REGULATORY AND HISTORICAL BACKGROUND

The electric industry has undergone dramatic changes in the recent years. Electric utilities were once heavily regulated, vertically integrated monopolies. However, competition is emerging in the industry.

At the federal level, electricity is regulated by the Federal Energy Regulatory Commission ("FERC"). FERC approves rates for wholesale electric sales of electricity and transmission in interstate commerce for private utilities, power marketers, power pools, power exchanges and independent system operators. FERC acts under the legal authority of the Federal Power Act (FPA) of 1935, the Public Utility Regulatory Policies Act (PURPA), and the Energy Policy Act (EPAct). FERC oversees the issuance of certain stock and debt securities, assumption of obligations and liabilities, and mergers. FERC reviews the holding of officer and director positions between top officials in utilities and certain other firms they do business with. Finally, FERC reviews rates set by the federal power marketing administrations, such as the Bonneville Power Administration, confers exempt wholesale generator status under the EPAct, and certifies qualifying small power production and cogeneration facilities.

The federal government also engages in regulatory oversight over the electric power industry though the Environmental Protection Agency ("EPA") and the Nuclear Regulatory Commission ("NRC"). The Federal EPA oversees generation facilities by implementation of the provisions of Title IV of the Clean Air Act. The NRC licenses the construction and operation of nuclear power plants and fuel cycle facilities, inspects licensed nuclear facilities, oversees the decommissioning of nuclear facilities, and enforces the provisions of nuclear licenses.

In its infancy, commercial use of electricity by the general public was primarily for lighting purposes, and electricity competed with gas lighting. In the early 1990s, there were many private companies that set up to provide electric lighting for streets, theatres and galleries. In larger cities, it was not uncommon for more than one electric company to exist, with multiple sets of poles and wires along streets to deliver power to customers. As technology progressed, large centralized power plants emerged as the most efficient and inexpensive means for generating electric power. Large power generating plants, integrated with transmission and distribution systems, achieved better economies of scale and had lower operating costs than relatively smaller plants. Eventually, the electric industry aligned itself based on the concept that the most efficient structure derived from a central source of generation, supported by a single set of transmission and distribution assets. Since this structure is naturally monopolistic, to protect consumers from potential monopolistic abuses, federal and state regulatory bodies were created to oversee the operating procedures and prices of utilities. In the early 1900s states began to regulate the privately owned electric utilities. Georgia, New York, and Wisconsin established state public service commissions in 1907, followed shortly by more than 20 other states. The traditional regulatory structure of the electric power industry is based on the economic theory that both electric power production and transmission and distribution delivery are natural monopolies. State regulatory oversight was premised on protecting consumers and ensuring reliability, while providing a fair rate of return to the utility through cost-based regulation.

Mergers and consolidations in the early part of the twentieth century resulted in the creation of electric utility holding companies that ultimately controlled much of the industry. At their peak in the late 1920s, the 16 largest electric utility holding companies controlled more than 75 percent of all U.S. generation. Holding companies were originally formed to maximize the profitability and efficiency benefits deriving from the centralized ownership of the various utility service functions. However, through the ownership structures of their subsidiaries, each comprising of the various utility functions, the utility holding companies were able to avoid state regulation and exploit their monopoly status.

Due to abuses by holding companies and after several large holding company systems collapsed, the federal government intervened, which led to the passage of the Public Utility Holding Company Act of 1935 ("PUHCA"). The PUHCA subjected holding companies to regulation by the Securities and Exchange Commission, and further subjected utility functions engaging in the interstate sale or transmission of electricity to regulation by the Federal Power Commission, the predecessor to the present Federal Energy Regulatory Commission ("FERC"). Regulation of retail rates was subject to the jurisdiction of state commissions. For much of the twentieth century, this system of dual federal and state regulation set rates for electricity service under a traditional cost-based oversight model that permitted utilities to receive revenues to recover their cost of providing service, plus a return on capitol.

Several events that occurred over a relatively short time provided the impetus for change within the electric industry. These events included: (1) the passage of the Clean Air Act of 1970, and its amendments in 1977, that required utilities to reduce polluting emissions; (2) the Oil Embargo of 1973-74 that substantially increased fossil-fuel prices; (3) the Three Mile Island accident in 1979 that caused regulatory delays, increased costs, and greater uncertainty about nuclear electricity; and, (4) the slowing economy and increasing inflation of the 1970s that resulted in the tripling of interest rates. The influence of these events reversed the history of electricity prices in the United States, which has seen continuing declines in the real price of electricity due to greater economies of scale and scope for over fifty years. Between 1975 and 1985, residential and industrial electricity prices, rose 13 percent and 28 percent respectively in real terms. Also, delays in the completion of nuclear plant construction produced cost overruns over the projected initial costs of the plants. Significant differences in the prices for electricity, set using a cost-based regulatory model, began to appear between utilities.

The Oil Embargo of 1973-74 impelled the U.S. Congress to pass legislation designed to reduce U.S. dependence on foreign oil, develop renewable and alternative energy sources, encourage the efficient use of fossil fuels, and generally sustain economic growth. The National Energy Act ("NEA") is comprehensive energy legislation consisting of five separate statutes, which are: (1) The Public Utility Regulatory Policies Act ("PURPA"), (2) The Energy Tax Act, (3) The National Energy Conservation Policy Act, (4) The Power Plant and Industrial Fuel Use Act, and (5) The Natural Gas Policy Act. Generally, NEA's legislative policy was to ensure sustained economic growth while transitioning the nation's energy consumption from the availability of historically abundant and inexpensive energy resources to less abundant and more expensive energy resources. Although the NEA had numerous objectives, a primary goal was to develop alternative and renewable energy sources to reduce the United States' significant dependence on foreign oil and its associated vulnerability to interruptions in energy supply.

PURPA catalyzed competition in the electricity supply industry by permitting non-utility "Qualified Facilities ("QFs") to enter the wholesale power market. The policy goals of PURPA included encouraging the creation of non-utility generators and encouraging the efficient use of fossil fuels and renewable resources in electric power production through cogeneration and other small power producers. PURPA requires electric utilities to interconnect with and buy all available generated electricity that is offered for sale by non-utility generators that achieve the status of a Qualifying Facility ("QF"). To achieve QF status under PURPA, non-utility generating facilities must meet certain Federal Energy Regulatory Commission ("FERC") guidelines that concern, among others, ownership interests in the generating facility, operating and efficiency standards, and type of fuel used to generate electricity. Successful QF facilities refuted the theory that large, monopoly owned, central station power plants were the most economic.

The Energy Policy Act of 1992 ("EPACT") further advanced the growth of non-utility electric industry participants, by creating a new category of non-utility power producers identified as Exempt Wholesale Generators ("EWG"). EWGs are power producers that are exempt from PUHCA's corporate and geographic restrictions. Further, EWGs are wholesale electricity producers, in that they do not sell electricity directly to retail customers. Under the EPACT, FERC was authorized to permit EWGs to charge market-based rates. Also, unlike QF non-utility generators under PURPA, utilities are not obligated to buy the power produced by EWGs.

To support non-utility generators, EPACT also expanded FERC's authority to order vertically integrated IOUs to permit non-utility power producers to access the transmission grid to sell power in the open market. However, FERC's authority pursuant to EPACT to order utilities to grant transmission access to non-utilities was subject to case-by-case implementation, which was very slow. To remedy this slow implementation, and as a result of finding widespread discrimination among utilities in the voluntary provision of transmission access to third parties, FERC issued Order 888. Order 888 required all IOUs to file Open Access Transmission Tariffs ("OATTs") with provisions for universal access to the utilities' transmission system to all qualified users. The combination of open access to transmission service, coupled with the creation of EWGs stimulated the development and propagation of competitive wholesale power markets.

While competition was increasing at the wholesale level, wide disparities in retail rates still existed. This prompted some states to move towards permitting competition for retail customers to facilitate lower prices and greater choices in electricity services. As of July 1, 2000, 24 states and the District of Columbia had passed laws or issued regulatory orders to implement retail competition, and more are expected to follow. In Ohio, Amended Substitute Senate Bill 3 enacted retail competition, effective January 1, 2001. The introduction of wholesale and retail competition in the electric power industry has produced and is expected to continue to produce significant changes to operations and structure of the industry.