Energy Industry Updates for December 2008

30 December 2008 Publication

Legal News: Energy Industry

FERC Signals That Contract Modification Will Remain Rare

Last week, FERC responded to the U.S. Supreme Court’s opinion issued earlier this year addressing the violability of forward contracts executed during periods of market dysfunction by signaling that private wholesale electricity contracts will remain largely sacrosanct even under these circumstances, and will be modified only under truly extraordinary circumstances. In Morgan Stanley Capital Group, Inc. v. Pub. Util. Dist. No. 1 of Snohomish County, 128 S. Ct. 2733 (2008), the Supreme Court, in June 2008, rejected the Ninth Circuit’s interpretation of the Mobile-Sierra doctrine that had largely vitiated the viability of private contracts during periods of market dysfunction, particularly high-rate contracts. The Supreme Court held that freely negotiated contracts should be subject to a presumption of reasonableness even under these circumstances unless it is shown that (1) the contract imposed an excessive burden on consumers “down-the-line” relative to the rates that wholesale consumers could have obtained but for the contracts after the elimination of the dysfunctional market conditions, or (2) the unlawful activity of the contracting seller affected the contract terms.

In its December 18, 2008 order, FERC established a paper hearing to allow the development of additional evidence that would apply these two considerations to the contracts under examination here under standards developed in that order. With regard to the down-the-line consideration, FERC found that a buyer attempting to demonstrate that the contract imposes an excessive burden on consumers must demonstrate how the difference in prices between the contract under examination and those under a “comparable” contract imposes an excessive burden on wholesale purchasers, including whether the purchaser can pass through the additional costs to consumers and whether the higher-priced contract costs impair the buyer’s ability to continue to provide service. With regard to the second factor, FERC held that the appropriate test is whether the unlawful activity had a direct effect on the negotiation of the contracts at issue. Buyers attempting to show that a seller’s market behavior increased the contractual prices must demonstrate that a particular seller engaged in unlawful manipulation in the spot market and that such manipulation directly affected the particular contract to which the seller was a party. Importantly, FERC added that a mere link between the dysfunctional spot market and the forward markets will not be adequate to establish a causal connection between a particular seller’s alleged unlawful activity and the specific contract negotiations.

FERC’s application of the Supreme Court’s ruling on both matters will continue to make it very difficult for disgruntled purchasers of wholesale electricity to abrogate freely negotiated contracts. First, with regard to the down-the-line test, by linking the excessive burden test to prices under “comparable forward contracts,” FERC eschewed a standard that would have compared the contractual prices to those that arose after the market dysfunction passed, in favor of one that compares the contract price to the prevailing forward prices at the time of contracting, which by definition was a time of market dysfunction. Since long-term prices during periods of market dysfunction are likely to be high, FERC’s test will not automatically find high prices to be unjust and unreasonable down the line, but will do so only if the contract prices are excessively high even when compared with other high-price forward contracts. This effectively establishes that the “typical” high prices in effect during a period of market dysfunction will be “just and reasonable.” Second, by tying the market manipulation consideration to the specific behavior of the contracting party itself, rather than the market as a whole, and by insisting that a nexus be shown between the unlawful behavior and the prices paid by consumers, FERC once again rejected a view that would have required an innocent seller to pay refunds for the sins of other sellers.

In tandem, these two interpretations of the Supreme Court’s decision in Morgan Stanley mean that forward contracts will be modified only under the most egregious situations in the future. This should provide comfort to market participants who value the sanctity of their contracts.

FPL Energy Challenges Utility-Built Wind

In a case that brings to the fore an issue underlying public utility strategies to meet state renewable standards, an independent power producer is challenging a proposal by a utility to construct its own wind-generation facility.

FPL Energy, North America’s largest producer of wind energy, recently testified in a Public Service Commission of Wisconsin proceeding on a public utility’s proposal to construct a 200 megawatt (MW) wind farm in south central Minnesota. Wisconsin Power and Light Company (WPL), the Madison-based electric utility subsidiary of Alliant Energy Corporation, proposes a $500 million rate-based facility. FPL Energy’s testimony presented a competing proposal based on 200 MW power purchase agreement delivered from an existing wind project in Iowa.

The utility must meet the Wisconsin “10% by 2010” mandate, which requires all investor-owned utilities (IOUs) to increase the amount of renewable energy they sell to customers by 2010. The conventional wisdom has been that the IOUs are willing to support increased renewable energy requirements — despite the rate pressure they produce — because they also create opportunities to increase rate base even as state governments and others ramp-up energy efficiency efforts. FPL Energy’s challenge to that model in the WPL “Bent Tree” case has drawn interest among many stakeholders in Wisconsin, including Wisconsin Public Service Corporation, another energy IOU that has been pursuing a rate-based wind strategy.

Midwestern Greenhouse Gas Reduction Accord

Greenhouse gas legislation is in the air as the incoming Obama administration indicates support for a legislative response to the threat of global warming. The Midwestern Governors Association (MGA) has been looking at a cap-and-trade model and is nearing a final decision on critical features of the proposed program.

Recently, in anticipation of drafting of the model rules that will implement the Midwestern Greenhouse Gas Reduction Accord (Accord) in participating states, the MGA’s Greenhouse Gas Reduction Accord Advisory Group (Advisory Group) met to refine the Accord's design principles and the Midwest cap-and-trade program. The governors will face many key decisions involving the scope of the program, the use of allowances, and offset approvals. All of these components raise significant legal and political issues as well as economic concerns for businesses in the region.

The scoping issue addresses which businesses will be included under a declining greenhouse-gas emission regional cap. In general, an expansive view of “scope” is advocated by the Advisory Group to include businesses such as electric generation facilities, industrial boilers, and larger industrial processes. In addition, providers of transportation fuels also may be subject to the cap-and-trade program.

Recognizing the regional nature of the program, the Advisory Group's “point of regulation” for businesses covered by the scope of the program is the facility (if it is located in a participating state) or the point of “first entry into the MGA.” Thus, for transportation fuels, the point of first entry into the MGA — and hence regulation — would be at the terminal, while for electricity generated in a non-MGA state, it would be at the first distribution center.

Under the current Advisory Group approach, the scope of the MGA regulatory program includes many diverse business sectors, which makes the program much more complex than the Regional Greenhouse Gas Initiative (RGGI) of several Northeastern and Mid-Atlantic states. In addition, if the governors agree with the Advisory Group's recommendation, subjecting a large number of business facilities to the greenhouse-gas cap-and-trade system may lead to further economic erosion and greenhouse-gas “leakage” in the Midwest as businesses relocate to avoid the likely increase in energy prices.

In a cap-and-trade system, allowances are the “emission currency” permitting the holder to emit greenhouse gas. Allowances can be allocated to businesses by auction, by the government, or by a combination of both.

At this time, the allowance provisions of the MGA program need to be refined, but the Advisory Group recommends several key concepts. For example, unlike the European Union approach, allowances would not be directly allocated by the MGA to facilities “under the cap.” All allowances would be auctioned and money raised from the auction would be used to promote either emerging “green businesses” or directly aid existing industries coping with the competitive disadvantages associated with the cap-and-trade program. The mechanisms for redistributing the money between these competing goals (and potentially others) remain an open issue.

A critical component for the success of the MGA greenhouse-gas program is the development of a robust offset program. With no commercially viable means of capturing and sequestering carbon dioxide, offsets will be the primary method for achieving significant greenhouse-gas reductions (assuming no leakage due to plant closures), especially in the early years of the program.

The proposed MGA offset program attempts to streamline the approval process through the development of regional “protocols.” Following these protocols should provide offset-project developers greater assurance that the proposal will be approved than if an individual case-by-case review process were used. At the same time, environmental non-government organizations (ENGOs) advocate strongly for strict adherence to real, permanent, verifiable, enforceable, and sustainable approval criteria. In order to ensure these criteria are met, ENGOs want independent verification and periodic third-party auditing of each offset project.

Legal Issues
Noticeably absent from the MGA Advisory Group process is any legal review or analysis of the recommended program. Without an understanding of the constitutional and sovereignty constraints of a regional program, many of the key concepts, especially in the proposed scope and offset program, may be legally suspect. While some members of the Advisory Group are requesting a legal review, the Advisory Group process currently lacks a defined mechanism for addressing these concerns, other than through the recently formed model rule committee.

Decisions made by the participating states over the next months are likely to be key to the success of the MGA greenhouse-gas program. Clear direction from the governors will determine whether a legally workable and politically acceptable regional cap-and-trade program will emerge from the process. The MGA may well delay progress on a regional program in favor of pushing for its preferred approach on a national basis when the new Congress convenes.

Legal News is part of our ongoing commitment to providing legal insight to our energy clients and our colleagues.

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

Ronald N. Carroll
Washington, D.C.

Thomas McCann Mullooly
Milwaukee, Wisconsin

Bradley D. Jackson
Madison, Wisconsin

Mark A. Thimke
Milwaukee, Wisconsin

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