Energy Industry Updates for May 2010

27 May 2010 Publication

Legal News: Energy Industry

Despite Praise for Innovative Approach, FERC Denies Petition on Open Season Transmission Project

An innovative transmission proposal that requested negotiated rates and capacity allocation to owners was recently rejected by FERC. The proposal involved the development of two 500 kV transmission lines running 460 miles between New Mexico and Arizona. The project would have an expected capacity of up to 4,500 MW.

The petitioner, SunZia Transmission LLC, is jointly owned by numerous load-serving entities and generation owners in the region. SunZia itself did not propose to file an open access transmission tariff (OATT); rather, its owners proposed to file separate OATTs that would apply to their pro rata shares of the line.

The petition for declaratory order contained three significant requests, including an allocation of firm transmission rights, an allocation of capacity to serve affiliated generators, and a request for negotiated rate authority. Though FERC denied the requests, it did so without prejudice and provided guidance to permit the petitioner to revise its proposal and refile.

First, SunZia requested that its owners be allocated 100 percent of their pro rata shares of the project’s capacity. The project had been open to all potential investors and effectively engaged in “open season” bidding for the opportunity to invest in the project. FERC distinguished between the allocation of ownership shares in proportion to the pro rata investment and the allocation of firm transmission rights in the same proportion. FERC held that, although the SunZia owners could obtain ownership shares in proportion to their pro rata investment, “this does not equate to these entities having exclusive discretion to use the capacity on their portion … in any manner they wish.” That is, the ownership rights were subject to FERC’s open access policies, as described in Order No. 888.

Second, SunZia requested that certain of its owners be permitted to use their shares to transmit power from affiliated qualifying facilities and exempt wholesale generators without being subject to open access requirements. SunZia likened allowing an affiliate a priority to use this line without being subject to open access to allowing an affiliate priority to generator tie lines outside of the open access provisions, asserting that, “to the extent …. the line is used by affiliated generators, its use would be equivalent to a generat[or] tieline.” As a generator tieline, only the unutilized portion of the line would be subject to interconnection and transmission requests. FERC disagreed, noting that because the project would consist of two 500 kV transmission lines running 460 miles, with multiple points of interconnection, it could not be a generator tieline. The Commission found that SunZia “ha[d] not explained how the Project [could] be viewed simultaneously as a generator tieline for some [owners], as a network transmission facility for [a separate owner], and as a transmission line providing service to anchor customers under negotiated rate contracts for [other owners.]” Because of the physical attributes and flexible use, FERC found that this was not a generator tieline, and thus, granting priority capacity rights would not allow non-affiliates open, transparent, and non-discriminatory access.

Third, SunZia requested negotiated rate authority as a merchant transmission provider. FERC denied this request, in part because the proposal did not fully address concerns about “just and reasonable rates” under the Federal Power Act. In particular, FERC noted that certain affiliates could serve the same markets and that SunZia would need to refile to clarify the barriers to entry and competitive impacts associated with those affiliates.

FERC also expressed concern over the potential for undue discrimination inasmuch as two of the owners sought to allocate up to 100 percent of their shares on the project to serve anchor customers —  potentially affiliates — without any initial capacity being made available for allocation under open season bidding. Though not mandating a ceiling on the amount of pre-subscribed negotiated capacity with anchor customers, FERC found that on the facts here, SunZia did not comply with its open access precedent.

FERC stated that it found much to commend about the innovative proposal and that it could have provided needed additional transmission capacity in the region. FERC made clear, however, that innovative ideas alone do not provide a basis to skirt FERC’s open access requirements.


OTC Derivatives Legislative Developments

While there is yet no final legislation reforming the U.S. financial markets, which once enacted could impact energy trading and jurisdictional issues, that day is now closer at hand. On Thursday, May 20, 2010, the U.S. Senate voted to approve the Restoring American Financial Stability Act of 2010. The bill includes Title VII, the Wall Street Transparency and Accountability Act (Senate Derivatives Bill), which is the counterpart to the Derivatives Markets Transparency and Accountability Act (House Derivatives Bill) included as Title III of the Wall Street Reform and Consumer Protection Act of 2009 passed by the U.S. House last December. Both titles are intended to provide comprehensive regulation of derivatives markets, swap dealers and major swap participants through amendments to the Commodity Exchange Act, the federal securities laws and other laws. This chart (http://tinyurl.com/2wnmbl9) provides a high-level comparison of provisions in the bills that may affect market participants using commodity-based derivatives.

The two financial market reform bills will now be sent to conference committee between the Senate and House to reconcile differences and produce a final report to be voted upon in both chambers. That process is expected to begin in early June, with the objective to send a final bill to President Obama before the July 4th congressional recess.

The Commodity Futures Trading Commission (CFTC) expanded market authority under any final bill will likely exacerbate jurisdictional conflicts between the CFTC and FERC. The House Derivatives Bill attempts to deal with CFTC/FERC jurisdictional issues by authorizing the CFTC to exempt from Central Energy Authority (CEA)-regulation transactions entered into pursuant to a FERC-approved tariff, and directing the CFTC to consider and “not unreasonably deny” any request from FERC for such an exemption. The bill also directs the two agencies to enter into a Memorandum of Understanding to establish procedures to resolve jurisdictional overlap conflicts and avoid conflicting or duplicative regulation.

The Senate Derivatives Bill does not squarely address jurisdictional overlap between the CFTC and FERC. Instead, it directs the CFTC to appoint a nine-person Energy and Environmental Markets Advisory Committee, which would have the authority to conduct public meetings, submit reports and recommendations to the CFTC, and “otherwise serve as a vehicle for discussion and communication on matters of concern to exchanges, firms, end users, and regulators regarding energy and environmental markets and their regulation by the Commission.”

The bills are very similar, and confer significant authority on the CFTC and SEC to interpret and implement many important provisions. Both contain substantially identical definitions of the terms “swap” and “security-based swap,” which are important for defining the CFTC’s expanded jurisdiction under the CEA and the SEC’s under the federal securities laws. While the SEC will have jurisdiction over an expanded range of security-based derivatives, the majority of OTC derivatives appear destined for CFTC regulation and oversight under the CEA.

The broad swap definition in both bills covers traditional swap structures where a fixed payment is exchanged for a floating payment on one or more scheduled dates as well as option structures, event contracts, instruments that become commonly known in the trade as swaps, instruments that become commonly know by more specific names linked to the underlying interest such as “energy swaps,” “agricultural swaps,” “weather swaps”, “emissions swaps,” and combinations of the various structures or categories listed. Security-based swaps are a subset of swaps, defined in terms of the underlying interests being securities or securities-related.

Both bills also provide exclusions from the swap definition. Notably, they both carve out “any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically-settled.” This appears to be a variation of the CEA’s existing “forward contract exclusion,” which excludes deferred shipment commercial merchandizing transactions between two parties from regulation as futures contracts under the CEA. The qualifications limiting the exclusion to nonfinancial commodities and to transactions that are intended to be physically settled are new. The latter provision may be an effort to override the CFTC’s 1990 interpretation that transactions in 15-day Brent oil contracts could within the scope of the forward contract exclusion be chain traded among commercial parties and settled via cash payment through close out netting in lieu of physical delivery. The exclusion will likely raise interpretative questions as to how parties to a transaction demonstrate their “intention” to physically deliver the underlying commodity. The Brent oil interpretation aside, for purposes of the forward contract exclusion, the CFTC generally looks to whether delivery routinely occurs between the contracting parties, using as the standard that delivery should occur 75 percent or more of the time.

Both bills require transactions in swaps and security-based swaps to be cleared, unless no clearinghouse exists that provides clearing for the type of swap transaction at issue. That qualification will likely, as a practical matter, allow a broad range of tailored transactions to occur on a non-cleared basis given the myriad variables defining a particular transaction that could deviate from the standardized terms prescribed by a clearinghouse for the products it is willing to clear. Clearinghouses also may be unwilling to assume the risk of clearing illiquid swaps as they may pose special challenges for clearinghouse risk management. Transactions subject to mandatory clearing also are required under both bills to be traded on an exchange or swap execution facility, unless no such centralized market exists offering the swap for trading.

The Senate considered, but did not adopt, amendments to its bill to expand the clearing requirement, including a proposal to prohibit swap dealers from engaging in swap transactions that could not be cleared. That approach, if enacted, would essentially ban swap dealers from providing OTC markets in non-standardized swaps. There is the possibility that these restrictive measures may be raised again for consideration as amendments during the conference committee process.

Importantly, both bills provide an exclusion from mandatory clearing and centralized trading for swap transactions where one of the parties is an end user and has entered into the transaction for hedging. There are differences, though, in how the exemption is set out and the conditions to qualify for the exemption. Both bills impose similar restrictions on swap dealers and major swap participants with respect to non-cleared swap transactions such as reporting of transactions to a swap repository, obligations (subject to exceptions) to collect margin and obligations to hold the end-user’s margin deposits (again subject to exceptions) on a segregated basis, without comingling with their own funds.

The mandatory clearing provisions would not apply to existing OTC swap transactions. However, under the Senate Derivatives Bill, existing OTC swaps will have to be reported to a swap repository or, in the absence of a swap repository, to the CFTC (for swaps) or the SEC (for security-based swaps) following agency adoption of the necessary implementing rules.


Threats to Cut Off Power to Los Angeles by Arizona Corporation Commissioner Are Not Well Founded

A commissioner of the Arizona Corporation Commission recently suggested that, if Los Angeles implemented an economic boycott of Arizona, he would encourage Arizona utilities to renegotiate their power agreements to discontinue sales of power from Arizona-based generation to Los Angeles. The spat began after the Los Angeles City Council voted in May 2010 to ban future contracts with Arizona companies in response to a controversial Arizona law requiring local law enforcement to verify the immigration status of anyone whom they suspect of being an illegal immigrant. Approximately 25 percent of the electricity consumed in Los Angeles is generated by power plants in Arizona.

But no impact on power purchase arrangements should be expected. While it is true that Los Angeles and the State of California obtain electricity from nuclear power plants located at the Palo Verde hub west of Phoenix as well as from coal-fired power plants in northern Arizona, the nuclear plants are owned by several utilities, including several of whom purchase the power. Moreover, the generators need a market for their output and cannot simply cut off one of their major customer over an unrelated political pique. The Arizona utilities with stakes in the plant thus cannot afford to cut off the California utilities and keep all the power in Arizona.

Equally important, the purchased power agreements cannot simply be rescinded by the Arizona utilities, as the commissioner seems to assume, but must be renegotiated with the consuming utilities in California. There is no reason to assume that Los Angeles would willingly forego an important portion of its portfolio and allow the southern part of the state to go dark. Nor would the commissioner be able to rely on FERC to obtain his desired outcome, which has exclusive jurisdiction over the sale of the wholesale power at issue here. FERC’s plenary authority over interstate wholesale rates pre-empts any inconsistent state action. FERC must give effect to freely negotiated wholesale contracts unless FERC were to conclude that the contract seriously harms the public interest. There is no reason to believe that the Arizona power contracts harm the public interest, and it is unfathomable that FERC would find such a harm as arising out of Los Angeles’ boycott of Arizona businesses. For these reasons, neither a renegotiation of power contracts nor a regulatory-induced rescission of them is likely.


After Eight Years of Struggles, More Litigation for Cape Wind?

With nine years of legal and regulatory battling already under its belt, the nation’s first offshore wind farm achieved its most significant regulatory milestone so far in late April 2010. The project’s developer hopes that decision, along with the Federal Aviation Administration’s recent determination that the project posed no hazard to air traffic and the signing of a critical Power Purchase Agreement, will allow it to begin construction soon. The regulatory decision was made by the Minerals Management Service (MMS), a Department of the Interior agency currently in the news for its role in permitting offshore drilling by BP in the Gulf of Mexico. MMS granted Cape Wind Associates, LLC (CWA) permission to build 130 wind turbines in the middle of Nantucket Sound. Within hours of that decision, a coalition of opponents promised a battery of lawsuits aimed at stopping the project in its tracks.

The list of opponents is long. It includes the Alliance to Protect Nantucket Sound (Alliance), Three Bays Preservation, the Massachusetts Fisherman’s Partnership, several town and county governments, and two American Indian Tribes, among dozens of other local organizations. Opponents cite the Outer Continental Shelf Lands Act, the Endangered Species Act, the National Historic Preservation Act, and a host of other laws as possible grounds for lawsuits.

The Cape Wind project, to be built within sight of the historic Kennedy compound, has attracted controversy since it was first proposed in 2001. Historians and preservationists fear that seaside views around Nantucket Sound will never be the same, and environmentalists worry that local fauna cannot coexist with the 440-foot tall turbines.

Already, through nearly a decade of legal and regulatory wrangling, CWA has reportedly spent $45 million to keep its project on track. The Alliance has spent $20 million. This is a good time to gain an understanding of the prospective litigation.

Administrative Procedure Act (APA)
Judges usually try to avoid second-guessing the technical decisions of agency experts when those decisions are supported by adequate fact-finding and deliberation. This deference to agency decision making is not just judicial habit, though — it is also law. The APA authorizes courts to overturn agency decisions only when those decisions are “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with the law … .” To overturn an agency decision in court, a plaintiff must typically demonstrate that the challenged action was inadequately reasoned or explained.

This deference is the largest obstacle facing Cape Wind’s opponents. The decision to lease offshore lands to CWA is the result of nearly a decade of regulatory wrangling. In that time, MMS and other agencies have reviewed hundreds of studies and public comments and produced a record thousands of pages long. Plaintiffs will have to convince a judge that the MMS decision was made improperly.

National Environmental Policy Act (NEPA)
Enacted in 1970, NEPA requires federal agencies, before undertaking any major action, to prepare a detailed report of the action’s environmental impacts. As required by that mandate, MMS issued a Final Environmental Impact Statement (FEIS) in January 2010, in which it considered both adverse consequences from development of Cape Wind and likely benefits, including the reduction of carbon emissions.

Opponents of Cape Wind assert that MMS has violated NEPA. Because NEPA mandates only a process rather than specific decisions, opponents will likely attempt to persuade a court that MMS has overlooked critical environmental considerations, failed to follow required procedures, or failed to consider possible measures to mitigate the environmental consequences of the Cape Wind project. Their success will depend on whether, in the court’s judgment, the alleged inadequacies are so severe that they render the report’s determination arbitrary and capricious.

The Outer Continental Shelf Lands Act (OCSLA)
OCSLA, which originally established federal jurisdiction over the outer continental shelf, was amended in 2005 to give the Secretary of the Interior authority to grant leases for the development of renewable energy projects on the seafloor. Prior to that amendment, opponents twice invoked the act to stop construction of a meteorological data collection tower. Both times, the lawsuits failed.

The Alliance has publicly vowed again to invoke OCSLA in new lawsuits. While the exact grounds of the Alliance’s challenge are not clear, two assertions seem likely. First, that the lease allegedly can be granted only on a competitive basis. The general rule under OCSLA is that the right to use the continental shelf for energy production should be competitively bid. OCSLA sets numerous exceptions to this rule, and opponents will argue that Cape Wind does not qualify for any of those exceptions. It will be up to the court to interpret the exceptions, but courts can defer to any agency interpretation that does not violate the clear intent of Congress.

Second, that the Interior Secretary’s decision allegedly fails to adequately account for at least one of the several factors (safety, navigation, sustainability, and so forth) required by OCSLA. On judicial review, the Secretary’s decision is subject to the arbitrary and capricious standard, so the opponents will need to find a significant omission or mistake to win on this claim.

Endangered Species Act (ESA)
The ESA requires every federal agency to ensure that its actions will not “jeopardize the continued existence” of endangered or threatened species. In the FEIS, MMS was particularly attentive to the effect of Cape Wind on the northern right whale and two migratory bird species, the piping plover and the roseate tern. MMS concedes that some avian deaths will occur if Cape Wind is built, but concludes that the number of fatalities will not threaten either avian species. Regarding the whales, the two sides do not even agree about whether they ever visit Nantucket Sound.

MMS’ determination is supported by a substantial record, but opponents emphasize that room for debate remains. The FEIS is full of caveats about the studies on which it relies. Many of them describe wind projects in Europe or species that, though related, are different from those in Nantucket Sound. Moreover, uncertainty arises from practical limitations on the studies’ methods. The American Bird Conservancy has claimed that MMS’ scientific analysis of the bird collision risk is “inadequate.”

Opponents will argue that MMS did not rely on “the best scientific and commercial data available,” as required by the ESA. 16 U.S.C. 1536. If a court agrees and overturns the leasing decision, MMS may be forced to repeat much of the approval process a second time. Opponents also may argue that the MMS determinations were arbitrary and capricious for other reasons, but this is a more difficult route to take: “The question … is not whether an agency decision is ‘correct,’ but rather whether the decision reflects sufficient attention to environmental concerns and is adequately reasoned and explained.” Nat’l Audubon Soc’y v. Hester, 801 F.2d 405 (D.C. Cir. 1086).

National Historic Preservation Act (NHPA)
The vistas from more than two dozen historic sites will be affected if Cape Wind is built. Most of the sites are not generally known of outside the region. A few are asserted to be sacred by two local Wampanoag Indian tribes. Moreover, the Wampanoag Indians assert that the submerged lands in Nantucket Sound are an ancient tribal graveyard and that the Cape Wind project will destroy remains and artifacts.

The NHPA requires federal agencies to “take into account” the effect that proposed actions will have on historic sites. Pursuant to the act, MMS solicited the opinion of the Advisory Council on Historic Preservation (ACHP), which concluded that the Cape Wind could not be built without spoiling the historic sites. MMS decided to proceed despite the ACHP’s decision, noting that it “is bound to take ACHP’s comments seriously, but is not legally bound to follow the ACHP’s recommendations or conclusions.” It is not clear what ground opponents will stand on should they sue under the NHPA. Courts have clearly stated that the NHPA requires agencies to “stop, look, and listen” but that it does not compel any particular outcome.

The Wampanoag Tribes have argued that they were improperly excluded from the approval process until 2005, four years after CWA submitted its initial application to the Army Corps of Engineers. MMS’ likely response is that it brought the tribes into the process as soon as it obtained jurisdiction over the project and thus provided five years of NHPA consultation opportunities.

Conclusion
The first step for the Cape Wind opponents will be a petition for a preliminary injunction delaying construction of Cape Wind until all litigation has ended. In a variety of contexts, courts have held that “where the interim relief sought by the plaintiff is essentially the final relief sought, ‘the likelihood of success [on the merits] should be strong.” Strahan v. Pritchard, 473 F. Supp. 2d 230 (D. Mass. 2007). This means that opponents will need to prove, long before any actual trial, that the decision to grant a lease to CWA was probably flawed.

Meanwhile, CWA has stated that it expects construction to begin this year.


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.
202.295.4091
rcarroll@foley.com

Thomas McCann Mullooly
Milwaukee, Wisconsin
414.297.5566
tmullooly@foley.com

Andrea J. Chambers
Washington, D.C.
202.295.4770
achambers@foley.com

Mary Ann Christopher
Milwaukee, Wisconsin
414.297.5604
mchristopher@foley.com

Joseph L. Colaneri
Washington, D.C.
202.672.5471
jcolaneri@foley.com

Robert C. Geist, Jr.
Washington, D.C.
202.295.4090
rgeist@foley.com

Ladonna Y. Lee
Washington, D.C.
202.295.4107
llee@foley.com

Kathryn M. Trkla
Chicago, Illinois
312.832.5179
ktrkla@foley.com

John T. Dunlap
Milwaukee, Wisconsin
414.297.5020
jdunlap@foley.com

Svetlana V. Lyubchenko
Washington, D.C.
202.672.5492
slyubchenkop@foley.com

Trevor D. Stiles
Milwaukee, Wisconsin
414.319.7346
tstiles@foley.com

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