WhileMorgan Stanley Research previously said it believed units of and facea "very significant risk" that FERC will rescind their waivers ofaffiliate power sales restrictions in order to determine if certain of thecompanies' power purchase agreements are just and reasonable, the firm'sanalysts now say that result is "likely."

Moreover,they expect that FERC will ultimately find that those agreements fail the Edgar standard the agency uses to reviewaffiliate contracts to ensure that ratepayers are protected and that thetransactions are just, reasonable and transparent.

Whilethe analysts acknowledged that FERC still could decide not to interfere in apower contract that has been approved by a state, they noted that the pendingU.S. Supreme Court case addressing state subsidies for power plants in NewJersey and Maryland "highlight a situation where FERC has decided tobecome involved in order to ensure a fair, competitive marketplace."

"Webelieve FERC will decide to do so in Ohio as well, given the arguments thathave been raised by multiple parties, including [the ] and the[Pennsylvania Public Utility Commission], regarding the impacts from the OhioPPAs on the competitive marketplace for power," Morgan Stanley said in April4 report.

ThosePPAs are designed to provide income guarantees to FirstEnergy's and AEP's Ohioutilities for their share of the output from certain "" power plants that faceeconomic challenges. The cost of the eight-year subsidy plans will be recoveredthrough a non-bypassable "rider charge" assessed to all end-usecustomers in FirstEnergy's and AEP's Ohio service territories, regardless ofwhether they take retail service from those utilities.

to the PPAs has beenfierce and vocal, but the Public Utilities Commission of Ohio neverthelessunanimously approvedthe subsidy plans March 31.

PUCO'smove in signing off on the plans does not end the controversy, however, as thePPAs also are at the center of two complaints at FERC in January by a group ofstakeholders led by the Electric Power Supply Association. In those complaints,EPSA asked that FERC rescind waivers of its affiliate power sales restrictions,which were previously granted to the AEP and FirstEnergy utilities pursuant totheir blanket market-based rate authorization, so the commission can review thePPAs to determine whether they are just and reasonable.

FERCgranted the waivers assuming the utilities had no ability to pass the costs ofaffiliate agreements through to captive customers, but the establishment of thenon-bypassable rider charge — which would be applicable even to those takingretail service from competitive retail suppliers — changes that, EPSA said.More generally, EPSA expressed concern about the price distortion that couldresult from the subsidized plants' output being bid into PJM's markets.

Accordingto Morgan Stanley, EPSA is likely to prevail in its attempt to get FERC torescind the waivers and consider whether the PPAs are just and reasonable.

MorganStanley recalled that in Order697, FERC defined captive customers as those unable to choose totake retail service from an alternative power supplier in order to avoid thehigh costs of an incumbent utility.

"Thisis important because the rationale for waiving the usual restriction on PPAsbetween a merchant and an affiliated utility would be that, if power priceswere too high, a customer could 'shop' for an alternative power supplier,"Morgan Stanley said. "Given these Ohio PPAs do not allow customers tochoose an alternative supplier and avoid these power costs (i.e. they arenon-bypassable), which are well above market prices, we believe FERC willconclude that, while Ohio is a state that is generally open to retail competition, with respect to these PPAs, Ohio customers are captive and as aresult, FERC should review them."

Andassuming FERC rescinds those waivers, Morgan Stanley believes the agency willinvalidate the PPAs under a standard of review the agency established in 1991when ruling on a case involving affiliates Boston Edison Co. and Edgar ElectricCo. The analysts specifically cite language in that ruling stating that"market-based rates for sales involving affiliates will be found toviolate Section 205(a) of the [Federal Power Act] unless there is a clearshowing of lack of potential affiliate abuse."

Addressingwhat it considers the stronger of two arguments FirstEnergy and AEP couldpossibly raise to support their position, Morgan Stanley predicts that FERCwill reject the companies' assertions that non-price elements of the PPAs"are sufficiently valuable that the contracts are 'just andreasonable.'" In Edgar, FERC'sconsideration of the PPA proposed by Boston Edison was narrowly focused onwhether the pricing and terms of that contract would result in customers paying"no more than a nonaffiliate would pay for comparable power" and didnot appear to address non-price benefits such as the furtherance of policygoals, the analysts said.

Still,Morgan Stanley acknowledged that PUCO went to great pains to explain why itfound that the FirstEnergy and AEP PPAs were superior to alternatives proposedby other utilities such as ExelonCorp., and the analysts therefore said FERC could defer to thestate regulator's judgement on the matter. But based on the Edgar decision, in which FERC rejectedthe argument that it "need not worry about self-dealing" because astate regulator would have to sign off on the deal, the analysts said theybelieve FERC will feel the need to reach its own conclusions "given the magnitudeof the contracts and the lack of a competitive procurement process."