# United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued May 9, 2005 Decided July 12, 2005

No. 02-1374

S OUTHERN C ALIFORNIA E DISON C OMPANY AND

P ACIFIC G

AS AND E

LECTRIC C OMPANY

, P ETITIONERS

v.

F EDERAL E

NERGY R

EGULATORY C OMMISSION

, R ESPONDENT

S AN D IEGO G

AS & E LECTRIC C OMPANY

, ET AL

., I NTERVENORS

Consolidated with

02-1376, 02-1381, 02-1385, 02-1388

On Petitions for Review of Orders of the

Federal Energy Regulatory Commission

Nicholas W. Fels argued the cause for Utility Pe titioners.

With him on the briefs were M ark D. Patrizio

, Stuart K.

Gardi n er

, Carolyn F. Corwin

, Stuart J. Evans

, E. Gregory

Barnes

, Jennifer L. Key , and Michael D. Mackness

.2

Harvey L. Reiter argued the cause for petiti oners

Sacramento Municipal Utility District, et al. With him on the

briefs were Glen L. Ortman

, Walla ce L. Duncan

, J ames D.

Pembroke

, Michael Postar , and Sean M. Neal

.

Anthony J. Ivancovich

, J . Phillip Jordan , and M

ichael E.

Ward we re on the brief for intervenor California Independent

System Operator Corporation in support of petitioners.

Dennis Lane

, Solicitor, Federal Energy Regulatory

Commission

, argued the cause for respondent. With him on the

brief was Cynthia A. Marlette , General Counsel.

Before: G

INSBURG

, Chief Judge

, and S ENTELLE and

R OGERS

, Circuit Judges

.

Opinion for the Court filed by Circuit Judge S ENTELLE

.

S ENTELLE

, Ci rcuit Judge : The Federal Energy Regulatory

Commission (“FERC”

or “the Commission”) in the order before

us disallowed tariff provisions proposed by Sout hern California

Edison, Pacific Gas & Electric, and San Die go Gas & Electric

( “Utility Petitioners,” transmission operators, or “TOs”) in

which Utility P etitioners had proposed a rate designed to recover

from two classes of customers cost differentials from additional

expenses ar ising out of the formation and maintenance of an

ind e pendent system operator (“ISO”). Utility Petitioners

pro posed a tariff term passing costs through both to customers

under existing c o ntracts and to new customers. FERC

disallowed the pass-through as to the ne w customers. Both the

Utility Petitioners and muni cipal customers (customers under

pre-existing contracts) petition for review, ch allenging the

FERC decision as arbitrary and capricious in viola tion of section

706 of the Administrative Procedure Act (“APA”). Because the

order by FERC contravenes the explicit lan g uage of the FERC-3

1 According to the Utility Petitioners, “transmission losses” are

the small portion of energy that is lost “when electricity is scheduled

over transmission lines

. . . due principally to electrical re sistance of

the conductors transmitting the energy from generators to consumers”

and “ancillary servic es” means “the maintenance of generation at

variou s stages of readiness . . . in order to assure the continued

reliability of the grid.” approved ISO tariff schedule to which the tariffs must con form,

we find the order to have been arbitrary and capricious and grant

the petitions for review.

I. Background

A. Creation of ISO Tariff Schedule

In March 1998, as part of a FERC-instigated restructuring

of the California energy s ystem, Utility Petitioners transferred

control over their electricity transmission to the ne wly formed

California ISO. (For background on the formation of ISOs in

general, and this ISO in pa rticular, s ee California Independent

System Operator Corp. v. FERC

, 372 F.3d 395, 396-97 (D.C.

Cir. 2004)). When they merged into the ISO, Utility Petitioners

retained obligations to provide transmis sion to existing

wholesale customers und e r pre-existing contracts. S ee FERC

Electric Tariff, original vol. 1 o f Cal. Ind. Sys. Operator Corp.

§ 2.4.3.1 (“ISO Tariff”) (providing that existing contracts should

be hon ored such that, “to the extent possible, [doing so] imposes

no additional financial burden on ei t her the Participating TO or

the contract rights holder

. . . .”). But at the same time,

according to Utility Petitioners, they faced high er costs from the

ISO–in the form of t

ransmission losses and ancillary service

requirements 1 –than those they could recover under existing

contracts with their wholesale customers.4

Just before the ISO went into operation, FERC approved the

final version of the ISO Tariff agreed to by the various parties

to the restructuring that established a roadmap governing the

operation of the ISO, including principles g o verning the

individual TO Tariffs that Utility Petitioners could charge to

their customers. During the proce ss of negotiating this

agreement, Utility Petition

ers asked that a provision be included

to allo w them to recover the excess transmission and ancillary

service provision costs. This was done in section 7.1 of a revised

version of the ISO Tariff, issued in August 1997, which called

for including a “Transmission Revenue Credit” in the Access

Charge to be collected by the ISO on behalf of th e TOs; the

definition of “Tran

smission Revenue Credit” was revised to

include “the shortfall or surplus resulting from any cost

differences between Tra

nsmission Losses and Ancillary Service

requirements associated with Existing Rig h ts or Non-Converted

Rights and the ISO’s rules and protocols.” ISO Tariff, Master

Definitions Supplement, original sheet no. 350. Further, after

and pursuant to an October 30, 1997 FERC Order providing

interim and conditional authorization to the ISO to start

operations, Pacific Gas & Electric Co. et al, Order

Conditionally Authorizing Limited Operation of an Independent

System Operator and Power Exchange

, 81 FE R C 61,122

(“October 1997 Order”), the ISO su bmitted a revision to the

language of section 2.4.4.4.4.5, which provided that the ISO

“will provide the parties to the Existing Contracts with details of

its Transmission Losses and Ancillary Services calculations to

. . . enable the parties to the Existing Contracts to settle the

differences bilaterally or through the relevant TO Tarif f .” ISO

Tariff § 2.4.4.4.4.5 (emphasis added).

FERC accepted the IS O ’s proposed Access Charge,

i ncluding the revised definition of “Transmission Revenu e

C redit” in its order of October 30, 1997. It accepted the

proposed revision to the language of section 2.4.4.4.4.5 “for5

2 The term “new customers” includes all customers taking

service under contracts entered after the assumption of service by the

ISO, without regard to wh ether a particular customer may have

previously had service under some preexisting contract. filing

. . . to become effective on the date that ISO operations

commence” in December 1997. Order Conditionally Accepting

for Filing Certain Pro Fo rma Agreements , 81 FERC 61,322,

62,477 (Dec. 17, 1997). Utility Petitioners argue that, under this

final version of the ISO Tariff, they would be permitted to

recover the cost differentials either (a) by bilater ally negotiating

with existing contract holders, or (b) by adding them to the

Access Charge (through the Transmission Revenue Credit)

charged by the ISO to the TOs’ new customers, 2 paying ISO

tariff rates.

B. Administrative Proceedings

After the above-described negotiations w e re complete,

F ERC set the individual TO Tariffs for administrative hearings,

as r equired by FPA § 205(e), 16 U.S.C. § 824d(e) (“Whenever

any new schedule is filed the Commission shall ha ve authority,

. . . to enter upon a hearing concerning the lawfulness of such

rate, charge , classification, or service.”). I n a consolidated

hearing addressing the propose d TO Tariffs of all three Utility

Petitioners, the administrative law judge (“ALJ” ) decided that,

despite the above-cited language of the ISO Tariff, the cost

differentials could n ot be passed on to the TO’s tariff custo mers

via t he Transmission Revenue Credit in the Access Charge,

holding th at such a pass-through would amount to impermissible

cross-subsidization. P acific Gas & Elect r ic Co.

, Initial

Decision , 88 FERC 63,007, 65,051 (Sept. 1, 1999). Specifically,

the A LJ noted, “[a]ll other [TO] customers [aside from the

existing contract holders] would be responsible for costs

incurred o n their own behalf as well as those incurred on behalf6

of the Existing Contract customers.” I d. To make up the cost

differentials, the ALJ concluded, Utility Petitioners must either

(a) reform their c ontracts with existing contract holders, to the

extent permi

tted by those contracts and upon completion of a

FPA § 205 or FPA § 206 filing, or (b) “shoulde r th[e] cost

burden” themsel

ves, given that “they accepted the risk of

potential cost increases at the time they negotiated the Existing

Contracts.” Id. at 65,052.

Both Utility Petitioners and Municipal Pet itioners filed

exceptions to the ALJ’s decision to the Commission . FERC

affirmed, holding that the definition o f Transmission Credit

Revenue in the IS O Tariff did n ot control, and that the language

concerning reforming existing contracts in section 2.4.3 .1 was

“essentially precatory.” P acific Gas & Electric Co. et a l

, Opinion No. 458, Opinion and Order Affirming Initial Decision

, 100 FERC 61,156, 61,573-74 (August 5, 2002) (“Order 458”).

FERC fur ther held that the ALJ had correctly read the ISO

Tariff to require Utility P etitioners to recover the cost

differential by re forming existing contracts (or else absorb the

costs themselves), becau se “the costs are associated with service

provided under the existing con tracts, not the TO Tariffs . . . .”

Id. at 61,574.

Utility Petitioners and Municipal Petitioners sought

rehearing. FERC affirmed its prior conclusion, along with its

justifications. S ee Pacific Gas & Electric Co. et al, Opinion

458-A

, O rder Denying Rehearing, Granting Clarification and

Approving Partial Settlement

, 101 FERC 61,151, 61,6 2 0

(“Order 458-A”). At this point, FERC added new justific ations

for its affirmation of the ALJ’s decision: First, FERC noted that

although the ISO Tariff defined Transmission Revenue Credit

to include the cost differential (and thus seeming ly provided for

the ISO to collect the cost differen tial from the new customers

as part of the Access Charge), the definition “merely provided7

that the ISO will assess these costs to the [TOs], but says

nothing about what the [TOs] can do to recover these costs.” Id.

at 61,621. Second, despite the fact that the October 1997 Order

revised section 2.4.4.4.4.5 as set forth above, FER C averred it

had no t “sp[oken] to the issue in this case in the October 1997

Order.” Id. at 61,623. Instead, it said that all it had done was

provide that “‘

. . . the ISO will establis h a mechanism

acceptable to the [TO] to roll any shortfall or surpl us into the

ISO rate s applicable to that Transmission Owner.’” I d. (quoting

October 1997 Order at 61,464 n.1 45). FERC went on: “This

language does not, and was not intended to, explain the next step

in the process–how the TOs wo u ld recover the costs from their

customers.”

C. Current Petitions

Both Utility Petitioner s and Municipal Petitioners petition

this court for review of Orders 45 8 and 458-A. Utility

Petitioners argue that F E RC’s ruling that they may not recover

the cost different ials through their TO Tariffs is arbitrary and

capricious in violation of the Admini strative Procedure Act

(“APA”), insofar as it ignores or misco n strues the plain

language of sections 2 .4.4.4.4.5 and 7.1 of the ISO Tariff, and

relies instead on the ALJ’s “irrelevant” assertion that to allow

otherwise would shift costs from the existing contract holders to

the TO Tariff customers. Municipal Petitioners argue that it was

arbitrary and capricious for FERC to uphold the ALJ’s decision,

because (a) it ignored the ISO Tariff provisions that allowed for

recovery of the cost differe ntials through the TO Tariffs, and (b)

FERC “neither explains the basis for its subsidization finding

nor addresses Municipal Petitioners’ arguments that cost

causation principles require the opposite conclusion,” i.e., that

the existing cont ract holders were n ot responsible for the cost

differentials. Mun. Pet. Br. at 16.8

After Petitioners filed their petitio ns in December 2002,

FERC asked for a voluntary remand of the record so that it could

consider the issues further. The Commission issued an order on

rema nd in May 2004, noting that it had mistakenly stated that

the ISO Tariff languag

e established the rate the ISO collects

from ( rather than for) the TOs. O rder on Remand

, 107 FERC

61,115 (May 6, 2004) (ref erring to language in Opinion No.

458-A at 61,621, mentioned above, in which FERC states that

the definition of Transmission Revenue Credit “merely provided

that the ISO will assess these costs to the [TOs], but says

nothing ab out what the [TOs] can do to recover these costs.”)

However, FERC maintains that that error did not affect its basic

conclusions.

We have jurisdiction under 16 U.S.C. § 825 l (b ). S ee, e.g.

, In re American R ivers & Idaho Rivers United , 372 F.3d 413,

419 (D.C. Cir. 2004). Because we conclude that FERC cannot

disregard the definition of Transmission Revenue Credit that it

approved and included in

the ISO Tariff when considering later

TO Tariff filings by TOs seeking to confor m to that tariff, we

grant the petitions for review.

II. Discussion

In the tar iff context, this Court generally “gives substantial

deference to [FERC's] interpretation of filed tarif fs, even where

the issue simply involves the pro per construction of language.”

Koch Gateway Pipeline Co. v. FERC , 136 F.3d 810, 814 (D.C.

Cir. 1998) (internal q uotation marks omitted). But, “[i]f the

tariff's language is unambiguous, this c ourt need not defer to

FERC's interpretation.” I

daho Power v. FERC , 312 F.3d 454,

461 (D.C. Cir. 2002).

T he language of the ISO Tariff at issue in this case is clear.

Section 2.4.4.4.4.5 of

the ISO Tariff is permissive, allowing for9

the recovery of cost differentials throu gh the TO Tariffs, as well

as through bilateral negotiations to reform existing contracts.

The provi sion for the collection of a Transmission Revenue

Credit as pa rt of the Access Charge in section 7.1, combined

with the defin

ition of Transmission Revenue Credit, creates an

explicit accounting mechanism for the IS O to recover the cost

differentials through the TO Tariff on the TOs’ beh alf. Thus,

Utility Petitioners are correct that the ISO Tariff allows them to

recover the cost

differentials associated with the formation of

the ISO through their individual TO Tariffs.

FER C’s primary argument in support of its decision to

uphold t he ALJ’s decision disregarding the plain meaning of

these provisions of the ISO Tariff i s that the ISO Tariff is not

controlling. But FERC can only support this argument with its

own statements in the administrative proceedings below: (1)

That the main purpose o f those proceedings was to determine

wheth er the TO tariff on the table was just and reasonable, as

called for b y FPA § 205(e); and (2) that it had made clear that

the Access Charges (which includ e the Transmission Revenue

C redit) were to be evaluated in individual tariff proceeding s

. However, to hold an individual TO Tariff that conforms to the

ISO Tariff unjust and unreasonable would be to r ender section

7.1 and the definition of Tr ansmission Revenue Credit nullities.

This we can not do. See, e.g., Secretary of Labor v. Twentymile

Coal Company, 2005 U.S. App. LEXIS 10797 at *11, Case Nos.

04-1292 & 04-1312 (D.C. Cir., June 10, 2005) (rejecting

agency’s interpretation of a regulation as “particularly untenable

because it would render the pertinent regulation a nullity.”)

(emphasis removed).

FERC also argues, somewhat puzzlingly but consistent with

its statements in the Remand Order, that the ISO Tariff

provisions “leave[] open the question of who should pay the cost

differentials.”

Govt. Br. at 26. In so arguing, FERC undermines10

its own posi

tion–that the TOs cannot recover the cost

differentials through the TO Tariff s–when it notes that “the

Commission responded to that position by concluding r e covery

through the TO Tariff is not the sole option ,” and “recognize[d]

the TO Tariff as an option.” Govt. Br. at 29 (emphases in

original).

Further, FERC argues that despite the plain text of the ISO

Tariff, the “cost causation principle” dictated shifting the burden

entirely over to the existing contract holders. Because FERC

has already approved the mechanism in the ISO Tariff for

c ollecting the cost differentials from the tariff customers, an d

cannot retroactively reverse that det ermination in considering

individual TO Tariff filings, no argument concern ing cost

causation, regardless of how compelling, would permit the

Commission to disregard the approved ISO Tariff. Should the

Commission upon further reflection consider that mechanism to

violate the cost

causation principle, perhaps it may initiate

proceedings to change the ISO Tariff prospectively, but that is

not the case before us.

Thus, all of FERC’s counter-arguments f all away, leaving

us with the sim

ple conclusion that FERC must follow its own

roadmap enunciated in the ISO Tariff, and , in rate proceedings,

affirm individual TO Tariffs that conform their rate design to the

ISO Tariff. FERC may not, as FERC staff asserted and the ALJ

agreed, “order modi

fication of [Utility Petitioners’] TO Tariffs

irrespective of any inconsistenci es that such an order might

create with the collective ISO Tariff .” I nitial Decision

, 88

FERC at 65,051.

If FERC decided, after it began to look at the individual TO

Tariffs, that allowing Utility Pe titioners to include the cost

differentials associated with the formation of the California ISO

in the Access Charge collected from the new customers through11

the Transmission Revenue Credit mechanism wa s unjust and

unreasonable cross-subsidiza tion, the proper course of action

was to revise sections 2.4.4.4.4.5 and 7.1 of the ISO Tariff,

including th

e definition of Transmission Revenue Credit also

contained therein, as it is empowered to do under FPA § 206, 16

U.S.C. § 824e.

More generally, of course, agencies may alt er regulations.

Agencies may even alter their own regulations sua sponte, in the

absence of complaints, provided they have su fficient reason to

do so and follow applicable procedures. See NRDC v. EPA , 859

F .2d 156 (D.C. Cir. 1988); s ee also Dana Corp. v. ICC

, 703

F.2d 1297, 1305 (D.C. Cir. 1983) (“[T ]he agency is entitled to

have second thoughts, and to sustain action which it con siders

in the public interest upon whatever basis mor e mature

r eflection suggests.”). But agencies may not keep regulations in

place and t

h en disregard them in order to disapprove actions

taken by regulated entities to conform with those regulations.

Doing so is perhaps the essence of “arbitrary and capricious.”

Having so concluded, we need not reach the issue of

whether FERC was arbitrary and capricious i n assigning blame

for the cost differentials to the Municipal Petitioners.

III. Conclusion

In sum, FERC ac ted arbitrarily and capriciously in

upholding the ALJ’s Initial Decision that disregarded the plain

languag e of sections 2.4.4.4.4.5 and 7.1 of the ISO Tariff, and

the defini tion of Transmission Revenue Credit contained therein.

Opinions 458 and 458-A are vacated, and the case remanded for

further proceedings consistent with the ISO Tariff.

So ordered.