Today the Supreme Court issued a decision, described below, of interest to the business community.

Morgan Stanley Capital Group, Inc. v. Public Util. Dist. No. 1, Nos. 06-1457 & 06-1462 (previously discussed in the September 25, 2007 Docket Report).

Under the Federal Power Act (FPA), the Federal Energy Regulatory Commission (FERC) has the power to invalidate wholesale electricity rates that are not “just and reasonable.” 16 U.S.C. § 824d(a). Under the judicially created Mobile-Sierra presumption, a contract for the sale and purchase of wholesale electricity is presumed to be “just and reasonable,” unless the resultant electricity rates harm the public interest. In Morgan Stanley Capital Group, Inc. v. Public Util. Dist. No. 1 of Snohomish County, Washington, Nos. 06-1457 and 06-1462, the Court held that the Mobile-Sierra presumption applies broadly to all arms-length wholesale electricity contracts—even those that were entered into under dysfunctional market conditions and end up imposing onerous terms on one side after the market is stabilized.

Today’s decision is important to participants in the regulated energy market. Although the Court did not address whether FERC’s policy of pre-approving wholesale electricity contracts without considering their terms is statutorily permissible, the Court confirmed that when a wholesale electricity contract is subsequently challenged under § 824d(a), the level of regulatory scrutiny is affected neither by whether the contract was subject to prior FERC review nor by whether it is the seller or purchaser challenging the contractual rates.

The parties to the contracts at issue were institutional electricity purchasers (regional power companies in California, Washington, and other western states) and large wholesale electricity suppliers. The purchasers entered into long-term contracts with the suppliers during the California energy crisis of 2000-2001. Eager to hedge against price volatility during the crisis, the purchasers later came to regret being locked into contracts to buy electricity at rates that were onerously high in the post-crisis market.

The purchasers sought a rate reduction before FERC. Because the electricity contracts were filed under the “market-based rate system” (a FERC innovation from 1996 that allows parties, under certain conditions, to enter into power contracts at unspecified prices without explicit FERC approval), the purchasers urged FERC not to apply the Mobile-Sierra presumption. FERC, however, ruled that the Mobile-Sierra presumption applied, and then declined to adjust the rates, finding that they did not harm the public interest. In so doing, FERC rejected the suggestion that the energy suppliers’ alleged unlawful market manipulation had harmed the public interest, even though it was purportedly partly to blame for destabilizing the California energy markets.

The purchasers appealed to the Ninth Circuit, which significantly narrowed the reach of the Mobile-Sierra presumption, and then remanded the cases to FERC for further review. The Ninth Circuit held (1) that the Mobile-Sierra presumption does not apply unless FERC has first approved the contract rates in light of the market conditions under which the contract was formed; and (2) that a purchaser challenging a high rate can overcome the Mobile-Sierra presumption merely by demonstrating that the rate fell outside a “zone of reasonableness.”

The Supreme Court, per Justice Scalia, affirmed the judgment of the Ninth Circuit, but upon different grounds. First, the Court held that FERC had correctly decided to apply the Mobile-Sierra presumption to the market-based rate contracts at issue, even though FERC had not approved the rates to begin with. The Court stated that the Mobile-Sierra presumption applies whenever an electricity contract rate is challenged under the FPA—even if the contract is already in force. The Court stated that “the just-and-reasonable standard . . . applies regardless of when the contract is reviewed.” Slip op. at 17.

Second, the Court held that the Ninth Circuit’s modification of the Mobile-Sierra presumption for purchasers of electricity challenging high rates (as opposed to suppliers challenging low rates) was contrary to the purpose of the FPA. While high rates may be painful to some purchasers and their consumers in the short run, to invalidate such contracts based on a reasonableness test “would threaten to inject more volatility into the electricity market by undermining a key source of stability,” i.e., mutually agreed-upon contract prices. Slip op., at 22. The Court emphasized that only “unequivocal public necessity” or “extraordinary circumstances” can justify setting aside such arms-length contracts. Id.

Nonetheless, the Court remanded the cases to FERC for further consideration after the Court found two deficiencies in FERC’s prior proceedings. First, the Court directed FERC to consider not just the contracts’ short-term effects on consumer prices, but also the long-term effects. For example, if rates for the purchasers’ consumers will remain excessively high over the long term, the public’s interest in paying reasonable rates may outweigh the contracts’ positive effect on market stability, thus justifying the invalidation of the contract rates. Second, the Court directed FERC to amplify why it found that the energy suppliers’ allegedly unlawful market manipulation did not affect the contracts at issue. The Court held that if FERC could determine that such “causality has been established, the Mobile-Sierra presumption should not apply.” Slip op. at 26.

Justice Ginsburg filed an opinion concurring in part and concurring in the judgment. Justice Stevens filed a dissenting opinion in which Justice Souter joined. The Chief Justice and Justice Breyer took no part in the consideration or decision of the cases.