EU Energy Policy Blog

Long-term energy contracts are under attack by antitrust authorities and courts on both sides of the Atlantic. Should we protect contract certainty to promote infrastructure investments? Or should we deny the validity of contracts concluded in non-competitive energy markets?

In Europe the Commission, the Court of Justice and the Bundeskartellamt took decisions against wholesale gas supply contracts and electricity transmission capacity reservation contracts concluded by former monopolists. In US the Ninth Circuit’s federal judges reversed FERC’s decisions on long-term electricity contracts concluded in the wake of the Californian crisis and suggested new criteria for their modification. The US Supreme Court is expected to decide on this case in the next few months. The subject of those disputes is at the heart of energy markets reforms. After briefly describing the European and American cases, I advance two arguments: firstly, the present US and EU regulatory frameworks are inadequate to deal with the tradeoffs between investment incentives and liberalization policies; secondly, legal cultures exert a non negligible influence on the final outcomes and should be taken into account by proponents of energy markets reform.

In October 2007 the European Commission accepted the commitments made by Distrigas, the largest gas supplier and importer in Belgium, to remedy competition problems in Belgian gas markets. Under these commitments, Distrigas will reduce the volumes of gas sold in Belgium that are tied to it under long-term contracts. New contracts with gas resellers will not exceed two years (five years for industrial consumers and electricity generators). Such measures should enable other gas suppliers to compete with Distrigas for the demand freed up and to build up a portfolio of customers. The Commission added that long-term contracts are not as such illegal. In assessing their compatibility with competition rules, the following five elements will be considered: (i) the market position of the supplier, (ii) the share of the customer’s demand tied under the contract, (iii) the duration of the contracts, (iv) the overall share of the market covered by contracts containing such ties, and (v) efficiencies.

An important forerunner to the Distrigas case was the 2006 decision of the Bundeskartellamt in the E.On/Ruhrgas case. The dominant German gas operator was ordered to stop writing long-term supply contracts with distributors that a) cover more than 50% of its customers’ annual demand for more than 4 years, or b) cover more than 80% of annual demand for more than 2 years. Moreover, E.On/Ruhrgas will not be allowed to offer additional volumes under short-term contracts for customers’ residual needs. In this case, too, the German competition authority relied on the idea that contracts with foreclosing effects should be banned.

Much the same logic underlies the 2005 decision by the European Court of Justice in case C-17/03. The European judges decided that priority access to a portion of the capacity for the cross-border transmission of electricity conferred on the Dutch network operator must be regarded as discriminatory and as therefore being contrary to the competition-enhancing goals of the first electricity directive.

Taken together, these three decisions tip the balance toward fostering competition and dismiss the argument that any interference with long-term contracts could decrease investments and dampen security of supply.

On the American side, two decisions of the Court of Appeals for the Ninth Circuit, filed in December 2006, could revolutionize the way long-term energy contracts have been regulated in the last fifty years. Both disputes originated from the Western electricity crisis of 2000-2001. Western utilities entered into long-term contracts to protect from the volatility of spot markets, but they could not avoid paying high prices to sellers. Some months later they asked FERC to modify the contracts and relieve them from their financial burden. The federal regulator rejected the claims of Western utilities, holding that the public interest standard of the Mobile-Sierra doctrine did not justify contract modification. This doctrine, named after two 1956 US Supreme Court decisions, forbids unilateral modifications of contracts, but for a limited set of cases in which the contract originally agreed upon adversely affects the public interest. The Ninth Circuit’s decisions came to different conclusions. According to the federal judges, the Mobile-Sierra doctrine does not apply when there isn’t an effective oversight of energy markets and it is not clear whether the challenged contract was initially formed free from the influence of improper factors, such as market manipulation, the leverage of market power, or an otherwise dysfunctional market. Moreover, the Ninth Circuit rewrites the public interest standard for high-rate cases: FERC should establish 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.

There is much uncertainty on the position that the Supreme Court will take up. I would bet that the present conservative majority will endorse FERC’s position against modification of contracts. However, the Court cannot confine itself to reaffirming its 1956 doctrine. The role of the public interest standard in the new competitive scenario should be explicitly assessed and its content clarified. Note that the Mobile-Sierra doctrine is applied not only to supply contracts, but also to agreements which set up Regional Transmission Organizations. The importance of those organizations for the American electricity industry can hardly be overemphasized.

Interestingly, an Amicus Curiae’s brief was filed by twenty economists (including prominent figures like Baumol, Hahn, Hogan, Shavell and Nobel prize winner Vernon Smith). They advanced two arguments against the Ninth Circuit’s decisions: a) Contract certainty is especially important in energy markets because it helps manage price volatility and develop critical infrastructure; b) contracts should not be abrogated simply because they were negotiated in dysfunctional markets: deciding otherwise will force sellers to charge more to cover the potential future cost of litigation, enforcement, and abrogation, or to decline to offer long-term contracts at all.

Should the latter position prevail in the Supreme Court, the distance from the European approach could not be more marked. Though, going to the extremes does not seem the right answer to the trade-off between contract certainty and liberalization policies. To the arguments of the economists’ brief it could be replied that allowing sellers to pocket the benefits of competition-distorting behaviour does not help foster trust in energy markets. As suggested in the Amicus Brief filed by the National Association of Utility Commissioners, revising contracts “consummated during a period of extreme market dysfunction […] provides an incentive for market participants to improve market function and stability rather than exploiting market defects.”

The comparison between US and EU approaches to long-term energy contracts teaches two lessons. Firstly, neither the American nor the European regulatory frameworks were ready to confront the changes in contractual relationships springing from the disintegration of vertical monopolies. They tried to adapt old doctrines or to exploit the vagueness of existing rules to accommodate emerging needs, but have so far failed to give a more straightforward assessment of long-term energy contracts. One advantage of the European approach is that the five-pronged test suggested by the Commission seems able to capture the most relevant considerations, including the need to spur investments. After all, in the Distrigas case supplies to new power plants were excluded from the scope of the commitments.

However, and this is the second lesson, there is reason to believe that ex-post antitrust investigations are not the best way to tackle the issues raised by long-term contracts. Assessing their positive and negative effects is an information-demanding exercise. In the explanatory memorandum accompanying the Third Energy Package the Commission says it will provide guidance in an appropriate form on the compliance of downstream bilateral long-term supply agreements with EC competition law. This could prove useful, but it is doubtful whether it will dispel any uncertainty. A more satisfying solution would be to give the forthcoming Agency for the Cooperation of Energy Regulators the power to assess long-term contracts by means of transparent regulatory proceedings. This task can be accomplished on a case-by-case basis or within the consultation process for the Community-wide 10-year network investment plan to be published by the European Network of Transmission System Operators.

A more general point is that the outcome of liberalization policies is heavily dependent on national or continental legal cultures. I use the latter expression to mean the way rule-making and enforcement powers are allocated among institutional players, as well as their attitudes towards principles and values embedded in contract law, regulatory law and competition law. Exploring the way such principles and values mix and match in different legal systems helps gain a thorough understanding of energy markets and advance more consistent policy indications. On the contrary, it is ill-advised to rely exclusively on international best practices and believe they can be easily and successfully transplanted in every legal system.

Giuseppe Bellantuono, professor of comparative law, University of Trento

This entry was posted on Wednesday, January 30th, 2008 at 11:30 pm and is filed under Electricity, English, Gas. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.