Opinion ID: 3040019
Heading Depth: 2
Heading Rank: 2

Heading: Evolution of Power Utility Regulation

Text: Congress passed the Federal Power Act in 1920, establishing the statutory framework described above. Ch. 285, 41 Stat. 1063 (1920). This framework emerged from a wider body of state and federal regulation that revolved around the by-then “familiar mandate” that rates in various industries be PUBLIC UTILITY DISTRICT v. FERC 19557 “just and reasonable.” Verizon Commc’ns Inc. v. FCC, 535 U.S. 467, 477 (2002).9 Before Congress had passed many laws regulating national industries, state legislatures created specialized agencies “to set and regulate rates.” Id. In the electric power industry, this effort began in the first decade of the twentieth century. By 1914, forty-five states had enacted electricity regulation laws. RICHARD F. HIRSH, POWER LOSS: THE ORIGINS OF DEREGULATION AND RESTRUCTURING IN THE AMERICAN ELECTRIC UTILITY SYSTEM 19-26 (1999). The national government’s first substantial foray into rate regulation occurred in 1887, with the passage of the Interstate Commerce Act. Ch. 104, 24 Stat. 379 (1887). This statute, primarily concerned with interstate railroad rates, formed “the model for subsequent federal public-utility statutes like the Federal Power Act.” Verizon, 535 U.S. at 478 n.3. Under the Interstate Commerce Act, railroad carriers would first propose rate schedules, termed “tariffs.” Then, interested parties could comment to the agency, which would accept the tariff so long as it was “just and reasonable.” Id. at 478. The states and Congress applied this structure to the electric power industry on the basis of two widely-shared assumptions: First, policymakers assumed that public utilities were “natural monopolies” because, among other reasons, it would be inefficient for competing utilities to string parallel power lines. Timothy P. Duane, Regulation’s Rationale: Learning from the California Energy Crisis, 19 YALE J. ON REG. 471, 476-77 (2002). Also, utilities could benefit from economies of scale, making a monopoly more efficient than a competitive market. See HIRSH, supra, at 17-18. 9 Verizon concerned the Telecommunications Act of 1996, which is not relevant to the present case. Verizon did, however, include a broader historical discussion of utility regulation, see 535 U.S. at 477-89, that directly relates to energy regulation. 19558 PUBLIC UTILITY DISTRICT v. FERC Second, these monopolies, like any monopoly, would be tempted to abuse their market power. Moreover, because electricity cannot be stored, it needed to be produced at the same time consumers demanded it. Shortages anywhere on an interconnected electricity grid could threaten the entire system. The factors unique to the electric power industry made it particularly susceptible to abuse of market power: A local utility could withhold power, demand higher rates, and credibly threaten to disrupt a regional or national market. Regulation would keep local utilities in check. Duane, supra, at 477-78. Early state and federal agencies created two categories of regulated rates: “retail rates charged directly to the public and wholesale rates charged among businesses involved in providing” the regulated good or service. Verizon, 535 U.S. at 478. Under the FPA, the federal government regulates only interstate wholesale electric power sales and interstate electric power transmission, leaving to the states the regulation of rates charged to consumers. See 16 U.S.C. § 824(a), (b)(1). State and local governments, therefore, generally focused on rates “as between businesses and the public,” while the federal government regulated rates “as between businesses.” Verizon, 535 U.S. at 479. As a result of these differences in their regulatory focus, important differences in methodology developed between federal and state energy rate regulation. Knowing that state regulators focused on rates charged directly to the public and following Congress’s “acknowledg[ment] that contracts between commercial buyers and sellers could be used in ratesetting,” id. (citing section 205(d) and Mobile, 350 U.S. at 338-39), the Federal Power Commission (FPC) and, later, FERC — both bound by Mobile-Sierra — became less inclined to step in and alter filed rates charged among businesses in the energy industry. Even if those agencies wanted to change contract rates, courts, applying Mobile-Sierra, would generally assume that those rates were just and reasonable and would probably not harm the public interest. The PUBLIC UTILITY DISTRICT v. FERC 19559 underlying assumption was that “[i]n wholesale markets, the party charging the rate and the party charged were often sophisticated businesses enjoying presumptively equal bargaining power, who could be expected to negotiate a ‘just and reasonable’ rate as between the two of them.” Id. The equal market power of those businesses and the role of state regulation of rates charged to consumers allowed the federal government to set a relatively high bar for proving that a wholesale contract was unjust or unreasonable based on impact on the public. Federal agencies, including the FPC and its successor agency FERC, thus saw their “principal regulatory responsibility” as preventing discrimination “by favorable contract rates between allied businesses” as compared to other businesses. Id. At the same time, Sierra’s admonition that federal regulators should reform contracts if that was “necessary in the public interest,” Sierra, 350 U.S. at 355 (internal quotation mark omitted), confirmed a continuing federal responsibility to review the impact of wholesale contracts on the public, even though the federal government did not directly regulate rates charged to consumers. In contrast to federal regulators, state regulators “focused more on the demand for ‘just and reasonable’ rates to the public than on the perils of rate discrimination.” Verizon, 535 U.S. at 480. In California, for instance, the Public Utilities Commission ensured that rates charged by the state’s three primary utilities — Pacific Gas & Electric, Southern California Edison, and San Diego Gas & Electric — were just and reasonable to the consuming public. See CAL. CONST. art. XII, § 6; Duane, supra, at 480. Within this two-tiered regulatory structure, case law developed an evolving definition of the “just and reasonable” standard. See Verizon, 535 U.S. at 481-89. After decades-long debates not relevant here, courts and regulators settled on a system that attempted to match rates to the cost to the utility of providing the service, including “the cost of prudently invested capital used to provide the service.” Id. at 485. This 19560 PUBLIC UTILITY DISTRICT v. FERC “prudent-investor rule” was designed to provide incentives for utilities to invest in necessary capacity-building by allowing them to charge rates that would provide a fair rate of return on those investments while at the same time “protect[ing] ratepayers from supporting excessive capacity, or abandoned, destroyed, or phantom assets.” Id. at 486. These competing elements of cost of service regulation were intended to “mimic natural incentives in competitive markets.” Id.; see also Farmers Union Cent. Exch., Inc. v. FERC, 734 F.2d 1486, 1510 (D.C. Cir. 1984). As a result, cost of service regulation would, in theory, lead to the same rates that would exist in a properly functioning unregulated market.
Our description thus far covers the regulatory landscape through the mid-1990s. Beginning then, the electric power industry saw “complementary initiatives by the FERC and state agencies” to shift from a cost-based rate regulation regime to a market-based regime. Carmen L. Gentile, The Mobile-Sierra Rule: Its Illustrious Past and Uncertain Future, 21 ENERGY L.J. 353, 373 (2000). This move toward energy regulation reform was premised on a new set of widely-shared assumptions: First, cost-based regulation did not effectively check public utilities’ market power. See Verizon, 535 U.S. at 486 (“[T]he prudent-investment rule in practice often [was] no match for the capacity of utilities having all the relevant information to manipulate the rate base . . . .”); Promoting Wholesale Competition Through Open Access Non-Discriminatory Transmission Services by Public Utilities; Recovery of Stranded Costs by Public Utilities and Transmitting Utilities, FERC Order 888-A, 62 Fed. Reg. 12,274, 12,275 (Mar. 14, 1997) (“[A]bsent open access, undue discrimination will continue . . . .”); HIRSH, supra, at 33-54 (describing how “[u]tility [m]anagers [g]ain[ed] [d]ominance” within the earlier regulaPUBLIC UTILITY DISTRICT v. FERC 19561 tory scheme). Also, local utilities would often deny competitors access to their transmission networks, protecting their monopoly status within a geographic area. See Atl. City Elec. Co. v. FERC, 295 F.3d 1, 4 (D.C. Cir. 2002). Second, with technological changes, public power utilities no longer needed to be monopolies. Technological innovations now permitted transmission of power over longer distances, allowing consumers to obtain power from beyond the geographic range of their local utility. See Transmission Access Policy Study Group v. FERC, 225 F.3d 667, 681 (D.C. Cir. 2000) (per curiam) (upholding FERC’s 1996 reform orders), aff’d sub nom. New York v. FERC, 535 U.S. 1 (2002). Third, the newly feasible market competition could drive down wholesale prices and measure the cost of service, including the cost of long-term investments, more accurately than did the previous regulatory regime. Competition, this thesis posits, “at least over the long pull,” will lead to prices that “approximate [marginal] cost,” including a return on capital sufficient to ensure that companies have financial incentives to provide power. Interstate Natural Gas Ass’n of Am. v. FERC (INGAA), 285 F.3d 18, 31 (D.C. Cir. 2002). Based on these assumptions, FERC decided in 1996 to fundamentally reform its regulation of the nation’s interstate wholesale electricity markets. FERC’s orders implementing this electrical power reform, Orders 888 and 889, required each utility that operates transmission lines to allow any other utility in the interstate energy market to use its transmission lines on the same terms applicable to the operating utility itself.10 10 According to FERC, open access is the first of “two central components.” Order 888-A, 62 Fed. Reg. at 12,276. The second central component of the 1996 Orders is their mechanism for allowing utilities to recover “stranded costs,” that is, costs which they incurred under the previous regulatory regime based upon an expectation of repayment that may not occur in newly competitive markets. Id. 19562 PUBLIC UTILITY DISTRICT v. FERC Transmission Access, 225 F.3d at 681-82; Promoting Wholesale Competition Through Open Access Non-Discriminatory Transmission Services by Public Utilities; Recovery of Stranded Costs by Public Utilities and Transmitting Utilities, FERC Order No. 888, 61 Fed. Reg. 21,540, 21,541 (May 10, 1996). Taking advantage of the newly available “open access,” utilities would, in theory, have both the market incentives and the legal right to compete with each other. This competition would provide retail consumers with the opportunity to purchase power from a wide variety of producers at relatively lower rates. Transmission Access, 225 F.3d at 683. A factory in Albany, California, for example, could, in theory, purchase power from a power plant in Albany, New York, no longer limited in its options to whatever the local utility would sell. Local energy utilities, could, rather than producing their own power to sell to the public, choose between various competing producers and then transfer the expected savings from this competition to the public. FERC estimated that, as a result of such competition, consumers would benefit from annual savings of $3.8 billion to $5.4 billion. Order 888-A, 62 Fed. Reg. at 12,276. A crucial element of FERC’s 1996 “open access” reforms was the connection between “open access” and an “open access” utility’s authority to charge whatever rates the market would bear. “[A]pproximately a decade ago, companies began to file market-based tariffs that did not specify the precise rate to be charged,” and instead indicated that they would charge market-based rates. Lockyer, 383 F.3d at 1012. FERC would approve those tariffs if the public utility proved that it lacked, or had adequately mitigated, any ability to significantly affect market prices. La. Energy & Power Auth. v. FERC, 141 F.3d 364, 365 & n.1 (D.C. Cir. 1998); see also Sw. Pub. Serv. Co., 72 F.E.R.C. ¶ 61,208, at ¶ 61,966 (1995) (summarizing criteria for approving market-based rate tariffs). Such grants of market-based rate authorization were open-ended. See, e.g., So. Co. Servs., Inc., 87 F.E.R.C. ¶ 61,214, at ¶ 61,847 n.3. PUBLIC UTILITY DISTRICT v. FERC 19563 FERC’s 1990s reforms specified open access as one criteria necessary to demonstrate the lack, or adequate mitigation, of market power. When a public utility implemented an “open access” policy, it demonstrated that it lacked market power regarding “sales from its existing [power generation] capacity” and was thus entitled to market-based rate authority — that is, the ability to charge whatever rates the market would bear — when it sold power over open access transmission grids. See Order No. 888, 61 Fed. Reg. at 21,553; see Lockyer, 383 F.3d at 1013 (describing FERC’s test for granting market-based rate authority as “consist[ing] of a finding that the applicant lacks market power (or has taken sufficient steps to mitigate market power)”); cf. EDWARD KAHN, ELECTRIC UTILITY PLANNING AND REGULATION 319 (1991) (describing the lack of open access as allowing “market power [to] interfere with market efficiency”). FERC thus based its 1996 reform — and, as this case makes clear, much of its subsequent regulation — on the belief that “open access” would create market forces helping to ensure that no utility could exercise market power when selling wholesale power. See Order No. 888, 61 Fed. Reg. at 21,554 (“[I]ncreased competition resulting from open access transmission may reduce or even eliminate generation-related market power in the short-run market . . . .”); id. at 21,555 (“[T]he Commission expects this Rule to facilitate the development of competitive bulk power markets . . . .”). FERC tempered this expectation by promising to “continue our caseby-case approach” to granting market-based rate authority. Id. FERC’s “case-by-case approach” includes ensuring that sellers seeking market-based rate authority lack, or have sufficiently mitigated, market power and that FERC has a sufficient “means of monitoring the market in which [the seller’s] sales will take place.” Entergy Servs., Inc., 58 F.E.R.C. ¶ 61,234, ¶ 61,753-54 (1992); see also Lockyer, 383 F.3d at 1016 (requiring a market-based regime to include “implied enforcement mechanisms sufficient to provide substitute remedies for the obtaining of refunds”); Transwestern Pipeline 19564 PUBLIC UTILITY DISTRICT v. FERC Co., 43 F.E.R.C. ¶ 61,240, at ¶ 61,650 (1988) (requiring a finding that “competition in the relevant markets will operate as a meaningful constraint on the exercise of market power”). Following the Entergy approach, FERC also promised to “modify our market rate criteria if and when appropriate,” but specified that any such modification would “not upset transactions entered into pursuant to existing market-based rate authority.” Order 888, 61 Fed. Reg. at 21,555. Like FERC, California challenged the monopoly power of electric power utilities. California’s efforts to foster competition between utility monopolies had begun after the energy crises of the 1970s. See Duane, supra, at 482-87. Federal law then allowed a “qualifying small power production facility” to compete in wholesale power markets. See Public Utility Regulatory Policies Act of 1978, Pub. L. No. 95-617, §§ 201, 210, 92 Stat. 3117, 3134-35, 3144-47 (codified at 16 U.S.C. §§ 796(17)(C), 824a-3). California pursued these new options particularly aggressively so that, by 1991, California received a third of its energy from producers other than the monopolies held by local utilities. HIRSH, supra, at 93. Those producers demonstrated that a utility could efficiently produce power without taking advantage of economies of scale that supposedly made electricity monopolies “natural.” Through these reforms and market changes, the monopoly status of local utilities and the methodology of state regulation of monopoly utilities was eroding. California A.B. 1890, passed in 1996, sought to accelerate this breakup of local utility monopolies by requiring them to divest a substantial amount of their electricity generation facilities. Act of Sept. 23, 1996, ch. 854, 1996 Cal. Legis. Serv. 854 (West). Local utilities also were required to sell power generated by remaining facilities to the California Power Exchange Corporation (CalPX), which was to serve as PUBLIC UTILITY DISTRICT v. FERC 19565 an auction market for wholesale electricity sales. Lockyer, 383 F.3d at 1008-09.11
When combined with federal preemption law, one crucial result of these energy market regulatory reforms has been “a massive shift in regulatory jurisdiction from the states to the FERC.” Gentile, supra, at 373. As noted, a “bright line” exists between state and federal jurisdiction, with wholesale power sales — the type of sales at issue in the challenged contracts in this case — falling on the federal side of the line. Nantahala Power & Light Co. v. Thornburg, 476 U.S. 953, 966 (1986) (quoting Fed. Power Comm’n v. S. Cal. Edison Co., 376 U.S. 205, 215 (1964)). FERC’s jurisdiction to determine the reasonableness of wholesale rates is exclusive. Miss. Power & Light Co. v. Mississippi ex rel. Moore, 487 U.S. 354, 371 (1988). Prior to 1996, vertically-integrated state monopolies would charge public consumers rates regulated by state entities and would purchase power from interstate utilities at rates regulated by FERC. The 1996 FERC reforms opened up local monopolies to competition among suppliers in the wholesale power market, resulting in a sharp increase in wholesale power sales — subject to FERC’s exclusive jurisdiction — as utilities shopped among suppliers. See Gentile, supra, at 373; Pub. Util. Dist. No. 1 v. Idacorp Inc. (Grays Harbor), 379 F.3d 641 (9th Cir. 2004). Additionally, state regulatory reform laws, like California’s A.B. 1890, resulted in a less active role for state regulators and a more active one for FERC, as the breakup of vertically integrated utilities created the need for many more wholesale transactions. In California, for example, regulators “ceded most of their authority for regulating generator or trader behavior to FERC through A.B. 1890.” Duane, supra, at 507. 11 The details of A.B. 1890 are discussed below. 19566 PUBLIC UTILITY DISTRICT v. FERC The upshot of these federal and state innovations in electricity regulation is that state regulators, despite their continued authority over rates charged directly to consumers, have much less actual authority over those rates than they did when Mobile and Sierra were decided. Local utilities now obtain power largely through wholesale contracts subject to FERC’s exclusive regulation, rather than through self-generated and self-transmitted power. As a result, state regulators ordinarily must set retail rates with the wholesale rates as an established cost factor. FERC recognized this dynamic when issuing its reform orders, noting that customers will obtain more power delivered via “unbundled” wholesale transactions — in which the generation and transmission are separately traded rather than provided by an integrated local utility monopoly — making “[t]he exercise of our jurisdiction over rates, terms and conditions of unbundled retail transmission . . . more important.” Order 888-A, 62 Fed. Reg. at 12,279. Accordingly, while the state and federal regulatory reforms of the 1990s did not end regulation of the electric energy industry, they did begin a new regulatory era. Although state regulators formerly took an extremely active role so as to ensure the just and reasonable retail power rates, FERC has exclusive jurisdiction over the wholesale rates that now drive the electric power market and, as a practical matter, largely determine the rates ultimately charged to the public. These changes profoundly affect this case and require us to ensure that FERC’s application of the Mobile-Sierra doctrine reflects both the historical and regulatory purpose of the doctrine and contemporary regulatory reality. With the history of electric rate regulation thus in mind, we now turn to the facts of the particular contracts at issue and then consider whether FERC applied the correct legal standard to review of these challenged contracts. PUBLIC UTILITY DISTRICT v. FERC 19567