Thelen Reid Report No. 393: SEC Recognizes New Standard for Gas Utility "Integration"

The Securities and Exchange Commission (SEC) recently issued two orders under the Public Utility Holding Company Act of 1935 (PUHCA) reinterpreting the "integration" standards under PUHCA in light of changes that have taken place in the natural gas industry over the past two decades. The significance of these two decisions is that the SEC now recognizes that local gas distribution companies (LDCs), though separated by a substantial geographic distance, may nevertheless constitute an "integrated" gas system when they consolidate through a holding company structure.

In the first decision, issued February 1, 1999, the SEC approved the acquisition of a new gas distribution company in western North Carolina by Sempra Energy, the parent of Southern California Gas Company and San Diego Gas & Electric Company. In the second case, decided February 10, the SEC approved the acquisition of Bay State Gas Company, which operates in Massachusetts, New Hampshire and Maine, by NIPSCO Industries, which operates a gas distribution system in northern Indiana. Rick Farmer and Bill Baker in Thelen Reid & Priest's New York office; and Andy MacDonald, and Rick Roberts, in the firm's Washington, D.C. office, were involved in these proceedings.

Under PUHCA, in order to approve a combination of two LDCs, the SEC must affirmatively find that the two companies will together form an "integrated" gas system. Among other things, this requires a finding that the resulting system will be confined to a "single area or region [which is] not so large as to impair...the advantages of localized management, efficient operations, and the effectiveness of regulation." However, PUHCA provides that LDCs sharing a "common source of supply" may be deemed to be included in a "single area or region." PUHCA also directs the SEC to consider changes in the "state of the art" of the gas industry.

In the Sempra Energy case, the SEC determined that Sempra's acquisition of Frontier Energy, a company formed to construct and operate a new gas distribution system in western North Carolina, would satisfy the PUHCA integration standards even though Frontier Energy's service area is some 2500 miles away from Sempra's existing gas distribution system in southern California. In its application, Sempra argued that its existing subsidiaries and Frontier Energy would share a "common source of supply" for the majority of their gas supplies, namely the San Juan and Permian gas producing basins of Texas and New Mexico, and that, through its gas marketing arm, Sempra Energy Trading Corp., Sempra would be able to coordinate the gas supply needs of Frontier Energy with those of its California utilities in order to achieve the efficiencies and economies that PUHCA requires.

Similarly, NIPSCO Industries presented a substantial amount of evidence demonstrating that its Indiana LDCs and Bay State would derive almost all of their gas from two producing areas: the Texas/Louisiana Gulf Coast basins and the Western Canada Sedimentary Basin. Significantly, much of the gas imported into the U.S. from western Canada is expected to move through the Chicago market center, which is near NIPSCO Industries' service area, and move from there to eastern and northeastern U.S. markets on new pipeline links that are now under construction. Sempra Energy and NIPSCO Industries are the first cases decided under PUHCA in which the SEC has taken full measure of the fundamental changes that have taken place in the gas industry since PUHCA was enacted. These changes include, among others: the unbundling of the gas commodity and transportation functions of the interstate pipelines under the Federal Energy Regulatory Commission's Order No. 636 and development of the capacity release market; the enormous impact of western Canadian gas on U.S. markets; the completion of new capacity on the interstate pipeline network, which has eliminated pipeline capacity constraints in most areas of the country; and the development of trading hubs and market centers, which now enables gas purchasers and sellers a wide range of flexibility in moving gas from the major gas producing areas to almost any market. Given these "state of the art" changes in the gas industry since 1935, the SEC essentially agreed with Sempra and NIPSCO Industries that, in determining whether two LDCs together would form an "integrated" gas distribution system, the relevant inquiry should no longer be whether the LDCs are connected to and purchase their gas from the same interstate pipeline. Rather, the SEC agreed that the relevant inquiry is whether the combining LDCs both purchase substantial amounts of gas from the same supply basins and whether that gas is "deliverable" on economic terms on the interstate pipeline system.

In NIPSCO Industries, the SEC also agreed that NIPSCO Industries, which was already exempt from regula-tion under PUHCA as an "intrastate" holding company, was entitled to keep that exemption even though it was proposing to acquire the stock of a gas company (Bay State) operating in a different state. Section 3(a)(1) of PUHCA permits the SEC to exempt a holding company whose operations are "predominantly intrastate in character" even though it owns a small or non-material utility operating in a different state. Although Bay State is much smaller than NIPSCO Industries, in terms of relative size (based on such factors as operating revenues and margin), Bay State is substantially larger than in any previous case in which the SEC has granted an exemption under Section 3(a)(1) to a holding company that owned an out-of-state utility subsidiary.

The Thelen Reid Report is published as an information service to clients and friends. Please recognize that the information is general in nature and does not constitute legal advice.