In August, the District of Columbia Public Service Commission sent shockwaves through the electricity sector when it rejected the merger that would have created the nation’s largest utility at the final hurdle.

Regulators announced that they would block the proposed $6.8 billion acquisition of Pepco Holdings, a major Mid-Atlantic utility, by Chicago-based utility giant Exelon Corp., though it had already been approved by four states and federal energy regulators.

In their decision, regulators cited what they called an “inherent conflict of interest” between Exelon’s business model — especially its possession of a large generation fleet that competes in wholesale markets — and the city’s clean energy goals.

In particular, they wrote that the utility’s generation portfolio could lead it to favor building or buying power from large, centralized plants, rather than considering the deployment of distributed resources and demand-side management tools on an equal footing. Regulators worried that financial risks from Exelon’s generation fleet — including a number of older plants on the verge of being uneconomic — could bleed over into Pepco’s practices, leading the company to balance its books on the backs of D.C. ratepayers.

Those concerns, along with fears that the merged company would be too large and powerful for regulators to control, closely followed what local anti-merger activists have been saying about the merger since it was proposed about a year ago. But in their unanimous decision, D.C. regulators also noted that they had been presented with no settlement deal that satisfied many of the merger intervenors — seemingly opening the door for the companies to negotiate with the involved parties and present an improved proposal on appeal.

Exelon wasted little time in seizing the opportunity. In September, D.C. Mayor Muriel Bowser announced her administration was in talks with Exelon to hammer out a merger agreement, though sources with knowledge of the negotiations say they actually began soon after the initial rejection.

Though she had publicly welcomed the initial rejection of the merger proposal, Utility Dive first broke the news that less than a week after talks were announced, Bowser’s office came to a settlement agreement with Exelon and a majority of merger intervenors. At a press conference with the settlement parties and Exelon CEO Chris Crane, Bowser said that while she was unsatisfied with the initial merger proposal, the new deal was in the best interests of District ratepayers.

The settlement includes:

• A $25 million fund to offset future rate increases for residential ratepayers until 2019
• A fund to distribute a one-time ~$50 credit to D.C. residential ratepayers
• A $15 million fund to support low income residents through a home energy assistance program
• A commitment by Exelon to buy 100 MW of wind power and 10 MW of solar

While settlement parties welcomed the new commitments, many intervenors were not impressed. Most importantly, they said, the settlement wouldn’t do enough to address the “inherent conflict of interest” that was identified by regulators, and is instead full of one-time commitments that would not deliver any benefits after the first few years.

Settlement supporters argue that "ring fencing" provisions in the deal will protect Pepco ratepayers in the District and elsewhere from any financial risks in its generation fleet. To them, those strengthened commitments, along with millions of dollars of new Exelon money in the deal, means that D.C. struck a good bargain with the utility giant.

Ring fencing and financial risk

Back in January, when Exelon was making its initial case to state regulators up and down the mid-Atlantic, Vice President for Corporate Affairs Melissa Sherrod batted away concerns about financial risk and a possible bias against distributed generation.

Exelon included mechanisms called “ring fencing” in its merger application which, she said, would wall off the assets of a subsidiary from its parent company and other businesses. The company, she said, used the provisions successfully to protect Constellation customers when Exelon bought that company.

“That is what I would call a premium way of ensuring that no risk of any other affiliate will impact operations of Pepco,” Sherrod said. "So for all intents and purposes, they are essentially a standalone company financially.”

But even with those ring fencing provisions, D.C. regulators still turned back the merger proposal, citing financial risks for District ratepayers among their greatest worries.

This time around, parties to the settlement say the situation is different. At the press conference unveiling the deal, D.C. Peoples Counsel Sandra Mattavous-Frye, the city’s consumer advocate, said that while she considered the ring fencing provisions inadequate in the initial merger proposal, they had been strengthened considerably in the settlement.

“The ring fencing provisions that are established actually provide protections against any bad actions that happen to Exelon as a company, so they will not affect or impact the District,” Mattavous-Frye said when asked by Utility Dive how the settlement addresses the conflict of interest identified by the PSC.

“They have increased substantially,” she said. “They are more extensive and direct and targeted to make sure those types of violations do not occur.”

Others in D.C. government aren’t so sure. Councilmember Mary Cheh (D-Ward 3), a Harvard-educated lawyer and leading critic of the merger, doesn’t buy that the revised ring fencing provisions are really any better.

“The terms of that part of the deal haven’t changed significantly,” she said. “There are some provisions there about keeping separate books, but all I can tell you is that anybody who’s ever heard of the term creative bookkeeping or creative accounting knows there are different ways of accounting costs.”

In particular, Cheh sees a conflict between all of the cooperation Exelon promises between itself and its Pepco subsidiary, and its pledge to keep the companies’ books separate.

“Even though you might say, 'this is Exelon’s, this is Pepco’s' — what about the combined costs?” she said. “If we’re supposed to get all these benefits from cooperation and idea sharing and the facilities for Exelon that come into play, I don’t see how you can truly prevent a migration of costs that would be attributed to Exelon in a larger way, being allocated to Pepco.”

Exelon officials told Utility Dive it would not comment while the merger negotiations and proceedings continue, but other legal professionals not directly connected to the merger also looked at the settlement.

Drew Moratzka, a partner at Stoel Rives, said that Exelon appears to be ­­­choosing a financial structure that at least intends to separate risks.

Generally, what utilities do when they operate in different jurisdictions is set up interchange agreements – tariffs that lay out which area is paying for what. Or, he said, they set up “jurisdictional allocators” that determine costs for each region using jurisdictional cost of service studies.

Instead of going down either of those routes, Moratzka said, it seems that Exelon is “trying to say we’re going to keep things completely separate.”

Just whether those provisions will succeed in effectively walling off the risks of Exelon’s generation fleet is a question that’s best answered with time, since the way in which the company interprets and implements them remains to be seen.

Joe Hall, a partner at Dorsey Whitney, expressed confidence in the settlement. 

“If the mayor’s office feels that the ring fencing is sufficient, and they’ve obviously agreed to that, then I think the answer is yes,” he said when asked if the ring fencing provisions are sufficient. “It’s really more their risk tolerance than anything.”

Distributed vs. centralized generation

Besides the spread of financial risks from Exelon’s generation fleet, merger opponents and the PSC also seized on Exelon’s business model as a generation company.

Opponents see the merger taking them back to a utility model they abandoned over 20 years ago. In the early 1990s, regulators forced Pepco to divest from its generation plants in favor of buying power on the open market. Critics like Cheh don’t want to go back.

“What we tried to do in the ‘90s was to truly disassociate ourselves from [owning generation] and be in a market to get the best price possible and get all the benefits of being a distribution company and not tied up with any production,” she said. “The reason that they allowed that separation is that they said particularly on the economic side that we would be greatly advantaged and we wouldn’t be subject to any of these stranded costs of these large production facilities.”

“So I think it’s taking a step back,” she said. “I think it’s taking us back to the 1990s.”

But some power sector observers, like Hall, say that a utility holding company owning a generation fleet is no reason to block a merger, even if regulators fear it may impact how a company views distributed generation.

“Denying a merger or any other transaction based on the possibility of an incentive to deny third party developers access to the grid is legally questionable, and reasonable grounds to seek appeal,” he wrote to Utility Dive in an email after his interview. “By that standard, many viable mergers could be denied regardless of the relevant parties’ history of promoting renewable generation and/or accommodating generation interconnection requests.”

“There should be proof that an improper conduct occurred before that type of conclusion should be reached,” he added.

Merger opponents say they have plenty of history of improper conduct, including a history of slow-walking DER growth, especially from third parties, at Exelon’s other utilities, and its opposition to renewable energy tax credits that got the utility thrown out of the American Wind Energy Association. But more than that, Cheh said Exelon’s worldview is fundamentally opposed to her city’s clean energy vision, despite the “window dressings” of one-time renewables commitments in the merger settlement.

“We look at the world here in terms of renewables and progressive environmental policies,” she said. “They look at the world differently … The heart of their business is nuclear power and fossil fuel sources. It is a 20th century model, so they sprinkle in a couple of things that look like what we do here in the District, but it doesn’t change the essential nature of what they do.”

Regulation and enforcement

Whether or not the business model critiques are legitimate, Moratzka worries about how the ring fencing provisions — meant to mitigate for both business model and financial risk concerns — will be enforced.

“What I’m having a hard time understanding is, where are the teeth?” he said “Let’s assume, because I think it’s reasonably fair, that the provisions do exactly what they say they’re going to do, keep things separate, and then 5 or 10 years later the utility decides to throw it out the window. What’s the recourse?”

The recourse, others say, should come not from the settlement itself, but existing regulatory authorities.

“If someone has reason to believe a merged entity – whoever it is – is being unfair or discriminatory to a developer, well, they have the ability to raise that claim with the state, or FERC, or a court, depending on what the concern is,” Hall said. “They are provided remedies [by the regulatory structure].”

The same goes for Exelon’s relationships with its potential subsidiaries, he said.

“It really goes to the heart of public service regulation,” Hall said. ‘I think that because there’s been such a long history of close scrutiny of those types of relationships, at least in my experience I think utilities tend to be pretty good about those types of issues.”

“To the extent that they’re not,” he added, “there’s a risk that FERC or the state will audit them and they will be held accountable, so they engage in violations at their own risk.”

The problem with that logic, critics say, is that transforming Pepco into a subsidiary of the nation’s largest utility would make it difficult for regulators, especially in a PSC jurisdiction as small as D.C., to control the resulting giant power company.

The difficult part of the deal, Moratzka said, is that “there aren’t specific default provisions” in the merger settlement, leaving all enforcement up to regulators.

Cheh said that while the PSC looked as if it took a hard line against Pepco in rejecting its initial merger proposal, she worries that in a D.C. government already “shot through” with Pepco influence, Exelon’s size and resources will make it even more difficult to control.

Some of that influence was on display this summer when the D.C. Council voted over whether to fund a study to assess the costs and benefits of converting Pepco into a public utility – something that merger opponents like Cheh had floated as an alternative to the Exelon deal.

That study appears to have sparked a behind-the-scenes campaign by Pepco to eliminate the study from the proposed budget. RTO Insider reported that in June alone, public records show that Pepco lobbyists communicated more than 60 times with seven of the 13 councilmembers or their staffs, and those conversations are only one facet of its influence. 

Councilmember Vincent Orange, chair of the committee on business and regulatory affairs, was a former regional vice president for Pepco, and the chair of the council, Phil Mendelson, owns enough stock in Pepco that he has to publicly disclose it. In the mayor’s office, senior advisor Beverly Perry retired from Pepco in 2013 as a vice president, and District Attorney General Karl Racine and his deputy worked for Pepco at their law firms in the past.

On the morning of the final vote on the budget, Cheh said she was “ambushed” by a new amendment to eliminate the public utility study from the proposal. It passed with votes from the councilmembers that Pepco had spoken with earlier in the month.

Pepco, for its part, maintains that its lobbying practices are above board and little different from any other company so invested in the District.

"We work with officials in all of our jurisdictions and regularly meet with them on a wide variety of matters critical to our customers, our communities and our operations," Myra Oppel, a Pepco spokesperson, wrote to Utility Dive in an email. "The concept of municipalization raises many legal, financial, regulatory, operational and commercial considerations, and — as we would on other issues of importance — we communicate those concerns to ensure that officials have accurate information and understand these complexities." 

Exelon’s chances on appeal

Pepco's existing political clout, along with other political factors in the city, could well pave the way for the merger’s approval on appeal.

Cheh pointed out that many of the parties in the settlement either have something big to lose – or gain – as a part of the merger settlement.

At least half of the non-profit groups listed in support of the deal received contributions from Pepco in 2014, or from United Way of the National Capital Area, where the Pepco CEO was the last chairman, RTO Insider reports. 

On the political side, Peoples Counsel Mattavous-Frye and PSC Commissioner Betty Todd Ford are also both up for re-appointment soon, Cheh said, and the mayor is the one who nominates them, potentially putting pressure on them to accept the settlement deal.

Cheh worries that all of the money floating around, combined with political pressure, has enticed stakeholders to sign on to a deal with many one-time conditions, but not many benefits past the first few years.

But for some intervenors, the settlement agreement seems to have hit on much of what they wanted. 

"We are happy that the terms of this settlement agreement protect master metered apartments, including condominiums, by providing rate credits against future increases," said Margaret "Peggy" Jeffers, executive vice president of the Apartment and Office Building Association of Metropolitian Washington, an intervenor which opposed the merger at the outset. "In addition, with the support of the DC government and Exelon, this Agreement preserves and enhances the DC Public Service Commission’s stated policy to gradually end negative class rates of return that unduly burden commercial ratepayers."

Moratzka said that while some parties may still be unsatisfied, that’s why they call it a compromise.

“The settlement went fairly far I think in trying to address all these concerns,” he said. “Could it have gone further? Yes, but it’s a settlement, so it’s not going to be a 100% victory on either side.”

But will that compromise land Exelon a merger approval?

“I would think so,” he said. “It seems like you have all the right parties signed on, but it’s never approved until the commission votes.”