Opinion ID: 721438
Heading Depth: 2
Heading Rank: 2

Heading: Right of First Refusal

Text: 61 Section 7(b) of the Natural Gas Act prohibits pipelines from abandoning certificated firm-transportation service until the Commission makes a finding that the present or future public convenience or necessity permit such abandonment. 15 U.S.C. § 717f(b). In its original adoption of open-access transportation in Order No. 436, the Commission provided automatic pre-granted abandonment 38 for all firm-transportation service provided under a Part 284 blanket certificate. 18 C.F.R. § 284.221(d) (1989). After the order was twice vacated on other grounds, 39 the Commission re-promulgated the automatic pre-granted abandonment rule in Order No. 500-H, p 30,867, at 31,583-85. In its review of Order No. 500-H, the court remanded automatic pre-granted abandonment because the Commission has not yet adequately explained how pregranted abandonment trumps another basic precept of natural gas regulation--protection of gas customers from pipeline exercise of monopoly power through refusal of service at the end of a contract period. AGA II, 912 F.2d at 1518. In AGA II, the court concluded that the Commission's reliance on various market alternatives available to LDCs--namely interruptible transportation, stand-by gas service and gas from alternative suppliers--provided inadequate protection for LDCs. Id. at 1517. The court similarly rejected the Commission's contention that it was furthering purposes other than the protection of existing customers because the Commission's response seems to entail an enormous qualification of its basic purpose. Id. On remand from AGA II, the Commission decided to hold the issue of pre-granted abandonment in abeyance until Order No. 636. See Order No. 500-J, [Current] F.E.R.C. Stats. & Regs. (CCH) p 30,915 (1991). 62 In Order No. 636, the Commission responded to AGA II by amending its regulations to provide that an existing customer of long-term firm-transportation service could avoid pre-granted abandonment if it abided by a new right-of-first-refusal (ROFR) mechanism. 18 C.F.R. § 284.221(d). No petitioner challenges the Commission's rule [319 U.S.App.D.C. 75] that interruptible transportation, and firm transportation with a contract term of less than one year, are subject to automatic pre-granted abandonment even without the right of first refusal. Order No. 636, p 30,939, at 30,446; Order No. 636-A, p 30,950, at 30,625-26. But the petitioners do challenge pre-granted abandonment for long-term firm transportation. In essence, the issue is whether the right-of-first-refusal mechanism provides the protection for pipeline customers that AGA II requires. 63 The right-of-first-refusal mechanism consists principally of two matching requirements: rate and contract term. See 18 C.F.R. § 284.221(d)(2)(ii). Near the end of a long-term firm-transportation contract, the existing customer may notify the pipeline that it intends to exercise its right of first refusal. The pipeline must post the availability of that capacity on its electronic bulletin board and, in accordance with the criteria set forth in its tariff, identify the best bid offered by any competing shippers. Order No. 636, p 30,939, at 30,451; Order No. 636-A, p 30,950, at 30,634. The customer then has the right to match the competing bid's rate, up to the maximum just and reasonable rate that the Commission has approved for that service, and the competing bid's contract term. Competing shippers may choose to bid for only a portion of the capacity in the expiring contract. Order No. 636, p 30,939, at 30,451-52; Order No. 636-A, p 30,950, at 30,634-35. The Commission promised that it would scrutinize competing bids from pipelines' marketing affiliates to ensure that they did not collude to increase the bidding level. 40 Order No. 636, p 30,939, at 30,451; Order No. 636-A, p 30,950, at 30,634. 64 Originally, the Commission contemplated that competing bids could be for any contract length. According to the Commission, [o]ther things being equal, the satisfaction of long-term transportation needs should have priority over the satisfaction of shorter-term needs. Order No. 636, p 30,939, at 30,450. In Order No. 636-A, the Commission reconsidered that decision and found 65 that capping the contract term that must be matched by a customer exercising its right of first refusal at a period of 20 years strikes an appropriate balance between the pipeline's need for stability, the customer's need for flexibility, and the Commission's overall goal in Order No. 636 to foster long-term, market driven arrangements in the gas industry. This cap, in the Commission's judgement, ensures that the customer obtaining the service values the service sufficiently to commit to using it for a reasonable period and provides the pipeline with a reasonable level of stability. Twenty years has been the traditional length of long-term contracts in the natural gas industry and a number of recent contracts for new capacity are for a twenty year term. 66 Order No. 636-A, p 30,950, at 30,631. Commissioner Moler, dissenting in part, characterized the twenty-year period as a blatantly anti-LDC rule, given that LDCs typically have existing contractual relationships jeopardized by pre-granted abandonment, and urged the adoption of a shorter contract-term cap. Id. at 30,678-79.
67 Many of the petitioners 41 contend that the Commission's pre-granted abandonment of firm-transportation service violates § 7. The petitioners maintain that the right-of-first-refusal mechanism provides inadequate protection to existing pipeline customers from the pipelines' market power. 68 [319 U.S.App.D.C. 76] The Commission may satisfy its § 7 obligations by making generic findings of public convenience and necessity. In Mobil Oil Exploration & Producing Southeast Inc. v. United Distribution Cos., 498 U.S. 211, 227, 111 S.Ct. 615, 625, 112 L.Ed.2d 636 (1991), the Supreme Court upheld a pre-granted abandonment scheme under the Commission's Order No. 451, even though the Commission's approval is not specific to any single abandonment but is instead general, prospective, and conditional. See also FPC v. Moss, 424 U.S. 494, 499-502, 96 S.Ct. 1003, 1007-08, 47 L.Ed.2d 186 (1976). The Court approved the Commission's findings that, under its good-faith negotiation procedures for the pre-granted abandonment of producers' sale of old gas under the NGPA to pipelines, pipelines would be protected by allowing them to buy at market rates elsewhere if contracting producers insisted on the new ceiling price. Mobil Oil, 498 U.S. at 227, 111 S.Ct. at 626. In AGA II, by contrast, the court held that the Commission had not adequately explained why pre-granted abandonment of firm-transportation in Order No. 500-H would not allow pipelines indirectly to extract monopoly profits from their customers. 912 F.2d at 1516. Most important, the Commission's proposed alternatives to existing firm-transportation service, such as interruptible transportation and stand-by service, failed to provide the existing customer with an adequate level of protection. Id. at 1517. From Mobil Oil and AGA II, we conclude that, for a finding of public convenience and necessity for pre-granted abandonment under § 7, the Commission must make appropriate findings that existing market conditions and regulatory structures protect customers from pipeline market power. 69 The Commission's initial protective measures--contractual evergreen or roll-over clauses--are by themselves inadequate. The Commission allows the pipeline and the customer to negotiate such a contractual provision allowing the parties to extend the contract before termination and thereby avoid the abandonment issue. Moreover, the Commission requires pipelines that offer evergreen or roll-over clauses to do so on a non-discriminatory basis. Order No. 636-A, p 30,950, at 30,628. Yet the Commission declined to mandate the inclusion of contract-extension clauses. Id. As the petitioners note, the voluntary nature of evergreen and roll-over clauses means that those pipelines that do enjoy market power will likely refuse to offer such clauses to their customers. Thus, voluntary contract-extension clauses alone do not provide sufficient protection to existing pipeline customers. 70 The mandatory right-of-first-refusal mechanism, however, provides substantially more protection to existing customers. 42 First, shippers bid against one another for capacity, which in the Commission's view will prevent the pipeline from using the right-of-first-refusal mechanism to push the rate above the competitive market price. 43 Second, under the right-of-first-refusal mechanism the competing bid is capped at the maximum just and reasonable rate, which protects the existing shipper from having to match a bid higher than the Commission-approved rate. [319 U.S.App.D.C. 77] If the existing customer is willing to pay the maximum approved rate, then the right-of-first-refusal mechanism ensures that the pipeline may not abandon the certificated service. In this way, even a captive customer served by a single pipeline can exercise its right of first refusal and retain its long-term firm-transportation service against rival bidders. Hence, the basic structure of the right-of-first-refusal mechanism provides the protections from pipeline market power required for pre-granted abandonment under § 7.
71 The petitioners also contend that the contract term-matching condition allows pipelines to exercise market power inconsonant with pre-granted abandonment. Thus, oncapacity-constrained pipelines existing customers may be forced to match competing bids for twenty years' duration, which would not be the outcome in a competitive market without pipelines' natural monopoly. Competing bidders who come up against the rate ceiling for this scarce resource--capacity on constrained pipelines--may bid up the length of the contract term to try to win the auction. In effect, bidding for a longer contract term becomes a surrogate for bidding beyond the maximum rate level. Especially with the new capacity-release mechanism, a competing bidder could bid for a longer contract term than it would contract for in a competitive market, release the excess capacity at a discount, and absorb the loss just as though it had bid an above-maximum rate for a shorter term. 72 The Commission acknowledged the reality that contract duration is a measure of value when it declared that its policy was for the capacity to go to the person who values it the most, as evidenced by its willingness to bid the highest price for the longest reasonable time. Order No. 636-A, p 30,950, at 30,630. As a general matter, in a perfectly competitive market, a long-term contract incorporates a premium for stability, and a pipeline naturally values a longer-term transportation contract more highly, ceteris paribus. Order No. 636, p 30,939, at 30,450. Thus, the contract term-matching condition is a rational means of emulating a competitive market for allocating firm-transportation capacity. There are obvious drawbacks--the industrial petitioners provide the example of a factory owner with a productive asset that has only a short useful life. Order No. 636-A, p 30,950, at 30,629-30. But industrial end-users are also far more likely to have ready access to alternative fuels than do the residential consumers served by LDCs. See AGD I, 824 F.2d at 995. 73 For purposes of pre-granted abandonment, however, the issue is whether the Commission has shown that its choice of a twenty-year term-matching cap protects consumers against the exercise of pipeline market power. The petitioners note that longer-term contracts lock in customers and serve as a barrier to entry into the pipeline market by potential competitors. Rival pipelines will not build extensions to their system if the market for additional capacity has been foreclosed by long-term contracts with the existing pipeline. The Commission responds only that the pipeline plays no role in the competitive bidding process and thus cannot exercise market power. In the Commission's view, its choice of a twenty-year period reflects a reasonable weighing of the relative interests in preventing market constraint and encouraging market stability. None of these explanations, however, supports a finding that the twenty-year term-matching cap adequately protects against pipelines' pre-existing market power, which they enjoy by virtue of natural-monopoly conditions. The Commission has not explained why the twenty-year cap will prevent bidders on capacity-constrained pipelines from using long contract duration as a price surrogate to bid beyond the maximum approved rate, to the detriment of captive customers. If the maximum approved rate artificially limits a rival shipper's ability to outbid the existing shipper, the rival shipper may offer a higher-value contract by bidding up the contract duration instead. 44 74 [319 U.S.App.D.C. 78] A further concern with the Commission's choice of a twenty-year cap is the Commission's reasoning in selecting twenty years. Most of the commentators before the agency had proposed much shorter contract-term caps, such as five years. 45 The Commission relied on the fact that twenty-year contracts have been traditional in the natural-gas industry. Order No. 636-A, p 30,950, at 30,631 n.437. However, numerous commentators on rehearing of Order No. 636-A, as well as Commissioner Moler, id. at 30,679, pointed out that twenty-year contracts have been traditional only for contracts involving the construction of new facilities, where the pipeline requires a long-term contract to secure financing for the project, but not for contracts for the continuation of service after contract expiration. Indeed, both of the decisions that the Commission cited for the proposition that twenty-year contracts are customary were for new facilities. 46 Also, renewal contracts appear more similar to the situation in the right-of-first-refusal mechanism. The Commission in its brief responds that the term-matching cap was designed not to determine the length of typical gas contracts, but to establish a reasonable outer boundary for contract length, within which the ROFR might reasonably function. The petitioners' claim, however, is that because the Commission looked to the wrong type of contract to determine the typical contract length it may have selected an outer boundary that is longer than it would have been if the Commission had examined the duration of renewal contracts. The Commission failed to respond to this objection in the Order No. 636 series. 75 Both of these reasons--the Commission's failure to explain why the twenty-year cap will protect against pipelines' market power, and the failure to explain why it looked at new-construction contracts in arriving at the twenty-year figure--persuade us to remand the length of the contract term-matching condition to the Commission for further consideration. 47 The right-of-first-refusal mechanism, incorporating the twin matching conditions of rate and contract term, is sufficiently justified. We remand only as to the Commission's reasons for adopting a twenty-year cap.
76 Petitioner Meridian Oil Inc., joined by the American Public Gas Association, challenges a different aspect of the right-of-first-refusal mechanism. The Commission declared that a pipeline need not accept a competing bid for a rate less than the maximum approved rate; in other words, pipelines are not required to discount under the rule. Order No. 636-A, p 30,950, at 30,629. The result is that a pipeline can choose between providing service to the highest bidder at a discounted rate and not providing service at all unless a shipper is willing to pay the maximum approved rate. In its comments to the Commission, [319 U.S.App.D.C. 79] Meridian urged that pipelines be required to accept the best bid, which on pipelines on which capacity was not constrained would likely be less than the maximum approved rate. The Commission responded that it would 77 not require pipelines to discount transportation rates. However, if a pipeline fails to attempt to maximize throughput, there is no guarantee that it will be able to recover all the costs of its underutilized capacity from its firm customers when it files its next rate case. Evidence that a pipeline refused to accept the highest valued bid for capacity below the maximum rate will be given significant weight during its next rate case. 78 Order No. 636-B, p 61,272, at 62,028 (footnote omitted). 79 Meridian contends first that the Commission violated § 7(b) by authorizing pre-granted abandonment without requiring the pipeline to discount. In Meridian's view, by forcing the existing customer to pay the maximum approved rate to ensure continuity of service, even if the competitive outcome as determined by the bidding process is a below-maximum rate, the Commission has failed to protect customers against pipelines' market power. See Mobil Oil, 498 U.S. at 227, 111 S.Ct. at 625; AGA II, 912 F.2d at 1517. However, as we held above, the Commission has already protected against pipelines' market power by removing the pipeline's ability to influence the bidding and by limiting the maximum rate that the pipeline may charge. See supra at 76. The Commission first authorized selective discounting by pipelines providing transportation under a Part 284 blanket certificate in Order No. 436, p 30,665, at 31,540-48. See 18 C.F.R. § 284.7(d)(5); AGD I, 824 F.2d at 1007-13; see also Mississippi Valley Gas Co., 68 F.3d at 507. Given that the purpose of selective discounting is to increase throughput by allowing pipelines to engage in price discrimination in favor of demand-elastic customers, AGD I, 824 F.2d at 1011, Meridian's proposal that pipelines be required to discount in favor of demand-inelastic, captive customers would render meaningless pipelines' ability to charge up to the maximum approved rate. The § 7(b) abandonment provisions protect customers against loss of service only if the customer is willing to pay the maximum rate approved in a rate proceeding. 80 Meridian's second contention is that the Commission acted in an arbitrary and capricious manner by not responding to Meridian's comments that the lack of a requirement to discount would prevent the right-of-first-refusal mechanism from reflecting competitive market forces on pipelines with excess capacity. The Commission responded to Meridian's objection by assuring that a pipeline is not entitled to full cost recovery in its next rate proceeding when it forgoes the opportunity to recover some of its fixed costs from a bid rate between the minimum and maximum filed rates. 48 Order No. 636-B, p 61,272, at 62,028. Meridian has offered no reason why the Commission's rate scrutiny will not provide sufficient incentives for pipelines to discount in appropriate circumstances. Accordingly, we affirm the Commission's decision not to require pipelines to discount in the right-of-first-refusal process.