standards set by the EPA. One recent court case that is relevant for the management to reference: Environmental Defense Fund v. Duke Energy (2007), as it gave the EPA the ability to regulate modifications to generating plants under the NSPS rules. If a carbon tax is instituted, the cost of delivered power from the RS and PS coal plants will likely rise from current levels of $0.04/kWh and $0.042/kWh respectively. It is difficult to project the exact tax per kWh that coal generation would have to bear, however it would likely rise above hydroelectric. Future models can development scenarios would help to enumerate the exact impact from different types of carbon legislation. The price of electricity generated by gas would also rise since it is a hydrocarbon, but since it contains ~40% less CO2 than coal, the cheapest coal generation would likely be just above or at cost parity with the most expensive gas. The price of wind generation will likely remain above the cost from coal, but that exact calculation is undetermined. Natural Gas: MaPL can benefit from potential carbon legislation by switching to a lower carbon intensive form of generation by deploying more power from the Morgan Heights Facility. There are 800 MW which can be operated at $0.05/kWh. MaPL should explore expanding the plant in the event of a carbon tax as In addition, there is the price advantage the MaPL can take advantage of. This lower input cost can help to allow MaPL to offset the expense of the carbon tax to the RS and PS coal plants. The efficiency of gas turbines has increased greatly over the last decade or so and has allowed gas to approach the best coal plants in terms of efficiency. Though gas is a great benefit as an input fuel for power generation, there are some regulatory risks to the supply of cheap gas as well as to the future value of the leases owned by UGC. Currently, UGC owns leases in eastern Ohio and New York State. The New York assets are currently undevelopable because of a drilling moratorium put in place. This makes these leases somewhat problematic to value,
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John P Maxwell Energy Law Final Problem 12/12/12

since the ban may or may not be overturned which could enhance or impair the value depending on the outcome of the Governors decision. The Ohio leases should be valued properly given available information, but there are risks that could disrupt the cheap gas supply and the ability of UGC to produce gas through hydraulic fracturing. One risk is the federal government which currently exempts hydraulic fracturing from the CWA could revoke that exemption if there is a study which connects of fracking to groundwater contamination. Second, there is a risk that the federal government may replace the current state-by-state legislation through a national regulatory structure. This may include a national fracturing fluid disclosure rule, strong rules to prevent methane flaring, and strengthening of the green completion well rules which seek to reduce the methane leaking (outside of pure flaring) which is a powerful greenhouse gas. There are also some policy possibilities which could enhance the value of the gas leases owned by UGC. If there is a significant push to allow LNG export of natural gas and increased efficiency in FERC pipeline permitting, the gas could reach markets which can push up the value even greater. Natural gas development can be very valuable to MaPL if there are regulations which are crafted to be fair to producers and the environment. Hydroelectric: Hydroelectric power was one of the first generating types and thus was subject to regulation from the FPC which then became the FERC. The FERC was charged with the balancing of the public v. private interest with respect to public waterways. Permits for privately constructed dams needed approval, but publically owned facilities do not require permits. MaPL currently owns two hydro assets, Moray Hydro (MH) and Steall Falls (SF) totaling 108 MW of capacity. These generating assets are small in relation to MaPLs available capacity at ~6.0% of the total. These assets are governed by the FERC and require an approval for the initial generation plant as well as to continue to operate the plant. Generally the permits last about 30 years depending on FERCs definition of the public interest. Since these dams were built in the late 1980s, MH will come up for review in 2017 and SF will be up the following year. The regulatory risks for these assets are that there will be environmental backlash to the continued operation of the dams. If there is an ESA controversy within either the MHs or SFs operating area, this will put likely continual legal challenges to any FERC approval of operating licenses. Any carbon legislation will make these generating assets very valuable as they provide relatively cheap base load generation and would help with MaPLs profitability. Wind: The wind generating assets in MaPLs portfolio are a minor component with 2.0% of the total capacity. Since this generation type was placed in service prior to the expiration of the Production Tax Credit (PTC), there is a value proposition on the wind generation since any wind power generated will receive a tax credit toward the total federal income tax bill that MaPL will be liable for. At the margin, if this asset is fully deployed it can make the value of the tax reduction a share in boosting the profitability of NEAs total worth. The regulation risk here is any repeal to this tax credit, but similar to the hydroelectric generation capacity any carbon legislation will increase the cost of the fossil fuel generation to the advantage of non-fossil generation types. This memo covers the generation types in the NEA portfolio to show policy history for electricity generation and each generation type to focus on regulatory issues that may arise to damage or augment the value of the assets depending on how the rules are crafted. Endesa should price these risks into in the future value calculation to weight transaction proceeds are fair.