Reinvent FERC for Deregulated Electricity, Says Antitrust Institute

Aug 21 1998
Testimony and Interventions

In comments filed today with the Federal Energy Regulatory Commission concerning public utility mergers, the American Antitrust Institute called on FERC and the Congress to learn a lesson from the recent history of deregulation by re-shaping the regulatory framework of the electricity industry prior to substantial deregulation.

"We have learned that deregulation can be beneficial," said AAI President Albert A. Foer, "but if the competitive framework is to work, vigorous antitrust oversight and direction must be an integral part of the plan from an early stage. Too frequently, the role of antitrust in deregulated industries has not lived up to expectation and this has often been caused by the regulatory agency being too lax in its approval of mergers."

In order to assure that the current public utility merger wave does not undermine the potential for competition in deregulated markets, the AAI endorses the idea of a moratorium on large mergers and emphasizes the need for building an incipiency orientation into FERC's merger guidelines, with increased attention to the antitrust concept of preserving potential competition. An incipiency orientation, based on the Clayton Act's approach to mergers, looks toward a merger's tendency to negatively affect competition in the future, and not merely its impact in the current, regulated context.

As FERC moves from regulator to antitrust enforcer, it needs to revisit the question of how best to obtain and control proprietary information that is frequently invaluable to an antitrust analysis. "The current process is conducted in a fishbowl," says Foer. "We urge FERC and Congress to take advantage of the techniques and procedures used by the FTC and the Antitrust Division under the Premerger Notification Act. We also call for a focus on the human resources side of electricity deregulation: immediately put in place, both at FERC and the antitrust agencies, an adequate number of well-trained economists and attorneys, experienced in antitrust and knowledgeable of the electricity industry. Don't wait until deregulation has already occurred, markets have become overly concentrated, and it is too late to make corrections."

In other comments, the AAI endorsed the use of a rebuttable presumption in favor of appropriately structured Independent System Operators as a condition of approving mergers that include transmission facilities; and warned FERC to approach with skepticism efforts to justify utility mergers on the basis of prospective efficiencies.

The AAI comments are reproduced on the organization's homepage at www.antitrustinstitute.org.

Contact: Albert A. Foer, President

UNITED STATES FEDERAL ENERGY REGULATORY COMMISSIONCOMMENTS OFTHE AMERICAN ANTITRUST INSTITUTEREGARDINGFILING REQUIREMENTS FOR PUBLIC UTILITY MERGERSDOCKET NO. RM98-4-000

The American Antitrust Institute is a non-profit organization whose mission is to advocate policies that increase the role of competition, assure that competition is fair, and challenge unduly concentrated power in the economy.

I. Overview: Learn from history that deregulation requires a reinvention of the regulatory framework in order to create the conditions for a more competitive electricity market.

The economy of the United States has been re-structured over the past thirty years as a result of public policy decisions to deregulate key industries and thereby free up market forces previously constrained by regulatory frameworks. We now have sufficient experience with such industries as transportation and telecommunications to recognize that deregulation can indeed be beneficial in terms of promoting efficiency, reducing prices, and spurring innovation.

But we have also learned that competitive industries are not easily arrived at where monopoly had previously reigned. In particular, we have learned that if the competitive framework is to work, vigorous antitrust oversight and direction must be an integral part of the plan from an early stage. Too frequently, the role of antitrust in deregulated industries has not lived up to expectation and this has often been caused by the regulatory agency being too lax in its approval of mergers.1 It is with the objective of assuring that the deregulation of electricity results in an industry that is robustly competitive that we offer these comments.

As we look at the current movement toward the deregulation of electricity, we are concerned that an unsatisfactory history will repeat itself unless FERC and the Congress make a considered effort to reinvent the regulatory framework in preparation for a competitive market. We have tried to relate our comments on the handling of mergers to larger questions of reinvention.

II. FERC's "Public Interest" standard should incorporate the idea of facilitating a competitive industry structure.

The process of transitioning from regulation to competition should be recognized as a special context for the evaluation and regulation of mergers. In stable, competitive industries, the concern is usually that mergers will move the market away from competition toward concentration, and that a highly concentrated market will perform in a less desirable manner than one that is workably competitive. The emphasis is on the possible deterioration of an existing market. With a regulated industry, however, we are generally starting with a high level of concentration and seeking to facilitate a more competitive structure, so that market forces (watched over by active enforcement of antitrust laws) will be able to stand effectively in the place of direct economic regulation. Extraordinary price volatility in the bulk power market in the Midwest during June of this year demonstrates that regulated markets, markets in transition to competition, and competitive markets all behave very differently. In this context, it is necessary to give special emphasis to the "incipiency" nature of Section 7 of the Clayton Act, which sets our national policy toward mergers.2

An incipiency orientation implies that FERC will examine mergers with a particular eye to their impact not only on markets that exist today under regulation, but also on markets that can reasonably exist in the future in a competitive regime. Historical conditions cannot necessarily be used to predict future competitive effects of mergers, because of the discontinuity created by deregulation. We want to suggest several implications of an incipiency orientation.

First, the current merger wave, in which many mergers are undertaken for the purpose of strategic positioning in the future deregulated regime, should be viewed as a direct challenge to the viability of deregulation. Mergers during the volatile transition period can foreclose future competition. Large electric utility mergers should be subjected to a temporary moratorium until policies and conditions are established for assuring that competition will indeed be an adequate replacement for regulation.3

Second, mergers should be subjected to a strict and future-oriented standard of review, consistent with the Commission's discretionary authority under the governing statute, Section 203(a) of the Federal Power Act, which provides that, "if the Commission finds that [a proposed merger] will be consistent with the public interest, it shall approve the same."4 As well-expressed in the Merger Policy Statement, "the public interest requires policies that do not impede the development of vibrant, fully competitive generation markets."5 In other words, what is consistent with the public interest depends on circumstances, which change over time, and the key circumstance today is the need to assure a viable transition to competitive markets. Mergers that undermine the potential for vigorous competition in a deregulated marketplace do not meet the public interest standard.

Third, an incipiency orientation requires giving special attention to the antitrust concept of potential competition.6 Mergers that eliminate a significant potential competitor may not reduce competition today, in a regulated market, but can materially impact the probability of vibrant competition emerging in a deregulated environment. Certainly, the approval of a merger that eliminates a significant potential competitor, where there are no more than a few significant potential competitors, should only be justified where there are clear and substantial public benefits. The filing requirements do not require adequate information about the merger's impact on potential competition, such as identification of relevant markets in which there could have been workable competition but for the merger, and why competition in such markets will not be reduced.

III. The problem of handling confidential information requires re-thinking of how FERC should approach its new role.

In the regulatory environment, merger analysis has occurred in a fishbowl. A major role is played by intervenors, i.e. private parties that volunteer to put forward arguments to the Commission. All documents generated in the matter are made available to the intervenors (who may be competitors), so that they can play out their roles. This is quite different from the way in which mergers are handled by the federal antitrust agencies. To generalize, private parties play a role in federal antitrust investigations, by providing statements and other evidence to the investigators, but more of the burden is on the federal staff, which alone has access to confidential data provided by the merger applicants or other sources.

The importance of certain types of data changes in a deregulated, competitive environment; what once would have had little competitive consequence (in the absence of competition as a primary driving force) will become more critical to the efficient functioning of markets. As FERC moves from regulator to antitrust enforcer, it needs to revisit the question of how best to obtain and control proprietary information that is often invaluable to an antitrust analysis.

The proposed filing requirements, recognizing that information provided by the merging companies will not be protected, do not seek strategic plans or other internal memoranda or documents that can help clarify the motivations and expectations of the merger.7

We consider this a major drawback to the staff's investigative ability, and urge you to create a carefully defined category of documents that may be labeled by the submitter as "confidential and proprietary competitive information". Properly labeled data would not be made available to competitors, but could be used by regulatory staff in their evaluation of a merger's effects.

There are pitfalls in this process, e.g. how to include or protect proprietary data in public justifications of decisions; but fortunately the federal government and the antitrust community have ample experience to share with FERC. The detailed procedures for the handling of such information, including its disclosure in hearings and opinions, should be based on procedures that have worked for the FTC and the Antitrust Division. In particular, FERC and the Congress should give serious consideration to integrating public utility merger procedures with the procedures that have worked reasonably well under the Hart-Scott-Rodino Act. This inquiry should be part of a larger look at how FERC should reinvent itself in light of its changing role.

In this context, we note that an incipiency orientation is not simply a matter of attitude and philosophy. It also requires appropriate personnel planning. Ultimately, proper merger oversight can occur only if an adequate number of well-trained economists and attorneys, experienced in antitrust analysis and knowledgeable of the electricity industry, are in place at FERC and at the antitrust agencies. We urge FERC, the antitrust agencies, and Congress to focus on the human resources side of electricity deregulation immediately, rather than waiting until deregulation has occurred, markets have become overly concentrated, and it is too late to make corrections.

IV. Mergers that involve transmission should be conditioned upon independent ownership and management of transmission facilities.

A frequent concern in mergers affecting the transmission of electricity is whether all post-merger competitors will receive equal and fair access to transmission. The filing should therefore specify if transmission is involved and should identify anyone who could potentially be disadvantaged if access were not fully fair. At this stage, with an incipiency orientation, we believe that many potential competitive problems can best be solved by conditioning approval of a merger upon the agreement to participate in an appropriately structured Independent System Operator (ISO). By this we mean there should be a rebuttable presumption in favor of ISO's that are large and structurally separate from the merging firms, and that participation in such an ISO must be accomplished prior to consummation of the merger.

Further, FERC must be able to reserve the right periodically to revisit the merger to assure that the intended competitive conditions have occurred. (For example, if the merger were conditioned upon joining an appropriate ISO, but the utility later abandons the ISO or the conditions surrounding the ISO change, FERC should be able to re-enter the case.)

This raises another reinvention question: once an electrical market has been deregulated, should it not be comparable to other markets, in that the federal antitrust agencies and private parties should have clear enforcement rights against anticompetitive practices? This, too, ought to be clarified by Congress in advance of deregulation.

V. Claims of efficiency should be received with skepticism.

Some utility mergers can produce substantial cost savings. While it is appropriate for FERC to take into account the efficiencies which merger applicants predict will occur, experience under the antitrust laws generally and in the electric utility field require that FERC approach efficiency claims with skepticism.

For example, in the first case to come to the FTC after the Horizontal Merger Guidelines8 added a specific role for efficiency to be considered, the attempted merger of Office Depot with Staples presented the District Court with claims that the merger would save $4.9 to 6.5 billion over the next 5 years and that 2/3's would be passed on to consumers.9 The Court found the evidence to be unreliable and noted that the savings exceeded by 500% figures presented to the two boards of directors when they approved the merger. Also, previous cost savings appeared to be passed on at the level of 15-17% only. Moreover, the Court found that 40% of the suggested savings were based on obtaining better prices from vendors, but this could have been obtained by internal growth and was therefore not merger-specific.

This is not a unique situation.10 The argument for skepticism is borne out by an extensive literature.11 Raymond S. Hartman summarized what scholars have found in retrospective studies of mergers in a broad cross-section of industries:

"The accuracy of ex ante measures is found to be surprisingly and consistently inadequate. Ex post analysis of merger performance indicates that the majority of ex ante studies developed to assess merger-induced efficiencies are incorrect and over optimistic. It appears to be true for efficiency studies, productivity studies and event studies. This seems to be true for mergers in this country and internationally; for mergers in this country over the last century; for mergers in competitive sectors and for mergers in recently deregulated sectors. Almost all mergers are undertaken with the ex ante prediction that benefits and efficiencies will occur. However, ex post, the vast majority (60%-80%) of mergers can be characterized as unsuccessful."12

Hartman found that the vast majority of mergers fail to achieve the expected benefits identified in pre-merger ex ante productivity/efficiency studies for two principal reasons: (1) the gains are usually overestimated (or they are nonexistent); and (2) the actual costs and difficulties of integrating the merging firms are usually underestimated.13

Robert D. Stoner published an efficiency analysis of electric utility mergers.14 He concluded, like Hartman, that scale efficiencies are unlikely in the case of mergers among very large utilities. Stoner's review of recent electric utility mergers found that efficiency claims in a number of cases were very large and that "except in a few cases, many of the claimed savings have been rejected by the regulatory authorities. Claims of deferred capacity savings and administrative overhead savings have been especially problematic."15

Whether or not efficiency claims are valid, there is little incentive for a supplier to exploit potential efficiencies if that supplier does not face significant competition. (Why go to the trouble of trying to be efficient?) Therefore, claimed efficiencies should not offset a serious and well-founded competitive concern.

Given this background, it is appropriate that the filing requirements should place more of a burden on a utility seeking to make an efficiency argument.16 For example, all assumptions underlying any efficiency claims must be presented. The discount rate must be specified, including the component that is intended to apply to the increased riskiness of distant projections compared to near-term projections. Stand-alone costs should be estimated assuming that both merging firms take all prudent and reasonable steps to operate efficiently, including entering into cost-reducing contractual relationships with each other or third parties. Claimed benefits deriving from capacity deferral should be shown in terms of the present value of delaying capital costs (less any increases in fuel costs implied by postponement of more efficient units). Claims of savings in customer service and overhead costs must be demonstrated rather than asserted. Putting these specifications into the filing requirements should enhance efficiencies of evaluating the claims that are put forward.

VI. Approach computer models with caution.

The use of computer models for analyzing the competitive effects of utility mergers may be beneficial in the long run, but should not be hurried.17 We are concerned that the door may be opened for each new merger to introduce a new model, created by the proponents of the merger to advance the most favorable outcome. This would generate a black hole for the resources of the Commission and intervenors, who would need specialized expertise in order to fully evaluate the model and the validity of its assumptions. It is likely under such an open-door scenario that the choice of one model rather than another would be outcome-motivated, which means that those trying to understand the merger would have to figure out why this model, rather than some other, was used in the particular case at hand. This will be especially burdensome on public interest groups or small utilities that want to question a merger. It would be far better for FERC to identify only a few commercially available models which, on the basis of extensive testing, would be certified for use.

Respectfully Submitted,Albert A. Foer, President American Antitrust InstituteM2919 Ellicott Street, NWWashington, DC 20008(202) 362-8704

1 Consider, for example, the problems caused by concentration of air transportation at hub terminals, now being addressed by the Department of Transportation in Docket No. OST-98-3713. The AAI's comments in this matter are available at our home page, www.antitrustinstitute.org . Consider also the recent merger of Union Pacific and Southern Pacific, leading to a completely disaster in the railroad industry. 2 As the Supreme Court explained in United States v. El Paso Natural Gas Co., 376 U.S. 651, 659 (1964), "…one purpose of Sec. 7 was 'to arrest the trend toward concentration, the tendency to monopoly, before the consumer's alternatives disappeared through merger…" Also, Sec. 5 of the Federal Trade Commission Act was designed "to stop in their incipiency acts and practices which, when full blown, would violate" the Sherman Act or the Clayton Act. FTC v. Brown Shoe Co., 384 U.S. 316, 322 (1966). 3 We support the joint petition of the American Public Power Association and the National Rural Electric Cooperative Association in Docket No. RM98-6-000. 4 16 U.S.C. Sec. 824b(a). 5 FERC Stats. & Regs. Para. 31,044, at 30,115. 6 See F.M. Scherer and David Ross, Industrial Market Structure and Economic Performance (Boston: Houghton Mifflin Company, 1990, third edition) at 188-90. 7 The NOPR's effort to create a screen for vertical mergers is general and amorphous, but at least identifies the right issues for intervenors to focus on. The problem is that proper analysis requires a detailed investigation, including review of highly proprietary internal strategic planning documents that may throw light on the parties' intentions and expectations. We are concerned, again, that the fishbowl atmosphere will stand in the way of enforcement initiatives by the staff. 8 Department of Justice and Federal Trade Commission, Horizontal Merger Guidelines, 57 Fed. Reg. 41,552 (1992) [CCH Trade Regulation Reports para. 13,104]. 9 Federal Trade Commission v. Staples, Inc., 970 F. Supp. 1066 (D.D.C. 1997). 10 The Union Pacific/Southern Pacific railroad merger was permitted by the Surface Transportation Board in part so as to allow predicted efficiencies. Post-merger, the companies discovered that their computers would not talk to each other. A multitude of problems ensued, leading to terrible congestion, delays, higher costs to customers, lawsuits, extended hearings, and more. 11 See, e.g., the references in footnote 24 of Raymond S. Hartman, The Efficiency Effects of Electric Utility Mergers: Lessons From Statistical Cost Analysis, 17 Energy Law Journal 425 (1996), supporting the proposition that "the ex ante analyses of merger-induced efficiencies are incorrect for most mergers, whether in the utility industry or elsewhere." 12 Id. At 438. 13 Id. 14 Mark W. Frankena and Bruce M. Owen, Electric Utility Mergers: Principles of Antitrust Analysis (Westport, Conn.: Praeger, 1994) at pages 147-164. 15 Id. At 164. 16 The following suggestions flow from common flaws in efficiency claims that were reported by Stoner, op. cit. At 162-3. 17 A volatile environment, associated with the transition from regulation to markets, may increase the difficulty of modeling with precision.