Overlooked Transmission Sector Drawing New Investment

By M. Douglas Dunn and Robert B. Williams, Milbank

RECENT DEVELOPMENTS INVOLVING ELECTRICITY transmission demonstrate that this long overlooked sector is becoming the focus of new infrastructure investment, targeting traditional utilities, independent transmission companies and joint ventures, and leading to an increase in mergers and acquisitions. This follows enactment of the Energy Policy Act of 2005 ("EPAct 2005"), which includes provisions designed to promote transmission investment and improve reliability of the nation's electric transmission grid. In response to EPAct 2005 – and such fundamental concerns as congestion, declining reserve margins and aging infrastructure – electric transmission is poised for a renaissance.

In response to EPAct 2005, the Federal Energy Regulatory Commission ("FERC") has established rules allowing incentive-based rate treatments for utilities and transmission project developers, and transmission owners are increasing their attention to grid reliability as mandatory standards replace the prior voluntary regime. EPAct 2005 also provides tax incentives for needed transmission investments. Incentives include accelerated depreciation for new investment and deferral of taxable gain for utilities transferring transmission assets to an independent transmission company. And by repealing the Public Utility Holding Company Act of 1935, EPAct 2005 removed a long-standing regulatory barrier to the entry of new companies and business models in the power transmission sector. EPAct 2005 also indirectly encourages transmission investments by extending tax credits for renewable and geothermal energy, causing a boom in development. These often remote projects require new transmission lines to bring power sources to market.

In response, traditional investor-owned electric utilities, as well as cooperative and government-owned utilities, are planning new transmission projects. New players are also entering the transmission business, including stand-alone transmission companies and special purpose transmission companies proposing to develop discrete projects under a "project finance" structure. In each case, industry players are seeking the most efficient ways to structure and finance the expected wave of investment necessary to upgrade the U.S. power transmission system. Congress' efforts to spur transmission investment through EPAct 2005 are beginning to work. This article describes recent developments involving new transmission investment and mergers and acquisitions.

Stand-Alone Transmission

The stand-alone transmission sector is still in its infancy, although many industry and financial players are looking seriously at entering this space. The only publicly traded and independently owned, stand-alone transmission company is ITC Holdings Corp. ("ITC") which went public in July, 2005. ITC's existing operating subsidiaries, ITCTransmission and Michigan Electric Transmission Company ("METC"), together own the majority of the high-voltage transmission system in Michigan's Lower Peninsula. ITC recently signed an agreement to acquire for $750 million the electric transmission assets of Interstate Power and Light Company ("IP&L"), a subsidiary of Wisconsin based Alliant Energy. ITC is currently the largest independent transmission company in the U.S., and after the acquisition is expected to be the sixth largest electric transmission company based on transmission load served.

ITC's proposed acquisition of IP&L's transmission assets follows closely ITC's October, 2006, acquisition of METC, the former Consumers Energy transmission system, for $866 million, which nearly doubled ITC's transmission load and more than tripled its owned transmission miles. Both Michigan legislation and FERC policy promoted independent transmission. Private equity players provided the initial financing for METC and ITC: Kohlberg, Kravis, Roberts & Co., Trimaran Capital Partners and CIBC backed ITC, while GFI Energy Ventures, affiliates of Evercore, Macquaries and other private investors provided financing to METC. Independent transmission attracted private equity players due to the steady returns and the potential for increased equity value resulting from FERC's rate incentives for the formation of independent stand-alone transmission companies, including upward adjustment to return on equity and the use of a hypothetical capital structure more heavily weighted toward equity.

ITC's operating subsidiaries have common characteristics: the need for investment to improve and expand the existing transmission system to support reliability and economic growth, membership in the Midwest Independent System Operator, or MISO, and being subject to rate regulation by FERC. In contrast to state regulated utilities, which must seek to recover investments through traditional rate cases that lead to regulatory lag and uncertainty as to cost recovery, rates for MISO members are determined using a FERC-approved rate formula known as Attachment O, which allows for automatic annual rate adjustments without the need to file a rate case at FERC. The combination of needed investment, FERC rate incentives, and a predictable rate recovery mechanism are attractive attributes to growth oriented investors.

American Transmission Co. ("ATC"), a Wisconsin based stand-alone transmission company and MISO member serving Wisconsin and Michigan's Upper Peninsula, is the other major company in the stand-alone transmission space. Unlike ITC, ATC is a private entity owned by IOUs, municipalities and electric cooperatives that invested transmission assets for an ownership stake in ATC. ATC also plans additional investment in transmission in the coming years. Having invested over $1 billion in the transmission grid in its service territory over the last five years, ATC plans to invest up to $3 billion over the next ten years.

Transmission Developments Involving Vertically-Integrated Utilities

EPAct 2005 incentives have also spurred transmission investment by traditional utilities, either on their own or in alliances with others. For example, FERC has granted transmission rate incentives to American Electric Power Company ("AEP") and Allegheny Energy, Inc. for the development of large, high voltage, multi-state transmission projects, and recently granted rate incentives for Duquesne Light Company's proposal to build high voltage transmission to enhance reliability of transmission service to the City of Pittsburgh and surrounding areas. FERC's transmission rate incentives may include higher return on equity, full recovery of prudently incurred construction work in progress, pre-operation costs and costs of abandoned facilities, use of hypothetical capital structures and accelerated depreciation.

In addition, in November 2006, AEP announced a partnership with Warren Buffet's MidAmerican Energy Holdings to focus on the development of large transmission projects. AEP, the largest transmission owner in the U.S., has planned an additional $2.1 billion of transmission expenditures through 2009 to improve the robustness of the transmission grid in AEP's service territory. Rather than go it alone, AEP formed a joint venture with MidAmerican to build and own transmission assets in the region covered by the Electric Reliability Counsel of Texas, or ERCOT. AEP plans to contribute to the joint venture Texas transmission assets valued at approximately $150 million, and a MidAmerican subsidiary will make a cash contribution to the joint venture, which anticipates that up to $1 billion of transmission projects could be undertaken by the joint venture over the next several years. The joint venture structure allows much needed investment in transmission while sharing risk and attracting capital to transmission specific investments.

Why a joint venture rather than a go it alone strategy? Based on statements by AEP personnel, AEP saw an opportunity for significant incremental investment in transmission, above and beyond planned capital expenditures outlined to the investment community and rating agencies. By partnering with MidAmerican, AEP gained a venture partner with a strong balance sheet, a desire to invest in transmission assets and familiarity with the regulatory process. MidAmerican is also a long term investor. According to AEP, many financial players sought to participate in the joint venture, but AEP chose MidAmerican based on it's financial strength and industry knowledge.

Also in November, 2006, AEP signed a Memorandum of Understanding with ITCTransmission to complete a "technical study" to evaluate the feasibility of extending AEP's 765-kV transmission infrastructure through Michigan's Lower Peninsula. The purpose of the expansion would be to improve reliability and support a competitive market for energy supply. The study is expected to take up to a year, after which a determination will be made regarding additional investment.

Project Financed Transmission

Another significant development involving transmission is "merchant transmission," or project financed transmission investments. Unlike joint ventures among established electric utilities or stand-alone transmission companies, merchant transmission projects are organized as special-purpose entities owning only a single power transmission asset and are financed with non-recourse debt. This is essentially the same business model that has been used to develop merchant generation projects, PURPA qualifying facilities, and capital intensive discrete projects such as pipelines and toll roads.

Although numerous merchant transmission projects have been announced, the record of success has been modest to date. The 330 MW Cross Sound Cable project, linking Connecticut with Long Island, was the first merchant transmission project to be completed, but its history of permitting difficulties has served more as a cautionary tale than as a role model. At the present time, the 665 MW Neptune Regional Transmission System, linking Sayreville, New Jersey with southern Long Island, is under construction, with commercial operation expected to occur in the summer of 2007. On the west coast, the 550 MW Juan de Fuca Cable Project, which will link Vancouver Island with Washington State's Olympic Peninsula, is nearing permit completion. The 400 MW Trans Bay Cable Project, which would link San Francisco with Pittsburg, California, is also undergoing permitting. Other projects are under development.

These merchant transmission projects, not coincidentally, all use direct current technology and all follow underwater routes. Direct current technology allows for precise control of power flows on the line, which is necessary for the project to obtain long-term contractual commitments from credit-worthy customers, which contracts, in turn, are necessary for obtaining the debt financing needed to construct and maintain the project. The underwater routes are indicative of difficulties in obtaining rights of way on the part of special purpose companies without the eminent domain authority of a franchised utility. Backstop transmission siting authority granted to FERC by EPAct 2005 may ultimately provide relief to merchant transmission projects. At the present time, however, siting and permitting problems, coupled with financing difficulties, have proven challenging for such projects. If these challenges can be addressed, the role of merchant transmission in strengthening our nation's infrastructure may yet be realized.

Conclusion

The nation's electric transmission system has long been overlooked because of the focus on local delivery of electricity to customers. Transmission was not managed to provide shareholder value. With generation now separated from distribution in many areas of the country, remote generation resources on the rise, attention to grid reliability increasing, and with the implementation of rate incentives due to EPAct 2005 and FERC's rules, the spotlight is on transmission investment. Happily, non-traditional sources of capital, such as private equity and infrastructure and hedge funds, now target transmission investment. The proposed buyout of TXU Corp. demonstrates the depth of capital in the hands of private equity players willing to invest in the utility space. These sources of capital will support industry consolidation. More broadly, the need for the efficient operation of segmented utility businesses and the need for significant transmission investment are likely to lead to even broader utility industry consolidation.