United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued September 14, 2005 Decided October 14, 2005

No. 04-1250

THE INDUSTRIALS, ET AL.,

PETITIONERS

v.

FEDERAL ENERGY REGULATORY COMMISSION,

RESPONDENT

NORTHERN NATURAL GAS COMPANY AND

SEMCO ENERGY GAS COMPANY,

INTERVENORS

Consolidated with

04-1253, 04-1257

On Petitions for Review of Orders of the

Federal Energy Regulatory Commission

Thomas C. Gorak argued the cause for petitioners. With

him on the briefs were Paul F. Forshay, Kirstin E. Gibbs,

Katherine B. Edwards, and John Paul Floom. Frederick T.

Kolb entered an appearance.
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1

 Northern’s cash-out mechanism also contained a tiered

component for imbalances exceeding 3% which is not at issue here. 

This component provided that for such excesses the price would be

multiplied by a specified factor. If net imbalance was below 3% of

the schedule amount, the price multiplier would be 1.

Beth G. Pacella, Attorney, Federal Energy Regulatory

Commission, argued the cause for respondent. With her on

the brief were Cynthia A. Marlette, General Counsel, and

Dennis Lane, Solicitor.

Frank X. Kelly, Steve Stojic, J. Gregory Porter, and

Maria K. Pavlou were on the brief for intervenor Northern

Natural Gas Company in support of respondent.

Before: SENTELLE and RANDOLPH, Circuit Judges, and

WILLIAMS, Senior Circuit Judge.

Opinion for the Court filed by Senior Circuit Judge

WILLIAMS. 

Concurring opinion filed by Circuit Judge SENTELLE. 

WILLIAMS, Senior Circuit Judge: Firms that ship gas on

pipelines sometimes take more—or less—gas out of the

pipeline at the end of the shipment than they had delivered

upstream. Periodically (usually monthly), the resulting

imbalances are adjusted by a “cash-out.” But the cash-out

price may create perverse incentives. Specifically it may

create an incentive to “game” the system, deliberately taking

more or less gas when it appears likely that the ultimate cashout price will be such as to make deviations profitable. For

example, if the cash-out price is set at the average monthly

price (as was true for the pipeline involved in this case,

Northern Natural, before the orders at issue here),1

 and prices
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have been rising for the month’s first 25 days, there is a

considerable likelihood that the end-of-the-month price will

be above the monthly average. Shippers may respond by

deliberately taking extra gas from the system, reselling it in

the spot market, and paying for it in the cash-out at the lower

(monthly average) rate. Northern’s system took account of

the problem to some degree by calculating the average

monthly price on a 10-day lag (from the 11th day of the

month to the 10th day thereafter), Joint Appendix (“J.A.”) 73,

83, but even this left some incentive for arbitrage at the very

end of the month. 

Where such temptations to arbitrage exist, the pipeline’s

net imbalances are naturally likely to rise. Although the

pipeline can recover the net expense in its rates, individual

shippers will not bear the resulting cost in the proportion that

their conduct caused the expense. In an extreme case, the

imbalances could make it hard for the pipeline to manage its

load. 

In 2003 Northern filed a proposal under § 4 of the Natural

Gas Act, 15 U.S.C. § 717c, to change its cash-out mechanism

so as to eliminate this arbitrage opportunity. Under the

proposal a shipper that took more gas than it delivered in the

course of a month would pay Northern for the net excess at

the highest of the five weekly average prices applying to that

month. If a shipper took out less than it delivered, Northern

would pay the shipper at the lowest of the five weekly

averages. 

In two orders the Federal Energy Regulatory Commission

approved a slightly modified version of Northern’s proposal.

Northern Natural Gas Co., 105 FERC ¶ 61,172 (2003), order

on reh’g, 107 FERC ¶ 61,252 (2004). Various consumers of

gas that is delivered on Northern, buyers of Northern’s
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transportation services, and producers of natural gas petition

here for review. They attack the orders as inconsistent with

the principles the Commission had developed in Order No.

637, Regulation of Short-Term Natural Gas Transportation

Services, and Regulation of Interstate Natural Gas

Transportation Services, FERC Stats. & Regs. [Regs.

Preambles 1996-2000] (CCH) ¶ 31,091 (2000) (“Order No.

637”), order on reh’g, Order No. 637-A, FERC Stats. &

Regs., [Regs. Preambles 1996-2000] (CCH) ¶ 31,099 (2000)

(“Order No. 637-A”), order on reh’g, Order No. 637-B, 92

FERC ¶ 61,062 (2000), particularly claiming that Order No.

637 requires that any “penalties” be justified by a need to

protect system reliability. They also assert deviation from

later Commission decisions purporting to apply Order No.

637. Because of these claimed deficiencies the orders are said

to be arbitrary and capricious. See 5 U.S.C. § 706(2)(A).

Further, petitioners claim that the Commission lacked

substantial evidence. 15 U.S.C. § 717r(b). We deny the

petitions.

* * *

In Order No. 637 the Commission adopted what is now

codified as 18 C.F.R. § 284.12(b)(2)(v), stating that a pipeline

may include penalties in its tariff “only to the extent necessary

to prevent the impairment of reliable service.” But Order No.

637 also says that pipelines “may be able to change the

methods by which they cash-out imbalances to eliminate the

incentives for shippers to borrow gas from the pipeline

because the cash-out price is less than the market price for

gas.” Order No. 637 at 31,314-15. This suggests at least that

pipelines may adjust their cash-out mechanisms to

“eliminate” arbitrage incentives without showing that the

change is necessary to prevent the impairment of reliable

service. And in Order No. 637-A the Commission said that
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the existence of arbitrage “demands that pipelines revise the

level and structure of their penalty provisions to minimize the

opportunities for arbitrage.” Order No. 637-A at 31,607.

This language indicates that “penalty” is not a magic word

that automatically triggers the system-reliability criterion.

Rather, the Commission’s point is that pipelines may properly

seek to deter arbitrage. Yet, lest cash-out rules unduly limit

shipper flexibility, pipelines’ efforts against arbitrage should

not go too far. As we shall see, petitioners have failed to

show that the present orders deviated from those principles.

Commission decisions after Order No. 637 add some

specificity as to when pipelines have gone too far in the effort

to reduce arbitrage incentives. For example, the Commission

has rejected mechanisms that provided cash-outs for

imbalances measured over periods much shorter than a month.

ANR Pipeline Co., 103 FERC ¶ 61,252 (2003), order on

reh’g, 105 FERC ¶ 61,236 (2003) (five days); Williams Gas

Pipelines Central, Inc., 100 FERC ¶ 61,232 (2002), order on

reh’g, 102 FERC ¶ 61,119 (2003) (daily). The shorter the

period of calculation, the more stringent the sanction is likely

to be, as the shipper gets less benefit from the netting out of

short-term positive and negative imbalances. As a result, the

proposals went too far in reducing arbitrage incentives. And

the Commission has similarly rejected systems that would

have used as benchmarks the high/low of average prices from

periods of less than one week, as in Transcontinental Gas

Pipe Line Corp., 91 FERC ¶ 61,004 (2000). 

No Commission decision has passed on a proposal

identical to Northern’s. But one comes close. In Gulf South

Pipeline Co., 97 FERC ¶ 61,069 (2001), order on reh’g, 98

FERC ¶ 61,068 (2002), the pipeline already used a

mechanism similar to Northern’s proposal here (imbalance

calculation each month, using the high/low of weekly
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averages). Gulf South proposed the addition of a fifth week

in order to curtail the arbitrage incentive created by the

mechanism’s end-of-the-month days, during which the cashout price could be known to a penny. In the presence of an

obvious arbitrage incentive and evidence of substantial

resulting imbalances, the Commission approved the change. 

Much of the parties’ discussion revolves around a set of

orders relating to Texas Gas. Texas Gas Transmission Corp.,

95 FERC ¶ 61,093 (2001), order after tech. conf., 96 FERC

¶ 61,318 (2001), order on reh’g, 97 FERC ¶ 61,349 (2001). 

There the Commission approved a proposal under which

monthly imbalances under 2% of contracted capacity were not

“cashed-out” but were settled in kind; imbalances exceeding

2% were cashed out at the high/low of five weekly averages.

Explaining its order, the Commission expressed a happymedium principle: 

Therefore, to the extent that Texas Gas’ charges are

necessary to remove the incentive for arbitrage, they are

appropriate under Order No. 637. However, any change

that is beyond what is necessary to remove a customer’s

incentive to game the pipeline’s system and unnecessarily

removes a customer’s flexibility would be an

inappropriate penalty. 

Texas Gas, 96 FERC ¶ 61,318 at 62,218. Of course in the

absence of a perfect mechanism, one that neither overdeters

nor underdeters arbitrage, pipelines and the Commission can

be expected to test the waters, gradually ratcheting up any

scheme that generates substantial imbalances. (We note that

no one here proposes a system of cashing out at the spot price

at the moment the shipper takes more or less than its delivery.

Perhaps technical difficulties stand in the way.) The

Commission hasn’t articulated exactly where the process must
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stop, but its rejections in ANR, Williams, and Transcontinental

make clear its readiness to impose limits. 

The Commission in fact approved Texas Gas’s proposal,

explaining that for tightening a cash-out mechanism “a

pipeline does not need to show that price arbitrage causes

operational problems, particularly where the cashout

mechanism provides the opportunity for price arbitrage and

under-recovery of costs.” Texas Gas, 96 FERC ¶ 61,318 at

62,218. 

While Texas Gas is unclear on whether opportunities for

price arbitrage are enough to justify a new cash-out

mechanism absent actual under-recovery of costs, it is clear

that the combination suffices; and the record here shows both.

We have already described how Northern’s former system

would have provided an opportunity for price arbitrage. And

the record contained substantial evidence of under-recovery

by Northern under the prior regime, and even included

admissions by parties filing comments in opposition to the

proposed changes that imbalances were out of control, J.A.

501. Although petitioners’ brief argues that some of the

imbalance figures are in dollars and may reflect price

changes, others are in quantities of gas and are not subject to

that flaw. See testimony of Kent E. Miller, J.A. 88.

Petitioners distinguish Texas Gas on the ground that there the

first 2% of any shipper’s imbalance were to be resolved in

kind, but the distinction is not decisive, as the Texas Gas

system subjected an out-of-balance shipper to the risk of

having to buy the necessary differential at higher prices.

Particularly in this period when the Commission is evidently

experimenting with innovative mechanisms, the lack of

identity between Northern’s and Texas Gas’s proposals is not

very telling. The orders are thus supported by substantial
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evidence, as well as consistent with the Commission’s prior

decisions. 

Accordingly, the petitions for review are 

Denied. 
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SENTELLE, Circuit Judge, concurring: I am in full

concurrence with the majority’s resolution of this petition. I

write separately only to express my disagreement with the

majority’s conclusion that “Texas Gas is unclear on whether

opportunities for price arbitrage are enough to justify a new

cash-out mechanism absent actual under-recovery of costs.”

Maj. Op. at 7. 

In Texas Gas the Commission stated: 

When price arbitrage occurs, the pipeline is, in

essence, required to sell gas to its customers at below

market levels and buy gas from them at above-market

levels. As demonstrated by Texas Gas’ situation, this can

lead to the pipeline incurring a substantial underrecovery

of costs. There is no reason to make the correction of

such a problem contingent on a showing that the

imbalances are causing operational problems. It is not

just and reasonable to require pipelines to underrecover

their costs, and . . . the Commission did not require such

a thing in Order No. 637. 

Texas Gas, 97 FERC at 62,634-35 (emphasis added); see also

Texas Gas, 96 FERC at 62,218-19. It appears to me that the

Commission by this reasoning made it clear that opportunities

for price arbitrage are sufficient justification for a proposal to

modify a pipeline’s cash-out mechanism even in the absence

of actual arbitrage.