Justice Scalia: The energy regulation cases

Morgan Stanley—the “Sanctity of Contracts” vs. the “Just and Reasonable Standard”

Justice Scalia’s majority opinion in Morgan Stanley can be fairly viewed as an outlier from his usual approach to applying the plain language of statutes and precedent. There, he applied 50 years of precedent in sweeping fashion to carve out a significant role for private contracts within the Federal Power Act’s (FPA) tariff-based rate regulation regime, even though the statute does not explicitly provide for such a role.

Morgan Stanley arose from the politically charged aftermath of the California energy crisis, when a flawed market design and market manipulation combined to create electricity shortages and huge price spikes. At the height of that crisis, utilities were forced to sign contracts for wholesale electricity supply on behalf of their customers at extremely high prices. Those contracts were not initially reviewed by the Federal Energy Regulatory Commission (FERC), which had allowed the sellers to contract at “market-based” rates without filing individual contracts for preapproval.

After the crisis had passed, consumers demanded relief, and the utilities filed complaints on their behalf at FERC asserting that the high prices in the contracts violated the FPA’s requirement that wholesale rates be just and reasonable. That raised a key question: When can FERC, applying the FPA’s just and reasonable standard, reform electricity rates set by private contract?

Beginning with the Court’s decisions in United Gas Pipe Line Co. v. Mobile Gas Service Corp., 350 U.S. 332 (1956) and FPC v. Sierra Pacific Power Co., 350 U.S. 348 (1956), federal courts have consistently held that FERC must satisfy a higher threshold to modify or abrogate contractually-set rates. Called the “Mobile-Sierra doctrine,” this precedent was generally understood to require FERC to demonstrate not just that the existing rates in a private contract were unjust and unreasonable, but rather, that failing to reform them would “adversely affect the public interest” (e.g., by significantly impairing the utility’s finances or casting an excessive burden on other customers).

Justice Scalia penned the majority opinion in Morgan Stanley, however, and in so doing turned the Mobile-Sierra doctrine into more than just a higher burden on FERC. Instead, he concluded that the doctrine firmly establishes that wholesale rates set by private contract must be presumed to be just and reasonable, even where FERC has not had the opportunity to initially review them. Such a presumption, as Justice Stevens noted in dissent, placed private contacts in such a position as to arguably “immunize” them from the FPA’s just and reasonable standard. In addition, such a presumption is not reflected in the language of the FPA itself.

This new presumption represented a significant change from previously settled ideas about the scope of the Mobile-Sierra doctrine and the role of private contracts in the FPA’s tariff-based regulatory scheme. While FERC and the judiciary are still sorting out the scope of the presumption, when FERC may apply it, and what it takes to overcome it, Justice Scalia’s majority opinion will likely be remembered as constraining FERC’s authority under the FPA to reform private contracts.

Drawing the statutory “bright line” between federal and state jurisdiction

Both the FPA and the Natural Gas Act (NGA) similarly divide regulatory authority over electric and natural gas utility services between the federal and state governments: The federal government regulates the transmission and wholesale sale of electricity and natural gas in interstate commerce, while the states regulate local delivery and retail sales. Although simple in concept, this “bright line” drawn by the statutes has become much less clear as both industries have evolved.

During Justice Scalia’s last two terms, the Court grappled with where this jurisdictional line is drawn in three cases—all arising in the context of a much more competitive energy sector than the one that existed when the FPA and NGA were passed. Justice Scalia’s dissents in the two cases which he lived to hear reflected his more familiar approach of focusing squarely on the statutory text. In each case, he found that the Court had strayed too far from the text of each statute when resolving federal and state jurisdictional conflicts.

In the first, EPSA, the Court held that FERC may assert jurisdiction to regulate the rates paid in the wholesale market to retail customers providing what is known as “demand response.” Demand response is a commitment to refrain from consuming electricity. In the increasingly competitive wholesale power markets, FERC concluded that the ability to offer such commitments and receive compensation for them would make demand-side participants more active in the markets (similar to other commodities). This result, FERC reasoned, would improve competition, ensure just and reasonable wholesale rates, and contribute to reliability. It thus asserted jurisdiction to regulate the compensation paid to them. The Court upheld FERC’s exercise of jurisdiction over demand response as a “practice affecting” wholesale rates and concluded that because demand response occurs only in the wholesale market and FERC’s aims in regulating it only concern improving the wholesale markets subject to its jurisdiction, FERC’s regulation of the prices paid for demand response does not constitute regulation of retail sales, an area left explicitly to state regulation by the FPA.

Justice Scalia objected to the majority’s overall approach to resolving this federal-state jurisdictional question. He wrote that the majority’s focus on whether FERC’s regulation of demand response payments would improperly regulate retail sales subject to state jurisdiction “inverts the proper inquiry.” Because the statute affirmatively grants FERC jurisdiction over only wholesale sales, and prohibits FERC from regulating “any other sale of electric energy,” he argued that the Court should have focused on whether demand response is a sale at wholesale. He went on to answer that question in the negative, concluding that demand response is not within FERC’s regulatory purview. This framing of the jurisdictional question assumes that FERC’s authority is much narrower than the majority’s framing assumed.

In the second case, Oneok, the Court concluded that the NGA does not preempt the states from applying their own antitrust laws to the activities of interstate natural gas pipelines that are also subject to FERC jurisdiction. Here, too, Justice Scalia would have drawn a brighter line between state and federal jurisdiction based on the statutory text. This time, however, his reading of the statute favored federal authority and preemption of the states. Justice Scalia wrote that while the NGA expressly grants FERC authority to regulate “practice[s] . . . affecting [wholesale] rate[s],” nothing in the statute “suggests that the states share power to regulate those practices.” Because state antitrust suits “target pipelines (entities regulated by [FERC]) for behavior . . . regulated by [FERC],” Justice Scalia would have found them preempted, leaving FERC as the sole authority policing the conduct of natural gas market participants.

Justice Scalia’s application of the text of both the FPA and the NGA, had they prevailed, would have drawn much sharper divisions between federal and state regulatory authority. He would have rejected the shared (in the case of Oneok) or overlapping (in the case of EPSA) approaches found permissible by the majorities in those cases. As wholesale competition and other technological changes continue to transform the electricity and natural gas industries, and strain the jurisdictional provisions of these statutes, both approaches to resolving jurisdictional disputes will continue to be debated, likely giving Justice Scalia’s dissents continued life for some time to come.