EU Energy Policy Blog

On June 26, 2008 the US Supreme Court issued a 5-2 decision that reopens the debate on long-term contracts concluded in the wake of the California electricity crisis. It advances arguments that confirm the uncertainties surrounding contractual arrangements in the liberalized energy industries.

The facts of the case (Morgan Stanley Capital Group Inc. v. Public Utility District No. 1 of Snohomish County et al.) have already been described in a previous post. Western utilities asked the FERC to revise the onerous contracts they entered into to escape from the turmoil of California spot market. The federal regulator denied relief, but in 2006 the US Court of Appeals for the Ninth Circuit reversed the decision. According to the federal judges, the market context at the time of contract formation should be taken into account to establish whether the price originally agreed upon reflected the statutory requirements of justness and reasonableness. Moreover, the contracts should be deemed contrary to the public interest if they are outside the ‘zone of reasonableness’ and resulted in retail rates higher than would be the case if that zone were not exceeded.

This new interpretation of the Mobile-Sierra doctrine, the judicial standard applied in the last 50 years to the ex-post revision of contracts, would have wide implications for the whole electricity industry. When the Supreme Court granted certiorari, all the major players presented their arguments in detailed briefs. The organizations representing sellers and traders supported FERC’s position of minimal interference with long-term contracts. Those representing the buyers argued that nobody should be allowed to gain from market manipulation and, in any case, the new standard proposed by the Ninth Circuit would not have any demonstrable negative effect on investments in new infrastructure.

The Supreme Court’s majority opinion, authored by J. Scalia, is neatly divided in two parts. The first part rejects the Ninth Circuit’s interpretation of the Mobile-Sierra doctrine. The validity of the traditional standard, which allows contract reformation only when the agreed upon contract-rate seriously harms the consuming public, is reaffirmed. No space is left (at least in this part of the opinion) for a consideration of market dysfunctions existing at the time of contract formation. The Court shares the view, advanced by sellers, traders and a group of prominent economists led by William Baumol, that long-term contracts help parties to hedge against the volatility produced by market imperfections. Ex post revision without serious harm would reduce incentives to offer those contracts. Moreover, the Court rejects the Ninth Circuit’s argument that contracts exceeding marginal costs are outside the zone of reasonableness and should be revised.

Had J. Scalia stopped here, the controversy over Western contracts would have come to an end, the traditional meaning of the Mobile-Sierra doctrine would have been left untouched and the FERC and the federal judges would have to grapple with it as they did in the last fifty years. But there is a second part of the majority opinion, and it is the most surprising one. Two flaws in FERC’s analysis are found out, and they lead the Court to affirm the Ninth Court’s decision on alternative grounds. The case is remanded to the regulator for reconsideration.

The first flaw is the choice of the baseline. The excessive burden for consumers, required by the Mobile-Sierra doctrine, should not be judged with reference to the high market prices obtaining in the dysfunctional California spot market. Because the market prices reached unprecedented levels, it is possible that the contract price is lower but still excessive. Therefore, the baseline should be the rates that, had the contract not entered into, would apply after the market dysfunctions disappeared.

Secondly, the Court asked the FERC to clarify whether the manipulation of spot markets by the sellers could have affected the price of forward contracts. Although there are two different markets, the prices agreed upon could not be considered just and reasonable if there is proof of a causal connection with the unlawful behaviour.

How should the two parts of the decision be reconciled ? The Court bound the FERC to the high standard of excessive burden for consumers, but left the regulator a wide discretion on how that standard is to be specified. Regarding the first flaw, several econometric techniques can be employed to find the baseline price. But how much should the contract price depart from the market price before the burden on consumers can be judged excessive ? Is a 50%, 100% or 200% increase required ? There seems to be no definitive answers. Regarding the second flaw, there are many studies which find a relationship between spot and forward prices, but the question is whether a causal link can be proved between the manipulation of the spot market by one seller, the increase of spot prices and the resulting contract price. Therefore, much depends on how the FERC will interpret the requisite of causality. To sum up: there is ample room for the FERC to maintain its policy to grant revision of long-term contracts only in exceptional circumstances. From this point of view, there isn’t any contrast between the two parts of the decision.

For a European observer, it is interesting to note that the same issues debated in the Morgan Stanley case surface in the antitrust proceedings of the European Commission and national competition authorities against long-term contracts. Does the different legal framework produce divergent outcomes ? Art. 81 EC Treaty allows competition authorities to shape contract terms like duration, volumes and termination rights so as to avoid market foreclosure. However, according to art. 81(3) negative effects can be assessed against efficiency benefits. Much the same role is played by art. 82 EC Treaty on abuse of dominance. However, it is very difficult to use this provision against unfair and excessive energy prices. From the point of view of black letter rules, there seems to be no reason to believe that American and European regulators should reach a different balance between freedom of contract and pro-competitive measures.

But the real difference lies in the range of competences available to the FERC and the Commission. The former has the power to regulate wholesale markets and can influence the behaviour of market players in several different ways. Therefore, it can foster competition without imposing rigid restrictions on long-term contracts. The latter can regulate wholesale markets to a very limited extent and relies on antitrust enforcement as the most powerful tool to build the Internal Energy Market. Hence, there is a serious risk that in European antitrust proceedings on long-term contracts considerations related to investment incentives will be downplayed. Moreover, inconsistent approaches could arise because of the decentred application of European antitrust rules. The different distribution of powers in the two multi-level regulatory systems could widen the gap with the American approach.

This is a good example of why and how institutions matter. The outcome is not dictated exclusively by the economics of long-term contracts, but also by the internal dynamics of regulatory practice. Of course, the aim should be to reduce error rates. At present, they seem higher for the European Commission, which is forced to rely on a more limited set of tools and shall adapt them to different tasks. But note that the FERC is often blamed for not fighting against market abuse. It looks like the mirror image of European shortcomings.

Perhaps the legislative debate on the third energy package will improve the European regulatory system. In its first reading, the European Parliament proposed to strengthen the powers of the new Agency for the Cooperation of Energy Regulators (ACER). It should be able to issue binding guidelines and approve the 10-year investment plans of European Transmission Systems Operators. Could these provisions lay the ground for an ex-ante evaluation of efficiencies and potential foreclosure effects stemming from long-term contracts ?

Giuseppe Bellantuono, professor of comparative law, University of Trento

This entry was posted on Thursday, July 17th, 2008 at 10:21 am and is filed under Electricity. 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.