US Supreme Court Affirms Sanctity of Power Contracts — Sort Of

US Supreme Court Affirms Sanctity of Power Contracts — Sort Of

November 01, 2008

The United States Supreme Court upheld the application of the so-called “Mobile-Sierra doctrine” to certain long-term wholesale power contracts in a decision in late June. This was the first high court decision to address the Federal Power Act in more than 10 years.

The case involved power contracts that utilities in California and other western states signed during the California energy crisis in 2000 and 2001 during a period when electricity prices spiked. The utilities have been trying to get out of the contracts on grounds that the spot markets had become dysfunctional and noncompetitive due to market manipulation and for other reasons.

The Supreme Court held that power contracts signed by independent generators who had approval from the Federal Energy Regulatory Commission to sell at market rates are entitled to a presumption of validity, but it sent the case back to FERC for further consideration of two technical issues. In doing so, the court made clear the purchasing utilities have a high mountain to climb if they want to set aside the contracts.

The case is called Morgan Stanley Capital Group, Inc v. Snohomish.

Background

Under the Mobile-Sierra doctrine, there is a presumption of validity for power contracts against challenges that the rates in those contracts proved, in hindsight, to be too high or too low to be just and reasonable based on later events. Power contracts will not be modified by federal regulators unless they are found to violate the “public interest,” a very high standard to meet. The doctrine was created by the Supreme Court 50 years ago in an era of cost-based ratemaking, not competitive market rates. Because of the Supreme Court’s adherence to the doctrine in its latest decision, a power seller signing a long-term contract at prices that are consistent with the market-based rate tariff the seller has on file with the Federal Energy Regulatory Commission can feel confident that the contract cannot be overturned by FERC absent a finding of extreme public necessity.

The case before the Supreme Court concerned challenges to contracts signed during the California energy crisis in 2000 and 2001. Spot prices had exploded to levels that were several multiples of energy prices over the prior two or three years. In order to mitigate the impacts on ratepayers, purchasing utilities throughout the western United States signed hundreds of long-term contracts with dozens of suppliers during this period. After the spot prices moderated, many of the purchasing utilities, or state regulatory commissions or advocacy groups acting on their behalves, filed complaints at FERC seeking to have the contract prices reduced or the contracts abrogated.

The challengers offered a variety of arguments to support their claims. A number of the buying utilities claimed that the market was dysfunctional at the time of contract formation due to market manipulation by some of the sellers and, therefore, the historic Mobile-Sierra protection did not apply. Others contended that Mobile-Sierra protection should not apply to contracts signed under market-based rates because the contracts did not have to be filed and reviewed at FERC. Still others argued that Mobile-Sierra protection only applies in a so-called “low rate” case, where the selling utility is trying to increase the contract rate, but does not apply in a “high rate” case such as this one, where the purchasing utility is trying to lower the rate.

In general, all of the purchasing utilities wanted FERC to review the contract rates under the typical cost-based or “cost of service” standard of “just and reasonable” rates, rather than the more burdensome “public interest” standard of just and reasonable rates established by the court in Mobile and Sierra cases. Alternatively, even if the Mobile-Sierra doctrine applied, most of the utility buyers claimed that the “public interest” test was met because the contracts constituted an excessive burden on their ratepayers.

The Mobile-Sierra Doctrine

The Federal Power Act, among other things, approves wholesale rates between private sellers and either public or private buyers of electricity in the continental United States (except for most of Texas and Alaska). FERC establishes rates that are “just and reasonable” in the first instance, and if it later finds that rates have become unjust and unreasonable, it modifies the rates to a just and reasonable level. The statute also requires wholesale contracts to be filed at FERC, and the US Supreme Court, in two cases in 1956 — called United Gas Pipeline v. Mobile Gas Service Corp and Federal Power Commission v. Sierra Pacific Power Co. — held that “by requiring contracts to be filed with the Commission, the Act expressly recognizes that rates to particular customers may be set by individual contracts.” Although the Mobile case involved the Natural Gas Act and the Sierra case involved the Federal Power Act, the relevant sections of the two statutes were substantially the same and were thus interpreted together.

In the Sierra case, the Supreme Court determined that if a contract did not permit unilateral changes to the price by its terms, then the contract could not be modified later unless the price caused a greater problem than merely whether the rate would produce a rate of return above a typical cost-of-service level. The court held that a utility “may agree by contract” to accept a low rate and, by accepting a low rate, it is not “entitled to be relieved of its improvident bargain” later. However, the court noted that federal regulators still have jurisdiction to modify the rate if the public interest would be adversely affected. According to the court, the public interest would be adversely affected in three situations. One is if the rate might impair the financial ability of the utility to continue service. Another is if the rate would place an excessive burden on the utility’s other customers. The last is if the rate would be unduly discriminatory.

Since the Mobile and Sierra decisions, many United States courts of appeals have applied the Mobile-Sierra doctrine, but the Supreme Court did not have the opportunity to address the doctrine again, and never addressed the doctrine in today’s climate where rates for wholesale power sales were not set by the regulators in the first instance, but rather are market rates that the parties to the contract negotiated themselves.

The Federal Energy Regulatory Commission in this case turned aside the challenges to the fixed-rate contracts, holding that the Mobile-Sierra doctrine applied and that the challengers did not meet the high, public interest burden of proof needed to overturn the contract rates. Those challengers that sought to meet the burden challenged the contract prices on ground that they created an “excessive burden” on ratepayers, one of the three grounds the Supreme Court said in the Sierra case might justify setting aside rates. They did not seek to challenge the rate on either of the other two grounds.

On appeal of the FERC decision, a US appeals court invalidated the FERC order on a number of grounds, including that the Mobile-Sierra doctrine may not apply to contracts under market rate tariffs, rather than cost-of-service rates, since the contracts were not filed and reviewed by FERC and, even if the Mobile-Sierra doctrine applies, there is no higher “public interest” burden of proof to meet if the complaining party is the purchasing utility rather than the seller. In this case, the complaining parties were the purchasing utilities or their representatives. The appeals court sent the case back to FERC for further review.

What the Supreme Court Said

The Supreme Court rejected the reasoning by the appeals court and upheld the application of the Mobile-Sierra doctrine to long term contracts with market-based rates. The court said it does not matter whether FERC was asked to review the contract when the contract was signed. The Mobile-Sierra standard applies regardless of when FERC is asked to look at the contract.

The court also rejected the view that FERC must inquire whether the contract was formed in a dysfunctional market before deciding whether the Mobile-Sierra doctrine applies. The court noted that the ability of utilities to sign long-term contracts was a leading factor in eliminating volatility in the spot markets during the California energy crsis. The court said, “It would be a perverse rule that rendered contracts less likely to be enforced when there is volatility in the market . . . . Such a rule has no support in our case law . . . .” However, the court said FERC can set aside contracts if there is evidence of unfair dealing at the contract formation stage, or if the dysfunctional market conditions under which the contract was signed was caused by illegal action of one of the parties.

The court also rejected the view that in a “high rate” case, the buyer only has to show that the rate is outside of a “zone of reasonableness” to overturn the contract. Rather, a showing must be made that the contract prices are an excessive burden on the purchasing utility’s ratepayers, which is a much higher burden to meet than a test that the prices to which the contracting parties agreed are high in relation to the generator’s costs.

The Supreme Court sent the case back to FERC for further consideration of two issues.

The first issue dealt with the rule that a contract can be overturned if it places an “excessive burden” on other customers of the utility. FERC had concluded that the impact of the contract rates on the purchasing utilities and their customers was not excessive compared with existing rates to those customers at the time. The court said that this analysis was incomplete, because FERC should also have compared the contract rates with the rates that consumers would have paid once the markets were no longer dysfunctional.

The second issue related to the claim by some of the purchasing utilities that they were victims of market manipulation in the spot market. The court said that “if it is clear that one party to a contract engaged in such extensive market manipulation as to alter the playing field for contract negotiations, [then FERC] should not presume that the contract is just and reasonable.” The court emphasized that “the mere fact of a party’s engaging in unlawful activity in the spot market does not deprive its forward contracts of the benefit of the Mobile-Sierra presumption”; rather, the purchasing utility must show that market manipulation by the seller led directly to the high prices in its power contract. FERC failed in the case to address whether there was such a connection.

It is important to understand what the court did not say with respect to the second issue. For example, simply because a seller may have settled charges against it that it was involved in manipulating the California spot market does not mean, without more, that a long-term contract signed by that seller during this period can be abrogated. Nor would it be sufficient that there is evidence that some other seller engaged in unlawful spot market activity that affected the market during a period in which a purchasing utility signed a long-term contract with a different seller who was not so engaged.

What Happens Next

FERC had not yet issued an order concerning the two issues sent back to it by the Supreme Court as the NewsWire went to press in early November. It has a number of alternative paths to resolving the open issues.

If FERC believes the two issues were already fully addressed, then it could simply provide an analysis of each issue and decide the case again without reopening the proceeding for more evidence and briefing. This is unlikely to happen for all of the contracts at issue, although it is possible that the facts relating to one or more sellers would permit this result.

Most of the challenges to the long-term contracts entered into during the California energy crisis have been resolved through settlement agreements. FERC may try first to determine whether settlements are possible among the remaining parties.

If another hearing is required to gather additional evidence, then FERC could ask for a “paper hearing,” with limited discovery and prepared affidavits and no cross-examination, or FERC could instead direct that a more formal, full evidentiary hearing be held on one or both of the issues. It is also possible that the sheer difficulty of meeting the Mobile-Sierra burden laid down by the Supreme Court in late June may cause some of the purchasing utilities to drop their challenges.

Unless the litigants decide to settle, the chances are high that whatever FERC decides in the next round will be appealed again to the US court of appeals. And the beat goes on.