FERC guidance clarifies the scope of the hold-harmless commitments offered in electric utility mergers and acquisitions, but discards its initial proposal to make those commitments open-ended.

On May 19, the Federal Energy Regulatory Commission (FERC) issued a final policy statement on the scope of hold-harmless commitments that can be offered to satisfy ratepayer protection concerns when seeking FERC approval of electric power sector mergers, acquisitions, divestitures, and control transactions.

The final guidance generally affirms FERC’s earlier proposals on the scope of transaction-related costs that utilities cannot charge to ratepayers when offering a hold-harmless commitment and the requirement to establish controls for separating transaction-related costs. Importantly, however, FERC withdrew its proposal to require an open-ended hold-harmless commitment, concluding that the traditional five-year period during which ratepayers would need to be protected from transaction-related costs was sufficient.

Although many FERC-jurisdictional transactions are conducted under blanket authorizations or do not have an effect on FERC rates because the utility parties are permitted by FERC to sell electricity at negotiated rates, the new policy will apply to many larger, high-profile transactions, particularly those that involve utilities with cost of service rates, such as transmission-owning utilities. Under section 203 of the Federal Power Act, FERC may only authorize a transaction if it concludes that the transaction would be consistent with the public interest. For those utility transactions not granted blanket authorizations, a key part of FERC’s analysis involves the effect that a proposed transaction would have on rates, including whether that effect would be adverse and, if so, whether that adverse effect is offset by other benefits that flow from the transaction.

FERC has traditionally provided several methods by which utilities that undertake a transaction can demonstrate that the merger or acquisition would not have an adverse effect on rates, including open seasons, rate freezes, rate reductions, or hold-harmless commitments under which the utilities commit to not pass “transaction-related” costs through to ratepayers for a stated period, often five years. However, before the recently issued policy statement, FERC has not previously defined in detail the costs that are to be considered “transaction-related,” nor had it mandated a process for tracking such costs. The revised policy provides clarity on these issues for the first time.

Scope of Costs Subject to a Hold-Harmless Commitment

Because the scope of the costs subject to a hold-harmless commitment is key to properly implementing that commitment, the policy statement addresses specific guidance on two categories of costs considered “transaction-related.” 

First, utilities making a hold-harmless commitment must not pass through to their ratepayers the costs necessary to develop and consummate the merger, including the following:

• Costs of appraisals, formal written evaluations, and fairness opinions

• Transaction structuring costs, including the costs of negotiations and tax advice regarding that structure

• Costs related to drafting and reviewing the documents necessary to implement the transactions, such as a merger agreement, purchase agreement, or financing documents

• Costs of internal personnel (allocated between transaction and non-transaction tasks as needed) and third-party consultants and advisers used to evaluate the proposed transaction, negotiate the terms of the merger, execute related contracts, and obtain regulatory approvals

• Shareholder approval costs

• Costs of professional services such as accountants, attorneys, and engineers

• Costs to verify the operability of the facilities governed by the transaction

Second, utilities will be required to consider “transition” costs to be transaction-related costs and therefore not pass these costs through to ratepayers. Although FERC acknowledged that it can be difficult to separate these costs incurred to achieve merger synergies from the normal business expenses of a utility, FERC nevertheless put the onus on the transacting utilities to remove these costs from rates or demonstrate in the section 203 proceeding why they should be recoverable.

 These “transition” costs include the following:

• Engineering studies

• Severance payments

• Costs to integrate operations

• Costs to integrate accounting and operating systems

• Costs to end leases and other contracts found to be duplicative

• Costs to refinance any existing obligations “to achieve operational and financial synergies”

Although FERC provided these lists of costs, it noted that the burden to demonstrate compliance with a hold-harmless commitment is on the transacting utilities, which would be free to add to or remove costs from the lists so long as they can demonstrate that the changes will avoid an adverse effect on rates. FERC reiterated that a hold-harmless commitment is not a prohibition on rate increases. According to FERC, a transaction can be consistent with the public interest despite a rate increase if there are countervailing benefits.

FERC refused to issue a per se rule on whether capital costs would be considered transaction-related or not, explaining that such decisions would be case-specific. However, FERC did explain that three categories of capital costs would generally be considered transaction-related:

• Costs to construct facilities to resolve any competition concerns identified by FERC in approving the transaction

• Costs to replace equipment of the transacting utilities prior to the end of the useful life of that equipment in circumstances where the replacement resulted from the transaction

• Costs incurred to integrate previously separated systems

FERC cautioned applicants concerned about the recovery of certain capital costs to provide as much clarity as possible in their section 203 applications so that FERC can make a determination.

In the event that a utility pursues a transaction but the transaction ends before approval was sought from FERC (and FERC accepted a hold-harmless commitment), the transaction-related costs are subject to normal ratemaking principles, not FERC’s new policy. However, FERC noted that its Uniform System of Accounts for public utilities requires that costs incurred in consummating a transaction should be recorded in a non-operating expense account.

Controls to Track Transaction-Related Costs

In response to numerous comments on FERC’s initial proposal, FERC withdrew its proposal to require utilities seeking section 203 approval to describe the accounting procedures and practices for transaction-related costs subject to a hold-harmless commitment. According to FERC, existing utility accounting requirements should be sufficient for this purpose.

However, FERC did adopt its proposal to require applicants to describe how they will “define, designate, accrue, and allocate” transaction-related costs, including any criteria used by the utilities to identify the costs that are considered “transaction-related.” According to FERC, these detailed controls will allow the utilities to identify the costs for which they might seek recovery in the future, and to defend against complaints.

FERC also modified its past practice for the merger accounts submitted within six months after the transaction is consummated. Going forward, utilities that made hold-harmless commitments will be required to identify in these merger accountings the amounts of transaction-related costs incurred to that point.

Time Limits on Hold-Harmless Commitments

Possibly the most controversial part of FERC’s initial proposal was a proposed requirement that hold-harmless commitments have no expiration date. Under that proposal, utilities would have been required to demonstrate—10, 20, or 30 years after a transaction—that they were not passing transaction-related costs through to ratepayers.

In response to the comments on this issue raising concerns about the logistical difficulties in continuing to distinguish between merger costs and normal business costs many years after a transaction, FERC decided that it would continue to accept time-limited hold-harmless commitments. FERC concluded that the majority of transaction-related costs are incurred in the first five years after the transaction, driven in part by the desire by utilities to achieve synergies as soon as possible. FERC acknowledged that there is no single time period that utilities must use, but noted that “a five year hold-harmless period . . . has become the norm in the industry.” 

Alternatives to a Hold-Harmless Commitment

FERC also clarified that not all transactions require a hold-harmless commitment, although all section 203 applicants must be able to demonstrate that the transaction will not have a negative effect on rates. A hold-harmless commitment is only one of the possible mechanisms to meet this obligation. In some instances, rates cannot be affected because, for example, the ratepayers all receive service under long-term stated rate contracts that do not provide a mechanism for passing through such costs. In other instances, the transaction was undertaken to satisfy a legitimate utility need, such as a reliability improvement, which would provide benefits offsetting any rate increase. In many instances, all FERC-regulated electricity transactions are undertaken at “market-based” rates, and no hold-harmless commitment has typically been required with respect to this type of service.

Effective Date

The final policy statement, which had been pending for more than a year, provides significant additional certainty regarding the nature of the costs that cannot be passed to ratepayers and the controls necessary to ensure the hold-harmless commitment is implemented.

The policy statement will go into effect for new applications under section 203 of the Federal Power Act filed on or after 90 days after the publication of the policy in the Federal Register.