Morgan Stanley Capital Group v. Public Utility Dist. 1 (06-1457); Calpine Energy Svcs. v. Public Utility Dist. 1 (06-1462)

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Oral argument: Feb. 19, 2008

Appealed from: United States Court of Appeals, Ninth Circuit (Dec. 19, 2006)

DEREGULATION, ENERGY, FEDERAL ENERGY REGULATORY COMMISSION, FEDERAL POWER ACT

During the California energy crisis of 2000 and 2001, a combination of factors, including criminal activity, drastically inflated spot market prices for energy. This situation caused electrical utility Public Utility Dist. 1 Snohomish County and the other respondents in this case ("local utilities"), to enter into forward contracts with energy suppliers (the petitioners in this case). After the crisis receded, the local utilities clamed that artificially inflated spot price at the time forward contracts were signed had affected the rates set in those contracts, and they asked the Federal Energy Regulatory Commission (FERC) to make the contracts void. The Commission declined, citing several Supreme Court cases stating that the Commission should defer to rates set through a valid contractual process. The local utilities appealed and the Ninth Circuit ruled in their favor, holding that FERC's decision was based on an incorrect standard of review because it failed to consider the possible effect of spot market price manipulation on the forward contracts. The court, therefore, remanded the case back to FERC for reconsideration. The Supreme Court granted the suppliers' petition for certiorari to reconsider the Ninth Circuit's decision. The decision in this case will affect energy suppliers, distributors, and consumers.

Questions presented

Morgan Stanley Capital Group v. Public Utility Dist. 1 (06-1457)

Whether the Ninth Circuit erred by failing to abide by this Court's decisions in United Gas Pipe Line Co. v. Mobile Gas Service Corp., 350 U.S. 332 (1956), and Federal Power Commission v. Sierra Pacific Power Co., 350 U.S. 348 (1956), which preclude the Federal Energy Regulatory Commission from retroactively undoing valid, bilaterally negotiated, arms-length wholesale energy contracts that have, at most, minimal impact on retail rates.

Calpine Energy Svcs. v. Public Utility Dist. 1 (06-1462)

The Federal Power Act ("FPA"), 16 U.S.C. �� 791a et seq., sets forth the standards by which the Federal Energy Regulatory Commission ("FERC") regulates wholesale energy rates. In United Gas Pipe Line Co. v. Mobile Gas Service Corp., 350 U.S. 332 (1956), and Federal Power Commission v. Sierra Pacific Power Co., 350 U.S. 348 (1956), this Court determined that, under the FPA, FERC may undo a valid wholesale energy contract only in the extraordinary circumstance when the contract is contrary to the public interest. In conflict with Mobile and Sierra, and with decisions of the D.C. and First Circuits, the Ninth Circuit in the decision below held that FERC may nullify voluntary wholesale energy contracts-absent the requisite showing of public necessity-if FERC determines in hindsight that the negotiated rate is unreasonable or that, absent the challenged contracts, retail rates for energy would be slightly lower. Thus, this petition presents the following questions:

1. Whether the Ninth Circuit misapplied this Court's holdings in Mobile and Sierra and created conflicts with the D.C. and First Circuits when it reversed FERC's decision to uphold valid wholesale energy contracts absent any showing that the public interest required their abrogation.

2. Whether the Ninth Circuit misapplied the Mobile-Sierra doctrine by determining that the Mobile-Sierra public interest criteria apply only to sellers, but not to buyers, under wholesale power contracts, in direct conflict with Mobile, Sierra, and the decisions of other circuits.

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Issues

Under what conditions, if any, should the Federal Energy Regulatory Commission have the power to invalidate facially valid wholesale energy contracts? Did the unusual conditions of the energy market during the California energy crisis justify an exception to the FERC's general policy of respecting contracts set to the market rate?

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Facts

The Federal Power Act and FERC's Duty to Regulate Rates

The Federal Power Act of 1920 (FPA) requires the Federal Energy Regulatory Commission (FERC) to regulate utilities for the benefit of consumers, under the assumption that utilities are monopolies prone to abusing market power. Public Utility District No. 1 of Snohomish County Washington v. Federal Energy Regulatory Commission (FERC), Southern California Water Company v. FERC, Attn'y General, State of Nevada v. FERC, Nevada Power Company and Sierra Pacific Power Company v. FERC; Calpine Energy Services et al. v. FERC, 471 F.3d 1053, 1062 (9th Cir. 2006) (hereinafter Snohomish). In energy distribution, utilities play a key role by purchasing power wholesale from suppliers, and selling the energy to customers, or ratepayers. Id. at 1060. The FPA gives FERC exclusive jurisdiction to review rates filed by utilities in wholesale power transactions to ensure they are "just and reasonable" (states regulate prices utilities charge to ratepayers). Brief for Respondents (the Federal Energy Regulatory Commission (FERC)) at 2-3. Under the Supreme Court's Mobile-Sierra decisions, contract rates between suppliers and utilities are presumed to be just and reasonable, unless they are adverse to public interest. Snohomish, 471 F.3d at 1063.

FERC's Changing Role in a Deregulated Market

Historically, FERC applied the "just and reasonable" standard by matching the rates the utilities charged to the utility's costs. Snohomish, 471 F.3d at 1063. In the 1990s, FERC and states moved towards a market-based system. FERC ended monopolies of transmission lines; companies could charge whatever rate the market would bear. Id. at 1065.

California's reforms forced state utilities to sell power-producing assets and purchase power on a "spot market" (a day to day market on which suppliers sold energy to utilities). Id. at 1066. The shift to a market-based system had two consequences. First, utilities filed market-based rates, which pegged rates to market prices. Snohomish, 471 F.3d at 1064. Instead of conducting "just and reasonable" review at filing, FERC approved market-based rates when companies could show they would not affect market prices. Id. at 1065. Second, the reforms threw local monopolies, previously under state regulation, into the FERC-regulated wholesale market. Id. at 1066. Thus, FERC's restrained regulatory approach under Mobile-Sierra applied to local utilities that had once faced aggressive state regulation.

The Energy Crisis of 2000-2001: Securing Energy Through Forward Contracts

Western states experienced an energy crisis in 2000-01, precipitated by a combination of regulatory reform, demand, and market manipulation. Snohomish, 471 F.3d at 1068; Brief for Respondents (Public Utility District No. 1 of Snohomish County, Washington et al.) (hereinafter "Public Utilities") at 9-10. The dramatic spike in prices in the western states' integrated energy market put an enormous fiscal strain on utilities. Snohomish, 471 F.3d at 1069; Brief for Respondents (FERC) at 9. To alleviate the utilities' reliance on the dysfunctional spot market, FERC supported the execution of long-term, or “forward," contracts. Snohomish, 471 F.3d at 1069. To allay fears that forward market rates might violate the "just and reasonable" standard, FERC promised to "be vigilant in monitoring" forward market prices and abuse of market power. Id. This case consolidates disputes involving contracts made during the crisis. Snohomish, 471 F.3d at 1069.

Utilities entered long-term contracts with energy commodities dealers, generally agreeing to longer contract terms to obtain lower prices than available during the crisis. Id. at 1069-72; Brief for Respondents (Public Utility District No. 1 of Snohomish County, Washington et al.) at 17-18. Following the crisis, the utilities requested that FERC reform the contracts on grounds the contracts violated the "just and reasonable" standard, because the dysfunctional spot market affected the forward market. Brief for Respondents (Public Utilities) at 20. The utilities further claimed the contracts violated the public interest because ratepayers suffered hikes. Snohomish, 471 F.3d at 1069-72.

FERC rejected the application of the "just and reasonable" standard, instead applying Mobile-Sierra. Id. at 1073. Based on its finding that the rate increases would be minimal, FERC refused to reform the contracts because they were not contrary to the public interest. Id. The Ninth Circuit held that Mobile-Sierra applied in a market-based system only under limited circumstances. Id. at 1074. The court also found that FERC erred in its "public interest" determination because it used public interest factors from Sierra, a case involving rates that were too low, rather than too high. Id. at 1088-89. The court remanded, ordering the agency to determine whether Mobile Sierra applied, and if it did, to apply a revised public interest standard. Id. at 1090. The Supreme Court now must decide whether the Ninth Circuit correctly interpreted Mobile-Sierra as to permit the FERC to reform market-based contracts.

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Discussion

The Supreme Court's decision in this case will have an important impact on a component of the energy industry worth hundreds of billions of dollars. Brief of the Electric Power Supply Association, et al, as Amici Curiae in Support of Petitioners, at 1. The decision in this case may hinge on how the Court weighs two important and possibly conflicting values: the role of the Federal Energy Regulatory Commission (FERC) in protecting energy purchasers, and ultimately consumers, as well as the importance of stability and predictability to the energy market.

Consumer Protection

Supporters of the local utilities argue that the way FERC now operates is an abrogation of its intended role as a guardian of consumer interests. A collection of state governments and non-profits interested in consumer protection note that FERC's founding statute, the Federal Power Act (FPA), never envisioned the system FERC currently has established. Brief of Colorado Office of Consumer Council, et al, as Amici Curi for Affirmance, at 9. They go on to argue that under the new system, where FERC essentially pre-approves rates as long as they conform to the market, there should not be a judicial presumption that the rates are reasonable, and therefore the Ninth Circuit was correct in ordering that FERC more closely consider the local utilities' claims. Id. at 11-12. This is because the intent of the FPA was to ensure that consumers were not paying unfair prices, not to enforce market rates. Id. at 10.

Supporters of the energy suppliers counter by arguing that not questioning the market rate allows for stability and predictability in the energy market, which helps consumers. Brief of William J. Baumol, et al, as Amici Curiae in Support of Petitioners, at 8. Additionally, supporters of the local utilities point out that this case arises from the California energy crisis, which they argue was a unique situation. Brief of the Large Public Power Council as Amicus Curiae in support of Respondents, at 3-4. The California crisis has been described by the FERC's own documents as "unprecedented" and a "crisis that had never before been experienced." Id. citing FERC Brief. Supporters of the local utilities argue that the scale of the market malfunction, and the criminal and other factors that contributed to it mean two things: first, that if relief is due in any case, it should be due in this one, and, second, that if the Ninth Circuit's decision does create an exception to the general rule that rates should not be disturbed, it is a very narrow exception. Brief of the National Association of Regulatory Utility Commissioners, et al, as Amici Curiea in support of Respondents, at 7-8.

Stability of Contract

The energy suppliers argue that FERC is protecting the public interest by not disturbing contracts set at the market rate because this allows for stability and predictability. Brief for Petitioners (Calpine Energy Service, et al), at 29-30. Knowing that supply contracts which meet certain minimum requirements will be upheld gives everyone in the market confidence that they will be performed, helping "stability of supply" and keeping the market prices lower. Id. at 30. This position is supported by a group of economists, who warn against undermining confidence in long-term energy supply contracts, which, they argue, help decrease risk and instability in the markets. Brief of William J. Baumol, et al, as Amici Curiae in Support of Petitioners, at 8. Furthermore, the economists argue that the Ninth Circuit's ruling, if left unchecked, could damage the market, despite the fact it appears to apply only in limited circumstances. Id. at 8-9. This is because the term "market dysfunction," which is key to the rule in that case, is hard to define and therefore could create instability and confusion in the market. Id.

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Analysis

This case consolidates suits by public utilities against the FERC for refusing to reform long-term contracts made during the 2000-01 energy crisis. The Supreme Court will decide when the FERC can apply limited Mobile-Sierra review in a market-rate based system.

Mobile-Sierra: the Integrity of Private Contracts Under the FPA's "Just and Reasonable" Standard

The Federal Power Act ("FPA") grants the Federal Energy Regulatory Commission (FERC) authority to regulate wholesale electricity sales. 16 U.S.C. � 791a et seq. Under Section 205, companies must file rates with FERC. 16 U.S.C. � 824d(a)-(c); FERC may determine whether rates are "just and reasonable" at the time they are filed or any time afterwards. Brief for Respondents (Public Utility District No. 1 of Snohomish County, Washington et al.) (hereinafter "Public Utilities") at 3. Section 206 gives the FERC the power to reform contracts based on a finding a rate violates the "just and reasonable" standard; however, FERC's modification is only retroactive to the complaint's filing. 16 U.S.C. � 824e(a)-(b); Brief for Petitioners (Calpine Energy Services, American Electric Power Services Corp., and the Allegheny Energy Supply Company, LLC) (hereinafter "Calpine") at 3.

The Supreme Court has decided two cases that defined FERC's capacity to modify rates established by private, negotiated wholesale energy contracts. In United Gas Pipe Line Co. v. Mobile Gas Serv. Corp., the Court held that companies could not unilaterally modify contracts by simply filing a new rate with FERC, but that this did not prevent the agency from modifying contracts for the public interest. Brief for Respondents (Public Utilities) at 4. In Fed. Power Comm'n v. Sierra Pac. Power Co., the court held that FERC could only reform contracts under which utilities received less than a fair rate of return if the rate was so low that it harmed public interest. Snohomish, 472 F.3d at 1068. See Brief for Petitioners (Calpine) at 5.

FERC began to grant open-ended authorization to sellers to charge market-based rates in the 1990s. Administrative orders and court decisions fleshed out key requirements: sellers needed to show they could not exert market power, or could mitigate it, while FERC needed to ensure that it would monitor the market. Snohomish, 472 F.3d at 1065 (citing California ex rel. Lockyer v . FERC, 383 F.3d 1006 (9th Cir. 2004)).

Does the FERC Have the Authority to Determine When Mobile-Sierra Applies?

The Ninth Circuit held that the FPA established a single standard: all contract rates must be "just and reasonable." Snohomish, 472 F.3d at 1060, 1074. The court reasoned that FERC would abdicate its regulatory responsibility to ensure all contract rates are "just and reasonable" if FERC simply applied the Mobile-Sierra review to market-rate based contracts and allowed rates to stand as long as they did not violate the public interest. Id. at 1082.

FERC agrees with the remand because the Ninth Circuit interpreted the FPA as giving the FERC the authority to decide whether Mobile-Sierra applies. However, the agency argues that its own interpretation of the "just and reasonable" standard was correct because it furthered the FPA goal of permitting rate-setting through private contracts. Brief for Respondents (FERC) at 21. FERC determined that private contracts rates violate the "just and reasonable" standard only if they are contrary to the public interest, which in turn requires a showing of "unequivocal public necessity." Brief for Respondents (FERC) at 22 (quoting Permian Basin Area Rate Cases, 390 U.S. 747, 822 (1968)). According to FERC, "just and reasonable" is an ambiguous standard, and FERC's interpretation is entitled to deference, under Supreme Court precedent in Chevron. Brief for Respondents (FERC) at 26.

The public utilities contend that Mobile-Sierra does not create an exception to the "just and reasonable" standard. Brief for Respondents (Public Utilities) at 32. FERC clearly erred in interpreting Sierra and Mobile as blanket protection for contracts and thus ruling that the disputed contracts need not meet that standard. The utilities contend that such an interpretation contravenes the FPA's plain language and its mandate that FERC protect consumers. Id. at 29; Brief for Respondent Golden State Water Company (hereinafter "Golden") at 29. The utilities argue that FERC's approach in Mobile-Sierra would "immunize from review" contracts that are negotiated in extreme circumstances, in violation of the FPA's requirement that FERC regulate to protect consumers.

Do Grants of Market-Based Rate Authority Trigger Prerequisites to Applying Mobile-Sierra?

The Ninth Circuit held that FERC could only apply Mobile-Sierra review if (1) the contract itself did not provide for unilateral modification, (2) there was timely, effective review of contract rates, and (3) FERC examined whether the circumstances of contract formation supported the presumption that the contract rates were originally "just and reasonable." Id. at 1075-77.

Relying on Lockyer, the Ninth Circuit ruled that in a market-based rate system, adequate oversight requires effective oversight after the initial grant of authority, and that FERC erred procedurally in determining its oversight met this standard. Snohomish, 472 F.3d at 1081-82. FERC argues that the court improperly substituted its judgment for the agency's, because the FPA leaves timing of regulation to the agency's discretion and because the court, in past decisions, found FERC's market-based rate approach lawful under the FPA. Brief for Respondents (FERC) at 27-28 (citing Lockyer v . FERC, 383 F.3d 1006 (9th Cir. 2004)). The agency also contends that the court erred in ruling that Mobile-Sierra only applies if there is full review of rates at the time of the contract, since the Mobile and Sierra cases themselves involved orders made prior to FERC's full evaluation. Snohomish, 472 F.3d at 33.

FERC and the energy suppliers assert that FERC properly applied Mobile-Sierra to the disputed forward contracts. FERC claims it fulfills the FPA mandate to ensure "just and reasonable" rates by monitoring the market and requiring reports, and that Lockyer vetted the sufficiency of this system. Brief for Respondents (FERC) at 30. FERC's market-based rate authority is only granted examining the market power of parties and public review, and FERC has post-grant reporting requirements. FERC and the suppliers argue that because such a regime has been found FPA-compliant, the public interest test should govern regardless of the timing of the review of the contract or of market conditions. Id. at 27; Brief for Petitioners(Calpine) at 39.

The Ninth Circuit also held that FERC erred substantively by determining that the market conditions in which parties entered contracts were irrelevant, including disregarding the agency staff's findings of a dysfunctional market. Snohomish, 472 F.3d. at 1085-86. FERC argues that market dysfunction relates to the public interest standard, not to whether FERC may apply Mobile-Sierra review, because nothing in Mobile-Sierra precludes its application in cases of market dysfunction. Brief for Respondents (FERC) at 36. FERC argues that the Ninth Circuit's decision approach would allow the agency to invalidate contracts that do not warrant invalidation, simply because they were formed in a dysfunctional market. Id. at 37.

More generally, energy suppliers and FERC argue that the Ninth Circuit's prerequisites are contrary to the principal underlying Mobile-Sierra: the need to protect long-term contracts made by suppliers to obtain future certainty. Brief for Petitioners (Morgan Stanley Capital Group Inc.) (hereinafter "Morgan") at 27, 34; Brief for Respondents (FERC) at 37. The Mobile-Sierra decision bars "retrospective second-guessing" that undermines contract certainty, by preventing parties from unilaterally seeking to set aside a contract (by applying to FERC) that has become a bad bargain. Brief for Petitioners (Calpine) at 49. The Supreme Court affirmed the need to protect contracts made by sophisticated parties in Verizon Communications Inc. v. FCC. Id. at 30. Mobile-Sierra, virtually eliminated the risk of revision by the government. Brief for Petitioners (Morgan) at 34. The suppliers contend that the Ninth Circuit's decision destroys this certainty by giving FERC power to set aside contracts that are actually within the scope of Mobile-Sierra. Brief for Petitioners (Calpine) at 37, 50. The suppliers analogize to the facts in Sierra, painting a picture of public utilities who want to modify contracts that became a bad deal, after initially profiting from them. Brief for Petitioners (Morgan) at 31.

The public utilities argue that the preconditions to Mobile-Sierra review identified by the Ninth Circuit are not new requirements because they are inherent in the FPA. FERC's orders were unreasonable because its basis for applying Mobile-Sierra - that contracts by sophisticated parties lacking market power are just and reasonable - violates the FPA. Brief for Respondents (Public Utilities) at 35. Firstly, the utilities argue that the FPA's filing requirements show that Congress intended FERC to prevent unreasonable rates through timely review. They contend that such timely review is lacking in FERC's market-rate based approach because, unlike in Mobile and Sierra, there is no initial review. Id. at 42. The utilities distinguish past cases that approve FERC's market-based rate approach, claiming that such approval was only granted because FERC had enough oversight to ensure rates were reasonable if market competition failed to produce reasonable rates. Brief for Respondent 9(Golden) at 46. In contrast, FERC's remedy of revoking market-based rate authority after the fact is inadequate to solve contract problems and ensure that rates meet FPA requirements. Brief for Respondents (Public Utilities) at 43.

Citing Lockyer, the utilities further argue that a presumption of "just and reasonable" contract prices is invalid in a dysfunctional market because such a market is unlikely to produce reasonable prices. Brief for Respondents (Public Utilities) at 35. The utilities point to the way that high demand and market manipulation in the spot markets caused the collapse of the forward markets in the 2000 crisis. That collapse in turn forced utilities into contracts with energy suppliers who were aware (and took full advantage) of their market power. Id. at 38. According to the utilities, the Court's decision in Verizon did not give FERC the freedom to continue applying the Mobile-Sierra presumption in the event of market failure. Thus, the FPA's mandate obligated FERC to consider market circumstances and the agency erred in disregarding its staff's report of market dysfunction. Id. at 39.

The Public Interest Standard

The Ninth Circuit held that even if Mobile-Sierra applied, FERC erred in its "public interest" analysis because it had relied on public interest factors outlined in Sierra, which involved contracts for rates that were too low. Snohomish, 472 F.3d at 1088. Instead, the court turned to Permian Basin, a Supreme Court precedent holding that FERC had to consider whether rates fell into a "zone of reasonableness" before reaching the issue of how contract stability affected the public interest. Id. at 1089. The Ninth Circuit held that if contract rates fall outside this "zone of reasonableness," then FERC may reform the contract. Id. at 1090.

The energy suppliers respond by pointing out that Permian Basin required "unequivocal public necessity," and then by arguing there is no statutory or case precedent distinguishing high and low rate contexts. Brief for Petitioners (Calpine) at 47 (quoting Permian Basin, 390 U.S. 747, 822 (1968)). The suppliers argue that the "zone of reasonableness" test makes the public interest standard of review the same as the full "just and reasonable" review, and erases Mobile-Sierra's protection for private contracts in the market-based system. This is exacerbated by the ambiguity of the "zone of reasonableness," and the comparison of rates to marginal price, which can diverge from competitive market prices. Id. at 53. The suppliers contend such an approach would harm the public interest by making long-term contracts more risky for suppliers, since FERC could invalidate contracts based on hindsight findings of market dysfunction and unreasonable rates. Brief for Petitioners (Calpine) at 55.

The public utilities justify the distinction between low-rate and high-rate contexts by arguing that Supreme Court precedent consistently holds that FERC's authority to regulate excessive rates overrides contract sanctity. Brief for Respondents (Public Utilities) at 43. The utilities claim Permian Basin supports a less stringent public interest standard, since the court upheld reforming a contract involving excessive rates "without applying an insurmountable standard." Id. at 43. The utilities claim that reforming contracts that are the product of market abuse serves the public interest by encouraging participation in the forward markets and beneficial investment in the energy industry. Id. at 43.

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Conclusion

This case addresses an important question about when the Federal Energy Regulatory Commission can, or should, cancel a wholesale energy contract. The answer may hinge on whether, in the Court's view, the goals of the Commission are best furthered by directly intervening to protect the consumers of energy, or standing aside and letting the market work. Either way, this case is likely to have a large impact on the energy industry and, therefore, all consumers of energy.

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Authors

Prepared by: Deepa Sarkar and Joe Hashmall

Edited by: Tim Birnbaum

Additional Sources

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