Amicus Curiae Brief — American Electric Power Service Co. Corp. v. Public Utility District No. 1 of Snohomish County, Washington (Nos. 06-1462, 06-1457)

1S a aD FILED

41 psp_ Nos. 06-1457, 06-1462 Nov 28 2007

In the Supreme Court of the Hnited Sfated?* ™* CeAK

MORGAN STANLEY CAPITAL GROUP INC.,

‘ Petitioner,

PUBLIC UTILITY DISTRICT NO. 1

OF SNOHOMISH COUNTY, WASHINGTON, ET AL.,

Respondents.

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

‘ Petitioners,

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. HAN, 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

Sonera ere ater ears PL A A

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 heher 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

I. Suppliers Help Western Utilities Manage

The Energy Crisis mp vienna

AE aE a ee

Il. The Utilities Seek To pana Their

Eee Seen

III. The Ninth Circuit’s Decision ...................00.

Summary Of Argument .............::ssscese0 snvssescenonnnsoes

Argument... pleiiainacuabnanenupeanennenesecemenece

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

CR ciseiitiictnscvannpeimniatanncinenenssscnsceeee

C. Contract Certainty Is Especially

Important In The Energy Industry .......

1. Price Volatility In Energy

Markets Makes ented Stability

ee eiiatildeilactdtiantnnesiatiatenemsesesenee

2. Contract Certainty ieee

Development Of Critical

Infrastructure

(iii)

iv cae

TABLE OF CONTENTS—Continued

II. Contract Abrogation Should Be Allowed

Only In Exceptional Cases..................:ssesse0 18

A. The Court Should Not Permit

Abrogation Of Market-Based

Contracts Merely Because A Price

Seems Unreasonably High In

EE 19

B. Claims That A Contract Was

Negotiated In A “Dysfunctional

Market” Or “Crisis Conditions”

Should Not Justify Abrogation ............... 21

C. Fraud, Manipulation, Or

Anticompetitive Conduct Should

Justify Abrogation Only In Narrow

1. Contracts Should Not Be

Abrogated Absent Proof Of

Misconduct By One Of The

2. Contracts Should Not Be

Abrogated Absent Proof That The

Party's Misconduct Specifically

Involved The Long-Term

ee 29

3. Existing Remedies Are Sufficient... 31

I ciicnisclaiaiecttaiidaiteataitiiiiitateincanserentniteniiiiinienes 32

_ Appendix — List Of Signatories .................sscssseseseeees la

v

TABLE OF AUTHORITIES

Page

CASES

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

init ccean cantina nniietepementen 10

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

a iieiciiniiiintecisstiinnteetermemensenen 4

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

415 F. Supp. 429 (S.D. Fla. 1975).............0000000 27

FPC v. Sierra Pac. Power Co., 350 U.S.

SE ecicentieeeentintnincintdtinmmnnnn 6

La. Energy & Power Auth. v. FERC, 141 :

F.3d 364 (D.C. Cir. 1998)..........ccsrccsscsorsscesreseees 31

Nat'l Soc’y of Profl Eng’rs v. United

States, 485 U.S. 679 (1978).........c-ccesecrecsereeseesees 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,

| 6

Pub. Utils. Comm’n v. FERC, 474 F.3d

587 (Sth Cir. 2006)..........-rcececcsrseresees en 7, 24, 29

Tops Mkts., Inc. v. Quality Mkts., Inc.,

142 F.3d 90 (2d Cir. 1998) ............ccccescessessecceees 17

United Gas Pipe Line Co. v. Mobile Gas

Serv. Corp., 350 U.S. 332 (1956) ........-sssssereeseee 6

United States v. Addyston Pipe & Steel

Co., 85 F. 271 (6th Cir. 1898), aff'd as

modified, 175 U.S. 211 (1899)............cccceceeeeeees 20

Verizon Commce’ns Inc. v. FCC, 535 US.

vi

TABLE OF AUTHORITIES—Continued

Page

Verizon Commce’ns Inc. v. Law

of Curtis V. Trinko, LLP, 540 U.S.

398 (2004).... saisnaialeinenielDiieaiinteemenemasmenestee 23

STATUTES AND CONSTITUTIONAL

PROVISIONS

if Fo F Sa) YS ee 10

eres erstnerieneensetnegennentnnens 31

near crrrercnentncremncatenenns 31

Civil Rights Act of 1866, ch. 31, § 1,

14 Stat. 27, 27 ....cccvvesessssorerssseosesersssnseeesessanesesseeen 10

Cal. Pub. Util. Code § 368(a) ............cssssssssssersseseees 3

ADMINISTRATIVE MATERIALS

Ee 31

Nev. Power Co. v. Duke Energy Trading

& Mktg., L.L.C.,99 FERC 9 61,047

AS 1 Scone eae 16

Nev. Power Co. v. Enron Power

Mktg., Inc.:

101 FERC 1 63,031 (2002)..........c0:vereressererees 23

103 FERC 1 61,353 (2008)..................0. 6, 7, 23

105 FERC 9 61,185 (2008)...........sssecserseeesees 6

Pub. Utils. Comm'n v. Sellers of Long

Term Contracts:

99 FERC 9 61,087 (2002).............00ccecereeeeees 5

103 FERC 4 61,354 (2008).............0.. 6, 7, 23, 24

San Diego Gas & Elec. Co. v. Sellers of

Energy & Ancillary Servs.:

93 FERC 4 61,121 (2000)..............cc0ccceseees 4,5

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

vii

TABLE OF AUTHORITIES—Continued

Page

OTHER AUTHORITIES

Amy Abel, Electric Transmission:

Approaches for Energizing a Sagging

a CRS Report for omnsnandll

naa Allaz & Jean-Luc Vila, Caumnet

Competition, Forward Markets and

Efficiency, 59 J. Econ. Theory 1 (1993).......... 27

Severin Borenstein, The Trouble With

Electricity Markets: Understanding

California’s Restructuring Disaster,

16 J. Econ. Perspectives 19 191 (2002)............:0+- 26

Stephen Breyer, Analyzing Regulatory

Failure: Mismatches, Less Restrictive

Alternatives, and Reform, 92 Harv. 'L.

Rev. 549 (1979) .. ictisiaindieitenecenemneen 14

Congressional Budget Office, Causes and

Lessons of the California Electricity

nee 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 emcee

(2003)........0000ve00s » BB

Daniel A. Farber, Contract hee and

Modern Economic Theory, 78 Nw. U. L.

EE intricnctetitcinrrnntnenenpemmmemaeen 10

TABLE OF AUTHORITIES—Continued

FERC, 2004 State of the Markets ma

(2005) , 13, 16

FERC, Staff Report to the Federal me

Regulatory Commission on the Causes

of Wholesale Electric Pricing Abnor-

malities in the Midwest wivetend June

SE eteniitineniitnnttninaatcenenntntetennstcsrnenees 13

L.L. Fuller & William R. Perdue, Jr., The

ee ea

a es Ce I cctcrncrrrinterntessncnccntermecsncsses 10

Hélyette Geman, Commodities and

Commodity Derivatives (2005) ...............---000+ 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

ed., 2004) Eh LS 25

Scott M. Harvey & William W. ‘hom

Market Power and Market Simulations

(2002), available at http://ksghome.

harvard.edu/~whogan ia dieieemmemeenee 22

Scott M. Harvey & William W. Hogan,

Market Power and Withholding (2001) ,

available at http://ksghome.harvard.

EE 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)...........ccecseserevsssseers 23

Lawrence J. Makovich, California Power

Crisis Aftershock: The Potential

Modification of Western Power

Contracts (2007), available at http://

Wwwl.core.comy/Wwenternpowercomracts — 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 eleniantetegnene 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 A. Posner, Economic Analysis of

Ca cee 10

| x

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) .................cssesceseseeees 30

Adam Smith, The Wealth of Nations

(Edwin Cannan ed., Bantam Dell 2003)

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

Ge ntutuntcteniesenntemenacnees 17, 22, 27

Stephen L. Teichler & Ilia Levitine, Long-

Term Power Purchase Agreements in a

Restructured Electricity Industry,

40 Wake Forest L. Rev. 677 (2005) ...............+. 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)...........0.-0-00 23

Ge |)

Supreme Court of the Anited 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 mwme-

tary contribution intended to fund the preparation or submission ot

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 9 61,121, 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.” Jbid. 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 rome 1 61,294,

at 61,999 (2000) (emphasis added).

That same month, utilities like asin 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 Mkig., Inc.,

103 FERC 1 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 1 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., 108 FERC at 62,399-400. Ac-

cordingly, FERC refused to abrogate the contracts.

Ill. The Ninth Circuit’s Decision

The Ninth Circuit 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.” Id. 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. /d. at 62a-64a. The court remanded to

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

— = their contracts will be enforced. The Ninth Cir-

"8s approach threatens important tools for managing

“sak 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 effee-

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. 308, 315 (1983); L.L. Fuller & William R. Perdue,

Jr., The Reliance Interest in Contract Damages, 46 Yale

L.J. 52, 59 (1986). 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, Ine. 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 guaranteed 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 Poli-

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 will 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.

a

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.

——”

ay

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-

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 th ~ 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 4%

from 2005 to 2030. Energy Info. Admin., Annual Energy

Outlook 2007: With Projections to 2080, 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. “[AJll electricity demand regions * * * are

expected to need additional, currently unplanned, capac-

ity by 2030.” Id. 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://Awww?2.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 9 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-

nanciel 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 Mobile-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 Comme’ns Inc. v. FCC, 535 US.

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 inté the

reasonableness of the prices set by private agreement.”

Nat? Soc’y of Prof Eng’rs v. United States, 435 US.

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.).

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

“crisis 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 cure 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 encourage

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 monopoly 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 Mkig., Inc.,

101 FERC 463,031, 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., 108 FERC

1 61,353, at 62,399 (2008); Pub. Utils. Comm’n v. Sellers

of Long Term Contracts, 108 FERC 14 61,354, 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, 108 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

ity 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 contezt, 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-

1D CN, GS NERY Sar peraee Sy SE

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 market 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 generally 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

perme

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 & Tlic, 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 know 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).

82

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. Lema | CARL EDMAN

BAKER BOTTS L.L.P. SKADDEN, ARPS, SLATE,

os morn = peo te MEAGHER & FLOM LLP

ptm ok _ 1440 New York Ave., NW

Washington, DC 20005-2111

(202) 371-7950

Counsel for Amici Curiae

November 2007

APPENDIX

la

APPENDIX

LIST OF SIGNATORIES

William J. Baumol

' Professor of 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

Robert W. Hahn

Executive Director, AEI-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 School 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 a Bauer College of Business,

University of Houston

Director, Global Energy Management Institute

Michael A. Salinger

Professor of Economics and W. Everett —_

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 _

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 1

Professor of Economics and Public Affaire

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