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Contract Law and Regulation in Energy Markets

April 16th, 2009 by Giuseppe Bellantuono, University of Trento

How should energy regulators manage contractual relationships in wholesale and retail markets ? I suggest that two decades after the start of the first liberalization programs around the world this question is more pressing than ever. The opening of energy markets to competition was blessed with mixed results.

Although a variety of causal factors is at work, I argue in a recent book that successes and failures can be at least in part explained by the presence or absence of a sound institutional infrastructure. The legal and economic literatures appear to converge on this observation. However, they do not share the same view about the characteristics of the institutional infrastructure and the best methods to set it up.

The example of contractual relationships is a good starting point to explore the interplay between the development of competitive energy markets and the dynamics of institutional change. The dismantling of vertically integrated monopolies leads to an exponential increase of those relationships. At the same time, new intermediaries and innovative commercial practices displace old business models. The lively evolution of markets is matched by an extended rule-making activity on behalf of legislators and sector regulators. More often than not, those interventions are directed at moulding the contents of contracts. So what we see is the attempt to package a new hybrid. On one hand, market players are given the freedom to express their autonomy and produce innovative commercial schemes, which in turn should foster investments in new infrastructures. On the other hand, regulators try to channel such freedom towards the desired ends.

Was energy regulation able to achieve this happy equilibrium between freedom and coercion? I have tried to answer this question through a comparative assessment of European and American regulatory experiences in three areas: Business-to-business energy contracts, residential consumers contracts and quality regulation.

Let’s start with business-to-business energy contracts. Both in Europe and the USA private organizations representing the interests of the industry invested heavily in the standardization of contract models. They aimed at “commodifying” electricity and gas so as to reduce transaction costs. There were also clear links to the commercial practice of financial markets. But it is interesting to note that the standardization process is directly influenced by energy regulation and general contract law. Hence, commercial innovation in energy markets can be at the same time supported and constrained by developments in those two normative blocks. Much the same logic can be detected in the treatment of long-term contracts. In this case, too, the different assessment of their anti-competitive effects in the EU and the US is a consequence of the regulatory context in which they are embedded.

Regarding national experiences in network access, contractual contents are heavily regulated everywhere, but there is space for variations in the weight assigned to each normative block (i.e., contract law, competition policy, sector regulation) and the criteria employed to coordinate them. Italy shows an uneasy coexistence and a lack of explicit coordination between sector regulation, competition law and contract law. The United Kingdom chose to reduce the influence of general common law on the regulated sectors and invested heavily in “enforced self-regulation”. France tries to harmonize the development of a new regulatory system in the energy sector with the deepest characteristics of its national legal system. Germany shows that contract law and energy regulation need not be mutually exclusive normative blocks. Finally, the USA are the clearest example of an attempt to lodge contract principles in the regulatory system.

As far as contracts for residential users are concerned, two different options were pursued: An almost exclusive reliance on sector-specific consumer protection rules (UK and USA) and the joint use of sector-specific regulations and general consumer law (Italy, France and Germany). It is suggested that the second option raises a host of coordination problems and does not seem more effective than the first.

Regarding the regulation of quality in the energy sector, both from the point of view of system security and of individual protection of consumers the relevant comparison is between regulatory mechanisms directed at improving the functioning of the networks on one hand and private law liability rules on the other. Several differences can be detected in European jurisdictions. Italy implemented a sophisticated incentive mechanism for transmission and distribution networks. However, when major blackouts hit the national system, general liability rules were massively invoked before civil judges. The UK adopted both incentive mechanisms and a procedure before the energy regulator for awarding blackout damages. France laid down special liability rules for network operators. The same path was followed by Germany. In the USA, system security is guaranteed by mandatory standards enacted by a private organization under the surveillance of the FERC. Individual protection is shared between common law and sector-specific rules, although the former is often superseded by the latter. I argue that the conflict between collective and individual interests has so far received unsatisfactory answers. More innovative solutions are needed to tailor incentive mechanisms to the demand of final users for specific quality levels.

In my book I describe the main institutional aspects to consider when designing a regulatory system which has to manage the interaction between different levels and different normative blocks. As far as the rule-making function is concerned, I argue that the three main questions are who produces the rules, how their content should be defined and how the rules emanating from different institutions should be coordinated.

On the ‘who’ question, I maintain that the contrast between centralized and decentralized regulatory systems is too schematic and does not offer satisfactory solutions. A shift to a detailed analysis of the characteristics of rules and of coordination mechanisms is advocated.

With regard to the characteristics of rules, three aspects deserve a careful assessment: a) The alternative between mandatory and default rules; b) the decision costs of the regulators, including both the technical competence to evaluate the impact of rules on the relevant markets and error rates compared to other institutions; c) rule inclusiveness, that is the ability to balance competing interests.

With regard to the interaction among rules, the American debate about federal pre-emption distils some lessons for the European regulatory state. The choice among competing normative levels should be left to supranational regulators because they have the technical competence to evaluate the costs and benefits of uniformity and diversity. The Third Energy Package is striving to follow this path, but further refinements are needed on the relationships between European and national regulators on one hand and European and national judges on the other. The respective areas of influence should be clearly delineated and a heightened degree of deference should be accorded to regulators. At the same time, additional participatory mechanisms should be devised for those interests not adequately represented in regulatory proceedings.

Giuseppe Bellantuono, University of Trento

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2 Responses to “Contract Law and Regulation in Energy Markets”

  1. brian Says:

    Since there is some discussion about US federal pre-emption issues, I was wondering if in your book you touched upon emerging California energy law. That is probably the leading state for such issues. Often a leader for other states or ultimately US policy.

  2. Giuseppe Bellantuono Says:

    Dear Brian,
    I dealt with the California energy crisis and the many federal and state decisions trying to apply remedies for damaged utilities and consumers. I have mainly discussed the problems with the filed rate doctrine. I know that are more recent articles dealing with the same problem. Also, there are preemption issues with support mechanisms for renewable which are again connected to the filed rate doctrine. In any case the best discussion can be found in the 2005 book by Jim Rossi.

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