A majority of commissioners on the Federal Energy Regulatory Commission suggested at a meeting in late March that the agency is unlikely to set aside contracts that independent generators and power marketers signed to sell electricity to a state agency in California in 2001 when electricity prices were at their peak.

California has asked FERC to set aside the contracts on grounds that electricity prices were artificially high at the time because of “gaming” of the electricity market.

Background

The Federal Energy Regulatory Commission ruled at the end of March on several cases involving alleged market manipulation in California.  While the commission focused mainly on whether to order electricity suppliers in California to make refunds to the state on grounds that they had overcharged for electricity, the commissioners – discussed their views about requests by California for FERC to use its authority under the Federal Power Act to modify or cancel contracts for long-term power supplies entered into in the first half of 2001.

The contracts, which were requested by the state in two requests for bids, were priced on the basis of forward curves, which are projections of future prices, used by power sellers and buyers to estimate future electricity prices.  After the contracts were executed, projected future prices dropped, and today are significantly below prices projected in the first half of 2001.  A year after the contracts with the state were signed, the California Energy Oversight Board and the California Public Utilities Commission filed complaints at FERC in which they charged that the contracts were excessive.  California requested that the commission modify or cancel the contracts.

At issue in the FERC proceeding is the question whether FERC can and should exercise its authority under section 206 of the Federal Power Act to modify the challenged contracts.  That section provides that if FERC finds the rates, terms or conditions in a wholesale power sale or transmission contract are not “just and reasonable,” it must revise the contracts so that they are just, reasonable and not unduly discriminatory.

Unlike other federal regulatory laws, the Federal Power Act does not require that uniform rates be charged for electricity sales or for transmitting electricity across the grid.  Instead, it relies on voluntary contracts entered into by willing sellers and purchasers of power or transmission services to set prices.  While recent FERC orders have required transmission system owners to provide nondiscriminatory service to all customers seeking service, power sales remain voluntary and the prices for such sales are established by contract between buyers and sellers.  While the Federal Power Act grants FERC the authority to modify voluntary contracts, its longstanding policy has been not to modify contracts where the parties agreed to allocate the future risks and rewards of a transaction, but expectations changed and one party no longer finds the deal to be favorable.

Electric utilities are free to and often do sign contracts in which they reserve the right under section 205 of the Federal Power Act to file requests to increase rates over those established in their contracts.  Similarly, customers may retain the right to ask FERC to reduce the contractually-established rates.  However, particularly when contracts formed the basis for funding new facilities, sellers and buyers can waive their rights to request FERC to change the rates or terms of their contracts.  In two cases in which utilities sought to increase rates in violation of their agreement to waive their rights to do so, the US Supreme Court ruled that their rate filings were invalid.  It held that where sellers and buyers waived these rights to seek changes to their contracts, FERC still retained the authority to modify the contracts, but only if FERC found that failure to do so would be against the “public interest” (as opposed to the private interests of the buyer or seller).  This type of contract is called a “Mobile-Sierra” contract, based on the names of the Supreme Court cases that established this interpretation of the Federal Power Act.

Several of the contracts between power suppliers and California explicitly prohibit the parties from unilaterally requesting FERC to alter the contract.  They also direct FERC to use the higher “adverse-to-the-public-interest” standard for reviewing a proposed change to the contract.  Other contracts are silent, but none expressly reserves the rights of the seller or the purchaser to seek rate or contract term changes from FERC.

The California challenges to the contracts signed in 2001 to buy electricity for terms up to 11 years require FERC to address this issue once again.  The agency will also have to determine what weight to give to the contractually-established bargain struck by the parties, in a scenario where the prices reflected in those contracts, while extensively praised by the California officials who negotiated them at the time, are no longer viewed as favorable to the state.

FERC Signals

Two of three FERC commissioners suggested in a public meeting on March 26 that they do not intend to set aside the California contacts.

The chairman, Pat Wood, said he agrees with the FERC staff’s view that contract sanctity is vital to the industry and suggested the evidence presented so far by California does not constitute a basis for abrogating the contracts.  This is consistent with other signals that FERC has given in the case to date.  For example, the order the commission issued setting the case for hearing referred to FERC’s “long-standing policy” of recognizing the sanctity of contracts.  In an April 2002 order, FERC observed that preservation of contracts “has become even more critical” today, since “competitive power markets simply cannot attract the capital needed to build adequate generating infrastructure without regulatory certainty.”

The power suppliers and marketers who signed contracts to sell to California and the FERC staff have taken the position in the proceeding that a decision to set aside the contracts would complicate the financing of future power projects.  No lender could be certain that the deal the seller struck to sell electricity will last for the full term of the contract.  Such a result would be ironic, since the lack of sufficient supply is acknowledged by all of the California parties to have played a substantial role in the spot-market price increases that the long-term contracts were intended to remedy.

Meanwhile, California argues that the power shortages and extremely volatile spot-market prices at the time it agreed to the contracts were extraordinary market conditions that are not likely to recur.  A FERC decision to revise the contracts would be a non-recurring remedy to unique circumstances.

Another FERC commissioner – Nora Brownell – said at the March 26 meeting that the contract price is not the only consideration in the analysis, and that the “societal costs” of unwinding a contract must be compared to the benefits of contract modification.  She emphasized that contracts form the very basis of the economic system, and also are the underpinning of “infrastructure investment,” including “generation vital to the market.” She noted that the parties who entered into the contracts were sophisticated and experienced in the power industry, and the fact that California signed contracts and then waited a year to complain about them influenced her view that its complaints should be viewed with skepticism.  A more convincing case is made if a party concerned that the other side has undue market power does not wait, but instead files a complaint with FERC simultaneously with the execution of a contract.

The chairman, Pat Wood, said he agrees with Brownell, but wants to finish reading the large volume of materials submitted in a government investigation of alleged market manipulation in Western markets before making a final decision.

Wood and Brownell are the two Republicans on the commission.  There is only one Democrat, Raymond Massey.  Two other commissioner slots are vacant.

In contrast, Massey said concerns about the sanctity of contracts must be balanced against the staff’s finding that flaws in the California spot market carried over to prices in contracts with terms of one and two years.  The staff found that prices in longer-term contracts were not materially affected by problems in the spot market.

The commissioners also talked at the meeting about the standard that must be met under the Mobile-Sierra doctrine to justify modification of a contract in which the seller and buyer had agreed to waive their rights to seek changes to the agreed-upon contract rate or terms.  Wood and Brownell said they would permit contract modification only on a showing that the contract had a significant adverse financial impact on the purchaser as well as on the purchaser’s end users, that the contract was a significant part of the purchaser’s portfolio, that the purchaser had no alternative sources of supply (including from other generators), or that other adverse circumstances existed contemporaneously with entering into the contract, and that the purchaser complained to FERC in a timely manner.

A formal decision in the California case is expected this spring.  If the decision is consistent with the discussion at the March 26 meeting, then it will be good news for lenders and investors in project-financed energy projects, as the revenue stream for such projects is derived from rates established in contracts.