# Amicus Curiae Brief — Morgan Stanley Capital Group Inc. v. Public Util. Dist. No. 1 of Snohomish Cty.

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## Record

- **Collection:** Supreme Court brief
- **Document type:** Amicus Curiae Brief
- **Published:** January 1, 2008
- **Citation:** 554 U.S. 527

## Text

ag 18D aD FILED

In the Supreme Court of the United Sfated* ™* CAK

MORGAN STANLEY CAPITAL GROUP INC.,
Petitioner,

Vv

PUBLIC UTILITY DISTRICT NO. 1
OF SNOHOMISH COUNTY, WASHINGTON, ET AL.,

Respondents.

CALPINE ENERGY SERVICES, L.P., ET AL.,
Petitioners,

v

PUBLIC UTILITY DISTRICT NO. 1
OF SNOHOMISH COUNTY, WASHINGTON, ET AL.,

Respondents.

On Writ of Certiorari to the
United States Court of Appeals
for the Ninth Circuit

BRIEF OF WILLIAM J. BAUMOL, COLIN C. BLAYDON,
CHARLES J. CICCHETTI, JEFFREY A. DUBIN, FRANKLIN
M. FISHER, ROBERT W. HAHN, JERRY A. HAUSMAN,
WILLIAM W. HOGAN, JOSEPH P. KALT, PAUL R. KLEIN-
DORFER, ROBERT J. MICHAELS, BRUCE M. OWEN, CRAIG
PIRRONG, MICHAEL A. SALINGER, STEVEN M. SHAVELL,
VERNON L. SMITH, RENE M. STULZ, JAMES L. SWEENEY,
ROBERT D. WILLIG, AND CATHERINE D. WOLFRAM
AS AMICI CURIAE IN SUPPORT OF PETITIONERS

JEFFREY A. LAMKEN JOHN N. EsTEs III
ROBERT K. KRY Counsel of Record
MARTIN V. TOTARO CARL EDMAN

BAKER Botts LLP SKADDEN, ARPS, SLATE,

1299 Pennsylvania Ave., NW MEAGHER & FLOM LLP

Washington, DC 20004-2400 1440 New York Ave., NW

(202) 639-7700 Washington, DC 20005-2111
(202) 371-7950

Counsel for Amici Curiae

WILSON-EPES PRINTING CO., INC. — (202) 789-0096 -— WASHINGTON, D.C. 20002

QUESTIONS PRESENTED

1. Whether the Ninth Circuit erred in holding that the
Mobile-Sierra doctrine—which affirms the validity of
long-term wholesale energy contract rates unless they
are shown to be contrary to the public interest—is inap-
plicable. to contracts negotiated in full compliance with
FERC’s market-based ratemaking regime, unless and
until FERC retrospectively concludes that such contracts
were negotiated under conditions free from any influence
of “market dysfunction.”

2. Whether the Ninth Circuit failed to honor Mobile-
Sierra’s presumption of contract validity when it modi-
fied the public interest standard so that wholesale energy
contract rates challenged by buyers as too high are modi-
fied downward whenever they are outside a zone of rea-
sonableness defined at a later date.

(i)

TABLE OF CONTENTS

TT
TTI sinseenrrencepepccnndegnttiiieenisenseienenmnatsinaes
I i titicdctsntettninmnecmincionssonimpmismmnasnigetnnnmenennice

I. Suppliers Help Western Utilities Manage
The Energy Crisis Through Long-Term

eT iaccritiscnicneciininpadaninstintsialidtniantomneensncceane
II. The Utilities Seek To Abrogate Their
ici aaciiatsdinialtehiinntigtinicantasneseniesone
III. The Ninth Circuit’s Decision ..................00
Summary Of Argument ............scssseserrsssssssssesessesess
i sctnintetiaetiinctensttinctttintnctnntennsinatcsmscrsesscen
I. Certainty Of Long-Term Energy

Contracts Is Of Paramount Importance......

A. Contract Certainty Is Fundamental
To The Nation’s Economic Success........

B. Contract Certainty Is Especially
Important For Long-Term Forward
SI cciccittnniicteterniintaninisceaitintenenesncemense

C. Contract Certainty Is Especially
Important In The Energy Industry .......

1. Price Volatility In Energy
Markets Makes Contract Stability
SN ditersetittetiteiitinictentiieremnemeteeesces

2. Contract Certainty Ensures
Development Of Critical
ND

(iii)

i

iv

TABLE OF CONTENTS—Continued

II. Contract Abrogation Should Be Allowed
Only In Exceptional Cases...............sseseeseees

A. The Court Should Not Permit
Abrogation Of Market-Based
Contracts Merely Because A Price
Seems Unreasonably High In

Retrospect ...........000

B. Claims That A Contract Was
Negotiated In A “Dysfunctional
Market” Or “Crisis Conditions”

Should Not Justify Abrogation ...............

C. Fraud, Manipulation, Or
Anticompetitive Conduct Should
Justify Abrogation Only In Narrow

Circumstances...........

SCHERER HERE EERE E HEHE

1. Contracts Should Not Be
Abrogated Absent Proof Of
Misconduct By One Of The
Contracting Parties...

2. Contracts Should Not Be
Abrogated Absent Proof That The
Party’s Misconduct Specifically
Involved The Long-Term
Contract At ISS8UC..............ccrsessscesssrsees

3. Existing Remedies Are Sufficient ....

6 TE ar ON Sen eee

_ Appendix - List Of Signatories

SESH S HH HEHEHE REESE EEE EEE

18

' 19

21

26

32
la

i ——

Vv

TABLE OF AUTHORITIES
Page
CASES

Am. Airlines, Inc. v. Wolens, 513 U.S.

re 10
In re Cal. Power Exch. Corp., 245 F.3d

Ee 4
Eastern Air Lines, Inc. v. Gulf Oil Corp.,

415 F. Supp. 429 (S.D. Fla. 1975).............ccs000 27
FPC v. Sierra Pac. Power Co., 350 U.S.

ae 6
La. Energy & Power Auth. v. FERC, 141 .

F.3d 364 (D.C. Cir. 1998)...........csccccccossrserecerseeee 31
Nat'l Soc’y of Prof Eng’rs v. United

States, 435 U.S. 679 (1978).........ccccecceceseseecesenes 20
N. Ind. Pub. Serv. Co. v. Carbon County !

Coal Co., 799 F.2d 265 (7th Cir. 1986)............. 20
In re Permian Basin Area Rate Cases,

a 6
Pub. Utils. Comm'n v. FERC, 474 F.3d

587 (Sth Cir. 2006) ........c.cccecceserececeees — 7, 24, 29
Tops Mkts., Inc. v. Quality Mkts., Inc.,

142 FB 90 (2d Cir. 1998) ...............cscscsessesererees 17
United Gas Pipe Line Co. v. Mobile Gas

Serv. Corp., 350 U.S. 332 (1956) ...........cccccccceee: 6

United States v. Addyston Pipe & Steel
Co., 85 F. 271 (6th Cir. 1898), affd as
modified, 175 U.S. 211 (1899) .........c.ccccsessesesees 20

Verizon Comme'ns Inc. v. FCC, 535 U.S.

vi

TABLE OF AUTHORITIES—Continued

Page
Verizon Commce'ns Inc. v. Law Offices
of Curtis V. Trinko, LLP, 540 US.
TT sdiositiseanniemetsinimbicedidinianininanmnneen 23
STATUTES AND CONSTITUTIONAL
PROVISIONS
ON ae 10
A icttninnednemnnsemngennnnnin 31
EE eiiisirinntecemnsnnnnnmmmnnenen 31
Civil Rights Act of 1866, ch. 31, § 1,
te intieiniditiaiattaainiciinpnnnedimennenemensenes 10
Cal. Pub. Util. Code § 368(a) .............sssssssrssssseres 3
ADMINISTRATIVE MATERIALS
ee ae Bi cee 31
Nev. Power Co. v. Duke Energy Trading
& Mktg., L.L.C., 99 FERC 9 61,047
(iii iasincinustenitnndnestatininmesiibitinnaianmmmenmmnemnmsnee 16
Nev. Power Co. v. Enron Power
Mktg., Inc.:
101 FERC 19 63,031 (2002)...............csessseeee 23
103 FERC 9 61,353 (2008)...............00000 6, 7, 23
105 FERC 9 61,185 (2008)...........0.000eesersesees 6
Pub. Utils. Comm’n v. Sellers of Long
Term Contracts:
99 FERC 4 61,087 (2002)..................scccsesssseee 5
103 FERC 9 61,354 (2008).................. 6, 7, 23, 24
San Diego Gas & Elec. Co. v. Sellers of
Energy & Ancillary Servs.:
93 FERC 9 61,121 (2000)..................cccsseeee 4,5

93 FERC 9 61,294 (2000)................essesereee 5, 30

vii
TABLE OF AUTHORITIES—Continued

Page
OTHER AUTHORITIES
Amy Abel, Electric Transmission: .
Approaches for Energizing a Sagging
Industry, CRS Report for Congress

Blaise Allaz & Jean-Luc Vila, Cournot
Competition, Forward Markets and
Efficiency, 59 J. Econ. Theory 1 (1999).......... 27

Severin Borenstein, The Trouble With
Electricity Markets: Understanding
California’s Restructuring Disaster,
16 J. Econ. Perspectives 191 (2002)................. 26

Stephen Breyer, Analyzing Regulatory
Failure: Mismatches, Less Restrictive
Alternatives, and Reform, 92 Harv. 'L.
a 14

Congressional Budget Office, Causes and
Lessons of the California Electricity
ticnntienchietetiitindeninnteepenmnenee passim
Lingxiu Dong & Hong Liu, Equilibrium
Forward Contracts on Nonstorable
Commodities in the Presence of Market
Power, 55 Operations Res. 128 (2007)............. 11

Energy Info. Admin., Annual Energy
Outlook 2007: With Projections to

Alexander Eydeland & Krzysztof Wolyniec,
Energy and Power Risk Management

Daniel A. Farber, Contract Law and
Modern Economic Theory, 78 Nw. U. L.
TT RTE ae ea 10

TABLE OF AUTHORITIES—Continued

FERC, 2004 State of the Markets Report

FERC, Staff Report to the Federal Energy
Regulatory Commission on the Causes
of Wholesale Electric Pricing Abnor-
malities in the Midwest During June
i iriittnsaieedentencctacsiidesnmneistcemmcenes 13
L.L. Fuller & William R. Perdue, Jr., The
Reliance Interest in Contract Damages,

ee 10
Hélyette Geman, Commodities and
Commodity Derivatives (2005) ..........-00-0000 25

Kenneth W. Hansen, PRI and the Rise
(and Fall?) of Private Investment in
Public Infrastructure, in International
Political Risk Management: The Brave
New World 75 (Theodore H. Moran

Scott M. Harvey & William W. Hogan,
Market Power and Market Simulations
(2002), available at http://ksghome.

Scott M. Harvey & William W. Hogan,
Market Power and Withholding (2001) ,

available at http://ksghome.harvard.

I cccscreertntrctscenensntinstintnncermisemsccececsess 22
John C. Hull, Options, Futures, and

Other Derivatives (6th ed. 2006).......... 4, 10, 11, 30

Paul L. Joskow, California’s Electricity
Crisis, 17 Oxford Rev. Econ. Pol’y 365

ix
TABLE OF AUTHORITIES—Continued

Page
Paul L. Joskow & Edward Kahn,
A Quantitative Analysis of Pricing
Behavior in California's Wholesale
Electricity Market During Summer
2000, 23 Energy J. 1 (2002)...........ccccssseseeceeeeee 23

Lawrence J. Makovich, California Power
Crisis Aftershock: The Potential
Modification of Western Power
Contracts (2007), available at http://
www2.cera.com/westernpowercontracts ..... 15, 22

Robert J. Michaels & Jerry Ellig, Price
Spike Redux: A Market Emerged,
Remarkably Rational, Public Utilities
Fortnightly, Feb. 1, 1999, available at
http://www.pur.com/pubs/3132.cfm ..............++. 22

Richard J. Pierce, Reconsidering the Roles
of Regulation and Competition in the
Natural Gas Industry, 97 Harv. L. Rev.

Richard J. Pierce, Jr., Completing the
Process of Restructuring the Electricity
Market, 40 Wake Forest L. Rev. 451

Richard J. Pierce, Jr., How Will the
California Debacle Affect Energy
Deregulation?, 54 Admin. L. Rev. 389

Richard A. Posner, Economic Analysis of
Es TT niictininctnssitsitinntiriciietateciabinnaegnanaan 10

TABLE OF AUTHORITIES—Continued .

Page
Hany A. Shawky et al., A First Look at the
Empirical Relation Between Spot and
Futures Electricity Prices in the United
States, 23 J. Futures Markets 931 (2003).... 11, 12

Petter Skantze & Marija Ilic, The Joint
Dynamics of Electricity Spot and
Forward Markets: Implications on
Formulating Dynamic Hedging
Strategies (MIT Energy Lab. Report,
No. MIT_EL 00-005, 2000) 00... cccescssseseeees 30

Adam Smith, The Wealth of Nations
(Edwin Cannan ed., Bantam Dell 2003)
ga Ra Re 9

David B. Spence, The Politics of Electricity
Restructuring: Theory vs. Practice,

40 Wake Forest L. Rev. 417 (2005) .............. 11,14
Steven Stoft, Power System Economics:

Designing Markets for Electricity

(Sarai ichsntasitinnteesicnecsptciniatpatendtietiitipaiisiipeeppcesnes 17, 22, 27

Stephen L. Teichler & Ilia Levitine, Long-
Term Power Purchase Agreements in a
Restructured Electricity Industry,
40 Wake Forest L. Rev. 677 (2008) ................. 16

Paul Twomey et al., A Review of the
Monitoring of Market Power (MIT Ctr.
for Energy & Envtl. Policy Research,
Working Paper No. 05-002, 2005)............ss000« 23

IN THE

Supreme Court of the United States

Nos. 06-1457, 06-1462

MORGAN STANLEY CAPITAL GROUP INC.,
Petitioner,

Vv.

PUBLIC UTILITY DISTRICT No. 1
OF SNOHOMISH COUNTY, WASHINGTON, ET AL.,

Respondents.

CALPINE ENERGY SERVICES, L.P., ET AL.,
Petitioners,

Vv.

PUBLIC UTILITY DISTRICT NO. 1
OF SNOHOMISH COUNTY, WASHINGTON, ET AL.,

Respondents.

On Writ of Certiorari to the
United States Court of Appeals
for the Ninth Circuit

BRIEF OF WILLIAM J. BAUMOL, COLIN C. BLAYDON,
CHARLES J. CICCHETTI, JEFFREY A. DUBIN, FRANKLIN »
M. FISHER, ROBERT W. HAHN, JERRY A. HAUSMAN,
WILLIAM W. HOGAN, JOSEPH P. KALT, PAUL R. KLEIN-
DORFER, ROBERT J. MICHAELS, BRUCE M. OWEN, CRAIG
PIRRONG, MICHAEL A. SALINGER, STEVEN M. SHAVELL,
VERNON L. SMITH, RENE M. STULZ, JAMES L. SWEENEY,
ROBERT D. WILLIG, AND CATHERINE D. WOLFRAM
AS AMICI CURIAE IN SUPPORT OF PETITIONERS

2

INTEREST OF AMICI

Amici are leading professors and scholars who teach
and write on economic issues and are concerned about
the economic effects that the decision below will have on
contract certainty in commodities markets. Many have
taught, researched, and published analyses of the eco-
nomics of the electricity industry. Several have also tes-
tified in various proceedings about the nature, structure,
and appropriate regulation of electricity markets. Amici _
have a particular interest in the role and importance of
contract certainty in promoting the proper functioning of
markets such as the electricity market.

A summary of the qualifications and affiliations of the
_ amici is provided as an appendix to this brief. See App.,
infra, la-4a. Amici file this brief as individuals and not
on behalf of the institutions with which they are affiliated.
None of the amici is being compensated in connection
with this brief.’

BACKGROUND

I. Suppliers Help Western Utilities Manage The En-

ergy Crisis Through Long-Term Contracts

This case concerns long-term contracts that were en-
tered into during a period of extreme volatility in the
Western electricity market. From mid-2000 through

' The parties have consented to the filing of this brief, and their let-
ters of consent have been filed with the Clerk of the Court. Amici
state that no counsel for a party authored this brief in whole or in
part, and that no such counsel or party made a monetary contribu-
tion intended to fund the preparation or submission of the brief.
Counsel’s fees and expenses incurred to prepare this brief were paid
by NRG Energy, Inc. NRG is the parent company of Cabrillo Power
I LLC, El] Segundo Power LLC, and Long Beach Generation LLC,
which have filed a petition for a writ of certiorari (No. 06-1468) now
pending before this Court. No other person or entity made a mone-
tary contribution intended to fund the preparation or submission of
this brief.

3

mid-2001, electricity prices in California fluctuated sub-
stantially and reached unusually high levels. “Prices in
California’s competitive wholesale electricity market in-
creased by 500 per cent between the second half of 1999
and the second half of 2000. For the first 4 months of
2001, wholesale spot prices averaged over $300/MWh, ten
times what they were in 1998 and 1999.” Paul L. Joskow,
California’s Electricity Crisis, 17 Oxford Rev. Econ.
Pol’y 365, 365 (2001).

As explained below, volatility is a common feature of
electricity markets. The volatility during 2000 and 2001
was of unusual magnitude for a variety of reasons. High
- temperatures during the summer of 2000 drove up the
demand for electricity sharply. See Congressional Bud-
get Office, Causes and Lessons of the California Elec-
tricity Crisis 11-12 (2001). The drought in the Pacific
Northwest in 2000 impeded the generation of hydroelec-
tric power. See Richard J. Pierce, Jr., How Will the Cali-
fornia Debacle Affect Energy Deregulation?, 54 Admin.
L. Rev. 389, 399 (2002). High natural gas prices in-
creased the cost of generating power. Jd. at 397. Califor-
nia had done a poor job of adding generating capacity in
the 1990s. Jd. at 396. And California’s regulatory struc-
ture created incentives for wholesalers to exercise mar-
ket power on the spot market. See Congressional Bud-
get Office, supra, at 23-24; Pierce, supra, at 400-401.

Two features of California’s regulatory regime magni-
fied the effect of those factors. First, California imposed
a rate cap that limited the price utilities were allowed to
charge consumers. See Cal. Pub. Util. Code § 368(a).
That rate cap interfered with the ordinary, long-term
price-demand relationship, causing demand to outstrip
supply. See Pierce, supra, at 397.

Second, before the Western energy crisis, the Califor-
nia Public Utilities Commission had restricted the ability
of wholesale electricity purchasers to enter into long-

4

term forward contracts. See Jn re Cal. Power Exch.
Corp., 245 F.3d 1110, 1116 (9th Cir. 2001). Generally, a
buyer can purchase a commodity in one of two ways. It
can purchase on the “spot” market, in which case it pays
the going price in return for immediate delivery of the
commodity. See John C. Hull, Options, Futures, and
Other Derivatives 3-4 (6th ed. 2006). Alternatively, it can
purchase on the “forward” market, in which case it en-
ters into a long-term contract to pay for delivery of the
commodity at a specified future date at a price fixed at
the time of contracting. See ibid. By setting a fixed
price in advance, forward contracts allow buyers to
“hedge” their financial risk and ameliorate the effects of
spot market volatility. See id. at 9-10. By restricting the
use of long-term forward contracts, California impaired
utilities’ ability to manage risk and magnified the effect
of the energy crisis: When prices rose, California utilities
were forced to buy all their power at the increased price
on the spot market, with no long-term supply at stable
prices to buffer that impact. See Congressional Budget
Office, supra, at 21-22.

This combination of consumer rate caps and extreme
exposure to spot-market volatility had a substantial im-
pact on California utilities. By the end of 2000, the utili-
ties were losing around $50 million a day. Joskow, supra,
at 381. Following an investigation, FERC found that
California’s price cap and forward-contract restrictions
had contributed substantially to that situation. The price
cap, FERC observed, had “thwarted competitive oppor-
tunities for new participants to enter the market.” San
Diego Gas & Elec. Co. v. Sellers of Energy & Ancillary
Servs., 93 FERC 961,121, at 61,359 (2000). And the “ex-
posure of California consumers to high prices c{ould] be
traced directly to an over reliance on spot markets.”
Ibid. FERC concluded that “[aJn essential remedy is the
elimination of rules that,” by precluding utilities from

5

“[mJoving significant amounts of wholesale transactions
into forward markets,” had “prevent{ed] market partici-
pants from managing their risks.” /bid. But “California
government officials did nothing during the year 2000 to
respond to the emerging crises.” Joskow, supra, at 382.
In December, FERC issued another order, emphasizing
that “eliminating any mandated reliance on the spot
market represents the single most important aspect of
wholesale market reform.” San Diego Gas & Elec. Co. v.
Sellers of Energy & Ancillary Servs., 93 FERC 4 61,294,
at 61,999 (2000) (emphasis added).

That same month, utilities like Snohomish sought to
enter into long-term contracts. Pet. App. 26a. In Febru-
ary 2001, California authorized its Department of Water
Resources (“CDWR”) to purchase energy for its collaps-
ing utilities. Jd. at 28a. CDWR became the dominant
buyer of electricity in California markets. After signifi-
cant negotiations, it agreed to several long-term con-
tracts that ranged in price and duration. See Pub. Utils.
Comm'n v. Sellers of Long Term Contracts, 99 FERC
1 61,087, at 61,377 (2002).

The forward prices at which suppliers offered those
long-term contracts were well below the then-prevailing
spot prices. See Pierce, supra, at 403; Pet. App. 26a-31a.
By agreeing to those contracts, CDWR gained several
advantages. First, if spot prices rose further (or even
stayed at the same level), the long-term contracts would
provide a substantial financial benefit by allowing CDWR
to receive electricity at prices lower than those prevailing
in the spot market. Second, even if spot prices fell, the
contracts would have permitted CDWR to reduce risk by
allowing it to know, in advance, how much it would have

to pay.

6

II. The Utilities Seek To Abrogate Their Contracts

After the Western energy crisis subsided, spot prices
fell. As a result, the forward prices fixed in the long-term
contracts were no longer below the prevailing spot prices.
See Pierce, supra, at 403. A number of buyers com-
menced proceedings at FERC to modify their contracts.
Pet. App. 2a.

FERC resolved those challenges in light of two deci-
sions of this Court that, for half a century, have provided
the framework for such claims. See United Gas Pipe
Line Co. v. Mobile Gas Serv. Corp., 350 U.S. 332 (1956);
FPC v. Sierra Pac. Power Co., 350 U.S. 348 (1956). The
Mobile-Sierra doctrine prohibits FERC from setting
aside contractually agreed-upon rates as “unjust or un-
reasonable” unless the rate “conflict{s] with the public
interest.” Mobile, 350 U.S. at 345. Because “(t]he regu-
latory system created by the [Federal Power] Act is
premised on contractual agreements voluntarily devised
by the regulated companies[,] it contemplates abrogation
of these agreements only in circumstances of unequivo-
cal public necessity.” In re Permian Basin Area Rate
Cases, 390 U.S. 747, 822 (1968) (emphasis added).

FERC investigated respondents’ claims and found
that “there is nothing in the record before the ALJ, in
the Staff Final Report, or in the 100-Day Discovery Pro-
ceeding evidence to support a finding that there was mar-
ket manipulation specific to the long-term contracts at
issue here.” Nev. Power Co. v. Enron Power Mktg., Inc.,
103 FERC 49 61,353, at 62,399 (2003); see also Pub. Utils.
Comm'n v. Sellers of Long Term Contracts, 103 FERC
161,354, at 62,418 (2003); Nev. Power Co. v. Enron
Power Mktg., Inc., 105 FERC { 61,185, at 61,982 (2003)
(on rehearing). FERC stated that respondents’ “only
basis for contract modification is their dissatisfaction
with the bargain,” and that, “because there is no evidence
of unfairness, bad faith, or duress in the original negotia-

7

tions, [respondents] are not entitled to change their bar- —
gains.” Nev. Power Co., 103 FERC at 62,399-400. Ac-
cordingly, FERC refused to abrogate the contracts.

III. The Ninth Circuit’s Decision

The Ninth Cirenit granted respondents’ petition for
review. Pet. App. la-67a. It held that Mobile-Sierra
would not apply to market-based contracts unless FERC
had made a prior determination “that the challenged con-
tract was initially formed free from the influence of im-
proper factors, such as market manipulation, the lever-
age of market power, or an otherwise dysfunctional mar-
ket.” Jd. at 57a. The Ninth Circuit did not define what it
meant for a market to be “dysfunctional.” Nor did it limit
the inquiry into misconduct by the parties to the contract
themselves. As the court noted, “the local utilities do not
allege that the energy companies manipulated their ne-
gotiations of the contracts here at issue,” but merely
“challenge[d]} the context, not the conduct, of those nego-
tiations.” Jd. at 59a. The Ninth Circuit, moreover, held
that a contract could be abrogated even if both contract-
ing parties were aware of the existence of manipulation in
the spot market, so long as the “full scale of spot market
manipulation and forward market dysfunction was not
nearly as fully known as it is today.” Pub. Utils.
Comm'n v. FERC, 474 F.3d 587, 595 (9th Cir. 2006) (em-
phasis added).

The Ninth Circuit then held that, even when Mobile-
Sierra applies, the standard for abrogation depends on
whether the price is alleged to be too high or too low.
For “high price” challenges, the court declared, a con-
tract price may be set aside if it falls above a “‘zone of
reasonableness’ and results in retail rates higher than
would be the case if that zone were not exceeded.” Pet.
App. 65a. The court stated that a more demanding stan-
dard would apply if a seller claimed that a contract price
was too low. Jd. at 62a-64a. The court remanded w

8

FERC for an application of the new standards it had an-
nounced. /d. at 66a-67a.

SUMMARY OF ARGUMENT

Economists have long recognized that certainty of con-
tract is essential to a healthy economy. Long-term for-
ward contracts, in particular, help reduce financial risk.
Those contracts can only accomplish that goal, however,
if parties know the contracts will be enforced.

That certainty is especially important in energy mar-
kets. Because electricity cannot be stored in large quan-
tities, electricity prices are inherently volatile. Long-
term forward contracts allow buyers and sellers to insu-
late themselves from those price swings, hedging finan-
cial risk for both parties. The contracts also guarantee
future revenue streams that help electricity producers
obtain financing needed to develop necessary infrastruc-
ture. Those benefits of long-term forward contracts can-
not accrue in a legal environment where parties cannot
be sure their contracts will be enforced. The Ninth Cir-
cuit’s approach threatens important tools for managing
risk in the energy industry.

The Ninth Circuit’s approach is particularly pernicious
where, as here, long-term contracts are entered into dur-
ing a market crisis. Long-term contracts are a remedy
for crisis conditions because they allow buyers to reduce
the risk posed by extreme volatility in spot markets.
Sellers cannot be expected to enter into long-term con-
tracts during a crisis—forgoing profits they would oth-
erwise make by selling in spot markets—if their con-
tracts will not be respected.

From an economic and policy standpoint, long-term
energy contracts should be abrogated only in truly ex-
ceptional circumstances. The mere fact that a price
seems too high in retrospect does not justify abrogating
contracts voluntarily agreed to by sophisticated buyers

9

and sellers. Nor do generalized claims of “market dys-
function” at the time the contract was formed. The term
“market dysfunction” has no fixed meaning and, in cases
like this one, is all too easily invoked to seek abrogation
of contracts that were formed precisely when certainty is
needed most—in crisis conditions, where the stability
provided by long-term commitments is crucial. Finally,
while fraud or manipulation by one of the contracting
parties themselves might justify abrogation if the mis-
conduct specifically involved the long-term contract at
issue, there are already ample remedies for misconduct
of that nature, and there is thus no need to craft new
regulatory exceptions to contract certainty.
ARGUMENT

I. CERTAINTY OF LONG-TERM ENERGY CON-
TRACTS IS OF PARAMOUNT IMPORTANCE
Since the time of the Nation’s founding, most of the
economic activity essential to the national welfare has
been based on voluntary agreements among individuals.
Those agreements would be meaningless without effec-
tive means to enforce them.

A. Contract Certainty Is Fundamental To The Na-
tion’s Economic Success

Centuries ago, Adam Smith recognized that certainty
of contract is essential to economic development. Con-
tracting in the face of uncertain enforcement, he argued,
made voluntary agreements too risky to be worthwhile:
“When the law does not enforce the performance of con-
tracts,” he explained, “it puts all borrowers nearly upon
the same footing with bankrupts ***.” Adam Smith,
The Wealth of Nations bk. I, ch. IX, at 183 (Edwin Can-
nan ed., Bantam Dell 2003) (1776).

The Framers likewise understood the necessity of con-
tract stability. They considered the sanctity of contracts
so important that they included a clause in the Constitu-

10

tion specifically prohibiting contract abrogation: “No
state shall * * * pass any * * * law impairing the obliga-
tion of contracts.” U.S. Const. art. I, $10, cl. 1. And
Congress later recognized that the right to enter into en-
forceable contracts is a necessary component of full eco-
nomic participation, when it provided that all citizens
“shall have the same right * * * to make and enforce con-
tracts” regardless of race. Civil Rights Act of 1866, ch.
31, $1, 14 Stat. 27, 27.

Modern economists have since elaborated on those
themes, but the basic principle remains the same: The
“fundamental function of contract law” is to “encourage
the optimal timing of economic activity” by “deter[ring]
people from behaving opportunistically toward their con-
tracting parties.” Richard A. Posner, Economic Analy-
sis of Law 91 (4th ed. 1992); see also Daniel A. Farber,
Contract Law and Modern Economic Theory, 78 Nw. U.
L. Rev. 303, 315 (1983); L.L. Fuller & William R. Perdue,
Jr., The Reliance Interest in Contract Damages, 46 Yale
L.J. 52, 59 (1936). That function cannot be accomplished
without effective means for enforcement. As this Court
has stated: “Market efficiency requires effective means
to enforce private agreements.” Am. Airlines, Inc. v.
Wolens, 513 U.S. 219, 230 (1995).

B. Contract Certainty Is Especially Important For
Long-Term Forward Contracts

Contract certainty is particularly important where
long-term forward contracts are at issue. As explained
above, p. 4, supra, commodity buyers and sellers often
enter into long-term forward contracts to manage risk. A
forward contract is an agreement for the delivery of a
commodity in the future at a specified price. See Hull,
supra, at 3-4. By agreeing to a fixed price ahead of time,
rather than waiting to purchase the commodity at some
unknown price in the spot market, buyers can “hedge”
their financial risks. See id. at 9-10. Sellers correspond-

11

ingly gain the certainty of a guararteed income stream
regardless of changes in demand. See ibid. Forward
contracts thus are all about providing certainty—avoid-
ing risk—for both sides.

Because risk avoidance is desirable in its own right,
firms will often enter into long-term contracts even
where the contracts are not expected to save the pur-
chaser money in comparison to buying exclusively on the
spot market. See Hull, supra, at 9-10; Lingxiu Dong &
Hong Liu, Equilibrium Forward Contracts on Nonstor-
able Commodities in the Presence of Market Power, 55
Operations Res. 128 (2007); David B. Spence, The Poll-
tics of Electricity Restructuring: Theory vs. Practice, 40
Wake Forest L. Rev. 417, 438 (2005). Indeed, if firms are
sufficiently risk averse, they may be willing to pay more
under a long-term contract than they expect to pay on
the spot market. See Hany A. Shawky et al., A First
Look at the Empirical Relation Between Spot and Fu-
tures Electricity Prices in the United States, 23 J. Fu-
tures Markets 931, 941-942 (2003).

Forward markets cannot function, however, if parties
are unsure whether the contract will be enforced. The
terms of a forward contract wil! often become onerous for
one of the parties during the life of the contract: If spot
prices fall, the buyer may wish to purchase on the spot
market rather than fulfill its bargain to purchase at the
agreed-upon price. Conversely, if spot prices rise, the
seller may wish it could renege. Unless each party knows
at the outset that the other will almost always be bound
by the contract, neither would have any incentive to
agree to the forward contract in the first place, and the
risk-reducing benefits of long-term forward contracts
would be lost.

12

C. Contract Certainty Is Especially Important In
The Energy Industry

The need to manage risk by ensuring contract cer-
tainty is particularly important in the energy industry.
Energy markets are inherently volatile. Because dra-
matic price swings threaten substantial financial risks for
buyers and sellers, enforceable forward contracts are
particularly important to hedge risk in those markets.
The energy industry, moreover, is exceedingly capital-
intensive, requiring enormous outlays for infrastructure
development that may take years or decades to recoup.
Contracts—particularly long-term forward contracts—
are indispensable to provide the certainty necessary to
encourage such enormous long-term investments.

1. Price Volatility in Energy Markets Makes Con-
tract Stability Critical

Contract certainty is crucial in the electric industry
because of the inherently volatile nature of electricity
spot markets. Multiple factors contribute to that volatil-
ity. Unlike other commodities, energy cannot be eco-
nomically stored in large quantities. See Shawky et al.,
supra, at 932. As a result, supply and demand must be in
constant equilibrium—there is no electricity inventory
that could be used to meet sharp increases in demand.
Additionally, the demand for electricity is extremely ine-
-lastic in the short term, even though a wide variety of
unpredictable factors such as temperature may cause
wild fluctuations in usage. As a result, a “properly-
functioning, fully-competitive electricity market is likely
to yield market prices that vary by a factor of ten or
twenty to one in a single day.” Pierce, supra, at 395.

The Western energy crisis vividly illustrates the vola-
tility of electricity markets, and the many different fac-
tors that can have severe effects on prices. See p. 3, su-
pra. But volatility is common to all electricity markets.

13

New England, for example, saw highly volatile spot mar-
ket energy prices in January 2004 as frigid temperatures
put upward pressure on demand. See FERC, 2004 State
of the Markets Report 13-24 (2005). And the price of elec-
tricity in the Midwest wholesale spot market also drama-
tically increased during June 1998. See FERC, Staff Re-
port to the Federal Energy Regulatory Commission on
the Causes of Wholesale Electric Pricing Abnormalities
in the Midwest During June 1998 (1998).

Long-term contracts are essential to allow electricity
providers to weather the uncertainties of the inherently
- volatile market in which they participate. Reflecting
that, forward contracts “represent the majority of in-
struments used for risk management” in the electricity
market. Alexander Eydeland & Krzysztof Wolyniec, E'n-
ergy and Power Risk Management 34 (2003).

The need for contract certainty to deal with price vola-
tility has been amplified by the shift toward a market-
based pricing regime. In a cost-based regime, energy
suppliers have little incentive to reduce costs or limit
production to the level of consumer demand, and accord-
ingly often have excess capacity. For example, before
the reforms of the 1990s, “[eJlectricity prices were high in
California partly because the regulated market, by assur-
ing producers of a high rate of return on their invest-
ments, provided incentives to build too much generating
capacity.” Congressional Budget Office, supra, at 1.
That excess capacity imposed wasteful costs that were
passed on to consumers: ;

One of the reasons that the state moved to a com-
petitive market structure was to help reduce elec-
tricity prices by lowering the costs of the utilities’
reserve capacity. In a competitive market, produc-
ers’ investment in reserve capacity should be con-
sistent with the amount of price stability (or, equi-
valently, supply security) that consumers are will-

14

- ing to pay for in the form of long-term supply con-
tracts

Id. at 32; see also Pierce, supra, at 393 (noting that the
California electricity market was “characterized by ex-
cess capacity, high costs, and regulated prices that were
approximately twice as high as the prices that would ex-
ist in an unregulated market”); Stephen Breyer, Analyz-
ing Regulatory Failure: Mismatches, Less Restrictive
Alternatives, and Reform, 92 Harv. L. Rev. 549, 562-565
(1979) (discussing the inefficiencies of cost-of-service
ratemaking). Market-based regimes reduce those ineffi-
ciencies by inducing suppliers to calibrate supply to de-
mand more closely.

One result of that efficiency improvement, however, is
that there tends to be less excess capacity to dampen
volatility. Long-term contracts allow firms to manage
the greater volatility that accompanies market-based
pricing by guaranteeing that at least part of their needs
will be met at a fixed price regardless of short-term con-
ditions.

The Western energy crisis of 2000-2001 was exacer-
bated by California’s former obstacles to long-term con-
tracts and its cap on consumer energy prices. Those re-
strictions “created a financial disaster for the investor-
owned utilities when wholesale electricity prices began to
rise.” Congressional Budget Office, supra, at 18. Rate
caps imposed losses on utilities when the spot price ex-
ceeded the amount the utilities could charge consumers.
Id. at 19. When those conditions persisted, utilities faced
a credit crunch because they were buying electricity at
much higher costs than they could sell it, resulting in
downgraded credit ratings that made borrowing even
more expensive. Jd. at xi. That financial crisis would
have been mitigated if the utilities had hedged their mar-
ket risk by entering into long-term contracts with whole-
sale electricity suppliers. See Spence, supra, at 439

15

(“Had PG&E and SCE protected themselves against
price risk [by hedging], the damage done to their credit
ratings (and the consequent exacerbation of the supply
crisis that grew out of the credit problem) might have
been reduced.”).

2. Contract Certainty Ensures Development Of
Critical Infrastructure

Contract certainty is also crucial in the energy indus-
try to ensure that necessary infrastructure is built. The
Nation currently faces explosive growth in demand for
electricity. According to the Department of Energy,
electricity sales are projected to grow by 28% to 54%
from 2005 to 2030. Energy Info. Admin., Annual Energy
Outlook 2007: With Projections to 2030, at 82 (2007).
“Growth in population and disposable income is expected
to lead to increased demand for products, services, and
floorspace, with a corresponding increase in demand for
electricity for space heating and cooling and to power the
appliances and equipment used by buildings and busi-
nesses.” Ibid. “{Alll electricity demand regions * * * are
expected to need additional, currently unplanned, capac-
ity by 2030.” Jd. at 84.

Massive expenditures in energy infrastructure are
needed over the next fifteen years to meet that rapidly
rising demand. The electric industry, however, is “inher-
ently capital-intensive.” Amy Abel, Electric Transmis-
sion: Approaches for Energizing a Sagging Industry,
CRS Report for Congress 1 (2007). Vast outlays of fi-
nancial resources are required for electric power pro-
duction and delivery. Generation, transmission, and dis-
tribution all require years of investment in infrastruc-
ture. Those investment costs may not be recouped for
decades, particularly in light of the fluctuating “boom”
and “bust” cycles that characterize the industry. See
Lawrence J. Makovich, California Power Crisis After-
shock: The Potential Modification of Western Power

16

Contracts 9 (2007), available at http://www2.cera.com/
westernpowercontracts (“Given the long power plant de-
velopment lead times, * * * investment decisions must be
made years in advance of operation, and * * * capital cost
recovery must span numerous market cycles.”).

Electricity producers will not invest the extraordinary
resources needed to develop new energy sources without
some assurance that they will recoup their investment:
Contracts that guarantee future revenue streams can
provide that assurance—but only if the energy producer
can be certain that the contracts will be enforced. As
FERC has stated, “[clompetitive power markets simply
cannot attract the capital needed to build adequate gen-
erating infrastructure without regulatory certainty, in-
cluding certainty that the Commission will not modify
market-based contracts unless there are extraordinary
circumstances.” Nev. Power Co. v. Duke Energy Trad-
ing & Mktg., L.L.C., 99 FERC 49 61,047, at 61,190 (2002);
see also Stephen L. Teichler & Ilia Levitine, Long-Term
Power Purchase Agreements in a Restructured Electric-
ity Industry, 40 Wake Forest L. Rev. 677, 699 (2005)
(noting that long-term contracts are “critical” to “en-
courage investments in aging infrastructure”). Without
contract certainty, long-term investment in desperately
needed infrastructure will be held back, and the spiraling
demand for energy will go unmet.

Contract certainty is also crucial when a contracting
party is an energy merchant rather than the ultimate
power generator. These financial intermediaries perform
a vital role by providing a ready market for the purchase
and sale of electricity. See FERC, 2004 State of the Mar-
kets Report 64 (2005) (reporting that the proliferation of
energy trading firms had “increased capital available to
market participants” and thereby “improved the indus-
try’s ability to address credit issues, increased the ability
of companies to buy and sell energy, and increased mar-

17

ket liquidity”). Without contract certainty, those institu-
tions also would not be able to function.

The California experience confirms that reliable long-
term contracts are critical to infrastructure development.
As the Congressional Budget Office stated:

Had the utilities been able to enter into long-term
contracts that guaranteed their future cost or sup-
ply of electricity, such arrangements would have
helped diminish the shortage of power-generating
capacity—and thus reduced the upward pressures
on prices. Such long-term guarantees would have

. encouraged independent generators to build new
capacity and would have improved the utilities’ fi-
nancial position, so generators might not have
charged higher prices as compensation for the risk
of nonpayment by the utilities.

Congressional Budget Office, supra, at 22.

Long-term contracts play a critical role in infrastruc-
ture development in other ways as well. A generator of
electricity faces high sunk costs upon entering the mar-
ket. Long-term contracts ease new entry: They may be
used to obtain credit, permitting a new entrant to sell its
future output to raise capital for the initial investment or
to expand generating capability. See Congressional Bud-
get Office, supra, at xi, 22. The resulting competition
from new entrants decreases the threat that any one sup-
plier will exercise market power, and thus promotes mar-
ket efficiency. See Steven Stoft, Power System Econom-
ics: Designing Markets for Electricity 335 (2002); Tops
Mkts., Inc. v. Quality Mkts., Inc., 142 F.3d 90, 98-99 (2d
Cir. 1998) (“relative ease of competitive entry” impedes
market power).

18

Long-term contracting will not occur if those contracts
are not enforceable. If the optimal level of infrastructure
does not get built, the likelihood of future crises will in-
crease dramatically.’ /
II. CONTRACT ABROGATION SHOULD BE AL-

LOWED ONLY IN EXCEPTIONAL CASES

Given the critical role of electricity in the U.S. econ-
omy, and the vital function that long-term contracts play
in electricity markets, those contracts should be re-
spected in all but the most exceptional circumstances. In
this case, however, the Ninth Circuit announced new con-
ditions that make those contracts much less certain and
therefore both more expensive and less desirable. The
Ninth Circuit held that Mobile-Sierra—the doctrine that
has ensured contract certainty for 50 years—does not
apply unless there has been a prior investigation and de-
termination that the market is not “dysfunctional.” Pet.
App. 57a. The court further held that, even where Mo-
bile-Sierra applies, a contract can be abrogated if the
price falls above some ill-defined “zone of reasonable-
ness.” Jd. at 65a. Those tests fall far short of an econom-
ically appropriate standard.

The mere fact that a price seems too high in retrospect
does not justify courts or agencies in second-guessing
trading decisions voluntarily made by sophisticated buy-
ers and sellers in energy markets. Nor do generalized
claims of market “dysfunction.” Although fraud or ma-
nipulation by one of the contracting parties themselves
might justify abrogation if it specifically involves the

* Contract certainty, especially for long-term contracts, is crucial in
the gas industry for similar reasons. See Richard J. Pierce, Recon-
sidering the Roles of Regulation and Competition in the Natural
Gas Industry, 97 Harv. L. Rev. 345, 356 (1983) (“Long-term con-
tracts allow parties to bargain for the socially optimum mix of price
and supply security.”).

19

long-term contract at issue, the law already provides am-
ple remedies for misconduct of that nature. There is thus
no need to create new sources of contract uncertainty by
expanding the potential for abrogation under Mobile-
Sierra.

The Ninth Circuit’s test would effectively punish sell-
ers even if only misconduct by third parties affected the
market. That test will deter the very conduct the law
should encourage—namely, sellers helping energy buy-
ers hedge their financial risk by offering long-term con-
tracts. And the Ninth Circuit’s test will deter that mar-
ket-stabilizing conduct precisely when it matters most—
in crisis conditions of high price volatility.

A. The Court Should Not Permit Abrogation Of

Market-Based Contracts Merely Because A
Price Seems Unreasonably High In Retrospect

Review of a forward contract under the Mobdile-Sierra
“public interest” standard should not focus on the rea-
sonableness of the particular price agreed to. Parties to
long-term contracts always operate in the face of incom-
plete information, both about the current state of the
world and about what the future may bring. Long-term
contracts are a method of allocating those inevitable
risks. The buyer bears the risk that future spot prices
will decrease, while the seller assumes the risk that fu-
ture spot prices will increase. New information that af-
fects price levels does not mean the price agreed to was
unreasonable; the whole point of a long-term contract is
to fix the price despite future price fluctuations that new
information may cause.

Courts and agencies have limited institutional compe-
tence to assess the “reasonableness” of prices voluntarily
agreed to by sophisticated buyers and sellers who make
such trading decisions every day. That is especially true
in energy markets, where prices fluctuate substantially

20

in the short term. See pp. 12-14, supra. As this Court
recently observed, “sophisticated businesses enjoying
presumptively equal bargaining power” can be “expected
to negotiate a ‘just and reasonable’ rate as between the
two of them.” Verizon Commce’ns Inc. v. FCC, 535 U.S.
467, 479 (2002). Neither courts nor regulators can relia-
bly reconstruct, years after the fact, the complete set of
circumstances that led two contracting parties to con-
clude that a particular price level was in both of their
best interests.

A focus on the reasonableness of particular price out-
comes has been avoided in other contexts as well. In an-
titrust cases, for example, this Court has held that its
precedents “unequivocally foreclose an interpretation of
the Rule [of Reason] as permitting an inquiry into the
reasonableness of the prices set by private agreement.”
Nat! Soc’y of Prof’l Eng’rs v. United States, 435 U:S.
679, 689 (1978); United States v. Addyston Pipe & Steel
Co., 85 F. 271, 282-283 (6th Cir. 1898), aff’d as modified,
175 U.S. 211 (1899). Similarly, when evaluating a com-
mercial impracticability defense, courts reject reliance on
the reasonableness of a particular agreed-upon price
level. Impracticability defenses generally fail when
based solely on a change in market conditions, especially
when parties have allocated the risk in the contract:
[A] fixed-price contract is an explicit assignment of
the risk of market price increases to the seller and
the risk of market price decreases to the buy-
er***. If*** the buyer forecasts the market in-
correctly and therefore finds himself locked into a
disadvantageous contract, he has only himself to
blame and so cannot shift the risk back to the seller
by invoking impossibility or related doctrines.

N. Ind. Pub. Serv. Co. v. Carbon County Coal Co., 799

F.2d 265, 278 (7th Cir. 1986) (Posner, J.).

7"

21

The very nature of a forward contract is to allocate
price risk. Attempting to evaluate the propriety of that
allocation through a post-hoc assessment of the price’s
reasonableness undermines the parties’ goal of allocating
risk. By requiring abrogation of contracts voluntarily
agreed to by sophisticated buyers and sellers merely be-
cause the price seems above some poorly defined “zone of
reasonableness” in retrospect, the Ninth Circuit’s rule
thrusts courts and agencies into a role they are ill-
equipped to handle and should not be undertaking.

B. Claims That A Contract Was Negotiated In A
“Dysfunctional Market” Or “Crisis Condi-
tions” Should Not Justify Abrogation

Mere generalized claims of “market dysfunction” or

“erisis conditions” also cannot justify contract abroga-
tion. Extreme market conditions can and do occur, par-
ticularly in markets as volatile as the electric spot mar-
ket. See pp. 12-14, supra. Those conditions do not un-
dermine the rationale, or the need, for contract certainty.
To the contrary, long-term contracts are the remedy for
uncertainty and the cwre for volatility.

The main reason for entering into long-term contracts
is to hedge risk. The ability to hedge risk is most impor-
tant precisely when a market is facing crisis conditions.
If one party to a contract could revisit its bargain mid-
stream, market participants would lose confidence in
their ability to hedge price risk. And if a market crisis or
other abnormal conditions justified abrogation, market
participants would see their price hedge evaporate just
when they need it most—in times of substantial volatility.
That is akin to losing fire insurance on one’s home when-
ever the fire damage becomes severe.

Abrogating contracts agreed to during periods of high
volatility creates exactly the wrong incentives. Long-
term forward contracts ameliorate market crises by pro-

22

viding price stability in the face of rapidly changing con-
ditions. They not only allow firms to manage the volatil-
ity of existing crises, but also lay the foundations that
avoid future ones. See pp. 15-18, supra. For those rea-
sons, the law should do everything possible to encowrage
long-term contracts in periods of extreme volatility, not
render those contracts useless—and thus potentially un-
available—by leaving contracting parties to speculate
about whether their agreements will later be upheld.
Adam Smith recognized over 200 years ago that the ab-
sence of means to enforce contracts renders all purchas-
ers the functional equivalent of “bankrupts.” See p. 9,
supra. The Ninth Circuit’s rule turns buyers into “bank-
rupts” precisely when their ability to purchase matters
most—in crisis conditions.

Market “dysfunction” is a particularly pernicious basis
for abrogation because it has no well-defined meaning.
Contracting parties and courts will inevitably disagree
over what conditions constitute “dysfunction.” Price phe-
nomena that appear abnormal are often entirely natural
consequences of supply and demand. Because high vola-
tility is a normal feature of electricity markets, for exam-
ple, price spikes do not necessarily reflect market dys-
function. See Robert J. Michaels & Jerry Ellig, Price
Spike Redux: A Market Emerged, Remarkably Rational,
Public Utilities Fortnightly, Feb. 1, 1999, available at
http://www.pur.com/pubs/3132.cfm; Makovich, supra, at
24. Nor do sales at levels that exceed marginal cost. See
Scott M. Harvey & William W. Hogan, Market Power
and Withholding 4, 11 (2001), available at http://
ksghome.harvard.edu/~whogan; Stoft, supra, at 372
(noting that even a supplier who makes high profits for
several consecutive years does not necessarily exercise
market power). Economists disagree about what role
market power or manipulation played in spot markets
during the California energy crisis. Compare, e.g., Scott

23

M. Harvey & William W. Hogan, Market Power and
Market Simulations (2002), available at http://ksghome.
harvard.edu/~whogan, with Paul L. Joskow & Edward
Kahn, A Quantitative Analysis of Pricing Behavior in
California’s Wholesale Electricity Market During Sum-
mer 2000, 23 Energy J. 1 (2002). Yet contracting parties
will inevitably allege these sorts of conditions as grounds
for repudiating a contract that turns unfavorable.

Although buyers in some markets might complain that
a seller had market power, this Court has made clear
that “(t]he mere possession of monopely power, and the
concomitant charging of monopoly prices, is not only not
unlawful; it is an important element of the free-market
system.” Verizon Commce’ns Inc. v. Law Offices of Cur-
tis V. Trinko, LLP, 540 U.S. 398, 407 (2004). And the
mere possession of market power does not necessarily
- mean that it was exercised. See Paul Twomey et al., A
Review of the Monitoring of Market Power 8 (MIT Ctr.
for Energy & Envtl. Policy Research, Working Paper
No. 05-002, 2005).

This very case provides an example of how amorphous
the concept of market dysfunction can be. The Adminis-
trative Law Judge below found that the forward markets
were “competitive,” “not dysfunctional,” and “well func-
tioning.” Nev. Power Co. v. Enron Power Mktg., Inc.,
101 FERC 163,031, at 65,288 (2002). In both this case
and a companion case, FERC found that “there is noth-
ing in the record before the ALJ, in the Staff Final Re-
port, or in the 100-Day Discovery Proceeding evidence to
support a finding that there was market manipulation
specific to the long-term contracts at issue here.” Nev.
Power Co. v. Enron Power Mktg., Inc., 103 FERC
1 61,353, at 62,399 (2003); Pub. Utils. Comm’n v. Sellers
of Long Term Contracts, 103 FERC 961,354, at 62,418

24

(2003). Nonetheless, the Ninth Circuit overturned
FERC’s decision, holding that FERC had failed to de-
termine whether “the challenged contract was initially
formed free from the influence of improper factors, such
as market manipulation, the leverage of market power, or
an otherwise dysfunctional market.” Pet. App. 57a. And
in the companion case, the Ninth Circuit went so far as to
question the validity of a properly filed contract merely
because, at the time the contract was filed, “the full scale
of spot market manipulation and forward market dys-
function was not nearly as fully known as it is today.”
Pub. Utils. Comm’n v. FERC, 474 F.3d 587, 595 (9th Cir.
2006) (emphasis added). Contract certainty should not be
upset merely because more is “fully known” today than
was known years before.

If a court or agency can abrogate a contract based on
its post hoc determination that a market was generally
“dysfunctional,” sellers will either charge more to cover
the potential future cost of litigation, enforcement, and
abrogation, or—particularly if rate caps or other con-
straints preclude price increases—will simply not offer
long-term contracts at all. The first alternative results in
higher prices for consumers; the second leaves consum-
ers and retailers with no protection against the volatile
spot market prices inherent in the electric industry.
Both results are economically inefficient. Given the high
price volatility of the spot market and the massive
amount of infrastructure investment needed over the

* While prices can rise above long-run marginal cost for extended
periods even in well-functioning markets, plaintiffs in the companion
case, Dynegy Power Marketing, Inc. v. Public Utilities Commis-
sion, No. 06-1468 (filed May 3, 2007), failed to prove even that the
CDWR contracts they sought to abrogate were at elevated prices.
See Pub. Utils. Comm'n, 103 FERC at 62,415 (“Complainants were
unable to demonstrate that the contracts were priced above long-run
competitive prices.”).

25

next several decades, see pp. 12-18, supra, the potential
additional costs to consumers would be very high. That
- new cost burden is entirely avoidable if the underlying
risk of contract uncertainty is eliminated.

The Ninth Circuit’s approach would not only harm en-
ergy markets, but also have far-reaching effects in other
commodity markets in the United States and elsewhere.
Buyers and sellers throughout the global economy now
hedge a very large number of commodity transactions
with forward contracts or other derivative instruments.
See Hélyette Geman, Commodities and Commodity De-
rivatives 21-22 (2005). A ruling affirming the Ninth Cir-
cuit’s decision—even if nominally limited to electricity
markets—could call into question this country’s commit-
ment to contract certainty generally. The results for in-
ternational trade could be very significant. In many de-
veloping nations, contract uncertainty imposes substan-
tial surcharges on capital costs. See Kenneth W. Hansen,
PRI and the Rise (and Fall?) of Private Investment in
Public Infrastructure, in International Political Risk
Management: The Brave New World 75, 87-90 (Theodore
H. Moran ed., 2004). The Ninth Circuit’s approach
threatens to create the same type of costs here.

C. Fraud, Manipulation, Or Anticompetitive Con-
duct Should Justify Abrogation Only In Nar-
row Circumstances

Finally, claims that a contract should be abrogated or

modified because of fraud, manipulation, anticompetitive
conduct, or the like should also be viewed with suspicion.
Even if such factors might sometimes justify contract
modification, those circumstances should be carefully de-
fined and limited. Such misconduct should not justify ab-
rogation or modification unless two conditions are met.
First, one of the contracting parties itself must be proved
to have engaged in misconduct. Second, even where that
is shown, the misconduct should not justify abrogation

26

absent proof that it specifically involved the contract at
issue. Existing legal remedies are more than adequate to
address those circumstances. There is thus no reason to
create new sources of regulatory uncertainty by expand-
ing the potential for abrogation under Mobile-Sierra.

1. Contracts Should Not Be Abrogated Absent
Proof Of Misconduct By One Of The Contract-
ing Parties

In virtually all markets for a wide range of products,
there are instances of market manipulation, anticompeti-
tive conduct, or other misconduct by various market par-
ticipants. These are simply examples of the many differ-
ent factors that may influence prices. Some types of con-
duct may be beneficial; others are discouraged, and the
legal system is structured to deter them accordingly.
But the binding nature of a contract between parties who
have not themselves engaged in misconduct should not be
conditioned on a finding that the market is free of any
influences the legal system seeks to discourage.

It is, in fact, particularly important for contracts to be
binding in those circumstances. Like other sources of
market “dysfunction,” manipulation by third parties in-
creases volatility and uncertainty. Thus, just like other
sources of volatility, manipulation increases the need for
mechanisms that reduce risk. Long-term contracts fulfill
that need. But those contracts cannot perform that func-
tion—and thus may not be available at all—if contracting
parties cannot be sure the contracts will be enforced.

Indeed, long-term contracts often ameliorate the mis-
conduct. A reliable forward market, for example, tends
to make the spot market more competitive. “Locking in
some sales in advance reduces the incentives of multiple
firms to behave less competitively among themselves.”
Severin Borenstein, The Trouble With Electricity Mar-
kets: Understanding California's Restructuring Disas-

27

ter, 16 J. Econ. Perspectives 191, 202 (2002) (citing Blaise
Allaz & Jean-Luc Vila, Cournot Competition, Forward
Markets and Efficiency, 59 J. Econ. Theory 1 (1993)); see
also Stoft, supra, at 80 (noting that long-term contracts
“can greatly increase competitiveness in the spot mar-
ket”). Locking in buyers and sellers to long-term con-
tracts at fixed prices can also help prevent manipulation.
See Richard J. Pierce, Jr., Completing the Process of Re-
structuring the Electricity Market, 40 Wake Forest L.
Rev. 451, 474 (2005) (describing long-term contracts as
“the most effective means of protecting [utilities] from
the risk of unilateral withholding”). Finally, long-term
contracts encourage infrastructure development and thus
increase sources of supply. See pp. 15-18, supra. That
reduces the impact of any individual participant’s mis-
conduct on the market.

To take just one example, OPEC routinely engages in
anticompetitive conduct that would violate U.S. antitrust
laws, and that indisputably distorts energy markets. But
that misconduct does not mean long-term contracts be-
tween other parties should be abrogated merely because
prices would have been different in OPEC’s absence. See
Eastern Air Lines, Inc. v. Gulf Oil Corp., 415 F. Supp.
429, 441 (S.D. Fla. 1975) (rejecting a claim that OPEC’s
exercise of market power and the ensuing “so-called en-
ergy crises” justified abrogating a contract under the
commercial impracticability doctrine). The risk-reducing
benefits of long-term contracts are no less important
than they would be in a perfectly competitive energy
market. In fact, they are even more important: Long-
term contracts ameliorate the effects of OPEC’s actions
by encouraging development of other sources of supply.

By directing FERC to investigate “the context, not the
conduct, of [the] negotiations,” Pet. App. 59a, the Ninth
Circuit adopted a standard that justifies abrogation even
when the contracting parties themselves are entirely in-

28

nocent of any misconduct. The fact that non-OPEC
members sell into a market affected by OPEC’s cartel
does not mean those non-OPEC members should have
their contracts abrogated. Likewise, parties offering
long-term contracts to buyers amid claims of third-party
manipulation in spot markets are not somehow complicit
in that manipulation. To the contrary, they are providing
the antidote for the manipulation by offering long-term
contracts that bring stability. When there is a fire, the
law should punish the arsonist, not the fireman. Other-
wise no one will show up to help put out the fire next
time. |

The Ninth Circuit’s standard creates precisely the
wrong incentives. Energy suppliers should be encour-
aged to offer long-term contracts that reduce risk, not
deterred from doing so. It is not reasonable to expect
innocent parties to reject mutually satisfactory offers
merely because some unknown third party might be in-
fluencing market prices. If such a standard were upheld,
parties would be discouraged from entering into long-
term contracts whenever they believed that a court or
agency might make a finding of fraud, manipulation, or
“dysfunction” by unknown third parties at some future
date. That deterrence of beneficial risk-reducing con-
tracts serves no rational policy purpose. If the Ninth
Circuit’s rule is upheld, the next time there is an energy
crisis, suppliers will simply refuse to offer long-term con-
tracts to utilities, or will require premiums to account for
the legal risks that substantially increase the contracts’
costs. The result will be more volatility, less infrastruc-
ture development, and ultimately higher prices for utili-
ties and consumers.

The Ninth Circuit’s standard is particularly irrational
in cases where both parties were aware of allegations of
market manipulation when they entered into the con-
tract, and were merely uncertain about the manipula-

~

29

tion’s extent. In the companion case below, for example,
the Ninth Circuit questioned the validity of a filed con-
tract because “the full scale of spot market manipulation
and forward market dysfunction was not nearly as fully
known as it is today.” Pub. Utils. Comm'n, 474 F.3d at
595 (emphasis added). But the purpose of forward con-
tracts is to allocate such difficult-to-assess risks. Abro-
gating the contract changes the allocation of risk that the
parties voluntarily agreed to.

2. Contracts Should Not Be Abrogated Absent
Proof That The Party’s Misconduct Specifically
Involved the Long-Term Contract At Issue

Contracts also should not be abrogated absent proof of
misconduct specific to the contract at issue. Any other
standard creates incentives for opportunistic behavior by
counterparties that will undercut contract certainty.

Claims that a party manipulated the price of a long-
term forward contract should be viewed with suspicion.
It is difficult to manipulate or exercise marke: power in
long-term forward markets. Both buyers and sellers
have many options: They can continue buying in spot
markets, they can do business with other counterparties,
and depending on the time horizon they can often self-
supply. The longer the term of the contract, the more op-
tions exist. Long-term contracts thus are inherently re-
sistant to manipulation or the exercise of market power.

Long-term forward contracts for electricity are par-
ticularly resistant to manipulation or the exercise of mar-
ket power. Where a commodity is storable, a close rela-
tionship generaily exists between spot prices and forward
prices because of arbitrage constraints. If forward prices
are too high relative to spot prices, traders can purchase
the commodity in the spot market while contracting to
sell it in the forward market; they can then store the
commodity purchased in the spot market and later use it

30

to satisfy their obligations under the forward contract.
That arbitrage by traders will tend to keep forward and
spot prices in equilibrium. See Hull, supra, at 14.

Because electricity is not economically storable, how-
ever, the spot price is far more independent from the
long-term forward price. See Petter Skantze & Marija
llic, The Joint Dynamics of Electricity Spot and For-
ward Markets: Implications on Formulating Dynamic
Hedging Strategies § 2.4.3 (MIT Energy Lab. Report,
No. MIT_EL 00-005, 2000) (“Since electricity is not stor-
able * * * the dynamic relationship between the spot and
forward price described above does not hold for electric-
ity.”); Shawky et al., supra, at 932 (“The inability to store
electricity means that the well known cost-of-carry rela-
tionship that links spot and forward prices cannot be
used * * * .”), As a result, manipulation in the spot mar-
ket will not have the same effect on the price of long-term
forward contracts that it might in other industries. Cf.
Skantze & Ilic, supra, § 2.4.3 (“If it were announced to-
day that a major nuclear plant in New England would be
out of commission for the month of July, this would cause
an immediate increase in today’s price of a forward con-
tract with delivery in July. However it would have no ef-
fect on the current spot price.”); San Diego Gas & Elec.
Co., 98 FERC at 61,994 (stating that the effect of input
costs on long-term contract prices “will be based on
analysis and expectations for next summer, and not last
summer”). For that reason, manipulation of spot prices
in electricity markets cannot alone justify any inference
that long-term contract prices were affected. But that is
precisely the sort of inference the Ninth Circuit relied on
here. Pet. App. 57a-60a.

Absent proof of manipulation or other misconduct spe-
cific to the forward contract at issue, it would be all too
easy for a party to escape its contractual obligations by
alleging misconduct by its counterparty. The possibility

31

of such claims, and the necessity of litigating them, will
damage the certainty that forward contracts require to
function. Thus, proof of misconduct specifically involving
the contract at issue must be required.

3. Existing Remedies Are Sufficient

In short, from an economic and policy perspective,
market dysfunction or manipulation should justify abro-
gation of a long-term contract only when a contracting
party proves that another party to the contract itself en-
gaged in misconduct specifically involving the long-term
contract at issue. Given that, there is no need to modify
Mobile-Sierra to provide new remedies; crafting new
remedies to protect contract parties from fraud or ma-
nipulation is a solution in search of a problem. FERC
should instead employ existing legal mechanisms, such as
prohibitions against fraud and market manipulation.
See, e.g., 7 U.S.C. § 2(h)(2)(B)-(C) (prohibiting fraud and
manipulation); 16 U.S.C. § 824v (prohibiting energy mar-
ket manipulation); 18 C.F.R. § 1c.2 (prohibiting fraud and
manipulation in electric energy markets).‘ Alternatively,
any exception to the Mobile-Sierra public interest test
should be limited, in this context, to circumstances that
would justify a remedy under those analogous traditional
legal doctrines.

The standard offered here will encourage efficient con-
tracting. Where a party to a long-term contract engages
in manipulation or other misconduct specific to that con-
tract, that party has no legitimate expectation that its
contract will be upheld, and it will knew that in advance.
By contrast, where a party is innocent of any wrongdo-
ing, or where the wrongdoing did not specifically involve

* In addition, where a seller develops market power, a buyer may file
a complaint with FERC seeking to rescind the seller’s authority to
charge market-based rates. See La. Energy & Power Auth. v.
FERC, 141 F.3d 364, 370-371 (D.C. Cir. 1998).

32

the long-term contract at issue, there is no economic jus-
tification for abrogating an agreement.

Economic efficiency is best served by encouraging |
long-term contracts, not impeding them. The Ninth Cir-
cuit’s approach will deter energy suppliers from offering
long-term contracts precisely when they are needed
most. It will impede investment in badly needed energy
infrastructure. Far from protecting utilities and con-
sumers, the Ninth Circuit’s standards will only exacer-
bate future energy crises.

CONCLUSION
The decision of the Ninth Circuit should be reversed.

Respectfully submitted.
JEFFREY A. LAMKEN JOHN N. ESTES III
ROBERT K. KRY Counsel of Record
MARTIN V. TOTARO CARL EDMAN
BAKER BOTTS L.L.P. SKADDEN, ARPS, SLATE,
1299 Pennsylvania Ave., NW MEAGHER & FLOM LLP

Washington, DC 20004-2400

(202) 639-7700 _ 1440 New York Ave., NW

Washington, DC 20005-2111
(202) 371-7950

Counsel for Amici Curiae

November 2007

APPENDIX

ae t%

la

APPENDIX
LIST OF SIGNATORIES

William J. Baumol
Professor ef Economics, New. York University
Academic Director, Berkley Center for
Entrepreneurial Studies
Professor of Economics (Emeritus),
Princeton University

Colin C. Blaydon
William and Josephine Buchanan Professor
of Management and Dean Emeritus,
Tuck School of Business, Dartmouth College
Director, Center for Private Equity and
Entrepreneurship

Charles J. Cicchetti
Adjunct Full Professor and former Jeffrey and
Paula Miller Chair and Professor of
Government, Business and the Economy,
University of Southern California

Jeffrey A. Dubin
Visiting Professor of Economics,
University of California, Santa Barbara
Professor of Economics, California Institute
of Technology (Retired)

Franklin M. Fisher
Jane Berkowitz Carlton and Dennis William Carlton
Professor of Microeconomics (Emeritus),
Massachusetts Institute of Technology
John Bates Clark Medal, 1973

2a

Robert W. Hahn
Executive Director, AE]-Brookings Joint Center

Jerry A. Hausman
John and Jennie S. MacDonald Professor
of Economics, Massachusetts Institute
of Technology
John Bates Clark Medal, 1985

William W. Hogan
Raymond Plank Professor of Global Energy Policy,
John F. Kennedy Schoo! of Government,
Harvard University
Research Director, Harvard Electricity Policy Group
Past President, International Association for
Energy Economics’ |

Joseph P. Kalt
Ford Foundation Professor of International
Political Economy, John F. Kennedy
School of Government, Harvard University”

Paul R. Kleindorfer
Anheuser Busch Professor of Management Science
(Emeritus), The Wharton School,
University of Pennsylvania
Distinguished Research Professor, INSEAD

Robert J. Michaels
Professor of Economics,
California State University, Fullerton

' Professor Hogan served as an expert in FERC proceedings below.
* Professor Kalt served as an expert in FERC proceedings below.

Bruce M. Owen

Gordon Cain Senior Fellow,
Stanford Institute for Economic Policy Research

Morris M. Doyle Centennial Professor in Public
Policy and Director, Public Policy Program,
Stanford University

Former Chief Economist, U.S. Department of
Justice, Antitrust Division

Craig Pirrong
Professor of Finance, Bauer College of Business,
University of Houston
Director, Global Energy Management Institute

Michael A. Salinger
Professor of Economics and W. Everett L Lord
Distinguished Scholar, Boston University
School of Management

Steven M. Shavell
Samuel R. Rosenthal Professor of Law
and Economics, Harvard Law School
Director, John M. Olin Center
for Law and Economics

Vernon L. Smith
Professor of Economics and Law,
George Mason University
Nobel Prize in Economics, 2002

4a

René M. Stulz
Everett D. Reese Chair of Banking and Monetary
Economics, Ohio State University 3
Director, Charles A. Dice Center for Research
in Financial Economics

James L. Sweeney
Professor of Management Science and Engineering,
Stanford University |
Director, Precourt Institute for Energy Efficiency

Robert D. Willig
Professor of Economics and Public Affairs,
Woodrow Wilson School of Public and
International Affairs, Princeton University
Former Deputy Assistant Attorney General
(Chief Economist), U.S. Department of Justice,
Antitrust Division

Catherine D. Wolfram
Associate Professor, Haas School of Business,
University of California, Berkeley

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385016_0538%3A26. Public record. Not legal advice.