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Freely Negotiated Wholesale Energy Contracts Are Presumed to Be Enforceable Unless They Seriously Harm Public Interest, U.S. Supreme Court Holds
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July 14, 2008
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By James K. Mitchell and Michael J. Connolly
Thelen Reid Brown Raysman & Steiner LLP
In a decision arising out of the 2000-2001 Western energy crisis, the U.S. Supreme Court has ruled that when the rates included in a wholesale power sale agreement were freely negotiated between the buyer and the seller, the Federal Energy Regulatory Commission (FERC) is required to presume that the rate meets the "just and reasonable" standard under the Federal Power Act. Morgan Stanley Capital Group, Inc. v. Public Utility District No. 1 of Snohomish County, No. 06-1457, 04-1462, 554 U.S. ___, 2008 WL 2520522 (2008) (June 26, 2008).
This presumption can be overcome only if FERC concludes that the contract "seriously harms the public interest." However, the "just-and-reasonable" presumption may not apply if one party to the contract engaged in such extensive and unlawful market manipulations as to alter the playing field during the contractual negotiations.
The underlying case was initiated at FERC when a group of purchasers of wholesale energy claimed that the contractual rates, which had been negotiated when the wholesale power market was dysfunctional, were excessive and, therefore, violated the public interest standard under the Mobile-Sierra line of cases. After the market had returned to more normal conditions, these purchasers asked FERC to relieve them of their contractual obligations.
Because the court concluded that FERC had not applied the proper standards in reviewing the purchasers' request, the case was remanded to FERC for consideration of factual issues.
The decision, written by Justice Scalia, relies strongly on the "basic premise" of the Mobile-Sierra cases that contract rates are the "product of fair, arms-length negotiations." The court noted that in the last 50 years, cases have refined the Mobile-Sierra principles to "allow greater freedom of contract" and applied the presumption of justness and reasonableness equally to both buyers and sellers of energy. The court observed that FERC has taken several actions to open up the energy market and break down monopolies in the field (such as establishing Regional Transmission Organizations and Independent System Operators) in order to promote competition and encourage development of a free market in wholesale energy.
The court noted that the only statutory standard in the Federal Power Act for assessing wholesale rates, including both those established by a seller's tariff filed at FERC and rates established by contract negotiations between the buyer and the seller, is the "just and reasonable" standard. Traditionally, rates on file at FERC have been subject to review under either the "public interest standard" or under the "just and reasonable standard." The court noted that the "public interest standard" was not a different standard of review but merely the "differing application of the just-and-reasonable standard to contract rates."
Although the contracts at issue had been negotiated when the wholesale power market was dysfunctional, the court ruled that FERC was required to determine whether the contract was made during a market "dysfunction" before applying the "just and reasonable" presumption. The court recognized that markets are imperfect and that by allowing a party to disavow a contract simply because of a "dysfunctional market," FERC would severely reduce parties' incentives to enter into such agreements in the first place. The court believed that contracts negotiated at a time of dysfunctional energy markets would allow "sophisticated parties" to weather the storm of a dysfunctional market by agreeing to a set rate acceptable to both parties.
Previously, courts and FERC applying the "public interest standard" of contract review looked to see whether a rate would impair the financial ability of the public utility to continue its service, impose upon other consumers an excessive burden or be unduly discriminatory. Although these factors are not exclusive, they were inapplicable to the factual circumstances addressed by the court.
Instead, the court held that FERC should evaluate whether the agreed-upon rates impose an "excessive burden on consumers 'down the line' relative to the rates they could have obtained (but for the contracts) after elimination of the dysfunctional market." This high standard was designed to encourage the market stability that comes from these purchase agreements.
The court noted that a party's unlawful activity in the marketplace does not warrant modification of its contract unless a causal connection exists between the unlawful activity and the contractual rate, which would require the "just and reasonable" presumption not to apply.
Justice Scalia was joined by Justices Kennedy, Thomas and Alito and supported in a concurring decision by Justice Ginsberg. Justice Stevens, joined by Justice Souter, dissented. In his view, the decision bound the hands of FERC and immunized contract rates from "just and reasonable" review. Concerned that the decision would give parties the ability to make an end run around FERC, Justice Stevens noted that the "fact that the FPA tolerates contracts does not make it subservient to contracts." Disagreeing with the majority's use of case law, Justice Stevens noted that Sierra required that the public interest (in affordable and adequate utilities) be the touchstone in determining the adequacy of "all rates, not just contract rates."
In the short run, this decision may provide parties to long-term power purchase agreements that contain rates in excess of the current market price the opportunity to seek FERC review of those rates on the basis that they seriously harm the public interest or were the product of market manipulation.
In the long run, however, this decision should give comfort to parties to power purchase contracts that their agreements will not be lightly regarded or easily overturned. The presumption that freely-negotiated rates are "just and reasonable" should, therefore, help to provide stability to negotiated rates in an ever-changing energy market.
As a result, the decision provides reasonable assurance that unless they have engaged in market manipulation, developers of new generation facilities that lack captive markets may rely on the freely-negotiated power sales agreements with sophisticated purchasers on which their facilities have been predicated.
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For more information about the issues covered in this report, please contact James K. Mitchell in our Washington, D.C. office at 202-508-4002 or at jmitchell@thelen.com or Michael J. Connolly in our New Jersey office at 973-660-4403 or at mconnolly@thelen.com or contact your Thelen attorney. For more information about Thelen’s Construction and Government Contracts Department, click here.
©2008 Thelen Reid Brown Raysman & Steiner LLP
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