Client Alert. In its Denial of a Power Plant Sale, FERC Sheds Light on the Meaning of Control and the Importance of Mitigation.

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1 Number 1492 March 26, 2013 Client Alert Latham & Watkins Finance Department In its Denial of a Power Plant Sale, FERC Sheds Light on the Meaning of Control and the Importance of Mitigation The decision marks a rare instance of FERC flatly rejecting a proposed sale of a power plant under Section 203 of the Federal Power Act and provides some insight as to what FERC considers to be sufficient mitigation when a proposed transaction raises horizontal market power concerns. On March 7, 2013, the Federal Energy Regulatory Commission (FERC) denied an application to approve MACH Gen, LLC s (MACH Gen) sale of a subsidiary owning the 1,054 MW Harquahala Facility in Arizona to Saddle Mountain Power, LLC (Saddle Mountain), a wholly-owned subsidiary of an investment fund managed by Wayzata Investment Partners, LLC (Wayzata). 1 The decision marks a rare instance of FERC flatly rejecting a proposed sale of a power plant under Section 203 of the Federal Power Act and provides some insight as to what FERC considers to be sufficient mitigation when a proposed transaction raises horizontal market power concerns. The Transaction The proposed transaction involved the sale to Saddle Mountain of New Harquahala Generating Company, LLC (New Harquahala), a wholly-owned subsidiary of MACH Gen that owns the Harquahala Facility, which is a natural gas-fired, combined-cycle generating facility located within the balancing area authority of the Arizona Public Service Company. Wayzata also indirectly owns two of the four natural gas-fired, combined-cycle generating units at the Gila River Facility in Gila Bend, Arizona with a combined summer rating of approximately 1,167 MW and located within the same balancing authority area as the Harquahala Facility. The proposed transaction would bring two facilities located in the same market under the control of the same upstream entity. FERC s Horizontal Market Power Analysis FERC s analysis of whether a proposed merger or acquisition involving jurisdictional facilities is consistent with the public interest and thus should be approved under Section 203 of the Federal Power Act includes a consideration of the effect the transaction will have on horizontal and vertical competition in the relevant market. 2 To evaluate the competitive effects of a proposed transaction, FERC uses a framework based on the US Department of Justice s and Federal Trade Commission s 1992 Horizontal Merger Guidelines (Merger Guidelines), which measure market concentration using the Herfindahl-Hirschman Index (HHI). 3 As Latham & Watkins operates worldwide as a limited liability partnership organized under the laws of the State of Delaware (USA) with affiliated limited liability partnerships conducting the practice in the United Kingdom, France, Italy and Singapore and as affiliated partnerships conducting the practice in Hong Kong and Japan. Latham & Watkins practices in Saudi Arabia in association with the Law Office of Salman M. Al-Sudairi. In Qatar, Latham & Watkins LLP is licensed by the Qatar Financial Centre Authority. Under New York s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New York s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY , Phone: Copyright 2013 Latham & Watkins. All Rights Reserved.

2 part of this framework, FERC adopted an analytic screen known as the Competitive Analysis Screen, or Appendix A analysis, that focuses on whether the transaction would significantly increase concentration in relevant markets. 4 This screen analysis includes a delivered price test (DPT), which is used to measure the capacity that can reach a given market at a price no higher than 105 percent of the destination market price. 5 FERC reviews the HHI calculations and compares them to the thresholds set forth in the Merger Guidelines. 6 If a proposed transaction passes the Competitive Analysis Screen, then it is deemed not to raise horizontal market power concerns. However, if the HHI calculations exceed certain thresholds, indicating that the proposed transaction will significantly increase market concentration, then applicants must either provide additional analysis to show that there are no market power concerns or propose mitigation measures. The Application As set forth in the application, the proposed transaction did not pass FERC s Competitive Analysis Screen. Of the ten periods analyzed in the DPT, the Harquahala and Gila River Facilities were economic during only seven of those periods, meaning that the two facilities would only run during seven of the ten periods analyzed. For each of those seven periods, the proposed transaction failed every screen. Given these screen violations, the applicants proposed a mitigation plan including an Energy Management Agreement (EMA) that would relinquish control of all available capacity and the authority to dispatch the Harquahala Facility to Twin Eagle Resources Management, LLC (Twin Eagle) on a rolling 12-month basis. Under the EMA, Twin Eagle would be responsible for economic dispatch, marketing, and execution of short-term transactions for capacity and related energy products, scheduling transmission, administering settlement and payment for its transactions, procuring fuel, and scheduling and tagging power. Additionally, Twin Eagle would only provide to New Harquahala summaries of revenue and expenses and forward commitment reports related to capacity commitments, market-to-market exposure and credit requirements. The applicants argued that New Harquahala would therefore not have any material, non-public information when such information would provide a market advantage. The applicants also proposed that New Harquahala would commit only to enter into long-term agreements for energy or capacity for the Harquahala Facility commencing at least one year after the execution of such an agreement and to submit these agreements for FERC s approval. Based on this mitigation plan, the applicants claimed that Twin Eagle would control the Harquahala Facility for market power purposes and thus alleviate any competitive issues. FERC s Decision FERC found the proposed mitigation plan insufficient and denied the application without prejudice so that the parties may re-file with an alternative mitigation plan. In doing so, FERC relied on its prior statements that energy management and comparable agreements do not necessarily convey unlimited discretion and control away from the entity that owns the plant and that instead, it is the totality of the circumstances that will determine which entity controls a specific asset. 7 Based on this totality of the circumstances standard, FERC found that New Harquahala retained a significant element of control over the Harquahala Facility 2 Number 1492 March 26, 2013

3 under the proposed EMA. 8 For example, under the EMA, Twin Eagle had to follow a detailed methodology for dispatching the Harquahala Facility from which it had little discretion to deviate. Additionally, New Harquahala would still establish the Harquahala Facility s operating limits, dispatch and efficiency curves, and operating costs. It would also retain responsibility for the operation and maintenance of the Harquahala Facility. Under these conditions, FERC found that New Harquahala would have advance knowledge of the short-term marketing strategy of the generation output of the Harquahala Facility and could use that information to withhold output from the Gila River Facility or to dispatch it at a higher price than what would result from a competitive process in order to maximize Wayzata s overall profits. FERC noted that the Harquahala and Gila River Facilities both use similar generation (i.e., combinedcycle, natural gas-fired turbines) that have similar dispatch costs and become available at similar points on the generation supply curve. FERC also expressed concern with the fact that New Harquahala retained the right to enter into long-term contracts for sales from the Harquahala Facility. FERC found that [i]f the facility can still be marketed for sales by New Harquahala, then it is still under New Harquahala s control to some degree and should properly be attributed to New Harquahala. 9 FERC underscored this concern, stating that Applicants cannot credibly argue that the Harquahala Facility will be under someone else s control when New Harquahala reserves the right to control the facility itself for purposes of marketing it for long-term sales. 10 FERC made no express statement as to what form of mitigation might suffice under these circumstances. Key Take-Aways Screen violations are critical. The proposed Harquahala transaction raised numerous red flags with respect to its effects on horizontal competition. FERC found that not only would the transaction have significantly increased market concentration, it would have done so in a market that was already concentrated. This case provides an example of FERC s willingness simply to deny an application that raises market power issues if FERC considers the proposed mitigation insufficient. EMAs do not necessarily relinquish control. FERC takes into account the totality of the circumstances in determining which party retains control of a generating facility in light of an EMA. The mere existence of an EMA does not mean that the associated generation is not attributable to the owner for purposes of analyzing the competitive effects of a proposed transaction. To be an effective form of mitigation, an EMA should be carefully tailored so as to minimize the plant owner s knowledge of how the plant s output will be marketed. Rigid marketing methodologies and the owner s involvement in the operations of the plant both suggest that the owner might retain some control or access to material information about the operation of the facility. Control over long-term contracting may indicate control for Section 203 purposes. Even though the applicants proposed requiring that long-term contracts be subject to FERC approval, FERC found that New Harquahala s ability to enter into longterm contracts for sales from the plant meant that it retained significant control over the output of the Harquahala Facility. Retaining this limited type of control, even when subject to FERC approval, may not to be an effective way to offset market power concerns associated with a transaction. 3 Number 1492 March 26, 2013

4 Endnotes 1 MACH Gen, LLC 142 FERC 61,178 (2013) (hereinafter MACH Gen ). 2 Inquiry Concerning the Commission s Merger Policy Under the Federal Power Act: Policy Statement, Order No. 592, FERC Stats. & Regs. 31,044 at 30,111 (1996) (Merger Policy Statement), reconsideration denied, Order No. 592-A, 79 FERC 61,321 (1997); see also FPA Section 203 Supplemental Policy Statement, FERC Stats. & Regs. 31,253 (2007); see also Analysis of Horizontal Market Power under the Federal Power Act, Order Reaffirming Commission Policy and Terminating Proceeding, 138 FERC 61,109 (2012) (affirming the Commission s use of the thresholds adopted in the Merger Policy Statement). 3 See Merger Policy Statement, FERC Stats. & Regs. 31,044 at 30,118, 30, Merger Policy Statement, FERC Stats. & Regs. 31,044 at 30,119-20, 30, See 18 C.F.R. 33.3(c)(4). Specifically, the DPT is used to measure Economic Capacity and Available Economic Capacity. Economic Capacity is defined as energy that can be delivered into a destination market at a delivered cost that is less than 105 percent of the destination market price. Available Economic Capacity is the Economic Capacity in excess of the generating capacity needed to serve native load commitments. See 18 C.F.R. 33.3(c)(4)(i)(A) and (B). 6 Merger Policy Statement, FERC Stats. & Regs. 31,044 at 30,119-20, 30, MACH Gen at P 29 (citing Market-Based Rates for Wholesale Sales of Electric Energy, Capacity and Ancillary Services by Public Utilities, Order No. 697, FERC Stats. & Regs. 31,252 at P 197, clarified, 121 FERC 61,260 (2007), order on reh g, Order No. 697-A, FERC Stats. & Regs. 31,268, clarified, 124 FERC 61,055, order on reh g, Order No. 697-B, FERC Stats. & Regs. 31,285 (2008), order on reh g, Order No. 697-C, FERC Stats. & Regs. 31,291 (2009), order on reh g, Order No. 697-D, FERC Stats. & Regs. 31,305 (2010), aff d sub nom. Montana Consumer Counsel v. FERC, 659 F.3d 910 (9th Cir. 2011), cert. denied sub nom. Pub. Citizen, Inc. v. FERC, 133 S. Ct. 26 (2012). 8 MACH Gen at P MACH Gen at P MACH Gen at P Number 1492 March 26, 2013

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