United States: Ninth Circuit Decisions Affect Competitive Wholesale Power Prices And Markets

On December 19, 2006, the U.S. Court of Appeals for the Ninth Circuit issued opinions in Public Utility District No. 1 of Snohomish County Washington v. FERC (Snohomish) and Public Utilities Commission of the State of California v. FERC (CPUC) and consolidated separate appeals that addressed several interrelated issues concerning unilateral attempts to modify forward contracts entered into by power companies in California, Nevada and Washington during the western energy crisis of 2000-01.

In Snohomish, the Ninth Circuit found that FERC erred both in its procedural reliance on Mobile-Sierra and in the substantive standard it used to determine that the contracts at issue did not adversely affect the public interest. The Mobile-Sierra doctrine provides that where parties have entered into a bilateral contract with a fixed rate or other fixed terms and conditions, FERC’s sole concern under the Federal Power Act (FPA) or the Natural Gas Act (NGA) is "whether the rate [could] adversely affect the public interest—as where it might impair the financial ability of the public utility to continue its service, cast upon other consumers an excessive burden, or be unduly discriminatory."

Moreover, the Ninth Circuit created a new standard of Mobile-Sierra review applicable in a "high-rate" challenge, holding that the relevant inquiry is "whether the wholesale energy contract is outside the ‘zone of reasonableness’ and results in retail rates higher than would be the case if that zone were not exceeded." The court then granted the public utilities’ petitions for review and remanded the case to FERC so that it can reassess whether Mobile-Sierra review or full, just and reasonable review of the challenged contracts is appropriate.

In CPUC, the court made consistent findings. In addition, the court directed FERC to consider the FERC staff report on market manipulation and discovery that was proffered in the California refund proceeding, San Diego Gas & Electric Co. v. Sellers. Finally, the CPUC court reversed FERC’s dismissal of a complaint brought by PacifiCorp Power Marketing (PPM) concerning a contract that was executed after FERC imposed a west-wide price cap on June 21, 2001.

The U.S. Supreme Court decided the Mobile and Sierra cases during the period when wholesale power rates were set by regulators based on the cost of production and a reasonable return on equity. During the 1990s, FERC changed the regulatory regime from cost-based rate regulation to the current market-based rate regulation paradigm. The Ninth Circuit modified the standard of review enunciated by the Supreme Court in Mobile and Sierra and held that parties seeking Mobile-Sierra protection in the market-based rate regime must meet each of the following prerequisites:

• The contract by its own terms must not preclude the limited Mobile-Sierra review.

• The regulatory scheme in which the contracts are formed must provide FERC with an opportunity for effective, timely review of the contracted rates.

• When FERC is relying on a market-based rate regime to produce just and reasonable rates, this review must permit consideration of all factors relevant to the propriety of the contract’s formation.

In those cases in which any of these prerequisites are not met, the court held that, "the Mobile-Sierra presumption cannot apply and FERC must find another method of evaluating whether the challenged rates are just and reasonable."

Contract Cannot Preclude Mobile-Sierra
The first prerequisite is that the contract cannot, by its own terms, preclude Mobile-Sierra review. In other words, the contract cannot contain a specific reservation (often referred to as a Memphis clause) by the parties of the unilateral right to seek revisions to the contracts under the FPA. Conversely, in the absence of such a contractual reservation, the contract will be subject to the Mobile-Sierra review. The panel concluded that the contracts at issue (contracts executed under the Western Systems Power Pool Agreement) did not contain a specific reservation by the parties of the right unilaterally to seek revisions to the contracts under FPA sections 205 or 206. Thus, the parties did not waive Mobile-Sierra review of unilaterally requested changes to their contracts.

Contract Must Be Subject to FERC Review and Oversight
The second prerequisite announced by the court is that the regulatory context in which the contracts were initially formed must provide a sound basis for FERC to conclude that the resulting rates are just and reasonable. According to the Ninth Circuit, in order to justify Mobile-Sierra review, FERC must have an opportunity to review initially the contracted rate. The fact that a contract counterparty has market-based rate authority is sufficient prior review to justify Mobile-Sierra review only if FERC has effective oversight enabling timely reconsideration of market-based authorization in the event that market conditions change. The court emphasized that, "[t]he requirement of continued oversight in a market-based rate regime applies equally to the section 206 context, and to the application of the Mobile-Sierra doctrine in section 206 review."

In the cases under review, the court held that FERC had failed to adopt an effective monitoring mechanism prior to applying Mobile-Sierra review to the challenged contracts. The court observed that "[t]he fatal flaw in FERC’s approach to oversight is that it precludes timely consideration of sudden market changes and offers no protection to purchasers victimized by the abuses of sellers or dysfunctional market conditions that FERC itself only notices in hindsight." Accordingly, the court concluded that FERC’s invocation of Mobile-Sierra review was erroneous.

FERC Must Have Ability to Review Context of Contract Formation
The third prerequisite is that,"[n]ot only must FERC have an opportunity for some initial review of rates, but the scope of that review must permit consideration of the factors relevant to the propriety of the contract’s formation" (emphasis added). To that end, the court determined that Mobile-Sierra review cannot apply unless there is a determination that "the challenged contract was initially formed free from the influence of improper factors such as: market manipulation, leveraging market power, or an otherwise dysfunctional market." Notably, in its discussion of the petitioner’s contentions on the influence of improper factors on the spot and forward markets, the court "accept[ed] FERC’s assumption that the two markets are sufficiently separate that there is at least a question as to the scope of the impact of the dysfunctional spot market on the forward market."

The court then turned to the effect of contract modification on the public interest and explained that FERC had relied on the wrong legal standard when it applied factors taken from the context of a "low-rate" challenge (i.e., the factors set forth in Sierra) rather than those relevant to a "high-rate" challenge, such as that presented in this case. Contrary to the Supreme Court’s holdings in Mobile and Sierra, the Ninth Circuit instructed FERC to "give predominant weight in determining whether to modify a contract under section 206 to the impact of a challenged wholesale contract on the rates paid by the consuming public who use the energy covered by the contract" (emphasis added).

The court rejected the use of the Sierra three-prong public interest "test" in all circumstances, and explained that FERC had erroneously assumed "that Sierra established a three-prong public interest standard applicable across all circumstances." The court concluded that, when applying Mobile-Sierra public interest review in a high-rate challenge, the relevant inquiry "is not whether the contracted rates pose an ‘excessive burden’ on consumers." Instead, it is "whether the wholesale energy contract is outside the ‘zone of reasonableness’ and results in retail rates higher than would be the case if that zone were not exceeded" (emphasis added). The court does not describe how much higher these retails rates would have to be to fall outside of the "zone of reasonableness."

In the companion CPUC case, the petitioners raised essentially the same arguments concerning contracts executed between the California Department of Water Resources and certain power suppliers that were raised in the Snohomish case. As in its companion opinion, the Ninth Circuit applied the Snohomish reasoning, granted the petition to review and remanded to FERC to apply the standard of review outlined in Snohomish.

In addition, the CPUC opinion directs FERC, on remand, to consider the FERC Staff Report on Price Manipulation in Western Markets (Staff Report) and the discovery proffered in the California refund proceeding in San Diego Gas & Electric Co. v. Sellers. Specifically, the court suggested that FERC should consider such evidence "before determining whether the Mobile-Sierra presumption applies."

Finally, the Ninth Circuit determined that FERC’s dismissal of the CPUC’s complaint against PacifiCorp Power Marketing (PPM) was inappropriate. The court held that FERC could not rely solely on the fact that it had instituted a west-wide price cap on June 19, 2001, as a basis for dismissing the PPM contract complaint. The court stated that "FERC should have at least considered the possibility that ill effects remained."

The new FPA section 206 standard of review for wholesale power contracts created by the Ninth Circuit purports to modify, and appears to be inconsistent with, the long-standing standard set by the U.S. Supreme Court in the Mobile and Sierra cases and their progeny by:

• Limiting the application of Mobile-Sierra protection to instances where markets are pre-determined by FERC to be free from manipulation, the leverage of market power or "dysfunction"

• Differentiating between low-rate challenges and high-rate challenges in the application of the Mobile-Sierra public interest test, which calls into question when and if Mobile-Sierra can be applied meaningfully to market-based rate contracts

• Casting doubt as to the efficacy of FERC’s market-based rate regime by finding that FERC has abdicated its requirement to oversee ongoing changes in market conditions in the interim periods between the grant of an entity’s market-based rate authority and typical triennial market-based rate review

Ultimately, the Ninth Circuit decision questions whether market-based rate transactions can invoke Mobile-Sierra "protection" as of the execution and/or effective date of a transaction as has been the case to date, absent FERC providing a mechanism to review ex ante the context in which such contracts are formed. In addition, the Ninth Circuit’s decision appears to reject widely accepted competition theory that holds that a market participant without market power cannot charge above-market rates.

Parties to the Ninth Circuit case are likely to see additional review of the order. Thus, the ultimate determination of the proper application of Mobile-Sierra protection to market-based rate wholesale power contracts will not occur until sometime in the future. In the interim, power marketers should consider whether it would be prudent to modify the language of contracts applicable to transactions occurring in the Ninth Circuit to provide more certainty about the enforceability of wholesale power contracts. They also should consider becoming active in advocating for contract certainty in legislative, regulatory and judicial forums.

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