ENERGY POLICY ACT OF 2005 - SELECTED ELECTRICITY PROVISIONS Gulf Coast Power Association Houston, Texas August 11, 2005

1. ENERGY POLICY ACT OF 2005 - SELECTED ELECTRICITY PROVISIONSGulf Coast Power AssociationHouston, TexasAugust 11, 2005 Kenneth G. Hurwitz, Esq. ken.hurwitz@haynesboone.com phone: (202) 654-4521 Haynes and Boone, LLP

2. Introduction to Energy Policy Act of 2005 - General • Most comprehensive piece of energy legislation (1,724 pages) ever passed by Congress. • Among other things it: • repeals the depression-era/New Deal Public Utility Holding Company Act • adds several important new provisions to the depression-era/New Deal Natural Gas Act and Federal Power Act • strengthens the protections afforded the nuclear industry in the Price-Anderson Act of the early 1950s • overhauls the Carter-era Public Utility Regulatory Policies Act of 1978 and other Carter-era energy conservation legislation • Overall emphasis is on stimulating suppliers of energy by providing tax incentives and other subsidies and, where applicable, streamlining regulatory review • With few exceptions, eschews new “command and control” mechanisms

3. Introduction to Energy Policy Act of 2005 – General (cont. 2) • Among the tax incentives and subsidies: • NUCLEAR – government funded risk insurance will be created to cover certain permitting and construction delays for the first six new nuclear power reactors • HYDROGEN – $1.25 billion will be made available to fund construction of the “next generation power plant” to produce hydrogen fuel from nuclear energy • RENEWABLES – Tax credits for renewable energy facilities will be expanded and extended • MORE RENEWABLES – Loan guarantees will be available for certain renewable energy technologies • CLEAN COAL – Tax credits and loan guarantees will be available for the development of certain clean coal and emissions technologies

4. Introduction to Energy Policy Act of 2005 – Electricity Title • The Electricity Modernization Act of 2005 • 10 Subtitles – A through J: • Reliability Standards ** • Transmission Infrastructure Modernization ** • Transmission Operation Improvements • Transmission Rate Reform ** • Amendments to PURPA ** • Repeal of PUHCA • Market Transparency, Enforcement, and Consumer Protection • Definitions • Technical and Conforming Amendments • Economic Dispatch • Presentation will cover asterisked Subtitles or subparts thereof • Reliability Standards and Amendments to PURPA apply in ERCOT

5. PURPA Reform and Selective Repeal

6. What’s Gone? What’s New?Overview of PURPA Modifications • What’s Gone? • The 50 percent utility ownership limitation • The unconditional mandatory purchase obligation, except for existing contracts with existing QFs • SPPs and a new category of “Super Cogen-QFs” are eligible for qualified purchase obligation in non-competitive markets • What’s New? • Just like under the 1978 version of PURPA, State regulatory authorities must consider and reach a determination on whether to adopt four separate ratemaking, fuel and metering standards

7. Why are the Act’s PURPA Reform Provisions Important? • The QF changes: • Limit the ability of new SPPs and “Super-QF Cogens” to force electric utilities to purchase their output, making obtaining financing more challenging. This change: • Ends the heyday of long term PPAs at projected avoided cost rates • Could negatively affect development of intermittent facilities, such as wind, except in states with non-competitive wholesale markets and/or mandatory portfolio standards with teeth • Allow utilities to buy existing QFs “with impunity” (elimination of 50% electric utility ownership restriction) • As before the Act, utilities continue to have an incentive to try to bust above-market contracts with QFs • Now utility affiliates have an opportunity to buy QFs and maintain existing PPAs (See slide 11) • A retail electric provider could be subject to a host of new state standards

8. What is a “Super-Cogen QF”? • Short Answer: One that meets new FERC “get real” criteria and therefore qualifies for the New Weak PURPA “Put” • FERC is required to revise the criteria (in 18 C.F.R. 292.205 – operating and efficiency standards) for new QFs to ensure: • that the thermal energy output of a new qualifying cogeneration facility is used in a productive and beneficial manner • that the electrical, thermal, and chemical output of the cogeneration facility is used fundamentally for industrial, commercial, or institutional purposes and is not intended fundamentally for sale to an electric utility • (taking into account technological, efficiency, economic, and variable thermal energy requirements, as well as State laws applicable to sales of electric energy from a qualifying facility to its host facility;) and • continuing progress in the development of efficient electric energy generating technology

9. The New Weak PURPA “Put” – A Bedrock Modification • The Act sets forth a revised requirement regarding the electric utility mandatory purchase obligation from QFs • Under the Act, new QF facilities are only eligible for the New Weak Put, and only if the QF is an SPP or a Super-Cogen QF • According to the Act, no electric utility shall be required to enter into a new contract or obligation to purchase electric energy from a QF if FERC finds that the QF has nondiscriminatory access to a competitive market. • The burden of proof is on the electric utility. The electric utility may file an application with the Commission for relief from the mandatory purchase obligation under one of the three competitive market criteria. In addition, the “put” can be reinstated upon application of the affected QF. • Even in non-competitive areas that are destined to fail the statutory test, the requirement could chill entry into long-term PPAs with electric utilities

10. What Constitutes a Competitive Market? • The Act sets forth 3 definitions of a competitive market: • [“DAY TWO” RTOs] “(A)(i) independently administered, auction-based day ahead and real time wholesale markets for the sale of electric energy; and (ii) wholesale markets for long-term sales of capacity and electric energy; or • [“DAY ONE” RTOs] (B)(i) transmission and interconnection services that are provided by a Commission-approved regional transmission entity and administered pursuant to an open access transmission tariff that affords nondiscriminatory treatment to all customers; and (ii) competitive wholesale markets that provide a meaningful opportunity to sell capacity, including long-term and short-term sales, and electric energy, including long-term, short-term and real-time sales, to buyers other than the utility to which the qualifying facility is interconnected. In determining whether a meaningful opportunity to sell exists, the Commission shall consider, among other factors, evidence of transactions within the relevant market; or • [BASKET CATEGORY] (C) wholesale markets for the sale of capacity and electric energy that are, at a minimum, of comparable competitive quality as markets described in subparagraphs (A) and (B)”

11. “Grandfathered” PURPA andPURPA Rules for Existing QFs • The old rules continue to apply, with the exception of the requirement that a QF must be at least 50%-owned by a person not primarily engaged in the generation or sale of electric power • In short, utilities can own (buy) existing (and new) QFs • QFs keep their exemptions from state regulation and the FPA • Existing cogeneration facilities must abide by the existing operating and efficiency standards (in 18 C.F.R. 292.205) • Upon the expiration of an existing contract, the mandatory purchase obligation expires for the QF if the utility operates in a competitive market • Existing rights of utility to recover costs of purchased energy and capacity from QFs are preserved

12. Cost Recovery Rule – An ImportantNew Provision that Benefits Utilities • The Act requires FERC to issue and enforce rules as are necessary to ensure • cost recovery by electric utilities of prudently incurred costs associated with purchase of capacity or energy • from qualifying cogeneration facility or qualifying small power production facility • These rules will apply across-the-board to new and existing QFs • Implications for stranded cost recovery proceedings

13. The Impact of PURPA Reform on Wind –The Put is “Blowing in the Wind” • The Act’s extension of the Production Tax Credit for two years is great, but … • Wind power is still in its relative infancy • The PURPA put was important historical force behind development of the QF industry and its elimination creates difficulties for wind • Wind units already confront difficulties not faced by other generating technologies in paying for transmission service • Balancing penalties for bilateral sales to buyers other than the directly connected utility or to day ahead markets (FERC has issued a NOPR to ease this problem) • Fixed charges for firm transmission service can be prohibitive • Because of New Weak PURPA Put, wind generators’ favored option – selling to the native utility at the point of interconnection – is compromised in competitive markets • Finding willing utility buyers could be difficult outside the 14 states with renewable portfolio standards

14. New § 111(d) Standards – The New 50 State“Traveling Road Show” – Procedural Requirements • The Act’s additions to PURPA’s § 111(d) will create a traveling road show, as regulators and nonregulated utilities in all 50 states will be required to consider four particular standards • Procedural requirements • Within 1 or 2 years (depending on the issue) of enactment, each state PUC and each nonregulated utility must commence consideration of these issues, and within 2 or 3 years must complete the consideration (or address them in a rate case one year later) • A State is not required to undertake consideration if it has implemented such a standard, it has conducted a proceeding to consider its implementation, or the State legislature has voted on the implementation of such a standard

15. Definitional Confusion in Amendments to PURPA § 111 • Before reviewing the amendments to PURPA § 111, it is important to understand how “electric utility” and “nonregulated electric utility” are defined in PURPA • Under § 3 of PURPA • “’electric utility’ means any person, State agency, or Federal agency, which sells electric energy” • “’nonregulated electric utility’ means any electric utility other than a State regulated electric utility” • PURPA § 111(a) (which was enacted in 1978) says • “Each State regulatory authority (with respect to each electric utility for which it has rate-making authority) and each nonregulated electric utility shall consider each standard establish by subsection (d) …” • In 1978, when there was no such thing as retail access, all this was clear • Today, however, read literally, the Act’s PURPA provisions would apply to third-party direct-access retail marketers • Did Congress really intend for the states to apply these provisions to retail electric providers?

16. 3 of the 4 Amendments to PURPA § 111(d) • Net metering • “Each electric utility shall make available upon request net metering service to any electric consumer that the electric utility serves” • Net metering is defined “during the applicable billing period” • Fuel sources • Each electric utility must shall develop a plan to minimize dependence on 1 fuel source and to ensure that the electric energy it sells is generated using a diverse range of fuels and technologies, including renewables • Each electric utility must develop a 10-year plan to increase the efficiency of its fossil fuel generation

17. The 4th Amendment to PURPA § 111(d) • Each electric utility must offer each of its customer classes and individual customers a time-based rate schedule under which the utility’s rate varies during different time periods and reflects the variance, if any, in the utility's costs of generating and purchasing electricity at wholesale. Time-based rate schedules include “among others”: • Not changing more often than twice a year • Critical peak pricing • Real time pricing • Credits under “pre-established peak load reduction agreements that reduce a utility’s planned capacity obligations” • Each electric utility must provide a customer requesting a time-based rate with a time-based meter • In a State with retail access, customers of “third-party marketers … shall be entitled to receive the same time-based metering and communications device and service as a retail electric consumer of the electric utility” • NOTE: “receive” from whom? the utility or the third-party marketer?

18. Clean Renewable Energy Bonds - “CREBs” • An interesting feature of the Act is a provision which allows certain electric cooperatives and state and local governments to issue “clean renewable energy bonds.” These bonds are referred to by the acronym “CREBs”, and can be used to finance investment in certain types of electricity generation projects. • Unlike with traditional bonds, the holder of a CREB receives payment of “interest” in the form of nonrefundable tax credits instead of cash. (Bond principal is repaid in cash.) • To qualify as a CREB, a bond must be issued by a mutual or cooperative electricity company or governmental body, and at least 95% of the bond issue proceeds must be used to finance capital expenditures incurred with respect to certain generation facilities that qualify for the renewable energy electricity production tax credit. • Thus, in general, these bonds may be used by the issuers to finance wind energy facilities, closed- and open-loop biomass facilities, geothermal energy facilities, solar energy facilities, small irrigation power facilities, landfill gas facilities, and trash combustion facilities which generate electricity.

19. Reliability Provisions

20. Reliability Provisions - Overview • The Act adds a new Section 215 to the Federal Power Act imposing mandatory reliability standards on owners, operators and users of the bulk power system • Reliability Provisions – Applicability – the Continental United States • including ERCOT and non-ERCOT portions of Texas • Canada and Mexico by Treaty • President is urged to negotiate international treaty with Canada and Mexico to extend reliability standards to apply there • Provisions empower FERC to certify an Electric Reliability Organization (“ERO”) which will develop and enforce reliability standards with FERC oversight • Widely believed and accepted that ERO will be North American Electric Reliability Council (“NERC”)

21. Reliability Provisions – Why Should I Care? • If you’re a Washington lawyer, there will be several new bureaucracies to contend with. (This is always exciting news for Washington lawyers.) • If you’re a Texas lawyer, note that the Reliability Provisions apply in the Continental United States, including the ERCOT and non-ERCOT areas of Texas. • If you’re from a company that owns generators, or from another type of company that uses the transmission system, such as a retail electric provider, or even a municipal or an electric cooperative, your company might now come under FERC’s reliability jurisdiction. • i.e., subject to reliability standards and penalties

22. Status Quo Ante – Federal Power Act –Post-Blackout Jurisdictional Grab • Federal Power Act did not allow FERC to impose a mandatory obligation to construct transmission lines or to impose reliability standards. • The closest the FPA came to such authority was in Section 207 which provides that, upon complaint of a state commission, if FERC finds that any interstate service is inadequate, it shall determine the appropriate service to be provided and “fix” the same by order • Nevertheless, as a constructive reaction to the August 2003 blackout, FERC attempted to push the envelope of its authority by imposing an obligation for jurisdictional utilities to comply with the NERC reliability standards • It did so under the “Good Utility Practice” provision of the pro forma Open Access Transmission Tariff • At the same time, FERC called upon Congress to enact a “clear Federal framework” allowing for the imposition of such standards • The jurisdictional basis for this action was weak

23. What is a Reliability Standard?(They’re Very Broad But Not All-Encompassing) • The term “reliability standard” means a requirement, approved by the Commission under FPA section 215, to provide for reliable operation of the bulk-power system • The term bulk-power system takes on an appropriately broad meaning including both transmission system network facilities and generation-based ancillary services needed to maintain reliability • Exclusions from definition/coverage of reliability standard • any requirement to enlarge bulk power system facilities or to construct new transmission or generation capacity • local distribution facilities

24. To Whom do the Reliability Standards Apply?(Who are the New Classes of “Victim”?) • Expanded scope of FERC reliability jurisdiction: • Expanded coverage of Reliability Standards • Owners, operators and users of the bulk power system • ERO • Regional entities • Implications • Conceptually could include large industrial customers interconnected with bulk power system and retail electric providers in competitive states • NERC Strawman No. 3 (August 4, 2005) (draft FERC rule to implement Section 215) excludes the large industrial customer but not the retail electric provider • All generators are now unambiguously included

25. What the Nation Needs is a New Bureaucracy -How Will the ERO be Established? • FERC to issue rule within 180 days of enactment – which occurred July 29, 2005 • Following issuance of rule, any person (read: “NERC”) may submit an application to FERC for certification as ERO. Such ERO must be independent from users, owners and operators of bulk power system and must satisfy other basic “due process” type standards • NERC, a voluntary organization to date run mainly by electric utilities, is in the process of internal reform to comply with these requirements • novel procedural requirements for NERC, which to date called itself a “voluntary organization relying on reciprocity, peer pressure and the mutual self-interest of all those involved” • traditional electric utilities were dominant • consensus, not “due process,” was the rule

26. Full Employment for Lawyers and Engineers:How Will Reliability Standards be Developed? • The procedural framework for development of reliability standards parallels the existing rate filing mechanisms under Federal Power Act • Three basic options: • ERO files proposed reliability standard with FERC • FERC applies just and reasonable, not unduly discriminatory or preferential and in public interest standard • FERC may remand to ERO any reliability standard that FERC disapproves in whole or in part • FERC may order ERO to submit a reliability standard that addresses a specific matter • In addition, a reliability standard can also be submitted by a regional entity (more on this later)

27. Full Employment for Lawyers and Engineers:How Will Reliability Standards be Enforced? • The ERO may impose penalties on any “user or owner or operator of the bulk power system” for violations of reliability standards, subject to review by FERC • The ERO must provide “notice and an opportunity for hearing” before levying a penalty • Note: ERO is not an agency or instrumentality of U.S. Government – Administrative Procedure Act does not apply! • Does the U.S. Constitution’s due process clause apply? • Penalties are subject to review by FERC with procedure analogous to appellate review (based on ERO written record) • FERC may impose penalties on its own motion or upon complaint • All penalties must fit the crime and must take into consideration efforts to remedy violation in a timely manner

28. A Washington Lawyer’s Dream – More Bureaucracy Still! – “Regional Entities” • The ERO may delegate authority to a regional entity for the purpose of proposing reliability standards to the ERO and enforcing reliability standards • A regional entity must • be governed by some combination of an independent board and/or a balanced stakeholder board • satisfy the same due process-type standards as the ERO • be organized on an Interconnection-wide basis • Who may qualify as a “regional entity”? • Logical answers include the existing Regional Reliability Councils and RTOs • However, NERC’s 8/4/05 Strawman No. 3 states that there are 3 Interconnections: the Eastern, Western and ERCOT. • Note that this interpretation would consolidate all of the 9 existing Eastern regional councils. • Present discussion among stakeholders suggests possibility that all 9 existing Eastern regional councils will be delegated authority as Regional Entities

29. “Hamilton, Jefferson and Electric Reliability” – Federalism Issues • States may still have a major role. But the dividing lines are unclear, inviting years of litigation to sort out inter-jurisdictional conflicts • The Act states: • Nothing in the reliability standards “preempt[s] any authority of any State to take action to ensure the safety, adequacy, and reliability of electric service within that State, as long as that action is not inconsistent with any reliability standard” • Overlapping jurisdiction – reliability or lack thereof always affects electric service within a state! • As stated above, the definition of “bulk power system” and therefore the coverage of reliability standards does not include local distribution facilities.

30. Conflicts between Reliability Standardsand Rules of Transmission Organization • All or most regional transmission organizations have reliability agreements or other mechanisms (tariffs, rules, etc.) that address reliability. • Potential for conflict between the reliability provisions of these agreements and reliability standards. • The Act requires FERC to address this subject in the reliability rule and incorporate fair processes for the identification and timely resolution of any conflict between a transmission organization rule and a reliability standard • Basically, FERC is authorized to consider changing the RTO rule or asking the ERO to modify the reliability standard; the RTO rule remains in place until any FERC-ordered change takes effect • In this respect the Act can be read not to apply to ERCOT, which makes sense, but the answer is not clear. FERC’s only option might be to modify the conflicting ERO reliability standard. • Alternatively, FERC might read the Act differently and assert jurisdiction to modify the ERCOT rule.

31. The Jurisdictional Picture on Reliability Standards Canadian Provinces; Mexico MOU FERC ERO States Regional Entities NAESB RTOs

32. Transmission Siting

33. What is an NIETC? • The backstop siting provisions are incorporated in a new Federal Power Act Section 216 • The first step in the backstop siting provisions is that the Secretary of Energy may designate as a National Interest Electric Transmission Corridor “any geographic area experiencing electric energy transmission capacity constraints or congestion that adversely affects consumers” • In deciding whether to make such a determination, the Secretary “may consider”: • the economic vitality and economic growth of the corridor or the end use markets served by the corridor • diversification of supply • energy independence, national energy policy, and national defense and homeland security

34. What May FERC Do in an NIETC? • FERC may issue permits for construction or modification of transmission facilities in an NIETC (if FERC determines that): There are problems within the relevant State. Specifically, if: • the State in which the transmission facilities are to be located lacks authority to approve the siting of the facilities or consider their interstate benefits; OR • the applicant does not qualify for a permit in the State because the applicant does not serve end-use customers in the State; OR • the State has withheld approval of the facilities for more than a year; OR • the State has conditioned its approval in such a way that construction or modification of the facilities will not “significantly reduce” congestion or is not economically feasible AND the proposed construction or modification is consistent with the public interest and meets other general standards (reduces transmission congestion, etc.) • Exception: Three or more contiguous States may form an interstate compact establishing a regional transmission siting agency that may not be overruled by FERC with respect to an NIETC project, unless the States disagree

35. What Other Incentives are There for Transmission? • FERC must establish “incentive-based (including performance-based) rate treatments” for transmission, including “a return on equity that attracts new investment in transmission facilities” • The “incentive-based rate” provision is vague as to the scope of its applicability and FERC will be left with responsibility to issue a rule, within a year of enactment, to administer it • FERC is required to “provide incentives to each transmitting utility or electric utility that joins [an RTO]” • The precise nature of the “incentives” is left to FERC • Prudently incurred costs to implement reliability standards are guaranteed recovery • The Act reduces the depreciable life for facilities “used in the transmission at 69 or more kilovolts of electricity for sale and the original use of which commences with the taxpayer after April 11, 2005” from 20 years to 15 • Permissive capital gain treatment for sales of transmission companies or facilities to independent transmission companies is extended for a year • A five-year net operating loss carryover is allowed for up to 20 percent of electric transmission property capital expenditures

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