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

SBOLY a

AIM5P Nos. 06-1457 and 06-1462

In the

Supreme Court of the United States

MORGAN STANLEY CAPITAL GROUP INC., PETITIONER,

V.

PUBLIC UTILITY DISTRICT NO. 1 OF SNOHOMISH COUNTY,

WASHINGTON, ETAL, 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 FOR THE STATES OF ILLINOIS,

CONNECTICUT, IOWA, MASSACHUSETTS,

MINNESOTA, MONTANA, NEW HAMPSHIRE;

OKLAHOMA, AND RHODE ISLAND AS AMICI

CURIAE IN SUPPORT OF RESPONDENTS

MICHAEL A. SCODRO* LISA MADIGAN

Solicitor General Attorney General of Illinois

JANE ELINOR NOTZ 100 West Randolph Street

Deputy Solicitor General Chicago, Illinois 60601

SUSAN HEDMAN (312) 814-3698

Sr. Ass't Attorney General

* Counsel of Record

[additional counsel listed on signature page]

QUESTION PRESENTED

Whether, in response to complaints filed under

§ 206 of the Federal Power Act, 16 U.S.C. § 824e, the

Federal Energy Regulatory Commission

misconstrued the public interest standard

established by this Court in United Gas Pipe Line

Co. v. Mobile Gas Serv. Corp., 350 U.S. 332 (1956),

and Federal Power Comm'n v. Sierra Pacific Power

Co., 350 U.S. 348 (1956).

ll

TABLE OF CONTENTS

Page

QUESTION PRESENTED ................:ccssssssssscssereesees i

TABLE OF AUTHORITIES. ..............cccecssssesessseees ill

INTEREST OF THE AMICI CURIAE .................00++ 1

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SUMMARY OF THE ARGUMENT .................:.:::00+ 6

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I. The “Public Interest” Inquiry Properly Turns

On A Comparison Between Price and

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Il. The “Public Interest” Test That FERC

Applied Is Incompatible With The Decisions

Of This Court And Ignores The Practical

Realities of State Utility Regulation ............... 12

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TABLE OF AUTHORITIES

Cases: Page

American Paper Inst. v. American Elec. Power,

SN Se: SI vcsccecocsnasnnccaninesrsesecaneperenties 13

Federal Power Comm'n v. Sierra Pacific Power Co.,

350 U.S. 348 (1956) ........esceccessccecsessesesseeee passim

FPC v. Texaco Inc., 417 U.S. 380 (1974) .......... 12, 13

Nantahala Power & Light Co. v. Thornburg,

A TT FE CD dntcnne cee ccnssecentsesescsscncocsoseoses 14

United Gas Pipe Line Co. v. Mobile Gas Serv. Corp.,

EE SEO .,sscradamdsiniaadaunanesionetdeia passim

Statutes and Rules:

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Miscellaneous:

James Bonbright, Principles of Utility

UII id als stsasieniniatnbbananpnsiniionnipiinimintits 14

I Alfred E. Kahn, The Economics of Regulation:

Principles & Institutions (1988) ...............-:0000000 9

INTEREST OF THE AMICI CURIAE'

This case asks whether the- Federal Energy

Regulatory Commission (“FERC”) misapplied this

Court’s decisions in United Gas Pipe Line Co. uv.

Mobile Gas Serv. Corp., 350 U.S. 332 (1956), and

Federal Power Comm'n v. Sierra Pacific Power Co.,

350 U.S. 348 (1956) (together, “Mobile-Sierra”), in

refusing to modify wholesale electricity contracts.’

Because state-regulated utilities across the country

increasingly purchase electricity in FERC-regulated

markets, and because FERC alone determines

whether wholesale electricity prices are lawful, this

case is of critical interest to the amici States.

Resolution of the question presented is likely to

have a particular impact on States that have

deregulated and/or restructured their electricity

sectors. In these States, public utilities rely on the

' Pursuant to this Court’s Rule 37.2(a), the amici curiae

provided notice of their intention to file this brief to counsel

of record at least 10 days prior to its filing.

* Under these contracts, petitioners sold electricity to

various entities, including public utilities, which purchased

power to provide service to retail customers. These entities,

as well as state agencies charged with protecting the

interests of retail customers, are the respondents and

intervenors in this case. Pet. App. 2a, 316a. (All citations

to “Pet. App.” in this brief refer to the appendix filed by

petitioner Morgan Stanley in No. 06-1457.)

wholesale markets heavily, and in some cases

exclusively, to purchase electricity for their retail

customers. Indeed, even States with a traditional

regulatory framework, in which public utilities both

generate and supply electricity at retail, will be

affected by the outcome of this case, for public

utilities in these States routinely purchase electricity

at wholesale to supplement the electricity they

generate themselves.

As a result of this increased reliance on the

wholesale markets to purchase electricity for

consumer use, retail rates in many States depend

largely on FERC-regulated wholesale prices.

Moreover, because the Federal Power Act (“FPA” or

“Act”) gives FERC exclusive jurisdiction over

wholesale markets, see 16 U.S.C. § 824d(a),

wholesale prices are not subject to regulation by the

States. Consequently, if FERC fails to ensure that

wholesale rates are lawful—and fails to modify rates

that are not—States cannot adequately protect their

retail customers.

STATEMENT

1. Sections 205 and 206 of the FPA set forth the

standards by which FERC regulates rates for the

sale of electricity at wholesale. Section 205 requires

that all such rates “be just and reasonable” and

declares “unlawful” any rate failing to meet that

standard. 16 U.S.C. § 824d(a). Section 206 then

provides that, if FERC determines that a wholesale

rate is “unjust, unreasonable, unduly discriminatory

or preferential,” FERC “shall determine the just and

reasonable rate” and “shall fix the same by order.”

Id. § 824e(a).

2. In late 2001 and 2002, respondents filed

complaints pursuant to § 206, seeking FERC review

of certain wholesale electricity contracts between

respondents and petitioners. Pet. App. 247a; J.A.

1484a. The complaints alleged that the contract

prices were unreasonably high because, at the time

the contracts were negotiated in 2000 and 2001,

electricity markets in the western United States

were dysfunctional. Pet. App. 247a-248a; J.A. 1485a.

The complaints asked FERC to modify the contracts

to render the terms just and reasonable. Ibid.

3. FERC concluded that the contracts were not

contrary to “the public interest” and therefore denied

respondents’ requests, purporting to apply the so-

called “Mobile-Sierra doctrine.” Pet. App. 248a-249a.

Mobile and Sierra, two cases decided on the same

day in 1956, involved requests by a natural gas

distributor and an electricity supplier, respectively,

to increase rates in their existing contracts.

Although the Court rejected both requests to change

the rates in those cases, it established FERC’s

authority to modify existing contracts to protect the

public interest. See Mobile, 350 U.S. at 344 (holding

that FERC may modify wholesale natural gas

contracts “when necessary to protect the public

interest”); Sierra, 350 U.S. at 355 (holding that

FERC may modify wholesale electricity contracts

that “adversely affect the public interest”).

Accordingly, while natural gas companies may not

change their contracts “simply because it is in their

private interests to do so,” the law affords them “an

avenue of relief when their interests coincide with

the public interest.” Mobile, 350 U.S. at 344. The

Court characterized this as “a reasonable

accommodation between the conflicting interests of

contract stability on the one hand and public

regulation on the other.” Ibid.

In Sierra, the Court identified factors that may

be used in determining whether a rate is so low that

it imperils the public interest—namely, whether the

rate threatens to “impair the financial ability of the

public utility to continue its service, cast upon other

consumers an excessive burden, or be unduly

discriminatory.” 350 U.S. at 355. The Court

emphasized, however, that “a contract may not be

said to be either ‘unjust’ or ‘unreasonable’ simply

because it is unprofitable to the public utility.” Ibid.

4. FERC purported to apply the Mobile-Sierra

“public interest” test to the contracts at issue in this

case—but in a form that FERC acknowledged would

render the standard for contract modification

“practically insurmountable.” Pet. App. 209a.

Concluding that the contracts failed to satisfy this

standard, FERC limited its analysis to the examples

from Sierra and held, specifically, that the

agreements did not cause the utility respondents

“financial distress” sufficient “to threaten their

ability to continue service * * * for] cast an excessive

burden on their customers.” Jd. at 252a. Nor were

the contracts “unduly discriminatory to the

detriment of other customers.” Ibid.

5. On respondents’ petition for review of the

FERC orders, the Ninth Circuit reversed, holding

that FERC’s application of Mobile-Sierra was both

procedurally and substantively flawed. Id. at 3a.

First, FERC erred procedurally by applying the

Mobile-Sierra public interest standard at all, for that

standard does not apply to contracts negotiated in a

dysfunctional market that fails to produce the just

and reasonable prices that the FPA requires. Id. at

42a-60a. Second, even if the Mobile-Sierra standard

does control, FERC misapplied it by focusing solely

on the extent to which the contracts placed an

“excessive burden” on respondents and their retail

customers, without comparing the contract prices to

the marginal cost of producing electricity to ensure

that those prices were within the “zone of

reasonableness.” Id. at 63a-65a. The court of

appeals remanded for FERC to determine whether

review under Mobile-Sierra is proper in this case

and, if so, to apply that standard correctly. Id. at

66a-67a.

SUMMARY OF THE ARGUMENT

The Ninth Circuit properly rejected FERC’s

misinterpretation of this Court’s holdings in Mobile

and Sierra.’ As the court of appeals recognized, the

Mobile-Sierra doctrine necessarily implies what

amounts to an economic test, under which the “public

interest” inquiry turns on a comparison between the

contract price and the marginal cost incurred in

producing the electricity. If the wholesale supplier

contracts to sell at a price either significantly above

or below its marginal cost, the test holds that the

public interest is threatened, and FERC must modify

the contract price. The standard applicable to high-

rate challenges (like this one) is identical to that

applied to the low-rate claims in Mobile and

Sierra—either way, what matters is whether the

contract price strays significantly from marginal

cost.

* The amici States adopt respondents’ argument that, as a

procedural matter, FERC erred in applying the Mobdile-

Sierra public interest standard without first determining

that the contracts, which were negotiated in a market so

dysfunctional that even FERC calls it “the worst electricity-

market crisis in American history,” FERC Br. Op. 12; FERC

Br. 16, were just and reasonable. See Snohomish Br. 28-49;

GSWC Br. 28-51; CPUC Br. 19-54. This brief argues that

FERC substantively misinterpreted Mobile and Sierra and,

as a result, used the wrong standard to determine whether

the contracts at issue were contrary to the public interest.

Rather than undertake the comparison between

price and marginal cost that Mobile-Sierra demands,

FERC mistakenly limited its inquiry to the burdens

on respondent utilities and their retail customers.

Not only is this approach inconsistent with Mobile

and Sierra, but it is impossible to square with other

decisions from this Court and ignores the practical

realities of state public utility regulation.

Accordingly, the amici States urge this Court to

affirm the judgment of the Ninth Circuit. On

remand, FERC must compare the contract prices

with the marginal cost of producing the electricity, as

Mobile-Sierra requires, and modify the challenged

contracts if these figures are not reasonably close.

ARGUMENT

FERC fundamentally misinterpreted the Mobile-

Sierra test. As the Ninth Circuit correctly

determined, that test requires FERC to compare

contract prices with the marginal costs of electricity

production. This approach follows not only from

Mobile and Sierra, but from bedrock economic

principles favoring a close connection between price

and marginal cost. Moreover, FERC’s “practically

insurmountable” alternative test—which asks

whether contract prices threaten “financial distress”

for the wholesale buyer and place an “excessive

burden” on consumers—cannot be reconciled with

decisions of this Court and ignores the practical

realities of state public utility regulation.

I. The “Public Interest” Inquiry Properly

Turns On A Comparison Between Price And

Marginal Cost.

It is undisputed that FERC may modify contract

rates that are “so low as to conflict with the public

interest,” Mobile, 350 U.S. at 345, such that the rates

threaten to “impair the financial ability of the public

utility to continue its service, cast upon other

consumers an excessive burden, or [are] unduly

discriminatory,” Sierra, 350 U.S. at 355. In short, it

is neither in the public interest for an electricity

supplier to jeopardize its financial integrity by

selling at a loss, nor for it to favor one customer and

cover its marginal costs by selling to others at higher

prices. Under either circumstance, FERC can and

should exercise its authority to modify the contract

rate.

At the same time, it is not enough that a contract

price is “unprofitable to a public utility,” for § 206

enables FERC to protect “the public interest, as

distinguished from the private interests of the

utilities.” Sierra, 350 U.S. at 355. Thus, the Court

drew a critical distinction between a price that

impairs the financial ability of a public utility to

operate and a rate that is sustainable but

unprofitable. This distinction may be expressed in

simple economic terms: it is in the public interest to

increase the utility’s contract price when that price is

less than the marginal cost of producing the

electricity. Indeed, an enterprise need not charge

prices in excess of marginal cost to be sustainable,

but it must cover its marginal expenses. See I Alfred

E. Kahn, The Economics of Regulation: Principles &

Institutions 67 (1988) (“[I]t pays * * * to continue to

produce and sell as long as * * * incremental

revenues cover * * * incremental cost.”). The

negative effects of underpricing that Mobile-Sierra

uses as examples of a threat to the public interest

follow inexorably from pricing below marginal cost,

for, to remain viable, a producer selling below cost

must choose between discontinuing service or

subsidizing the low-price contract by burdening other

customers with higher prices, precisely the ills that

Mobile-Sierra empowers FERC to prevent in the

public interest.

The converse is also true. It is well-established

that prices significantly above marginal cost arise

only in imperfectly competitive markets, and that

such prices lead to the misallocation of resources.

See Kahn, supra, at 66. Accordingly, in order to

maximize utility “from society’s limited aggregate

productive capacity * * * prices * * * for * * * various

goods and services * * * must accurately reflect their

respective [marginal] opportunity costs.” Ibid.

The Ninth Circuit thus correctly applied the

marginal cost test derived from Mobile-Sierra to

respondents’ claim that their contract rates are too

high. The court of appeals recognized that “a

functioning marketplace will drive prices toward

marginal cost,” Pet. App. 64a, and properly

determined that Mobile-Sierra requires the

10

wholesale contract price to fall within a “reasonable

range” of marginal cost:

[elven if a particular rate exceeds

marginal cost[,] * * * it may still be

within this reasonable range—or “zone of

reasonableness’—if that higher-than-

cost-based price results from normal

market forces and is part of a general

trend toward rates that do reflect costs.

Ibid. The court correctly concluded that “the proper

standard for the Mobile-Sierra ‘public interest’ mode

of review in a high-rate challenge is whether the

wholesale energy contract price is outside the ‘zone of

reasonableness,” too high relative to marginal cost.

Id. at 65a.

Accordingly, petitioners are wrong to say that

the Ninth Circuit held that “application of the

[Mobile-Sierra] standard must be asymmetrical,”

Calpine Br. 47, and specifically that the court of

appeals applied a less rigorous test to determine

whether a contract price is too high than Mobile and

Sierra applied to alleged underpricing, id. at 52-56;

Morgan Stanley Br. 48-50. In fact, the court of

appeals asked precisely the question that follows

from Mobile-Sierra—whether the contract price is

significantly out of line with marginal cost.

The court thus held that “FERC should have

performed a more sophisticated economic analysis to

determine if the challenged contract affected the

/

11

public interest.” Pet. App. 66a. In particular, FERC

should have analyzed the marginal cost of generating

the electricity needed to fulfill the terms of the

contracts. Because FERC did not collect or analyze

data on the cost of generating the electricity supplied

to respondents, moreover, it is impossible to

determine conclusively whether the contracted rates

depart impermissibly from marginal cost.‘ These

costs are readily ascertainable on remand, however,

and if FERC determines that a contract price is

significantly higher than marginal cost, FERC must

modify the contract price accordingly.

* The contract prices at issue here may have been

significantly above the marginal cost of generating the

electricity needed to supply the contracts. Since the electric

systems are typically operated by first deploying the low-

cost generators (typically, nuclear- and coal-powered), and

by operating the high-cost generators (powered by natural

gas) only during peak demand periods, the marginal cost of

generating electricity is usually much lower during off-peak

than peak periods. Thus, the marginal cost—which would

be expressed in dollars per megawatt-hour (““MWH”)}—of

producing electricity to fulfill a hypothetical contract to

supply electricity around the clock for a year might be less

than $30/MWH 90% of the time (during nonsummer months

and on summer nights, when only low-cost generators are

operating), and may exceed $100/MWH as little as 1% of the

time (on hot summer afternoons, when high-cost generators

are brought on line to meet the increased demand caused by

air-conditioning use). The contracts in this case called for

payment of as much as $290/MWH, even during off-peak

periods, when the marginal] cost of generating electricity is

low. Pet. App. 30a.

12

Il. The “Public Interest” Test That FERC

Applied Is Incompatible With The Decisions

Of This Court And Ignores The Practical

Realities Of State Utility Regulation.

Rather than compare price and marginal cost, as

the reasoning in Mobile-Sierra and fundamental

economics require, FERC asked whether the contract

prices caused “financial distress” for respondents, the

wholesale electricity buyers, sufficient to threaten

their viability or placed “an excessive burden” on the

ultimate consumer. Pet. App. 252a. This approach

is not only impossible to square with the principle

underlying Mobile-Sierra, but runs afoul of other

decisions by this Court and ignores the realities of

state public utility regulation.

First, requiring “an excessive burden” on the

consumer before FERC will modify a contract price

violates this Court’s “small dent’ admonition.” Pet.

App. 64a. This Court has long recognized that:

fijn the context of ratemaking, it is

typically the case that any increment in

the rate will “make a small dent in the

consumer's pocket,” FPC v. Texaco Inc.,

417 U.S. 380, 399 (1974), while that same

increment will have’ substantial

consequences for the parties to whom the

rate is paid. FERC’s statutory mandate to

prescribe a rate that “shall be just and

reasonable to the electric consumers of the

electric utility,” 16 U.S.C. 824a-3(b)(1)

13

(1976 ed., Supp. V), obviously reflects a

congressional determination that potential

savings for consumers as a class are

important even though rate changes will

generally not have great economic

significance for any individual consumer.

American Paper Inst. v. American Elec. Power, 461

U.S. 402, 417 n.11 (1983). In short, the impact on

consumer rates need not be “excessive” to impair the

public interest. To the contrary, “even a small dent

in the consumer’s pocket”—so long as that increase

arises from a contract price that is outside the zone

of reasonableness—may warrant contract

modification under Mobile-Sierra, as the Ninth

Circuit correctly held. Pet. App. 64a (quoting Texaco,

417 U.S. at 399). Indeed, to require “an excessive

burden” on the end user is to abandon Mobile-Sierra

for the “practically insurmountable” test that FERC

applied. Pet. App. 209a.

Second, the practical realities of utility

regulation make it nonsensical to define the “public

interest” entirely in terms of the contract rate’s effect

on the wholesale buyer’s viability and on the

“excessive[ness]” of the retail price. These factors

often have an inverse relation—the more the

wholesale buyer is able to pass along wholesale price

increases to the end user in the form of higher retail

rates, the smaller the effect of an increase on the

wholesale buyer and the greater its effect on the

ultimate consumer. Likewise, this Court has noted

that increases in wholesale rates need not lead to an

14

increase in retail rates at all, if savings in other

areas offset the wholesale rate increase. See

Nantahala Power & Light Co. v. Thornburg, 476 U.S.

953, 967-968 (1986).

State commissions decide the extent to which

regulated utilities may pass these costs along to

consumers, depending on a variety of factors

including public acceptability, rate stability, and

fairness to the various consumer classes.° The more

the wholesale buyer is allowed to pass along price

increases to the end user in the form of higher retail

rates, the smaller the effect of a price increase on the

wholesale buyer and the greater its effect on the

ultimate consumer. As a result, it is impossible for

FERC to determine accurately whether wholesale

contract prices are contrary to the public interest by

looking selectively at retail rates at fixed points in

time, as it did here, Pet. App. 210a-220a, and

nonsensical in any event to define the “public

interest” in terms of two criteria that are frequently

inversely related. For instance, a utility may be able

to avoid bankruptcy—but only if retail rates

skyrocket. That is, injury to the public utility can be

avoided by harming its customers. Conversely, retail

customers may benefit if the public utility fully

absorbs a wholesale rate increase, but doing so may

* For a complete list of criteria that state utility

commissions use to develop a sound rate structure, see

James Bonbright, Principles of Utility Rates 291 (1961).

15

cause the public utility to go bankrupt. Neither

scenario is in the public interest.

If FERC fails to ensure that wholesale rates are

just and reasonable and that wholesale contracts are

in the public interest, States will be faced with

unworkable choices, and, moreover, will not be able

to protect retail utilities or their customers

adequately. In short, FERC needs to do its job, so

States can properly do theirs.

16

CONCLUSION

The judgment of the court of appeals should be

affirmed.

Respectfully submitted,

LISA MADIGAN

Attorney General of Illinois

MICHAEL A. SCODRO*

Solicitor General

JANE ELINOR NoTz

Deputy Solicitor General

SUSAN HEDMAN

Sr. Ass't Attorney General

100 West Randolph Street

Chicago, Illinois 60601

(312) 814-3698

*Counsel of Record

January 2008

17

RICHARD BLUMENTHAL KELLY A. AYOTTE

Attorney General of Attorney General of

Connecticut New Hampshire

55 Elm Street 33 Capitol Street

Hartford, CT 06106 Concord, NH 03301

THOMAS J. MILLER W.A. DREW EDMONDSON

Attorney General of lowa Attorney General of

1305 E. Walnut Street Oklahoma

Des Moines, IA 50319 313 N.E. 21st Street

Oklahoma City, OK

MARTHA COAKLEY 73105-4894

Attorney General of

Massachusetts PATRICK C. LYNCH

One Ashburton Place, Attorney General of

20th Floor Rhode Island

Boston, MA 02108 150 South Main Street

Providence, RI 02903

LorI SWANSON

Attorney General of

Minnesota

102 State Capitol

75 Rev. Dr. Martin

Luther King, Jr. Blvd.

St. Paul, MN 55155-1609

MIKE MCGRATH

Attorney General of

Montana

P.O. Box 201401

Helena, MT 59620-1401