Energy Industry June 2008 Updates

The Supreme Court Reaffirms Mobile-Sierra Doctrine but Tinkers With Its Applications

On June 26, 2008, the U.S. Supreme Court issued its much-awaited decision in the appeal from the U.S. Court of Appeals for the Ninth Circuit’s 2006 ruling that found several long-term contracts entered into at the height of the Western energy crisis were unjust and unreasonable. Morgan Stanley Capital Group Inc., v. Snohomish County, Washington, Nos. 06-1457. This case involves a review of the Mobile-Sierra doctrine, named after two companion decisions issued by the Supreme Court in 1956, which held that freely negotiated contracts would be “just and reasonable” and enforced unless the “public interest” required that they be modified or abrogated. The public interest is a demanding test. While there are many considerations that go into it, the public interest requires the modification of a contract only when continued enforcement of the contract would impair the financial health of the public utility to continue service or impose an excess burden on consumers.

Speaking for a 5-2 majority, Justice Scalia rejected the Ninth Circuit’s holding that an energy contract could be subject to the public interest standard only if the contract had been reviewed in advance by the Federal Energy Regulatory Commission (FERC) and found to be reasonable. The Court also found it irrelevant if the contract was formed during a period of market dysfunction, as were the Western markets in 2002 when these contracts were signed. “Markets are not perfect, and one of the reasons that parties enter into wholesale-power contracts is precisely to hedge against the volatility that market imperfections produce,” reasoned Scalia. Finally, the Supreme Court rejected the Ninth Circuit’s ruling that the demanding public interest test would continue to apply when buyers negotiate a good deal, but not when the sellers do. According to Scalia, “[t]he Ninth Circuit’s standard would give short shrift to the important role of contracts” in the Federal Power Act.

Despite its significant disagreement with the Ninth Circuit on the core rulings of its decision below, the Supreme Court found that FERC’s analysis was “flawed — or at least incomplete” when it measured whether the contract cast an “excessive burden” on ratepayers based solely on conditions at the time the contract was negotiated. While acknowledging the “desirability of market-stabilizing long-term contracts,” the Supreme Court indicated the determination must take into account the burden imposed by the contract on consumers “down the line” relative to rates they could have obtained but for the contracts after the elimination of the dysfunctional market. The exception could prove significant for some of the parties to this case since prices fell dramatically after the contracts were negotiated. Finally, the Court stated that FERC also needs to “amplify or clarify its findings” as to whether one of the parties to the contract manipulated the market to such an extent that it altered the playing field for contract negotiations, in much the same way that courts will reject contracts whose formation is caused by fraud or duress. 

While the remanded proceeding could expose the specific sellers involved to potential refunds and reformed contract terms, the decision was good for the market in general since it recognizes the importance of contract sanctity and rejects the Ninth Circuit’s one-sided willingness to uphold that sanctity only when purchasers negotiate a good deal.

The extension of popular tax incentives for renewable energy sources such as wind and solar remains stuck in a political wilderness, and the road out of the wilderness is not yet clear. On June 19, 2008, Senate Finance Committee Chairman Max Baucus, D-Mont., stated that he did not expect the Senate to take a third procedural vote on the extenders package before the July 4, 2008 congressional recess. Baucus also said that it is unlikely that the Senate Democratic Leadership will use any floor time during June — before the recess — to call for a third cloture vote on a motion to proceed to the House-passed bill (H. R. 6049) extending expired and expiring energy tax provisions, including some non-energy provisions such as the research and development tax credit.

During the previous weeks, the Senate Democratic Leadership, lead by Majority Leader Senator Harry Reid, D-Nev.,has twice sought to invoke cloture on a motion to proceed to a vote on the extenders, only to be thwarted by Senate opponents of the so-called “pay-fors” — tax provisions that pay for the ongoing tax extender reductions. The oil and gas industry has been at the top of the pay-fors list but other corporate tax breaks also have had their turn during these extended House and Senate debates.

With time short the week before the July 4, 2008 recess, Senator Baucus has retreated for the time being. Dialogue with senior Senate staff close to this issue suggest increasing frustration with the lack of progress on this issue but no clear path to resolution. Democratic Tax Counsels in the Senate are no less frustrated with the impasse and are hearing from renewable energy stakeholders about the loss of jobs and investment without the extensions.

One counsel to a Democratic senator on the Senate Finance Committee (who has been a leader of the extension effort) thought that it was imperative that the extensions take place no later than the August 2008 summer recess or risk reaching a point of diminishing returns — that the economic damage to the renewable industries will be significant and in some case will be permanent if extension is delayed much longer.

On June 23, 2008, Bluewater Wind Delaware, LLC, a subsidiary of Babcock & Brown (Bluewater), announced that it signed a 25-year contract with Delmarva Power (Delmarva) to sell power from its offshore wind farm that will be built off the coast of Rehoboth Beach in Delaware. The Bluewater offshore wind farm is expected to have a maximum capacity of up to 600 megawatts (MW) generated by between 55 and 70 wind turbines.

Delmarva has agreed to purchase 200 MW and Delaware Electric Municipal Corporation has agreed to purchase 100,000 to 150,000 MW hours of power and 17 MW of capacity pursuant to a memorandum of understanding with Bluewater. The $800 million deal contains a clause that will allow Bluewater to back out of the deal if the project proves economically unfeasible after a two-year period. Both Delmarva and Bluewater will seek legislation in Delaware to allow Delmarva to spread costs associated with the project among its customers and to allow Delmarva to purchase more energy credits to satisfy renewable energy mandates. If completed, the Bluewater wind farm will be the first offshore wind farm in the United States.

The federal government has recently implemented new rules directed at preventing identity theft, which will affect the electric and natural gas utility sector and others in the energy industry that issue credit to consumers. The Fair and Accurate Credit Transactions Act (FACT Act) was one of the first federal financial privacy laws that applied to non-financial institutions. As new rules associated with the FACT Act have been implemented, the burdens placed upon non-financial institutions have only grown, and recently enacted rules have added to the burdens. This rule is of import to utilities because most provide credit to consumers when they bill them for services on a monthly or other basis.

On January 1, 2008, a new series of regulations that require companies to examine for and have programs in place if there are “red flags” that indicate identity theft had occurred, though there is a phased-in compliance date of November 1, 2008. These regulations apply to financial institutions or creditors that are an insured state nonmember bank, insured state licensed branch of a foreign bank, or a subsidiary of such entities (except brokers, dealers, persons providing insurance, investment companies, and investment advisers).

Periodic Identification
Affected companies must periodically determine whether it offers or maintains covered accounts. As a part of this determination, a financial institution or creditor must conduct a risk assessment to determine whether it offers or maintains covered accounts described in paragraph (b)(3)(ii) of the rule, taking into consideration:

• The methods it provides to open its accounts
• The methods it provides to access its accounts
• Its previous experiences with identity theft

Establish an Identity-Theft-Prevention Program
Affected companies that offer or maintain one or more covered accounts must develop and implement a written Identity Theft Prevention Program (Prevention Program) that is designed to detect, prevent, and mitigate identity theft in connection with the opening of a covered account or any existing covered account. The Prevention Program must be appropriate to the size and complexity of the financial institution or creditor and the nature and scope of its activities. The Prevention Program must include reasonable policies and procedures to:

• Identify relevant red flags for the covered accounts that the financial institution or creditor offers or maintains, and incorporate those red flags into its Prevention Program
• Detect red flags that have been incorporated into the Prevention Program of the affected company
• Respond appropriately to any red flags that are detected pursuant to paragraph (d)(2)(ii) of the rule to prevent and mitigate identity theft
• Ensure the Prevention Program (including the red flags determined to be relevant) is updated periodically to reflect changes in risks to customers and to the safety and soundness of the financial institution or creditor from identity theft

Administration
Affected companies, if required to implement a program, also must provide for the continued administration of the Prevention Program and must:

• Obtain approval of the initial written Prevention Program from either its board of directors or an appropriate committee of the board of directors
• Involve the board of directors, an appropriate committee thereof, or a designated employee at the level of senior management in the oversight, development, implementation, and administration of the Prevention Program
• Train staff, as necessary, to effectively implement the program
• Exercise appropriate and effective oversight of service provider arrangements

The regulations also contain guidelines for a Prevention Program that all financial institutions and creditors must consider when implementing a Prevention Program, and these are set forth completely in an appendix to the regulations. Many companies should now consider implementing a plan in order to address these new regulations as the November 1, 2008, deadline for compliance looms.

During the week of June 16, 2008, Congress enacted amendments to the Commodity Exchange Act (CEA) as one title of the Farm Bill by overriding President Bush’s veto of that bill. These are the first amendments to the CEA since the Commodity Futures Modernization Act (CFMA) was adopted in 2000, which materially restructured the CEA’s regulatory framework for the futures markets. The recent amendments, called the U.S. Commodity Futures Trading Commission (CFTC) Reauthorization Act of 2008 (CRA), represent in some respects a retreat from the CFMA’s de-regulatory approach. Several of the changes have implications for the energy markets; in particular, the “exempt commercial markets” offered by the Intercontinental Exchange (ICE) for various energy-related contracts.

Exempt Commercial Markets for Energy Contracts
The 2000 CFMA amendments added to the CEA, for the first time express exclusions and exemptions from CFTC-exchange registration for certain types of centralized derivatives markets. The CRA modifies the terms of the exemption available to a trading facility such ICE that operates under the exemption for an exempt commercial market. An exempt commercial market is an electronic trading facility that lists contracts on “exempt commodities” and limits its market participants to a subset of eligible contract participants called “exempt commercial entities.” The CEA definition of “exempt commodity” includes natural gas and electricity.

The CRA revises this exemption to apply core principles to an exempt commercial market in connection with its “significant price discovery contracts,” as determined by the CFTC. Under the core principles, an exempt commercial market, among other requirements, may list only a significant price discovery contract that is not readily susceptible to manipulation; must monitor trading in significant price discovery contracts; must adopt position limits or position accountability standards for significant price discovery contracts; must make certain market data public on a daily basis for significant price discovery contracts; and must monitor and enforce compliance with its rules applicable to significant price discovery contracts. The CRA also imposes large trader reporting requirements with respect to significant price discovery contracts listed on an exempt commercial market.

CFTC Anti-Manipulation Authority
The CRA increases the civil and criminal penalties for certain CEA violations such as manipulation or attempted manipulation of futures markets or commodities in interstate commerce in order to bring the penalty provisions in line with FERC’s enforcement authority under the Energy Policy Act of 2005. The CRA does not, however, resolve the issues of overlapping jurisdiction that have emerged between the CFTC and FERC for bringing manipulation or attempted manipulation cases involving the energy markets. The CRA also clarifies the CFTC’s anti-fraud authority over bilateral over-the-counter (OTC) transactions in energy commodities and other exempt commodities.

In a June 2008 staff presentation on the Cost of Electric Generation, Chairman Kelliher emphasized that FERC regulatory policy must be based on reality that higher pressure on electricity prices — higher capital costs for new power plants, higher construction costs, and higher fuel costs — will continue for some time, which means that electricity prices will be higher than Americans would like.

Chairman Kelliher stated that FERC is currently confronting three realities that affect prices. First, FERC and state commissions are regulating in a high-cost environment that is not likely to change soon. Second, the United States needs massive investments in new electricity generation, transmission, and distribution. Third, FERC is beginning to confront climate change challenge, and is in period of uncertainty regarding policy. Chairman Kelliher stressed that, as these three realities work at cross purposes, there is a natural tension among them. The Chairman observed that the United States cannot make the massive investment necessary to assure the security of its own electricity supply, make additional large investments to control climate change, and lower electricity prices at the same time, as trying to succeed in all three will likely result in failure.

In recognition of the fact that there is more than one path to support new generation, Chairman Kelliher stated that generating plants should be built so as to allow competitive pressures to govern the construction and operating costs in order to improve energy efficiency. The chairman noted that the risk of market manipulation may be greater in a high-cost environment and that FERC will remain vigilant to assure the wholesale prices reflect market fundamentals, rather than manipulation. He added that competition policy is best suited to address the hard realities FERC is confronting today.

FERC has approved guidelines for assessing penalties proposed by the North American Electric Reliability Corporation (NERC) — the electric reliability organization certified by FERC — for violations of FERC’s mandatory reliability standards. NERC will use “Violation Severity Levels,” which are post-violation measurements of the degree to which a reliability standard was violated, in determining monetary penalties for violations.

FERC approved four guidelines for evaluating which Violation Severity Level to assess in cases of violations: (1) a severity level should not cause entities to decrease their current level of compliance with reliability standards; (2) a severity level should ensure uniformity and consistency among all approved reliability standards in determining penalties; (3) a severity level should be consistent with the reliability requirement that was violated; and (4) a severity level must be based on a single violation and not cumulative violations. FERC stated that these guidelines will provide more consistency and fairness in establishing penalties for violations of mandatory reliability standards.

Please contact your Foley Energy attorney if you have any questions about these topics or want additional information regarding energy matters. Authors and editors: