Utility Regulation: Opportunities Exist to Improve Oversight
Published: 2008-05-01T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Under the Public Utility Holding Company Act of 1935 (PUHCA 1935) and other laws, federal agencies and state commissions have traditionally regulated utilities to protect consumers from supply disruptions and unfair pricing. The Energy Policy Act of 2005 (EPAct) repealed PUHCA 1935, removing some limitations on the companies that could merge with or invest in utilities, and leaving the Federal Energy Regulatory Commission (FERC), which already regulated utilities, with primary federal responsibility for regulating them. Because of the potential for new mergers or acquisitions between utilities and companies previously restricted from investing in utilities, there has been considerable interest in whether cross-subsidization--unfairly passing on to consumers the cost of transactions between utility companies and their "affiliates"--could occur. GAO was asked to testify on its February 2008 report, Utility Oversight: Recent Changes in Law Call for Improved Vigilance by FERC (GAO-08-289), which (1) examined the extent to which FERC changed its merger review and post merger oversight since EPAct to protect against cross-subsidization and (2) surveyed state utility commissions about their oversight. In this report, GAO recommended that FERC adopt a risk-based approach to auditing and improve its audit reports, among other things. The FERC Chairman disagreed with the need for our recommendations, but GAO maintains that implementing them would improve oversight.
section_title: What GAO Found
paragraphs: In its February 2008 report, GAO reported that FERC had made few substantive changes to either its merger review process or its post merger oversight since EPAct and, as a result, does not have a strong basis for ensuring that harmful cross-subsidization does not occur. FERC officials told GAO that they plan to require merging companies to disclose any cross-subsidization and to certify in writing that they will not engage in unapproved cross-subsidization. After mergers have taken place, FERC intends to rely on its existing enforcement mechanisms--primarily companies' self-reporting noncompliance and a limited number of compliance audits--to detect potential cross-subsidization. FERC officials told us that they believe the threat of the large fines allowed under EPAct will encourage companies to investigate and self-report noncompliance. To augment self-reporting, FERC officials told us that, in 2008, they are using an informal plan to reallocate their limited audit staff to audit the affiliate transactions of 3 of the 36 holding companies it regulates. In planning these compliance audits, FERC officials told us that they do not formally consider companies' risk for noncompliance --a factor that financial auditors and other experts told us is an important consideration in allocating audit resources. Rather, they rely on informal discussions between senior FERC managers and staff. Moreover, we found that FERC's audit reporting approach results in audit reports that often lack a clear description of the audit objectives, scope, methodology, and findings--inhibiting their use to stakeholders. GAO's survey of state utility commissions found that states' views varied on their current regulatory capacities to review utility mergers and acquisitions and oversee affiliate transactions; however many states reported a need for additional resources, such as staff and funding, to respond to changes in oversight after the repeal of PUHCA 1935. All but a few states have the authority to approve mergers, but many states expressed concern about their ability to regulate the resulting companies. In recent years, two state commissions denied mergers, in part because of these concerns. Most states also have some type of authority to approve, review, and audit affiliate transactions, but many states review or audit only a small percentage of the transactions; 28 of the 49 states that responded to our survey question about auditing said they audited 1 percent or fewer transactions over the last five years. In addition, although almost all states reported that they had access to financial books and records from utilities to review affiliate transactions, many states reported they do not have such direct access to the books and records of holding companies or their affiliated companies. While EPAct provides state regulators the ability to obtain such information, some states expressed concern that this access could require them to be extremely specific in identifying needed information, thus potentially limiting their audit access. Finally, 22 of the 50 states that responded to our survey question about resources said that they need additional staffing or funding, or both, to respond to changes that resulted from EPAct, and 8 states have proposed or actually increased staffing since EPAct was enacted.

section_title: Letter
paragraphs: Thank you for the opportunity to discuss our work on federal and state  efforts to protect against potential cross-subsidization in the utility  industry after the repeal of the Public Utility Holding Company Act of 1935  (PUHCA 1935). Public utilities sell about $325 billion worth of electricity  and natural gas to more than 140 million customers in U.S. homes and  businesses each year. These utilities may face the need to invest  potentially hundreds of billions of dollars to expand and upgrade the  utility infrastructure over the next 10 years. Oversight of utilities is carried  out by the federal government and state commissions––with the federal  role focused on regulation of interstate transmission and wholesale  markets and the states’ role focused on regulating retail markets. These  federal and state regulators seek to balance efforts to protect utility  consumers from potential supply disruptions and unfair pricing practices  while ensuring that utilities are profitable enough to attract private  investment. Traditionally, this regulation took place within the framework  of PUHCA 1935 and other federal laws. In 2005, the Energy Policy Act  (EPAct) repealed PUHCA 1935, removing some limitations on the  companies that could merge with or invest in utilities and opening the  sector to new investment. The repeal of PUHCA 1935 has raised concerns  about whether the remaining laws and regulations strike an appropriate  balance between encouraging investment in the utility sector and  protecting consumers.
PUHCA 1935 was a response to the rapid expansion, consolidation, and  subsequent bankruptcies in the utility sector during the early part of the  20th century. Prior to its enactment, utilities were regulated by state  commissions. As utilities grew, they began to span across multiple states  that often had different rules and jurisdictional authority, making it  difficult for state utility commissions to effectively regulate them. By the  1920s, as a result of mergers and acquisitions, utilities were largely  controlled by a handful of complex corporations––called holding  companies––many of which owned several utilities as well as other  companies. In many cases, the companies within these holding  companies—called affiliates—sold a wide range of goods and services to  utilities, such as fuel for power plants. Since the rates utility customers  pay generally include the cost of all the goods and services bought to serve  them, some transactions between these affiliates allowed the utilities to  take advantage of economies of scale to the benefit of utility customers,  such as when utilities effectively shared the cost of legal and other  administrative services with affiliates instead of each company  maintaining staff and other resources to provide these services separately.
However, affiliate transactions that were priced unfairly could inflate  customers’ rates to subsidize operations outside the utility—called cross- subsidization. Compounding this complex web of corporate ownership  and affiliate transactions, poor disclosure of financial information and  limited access to financial records made it difficult for investors to  accurately assess the utilities’ financial health. Many of these holding  companies were involved in risky business ventures outside the utility  industry and had pledged utility assets to support those investments.  Partly as a result of the poor financial disclosure and the complex web of  corporate ownership and affiliate transactions, many utilities went into  bankruptcy during the financial collapse followed by the Great Depression.
To restore public confidence after the Depression, the federal government  undertook three efforts that influenced the regulation of utilities. First, to  protect investors, including utility investors, the federal government  created the Securities and Exchange Commission (SEC) in 1934. SEC  established rules––including improved financial reporting––for the  financial markets and publicly traded companies participating in those  markets, as well as a means to regulate them. Second, to protect utility  customers, the federal government enacted the Federal Power Act of 1935  which served, and continues to serve today, as the foundation of federal  regulatory authority related to regulation of public utilities, and  empowered the Federal Energy Regulatory Commission (FERC) to serve  as the primary federal regulator of utilities. As such, FERC became  responsible for overseeing interstate transmission of electricity, wholesale  sales of electricity to resellers (e.g., sales by utilities to other utilities), and  reviewing proposed mergers or acquisitions involving companies it  regulates. In its role of regulating interstate transmission and wholesale  sales, FERC has been responsible for approving prices (i.e., rates) for the  use of transmission lines and the sales of electricity in wholesale  markets—also commonly called “rate setting.” As part of that process,  FERC has determined which costs, including affiliate transaction costs,  may be lawfully included in rates. Third, the federal government enacted  PUHCA 1935 to regulate investment in the utility industry and protect  investors and consumers from potential abuses such as cross- subsidization by holding companies. SEC was responsible for  administering PUHCA, including reviewing mergers or acquisitions  involving holding companies. To that end, SEC was given primary  responsibility for examining and determining how to allocate affiliate  transaction costs for holding companies it regulates. Among other things,  PUHCA limited the formation of new holding companies that were not  physically connected by electric power lines, and prohibited existing  holding companies from acquiring more than one utility, unless the  utilities were physically connected by power lines. Over time, other  statutory and regulatory changes reduced some of the strict limitations  PUHCA 1935 initially imposed.
Over the past two decades, some interested parties in the utility industry  sought repeal of PUHCA 1935, arguing that it was a roadblock to the  private investment that could reduce the cost of improvements to the  utility infrastructure, and noting that several federal antitrust laws that  apply to utility companies have been passed since PUHCA was enacted.  Opponents of PUHCA 1935’s repeal, including some business and  consumer representatives, expressed concern that its repeal would  encourage utilities to return to the kinds of risky business ventures that  spawned it, and that utilities would again become too complex to  effectively regulate, potentially raising prices for consumers. Business  groups outside the utility industry were also concerned that utilities could  use their monopolies to cross-subsidize investments into other kinds of  businesses and harm competition in those industries.
In 2005, EPAct repealed PUHCA 1935––thereby opening the sector to new  investment––and replaced it with PUHCA 2005. The repeal of EPAct 1935  eliminated SEC’s oversight role in regulating utility holding companies or  preventing cross-subsidies, giving FERC new authorities to regulate  corporate structures and transactions. FERC’s expanded authorities fall  into two broad areas: 1) FERC was required to ensure at the point of the  merger review that the proposed merger would not result in harmful cross- subsidization, and 2) FERC became the principal federal agency  responsible for determining how costs for affiliate transactions should be  allocated for all utility holding companies. To help FERC better oversee  these transactions, EPAct provided FERC specific postmerger access to  the books, accounts, memos, and financial records of utility owners and  their affiliates and subsidiaries, and granted state utility commissions  similar access. Furthermore, EPAct expanded FERC’s civil penalty  authority to help it enforce its new requirements, providing the  commission the ability to levy penalties of up to $1 million per day per  violation. After EPAct, states continue to play key roles overseeing utilities  and reviewing mergers, including conducting some audits of affiliate  transactions.
My testimony today will focus on our February 2008 report, Utility  Oversight: Recent Changes in Law Call for Improved Vigilance by FERC  (GAO-08-289), which examined: (1) the extent to which FERC, since  EPAct’s enactment, has changed its merger or acquisition review process  and postmerger or acquisition oversight to ensure that potential harmful  cross-subsidization by utilities does not occur; and (2) the views of state  utility commissions regarding their current capacity, in terms of  regulations and resources, to oversee utilities. For that report, we  reviewed relevant reports and data, interviewed key officials, visited four  states––California, New Jersey, Oregon, and Wisconsin––that had or were  considering implementing strong protections for overseeing holding and  related affiliate companies, and surveyed state utility regulators in all 50  states and the District of Columbia. We performed our review from May  2006 through February 2008 in accordance with generally accepted  government auditing standards. Those standards require that we plan and  perform the audit to obtain sufficient, appropriate evidence to provide a  reasonable basis for our findings and conclusions based on our audit  objectives. We believe that the evidence obtained provides a reasonable  basis for our findings and conclusions based on our audit objectives.
In summary, we found:    FERC has made few substantive changes to either its merger review  process or its postmerger oversight since EPAct and, as a result, does not  have a strong basis for ensuring that harmful cross-subsidization does not  occur. FERC officials told us that they plan to require merging companies  to disclose existing or planned cross-subsidization and to certify in writing  that they will not engage in unapproved cross-subsidization. Once mergers  have taken place, FERC intends to rely on its existing enforcement  mechanisms—primarily companies’ self-reporting noncompliance and a  limited number of compliance audits—to detect potential cross- subsidization. FERC officials told us that they believe the threat of large  fines, as allowed by EPAct, will encourage companies to investigate and  self-report noncompliance. To augment self-reporting, FERC officials told  us that they are using an informal plan to reallocate their limited audit  staff to conduct affiliate transaction audits of 3 of the 36 holding  companies it regulates in 2008. In planning these compliance audits, FERC  officials told us that they do not formally consider companies’ risk for  noncompliance––a factor that financial auditors and other experts told us  is an important consideration in allocating audit resources––relying  instead on informal discussions between senior FERC managers and staff.  Moreover, we found that FERC’s audit reporting approach results in audit  reports that often lack a clear description of the audit objectives, scope,  methodology, and findings—inhibiting their use to stakeholders.
Although states’ views varied on their current regulatory capacities to  review utility mergers and acquisitions and oversee affiliate transactions,  many states reported a need for additional resources, such as staff and  funding, to respond to changes in oversight after the repeal of PUHCA  1935. All but a few states have merger approval authority, but many states  expressed concern about their ability to regulate the resulting companies  after merger approval. In recent years, two state commissions denied  mergers, in part because of these concerns. Most states also have some  type of authority to approve, review, and audit affiliate transactions, but  many states review or audit only a small percentage of the transactions,  with 28 of the 49 reporting states auditing 1 percent or less over the last  five years. In addition, although almost all states reported that they had  access to financial books and records from utilities to review affiliate  transactions, many states reported they do not have such direct access to  the books and records of holding companies or their affiliated companies.  While EPAct provides state regulators the ability to obtain such  information, some states expressed concern that this access could require  them to be extremely specific in identifying needed information, thus  potentially limiting their audit access. Finally, 22 of the 50 states that  responded to our survey question about resources said that they need  additional staffing or funding, or both, to respond to changes that resulted  from EPAct, and 8 states have proposed or actually increased staffing  since EPAct was enacted.
subsections: section_title: FERC’S Merger and Acquisition Review and Postmerger Oversight to Prevent Cross-subsidization in Utility Holding Company Systems Are Limited
paragraphs: In February 2008, we reported that FERC had made few substantive  changes to either its merger and acquisition review process or its  postmerger oversight as a consequence of its new responsibilities and, as a  result, does not have a strong basis for ensuring that harmful cross- subsidization does not occur. Specifically:  Reviewing mergers and acquisitions. FERC’s merger and acquisition  review relies primarily on company disclosures and commitments not to  cross-subsidize. FERC-regulated companies that are proposing to merge  with or acquire a regulated company must submit a public application for  FERC to review and approve. If cross-subsidies already exist or are  planned, companies are required to describe how these are in the public  interest by, for example identifying how the planned cross-subsidy  benefits utility ratepayers and does not harm others. FERC also requires  company officials to attest that they will not engage in unapproved cross- subsidies in the future. This information becomes part of a public record  that stakeholders or other interested parties, such as state regulators,  consumer advocates, or others may review and comment on, and FERC  may hold a public hearing on the merger. FERC officials told us that they  evaluate the information in the public record for the application and do  not collect evidence or conduct separate analyses of a proposed merger.  On the basis of this information, FERC officials told us that they determine  which, if any, existing or planned cross-subsidies to allow, then include  this information in detail in the final merger or acquisition order. Between  the time EPAct was enacted in 2005 and July 10, 2007––when FERC  provided detailed information to us––FERC had reviewed or was in the  process of reviewing 15 mergers, acquisitions, or sales of assets. FERC had  approved 12 mergers, although it approved three of these with conditions– –for example, requiring the merging parties to provide further evidence of  provisions to protect customers. Of the remaining three applications, one  application was withdrawn by the merging parties prior to FERC’s  decision and the other two were still pending.
Postmerger oversight. FERC’s postmerger oversight relies on its existing  enforcement mechanisms—primarily self-reporting and a limited number  of compliance audits. FERC indicates that it places great importance on  self-reporting because it believes companies can actively police their own  behavior through internal and external audits, and that the companies are  in the best position to detect and correct both inadvertent and intentional  noncompliance. FERC officials told us that they expect companies to  become more vigilant in monitoring their behavior because FERC can now  levy much larger fines––up to $1 million per day per violation––and that a  violating company’s actions in following this self-reporting policy, along  with the seriousness of a potential violation, help inform FERC’s decision  on the appropriate penalty. Key stakeholders have raised concerns that  internal company audits tend to focus on areas of highest risk to the  company profits and, as a result, may not focus specifically on affiliate  transactions. One company official noted that the threat of large fines may  “chill” companies’ willingness to self-report violations. Between the  enactment of EPAct––when Congress formally highlighted its concern  about cross-subsidization––and our February 2008 report, no companies  had self-reported any of these types of violations. To augment self- reporting, FERC plans to conduct a limited number of compliance audits  of holding companies each year, although at the time of our February 2008  report, it had not completed any audits to detect whether cross- subsidization is occurring. In 2008, FERC’s plans to audit 3 of the 36  companies it regulates—Exelon Corporation, Allegheny, Inc., and the  Southern Company. If this rate continues, it would take FERC 12 years to  audit each of these companies once, although FERC officials noted that  they plan audits one year at a time and that the number of audits may  change in future years.
We found that FERC does not use a formal risk-based approach to plan its  compliance audits––a factor that financial auditors and other experts told  us is an important consideration in allocating audit resources. Instead,  FERC officials plan audits based on informal discussions between FERC’s  Office of Enforcement, including its Division of Audits, and relevant FERC  offices with related expertise. To obtain a more complete picture of risk,  FERC could more actively monitor company-specific data––something it  currently does not do. In addition, we found that FERC’s postmerger audit  reports on affiliate transactions often lack clear information––that they  may not always fully reflect key elements such as objectives, scope,  methodology, and the specific audit findings, and sometimes lacked key  information, such as the type, number, and value of affiliate transactions at  the company involved, the percentage of all affiliate transactions tested,  and the test results. Without this information, these audit reports are of  limited use in assessing the risk that affiliate transactions pose for utility  customers, shareholders, bondholders, and other stakeholders.
In our February 2008 report, we recommended that the Chairman of the  Federal Energy Regulatory Commission (FERC) develop a comprehensive,  risk-based approach to planning audits of affiliate transactions to better  target FERC’s audit resources to highest priority needs. Specifically, we  recommended that FERC monitor the financial condition of utilities, as  some state regulators have found useful, by leveraging analyses done by  the financial market and developing a standard set of performance  indicators. In addition, we recommended that FERC develop a better  means of collaborating with state regulators to leverage audit resources  states have already applied to enforcement efforts and to capitalize on  state regulators’ unique knowledge. We also recommended that FERC  develop an audit reporting approach to clearly identify the objectives,  scope and methodology, and the specific findings of the audit to improve  public confidence in FERC’s enforcement functions and the usefulness of  its audit reports. The Chairman strongly disagreed with our overall  findings and the need for our recommendations; nonetheless, we maintain  that implementing our recommendations would enhance the effectiveness  of FERC’s oversight.
section_title: States Vary in Their Capacities to Oversee Utilities
paragraphs: States utility commissions’ views of their oversight capacities vary, but  many states foresee a need for additional resources to respond to changes  from EPAct. The survey we conducted for our February 2008 report  highlighted the following concerns:    Almost all states have merger approval authority, but many states  expressed concern about their ability to regulate the resulting  companies. All but 3 states (out of 50 responses) have authority to review  and either approve or disapprove mergers, but their authorities varied. For  example, one state could only disapprove a merger and, as such, allows a  merger by taking no action to disapprove it. State regulators reported  being mostly concerned about the impact of mergers on customer rates,  but 25 of 45 reporting states also noted concerns that the resulting,  potentially more complex company could be more difficult to regulate. In  recent years, the difficulty of regulating merged companies has been cited  by two state commissions––one in Montana and one in Oregon––that  denied proposed mergers in their states. For example, a state commission  official in Montana told us the commission denied a FERC-approved  merger in July 2007 that involved a Montana regulated utility, whose  headquarters was in South Dakota, which would have been bought by an  Australian holding company.
Most states have authorities over affiliate transactions, but many states  report auditing few transactions. Nationally, 49 states noted they have  some type of affiliate transaction authority, and while some states  reported that they require periodic, specialized audits of affiliate  transactions, 28 of the 49 reporting states reported auditing 1 percent or  fewer over the last five years. Audit authorities vary from prohibitions  against certain types of transactions to less restrictive requirements such  as allowance of a transaction without prior review, but authority to  disallow the transaction at a later time if it was deemed inappropriate.  Only 3 states reported that affiliate transactions always needed prior  commission approval. One attorney in a state utility commission noted  that holding company and affiliate transactions can be very complex and  time-consuming to review, and had concerns about having enough  resources to do this.
Some states report not having access to holding company books and  records. Although almost all states report they have access to financial  books and records from utilities to review affiliate transactions, many  states reported they do not have such direct access to the books and  records of holding companies or their affiliated companies. While EPAct  provides state regulators the ability to obtain such information, some  states expressed concern that this access could require them to be  extremely specific in identifying needed information, which may be  difficult. Lack of direct access, experts noted, may limit the effectiveness  of state commission oversight and result in harmful cross-subsidization  because the states cannot link financial risks associated with affiliated  companies to their regulated utility customers. All of the 49 states that  responded to this survey question noted that they require utilities to  provide financial reports, and 8 of these states require reports that also  include the holding company or both the holding company and the  affiliated companies.
States foresee needing additional resources to respond to the changes  from EPAct. Specifically, 22 of the 50 states that responded to our survey  said that they need additional staffing or funding, or both, to respond to  the changes that resulted from EPAct. Further, 6 out of 30 states raised  staffing as a key challenge in overseeing utilities since the passage of  EPAct, and 8 states have proposed or actually increased staffing.
In conclusion, the repeal of PUHCA 1935 opened the door for needed  investment in the utility industry; however, it comes at the potential cost  of complicating regulation of the industry. Further, the introduction of  new types of investors and different corporate combinations––including  the ownership of utilities by complex international companies, equity  firms, or other investors with different incentives than providing  traditional utility company services––could change the utility industry into  something quite different than the industry that FERC and the states have  overseen for decades. In light of these changes, we believe FERC should  err on the side of a “vigilance first” approach to preventing potential cross- subsidization. As FERC and states approve mergers, the responsibility for  ensuring that cross-subsidization will not occur shifts to FERC’s Office of  Enforcement and state commission staffs. Without a risk-based approach  to guide its audit planning––the active portion of its postmerger oversight– –FERC may be missing opportunities to demonstrate its commitment to  ensuring that companies are not engaged in cross-subsidization at the  expense of consumers and may not be using its audit resources in the  most efficient and effective manner. Without reassessing its merger review  and postmerger oversight, FERC may approve the formation of companies  that are difficult and costly for it and states to oversee and potentially  risky for consumers and the broader market. In addition, the lack of clear  information in audit reports not only limits their value to stakeholders, but  may undermine regulated companies’ efforts to understand the nature of  FERC’s oversight concerns and to conduct internal audits to identify  potential violations that are consistent with those conducted by FERC— key elements in improving their self-reporting. We continue to encourage  the FERC Chairman to consider our recommendations.
Mr. Chairman, this completes my prepared statement. I would be happy to  respond to any questions you or other Members of the Committee may  have at this time.
section_title: GAO Contact and Acknowledgments
paragraphs: Contact points for our Offices of Congressional Relations and Public  Affairs may be found on the last page of this testimony. For further  information about this testimony, please contact Mark Gaffigan at (202)  512-3841 or at gaffiganm@gao.gov. Individuals who contributed to this  statement include Dan Haas, Randy Jones, Jon Ludwigson, Alison O’Neill,  Anthony Padilla, and Barbara Timmerman.
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