Morgan Stanley Capital Group v. Public Utility 1

Power suppliers who sold electricity to utilities during the 2001 California energy crisis have persuaded the Supreme Court to review a decision that might have required them to forfeit millions of dollars by modifying contracts worth millions of dollars with aggreived public utilities.

The consolidated case, Morgan Stanley Capital Grp., Inc. v. Public Util. Dist. No. 1, Nos. 06-1454, 06-1457, 06-1462, and 06-1468, stems from a Ninth Circuit Court of Appeals decision in favor of several utilities in California, Nevada and Washington State.

In the case, the Ninth Circuit held that the Supreme Court's well-established "Mobile-Sierra" doctrine -- generally honoring wholesale energy contracts between power suppliers and utilities even when market conditions later render the deal improvident -- did not prevent the Federal Energy Regulatory Commision from reforming deals struck during the California crisis. United Gas Pipe Line Co. v. Mobile Gas Serv. Corp., 350 U.S. 332 (1956), FPC v. Sierra Pac. Power Co., 350 U.S. 348 (1956).

That crisis arose after the California legislature dergulated the power industry in 1996, so that the state's three largest investor-owned utilities were required to get out of the business of generating power. Instead, the state established a so-called "spot market" in which power suppliers sold electricity for the present day and one day ahead. The utilities were required to purchase most of their energy on the spot market, but could buy some in long-term contracts on a "forward market." At the same time, the state put a lid on retail rates, blocking some new energy suppliers from entering the California market.

In the summer of 2000, wholesale electricity prices in California skyrocketed, moving from historic norms of $34 per megawatt hour to more than $3,000 per megawatt hour. FERC later traced the market anomoly to a combination of increased cost to produce power, increased demand because of an exceptionally hot summer, an overreliance on the spot markets and manipulation of the market by sellers -- most notoriously by now-defunct Enron Corp.

During the crisis, several utilities on the Western power grid concluded that they could no longer afford to buy electricity on the exorbitant spot market, and instead negotiated long-term contracts with power suppliers on the forward market. They have alleged in these cases that because forward market prices were also rising and because they had an immediate need to secure power for their customers, they had no choice but to accept the suppliers' excessively high electricity prices.

Once the crisis passed, and energy prices receded, the Western utilities asked FERC to let them modify the contracts so that they could pay more reasonable prices for wholesale energy and lower their customer rates accordingly.

FERC refused, explaining that the twin 1956 Supreme Court cases establishing the Mobile-Sierra doctrine established a presumption that contracts negotiated by sophisticated power suppliers and public utilities are "just and reasonable," as required by the Federal Power Act. In short, even if such contracts later turn out to be unprofitable for either party, they cannot be abrogated. The Court did carve out one exception to the Mobile-Sierra presumption, for cases in which the contracts are against the "public interest." Both of the situations before the Court in Mobile and Sierra involved power suppliers who contended they agreed to erroneously low energy prices. The Court held that only if such low prices would undermine the economic viability of a power supplier -- and thereby jeopardize the availability of power to retail users -- could FERC order higher rates despite the terms of the contract.

The power suppliers in the instant case persuaded FERC that Mobile-Sierra barred it from revisiting the terms of the contracts formed during the California crisis. The Ninth Circuit disagreed. First, it posited, Mobile-Sierra rests on an assumption that FERC had an opportunity to review power rates prior to the effective date of the contract. That was not the case here, it concluded, because in the 1980s FERC shifted from a regime whereby it reviewed individual contracts before they took effect. Under the new, "market-based," regime, the agency essentially pre-cleared power suppliers to undertake sales without prior approval after determining that the supplier did not have the leverage to negotiate above-market rates. This regime blocked FERC's opportunity to review the rates to ensure they were "just and reasonable."

Additionally, the Ninth Circuit held that Mobile-Sierra did not apply because the California market was so dysfunctional when the contracts were entered into that FERC could not presume the agreed rates were just and reasonable. Finally, the Ninth Circuit held that although Mobile-Sierra suggested that public interest would justify reforming the contracts only if they threatened the viability of the power supply because low rates decimated profitability, the public interest standard also permitted new contracts if high rates excessively burdened consumers.

The power companies argued in their petitions for certiorari that the Ninth Circuit had essentially killed the Mobile-Sierra doctrine, and would throw the electricity industry into disarray if its decision were allowed to stand. The utilities countered that the court had correctly applied the doctrine to a vastly changed industry in order to protect consumers.

Neither Chief Justice John Roberts nor Justice Stephen Breyer participated in the decision to grant certiorari.

The Supreme Court asked the Federal Energy Regulatory Commission and a federal appeals court on Thursday to review the conclusions both reached about whether electricity contracts signed during the 2001 Western energy crisis placed an excessive burden on customers.

The consolidated case, Morgan Stanley Capital Grp., Inc. v. Public Util. Dist. No. 1, Nos. 06-1454, 06-1457, 06-1462, and 06-1468, stems from a Ninth Circuit Court of Appeals decision in favor of several utilities in California, Nevada and Washington State.

In the case, the Ninth Circuit held that the Supreme Court's well-established "Mobile-Sierra" doctrine -- generally honoring wholesale energy contracts between power suppliers and utilities even when market conditions later render the deal improvident -- did not prevent the Federal Energy Regulatory Commission from reforming deals struck during the California crisis. United Gas Pipe Line Co. v. Mobile Gas Serv. Corp., 350 U.S. 332 (1956), FPC v. Sierra Pac. Power Co., 350 U.S. 348 (1956).

That crisis arose after the California legislature deregulated the power industry in 1996, so that the state's three largest investor-owned utilities were required to get out of the business of generating power. Instead, the state established a so-called "spot market" in which power suppliers sold electricity for the present day and one day ahead. The utilities were required to purchase most of their energy on the spot market, but could buy some in long-term contracts on a "forward market." At the same time, the state put a lid on retail rates, blocking some new energy suppliers from entering the California market.

In the summer of 2000, wholesale electricity prices in California skyrocketed, moving from historic norms of $34 per megawatt hour to more than $3,000 per megawatt hour. FERC later traced the market anomaly to a combination of increased cost to produce power, increased demand because of an exceptionally hot summer, an over reliance on the spot markets and manipulation of the market by sellers -- most notoriously by now-defunct Enron Corp.

During the crisis, several utilities on the Western power grid concluded that they could no longer afford to buy electricity on the exorbitant spot market, and instead negotiated long-term contracts with power suppliers on the forward market. They have alleged in these cases that because forward market prices were also rising and because they had an immediate need to secure power for their customers, they had no choice but to accept the suppliers' excessively high electricity prices.

Once the crisis passed, and energy prices receded, the Western utilities asked FERC to let them modify the contracts so that they could pay more reasonable prices for wholesale energy and lower their customer rates accordingly.

FERC refused, explaining that the twin 1956 Supreme Court cases establishing the Mobile-Sierra doctrine established a presumption that contracts negotiated by sophisticated power suppliers and public utilities are "just and reasonable," as required by the Federal Power Act. In short, even if such contracts later turn out to be unprofitable for either party, they cannot be abrogated. The Court did carve out one exception to the Mobile-Sierra presumption, for cases in which the contracts are against the "public interest." Both of the situations before the Court in Mobile and Sierra involved power suppliers who contended they agreed to erroneously low energy prices. The Court held that only if such low prices would undermine the economic viability of a power supplier -- and thereby jeopardize the availability of power to retail users -- could FERC order higher rates despite the terms of the contract.

The power suppliers in the instant case persuaded FERC that Mobile-Sierra barred it from revisiting the terms of the contracts formed during the California crisis. The Ninth Circuit disagreed. First, it posited, Mobile-Sierra rests on an assumption that FERC had an opportunity to review power rates prior to the effective date of the contract. That was not the case here, it concluded, because in the 1980s FERC shifted from a regime whereby it reviewed individual contracts before they took effect. Under the new, "market-based," regime, the agency essentially pre-cleared power suppliers to undertake sales without prior approval after determining that the supplier did not have the leverage to negotiate above-market rates. This regime blocked FERC's opportunity to review the rates to ensure they were "just and reasonable."

Additionally, the Ninth Circuit held that Mobile-Sierra did not apply because the California market was so dysfunctional when the contracts were entered into that FERC could not presume the agreed rates were just and reasonable. Finally, the Ninth Circuit held that although Mobile-Sierra suggested that public interest would justify reforming the contracts only if they threatened the viability of the power supply because low rates decimated profitability, the public interest standard also permitted new contracts if high rates excessively burdened consumers.

The power companies argued in their petitions for certiorari that the Ninth Circuit had essentially killed the Mobile-Sierra doctrine, and would throw the electricity industry into disarray if its decision were allowed to stand. The utilities countered that the court had correctly applied the doctrine to a vastly changed industry in order to protect consumers.

On June 26, the Supreme Court affirmed the Ninth Circuit’s decision in an opinion authored by Justice Antonin Scalia.

"Balancing the short-term and long-term interests of consumers entails difficult judgment calls, and to the extent FERC actually engages in this balancing, its reasoned determination is entitled to deference," Scalia wrote. "But FERC cannot abdicate its statutory responsibility to ensure just and reasonable rates through the expedient of a heavy-handed presumption."

Justice John Paul Stevens dissented, joined by Justice David H. Souter.

"Congress has not authorized courts to prescribe energy policy by imposing presumptions or prerequisites, or by making marginal cost the sole concern or no concern at all," Stevens wrote. "I would therefore vacate and remand the cases in order to give the Commission an opportunity to evaluate the contract rates in light of a proper understanding of its discretion."

Chief Justice John G. Roberts Jr. and Justice Stephen G. Breyer recused themselves from the case.