Union Pacific Fuels, Inc. v. Federal Energy Regulatory Commission

United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued September 30, 1997 Decided November 7, 1997

No. 93-1463

Union Pacific Fuels, Inc., et al.,

Petitioners

v.

Federal Energy Regulatory Commission,

Respondent

Transwestern Pipeline Company, et al.,

Intervenors

Consolidated with

Nos. 93-1505, 93-1595, 93-1601, 93-1603

On Petitions for Review of Orders of the

Federal Energy Regulatory Commission

Katherine B. Edwards argued the cause for petitioners,
with whom Nancy J. Skancke, Donald Ayer and Norman A.

Pedersen were on the briefs. Kerry R. Brittain entered an
appearance.

Susan Court, Special Counsel, Federal Energy Regulatory
Commission, argued the cause for respondent, with whom
Jay L. Witkin, Solicitor, John H. Conway, Deputy Solicitor,
and Eric Lee Christensen, Attorney, were on the brief.

Jeffrey D. Komarow, Michael J. Thompson, Paul M.
Flynn and Mark C. Moench were on the brief for intervenor
Kern River Gas Transmission Company.

Before: Edwards, Chief Judge, Ginsburg and Tatel,
Circuit Judges.

Opinion for the Court filed by Chief Judge Edwards.

Edwards, Chief Judge: In January 1990, the Federal Ener-
gy Regulatory Commission ("FERC") approved the construc-
tion of a pipeline by Kern River Gas Transmission Company
("Kern River") that would transport natural gas from the
Wyoming "Overthrust Region" to California. Kern River
negotiated long term contracts with purchasers of its trans-
portation services ("shippers") using the rate structure pre-
vailing in the industry at the time. The rate structure in the
gas pipeline industry passes on pipeline costs to shippers in
two components: a reservation charge covering fixed costs,
and a usage charge covering variable costs. Under "straight
fixed/variable" rating (hereinafter "straight f/v"), all fixed
costs are assigned to the reservation charge, which does not
vary with use, and all variable costs are assigned to the usage
charge, which does. Under "modified fixed/variable" rating
(hereinafter "modified f/v"), some of the fixed costs are
assigned to the reservation charge, but some of the fixed
costs, including return on equity and income taxes, are as-
signed to the usage charge along with all the variable costs.
In 1990, modified f/v prevailed in the pipeline industry; Kern
River's contracts with its shippers used modified f/v.

In 1993, implementing Congress' gradual deregulation of
the natural gas industry, FERC issued its landmark Order

No. 636,1 which changed the basic rate structure in the gas
pipeline industry from modified f/v to straight f/v in order to
enhance competition between gas producers. In two succes-
sive subsequent orders, FERC required Kern River to re-
place the modified f/v rate design for which it had contracted
with straight f/v. Kern River Gas Transmission Company,
Docket No. RS92-65-000, et al.: "Order on Compliance with
Restructuring Rule," issued March 2, 1993, 62 FERC (CCH)
p 61,191; "Order Accepting Revised Compliance Filing, Deny-
ing Rehearing and Granting Clarification," issued July 9,
1993, 64 FERC (CCH) p 61,049 (collectively, "Kern River
orders"). Petitioners, shippers who contracted with Kern
River to use its transportation services, challenge the rate
change on the grounds that it arbitrarily and unjustifiably
reallocates risk away from Kern River and onto them, and on
the grounds that FERC may not abrogate existing contracts
unless imperatively demanded by the public interest.

We deny the petition for review. The Kern River orders
do not abrogate the parties' contracts, but rather alter some
of their terms in a permissible manner anticipated by the
contracts themselves. While the orders do reallocate risk at
the expense of Petitioners, FERC articulated a rational, non-
arbitrary policy basis for its decision.

I. Background

FERC authorized construction of the Kern River pipeline
to transport gas from the Wyoming "Overthrust Region" to
California under special "Optional Certificate" procedures
authorized by the Natural Gas Act ("NGA") s 7, 15 U.S.C.
s 717f. See Kern River Gas Transmission Co., 50 FERC

__________
1 Order No. 636, Pipeline Service Obligations and Revisions to
Regulations Governing Self-Implementing Transportation Under
Part 284 of the Commission's Regulations, and Regulation of Natu-
ral Gas Pipelines After Partial Wellhead Decontrol, III F.E.R.C.
Stats. & Regs. (CCH) p 30,939, order on reh'g, Order No. 636-A,
F.E.R.C. Stats. & Regs. (CCH) p 30,950, order on reh'g, Order No.
636-B, 61 F.E.R.C. p 61,272 (1992), reh'g denied, 62 F.E.R.C.
p 61,007 (1993).

p 61,069 (1990). These Optional Certificate procedures allow
a pipeline builder to forgo a lengthy showing of a pipeline's
usefulness and necessity when the builder assumes the eco-
nomic risks associated with undertaking the project. Kern
River negotiated contracts of various terms with Petitioners
for a total of 98% of its capacity for fifteen years using the
modified f/v rate that prevailed at the time. Joint Initial
Brief of Petitioners 21.

Each contract contained a "Memphis clause," so named for
United Gas Pipe Line Co. v. Memphis Light, Gas and Water
Div., 358 U.S. 103 (1958). The Memphis clause specified that
"rates, charges, classifications and service" were subject to
FERC regulation, and allowed Kern River to request and
implement rate changes. Joint Appendix ("J.A.") 113-14.
Two of the contracts, those between Kern River and Petition-
ers Mobil Exploration & Production U.S., Inc. ("Mobil") and
Union Pacific Fuels, Inc. ("Union Pacific") expressly guaran-
teed that Kern River would not, without consent, "seek to
change ... the modified fixed variable rate design." J.A. 28,
33. The other contracts guaranteed what the parties call
"most favored nations" status, under which purchasers would
receive a rate as good as the most favorable rate negotiated
by any other party. The contracts, negotiated at arm's
length, functioned in part as an allocation of risk between
Kern River and Petitioners. The more of the fixed cost paid
in reservation fees by Petitioners, purchasers of transporta-
tion services, the greater the percentage of risk assumed by
them.

In 1992, FERC adopted Order No. 636, which effected a
variety of changes in the natural gas market. For purposes
of this case, the significant aspect of Order No. 636 was its
alteration of the required rate design from modified f/v to
straight f/v. See 18 C.F.R. s 284.8(d). This court upheld the
rate design change in United Distrib. Cos. v. F.E.R.C., 88
F.3d 1105, 1161-76 (1996) (per curiam), cert. denied 117 S. Ct.
1723 (1997). FERC intended the rate change to facilitate the
creation of a competitive, national gas market. Gas from
different producers is carried on different pipelines, each of
which has different fixed costs. When pipelines use modified
f/v, the price paid by the purchaser varies depending on the
fixed costs associated with the particular pipeline. When

pipelines use straight f/v, the price to the customer more
closely reflects the incremental cost of producing and trans-
porting the gas, and thus, in FERC's view, will lead to a
more competitive and efficient market. See Order No. 636,
III F.E.R.C. Stats. & Regs. at 30,434.

In August 1992, after Order No. 636 took effect, Kern
River applied to FERC to adopt straight f/v rate design for
all of its shippers except Mobil and Union Pacific. J.A. 1.
FERC responded by requiring straight f/v for all Kern
River's shippers. 62 FERC at 62,262. Various parties,
including Petitioners, filed for rehearing; Kern River asked
for further clarification. In its second Kern River order,
FERC concluded once more that straight f/v should be re-
quired for all customers. 64 FERC at 61,406. Although
Order No. 636 permits exceptions to the straight f/v policy,
FERC refused to make an exception for Kern River. It
reasoned that the modified f/v rate design would artificially
inflate the usage charges upon which gas purchasers base
their buying decisions. This would distort the market in
natural gas by creating an incentive for end purchasers to
buy gas transported through straight f/v pipelines. 62 FERC
at 62,257-58; 64 FERC at 61,407-08.

This challenge followed. The gravamen of Petitioners'
complaint is that modified f/v places the risk of the pipeline's
failure primarily on the pipeline owner, while straight f/v
spreads this risk by assigning virtually all the fixed costs to
shippers such as Petitioners, who pay reservation charges to
guarantee themselves pipeline capacity. If, as here, the
shippers reserve nearly all of a pipeline's capacity for a given
period, a pipeline using straight f/v rate design will recover
its fixed costs during that period irrespective of how much
capacity the shippers actually use. In other words, although
Order No. 636 aimed to rationalize pricing of natural gas for
end purchasers, implementing straight f/v in this case had a
coincidental, different effect: it altered the original risk allo-
cation for which the parties contracted, placing a higher
burden on the shippers and reducing significantly the burden
on Kern River. Petitioners seek to escape this alteration in

risk allocation that will bind them for the length of the
contracts.

II. Analysis

A. Standard of Review

We review FERC orders under the arbitrary and capri-
cious standard of 5 U.S.C. s 706(2)(A). City of Seattle v.
F.E.R.C., 883 F.2d 1084, 1087 (D.C. Cir. 1989). Petitioners
argue that the orders here must also satisfy the higher
Mobile-Sierra standard. See United Gas Pipe Line Co. v.
Mobile Gas Corp., 350 U.S. 332 (1956); FPC v. Sierra Pacific
Power Co., 350 U.S. 348 (1956). Mobile-Sierra doctrine
construes FERC's authority under NGA s 5 to order just
and reasonable rates where FERC has found existing rates
unjust and unreasonable. 15 U.S.C. s 717d. Under Mobile-
Sierra, FERC may exercise this rate-making authority to
abrogate existing contracts only where the public interest
"imperatively demands" such action. Metropolitan Edison
Co. v. F.E.R.C., 595 F.2d 851, 856 n.29 (D.C. Cir. 1979).

Whether Mobile-Sierra doctrine applies is a question of
contract interpretation:

The rule of Sierra, Mobile, and Memphis is refreshingly
simple: The contract between the parties governs the
legality of the filing. Rate filings consistent with con-
tractual obligations are valid; rate filings inconsistent
with contractual obligations are invalid.

Richmond Power & Light v. F.P.C., 481 F.2d 490, 493 (D.C.
Cir. 1973). Mobile-Sierra applies only where FERC abro-
gates private contracts that do not contemplate FERC re-
form. Mississippi Indus. v. F.E.R.C., 808 F.2d 1525, 1551-52
(D.C. Cir. 1987), cert. denied, 494 U.S. 1078 (1990). A
contract between private parties may preserve FERC's right
to impose new rates by "leav[ing] unaffected the power of the
Commission ... to replace not only rates that are contrary to
the public interest but also rates that are unjust [or] unrea-
sonable." Papago Tribal Util. Auth. v. F.E.R.C., 723 F.2d
950, 953 (D.C. Cir. 1983). Alternatively, parties may contract
to permit their own rate changes subject to FERC review, or

may contract in such a way as to invoke Mobile-Sierra and
thereby restrict FERC's ratemaking power to replacing rates
contrary to the public interest. Id.

The contracts between Kern River and Petitioners antici-
pated rate changes by FERC, and thus Mobile-Sierra doc-
trine does not apply. The contracts were of the type that
permitted FERC changes of unjust and unreasonable rates in
addition to those contrary to the public interest. See id. All
of the disputed contracts included Memphis clauses acknowl-
edging FERC regulation of rates and permitting Kern River
to request rate changes from FERC. The contracts provided
for the possibility of rate changes in other ways, as well. For
example, the Mobil and Union Pacific contracts provided that
if FERC ordered rate changes raising Kern River's costs,
Kern River could pass on some of those costs. 64 FERC at
61,412 n.49. The contracts with the other Petitioners guaran-
teed the shippers rates as good as those offered to any other
shipper.

Kern River's contracts with Mobil and Union Pacific includ-
ed an additional clause providing that neither party shall
"seek to change ... the modified fixed variable rate design."
This language simply prohibited the parties from requesting
from FERC, pursuant to NGA s 4, a change away from
modified f/v. Nothing in the contracts expressly exempted
the private agreement from rate changes initiated by FERC
under NGA s 5. The parties could have, but did not adopt
language that expressly limited FERC's right to change
modified f/v to the public interest standard required by
Mobile-Sierra. See Papago, 723 F.2d at 953. For example,
the contracts could have stated expressly that modified f/v
would apply unless FERC determined that it was not in the
public interest. While Petitioners protest that boilerplate
language acknowledging rate changes by FERC should not
render Mobile-Sierra doctrine inapplicable, and that the con-
tracts implicitly anticipated use of modified f/v, they do not
explain why they could not have adopted language that would
simply and clearly have invoked Mobile-Sierra. Cf. North-

east Util. Serv. Co. v. FERC, 993 F.2d 937, 960 (1st Cir. 1993)
(contract provided that "the FERC shall not change the rate
charged under this Agreement unless such rate is found to be
contrary to the public interest"). Because Mobile-Sierra
doctrine did not apply to these contracts, FERC did not have
to show that public interest demanded straight f/v in this
case.

B. Alleged Arbitrariness of Risk Reallocation

Petitioners challenge the rate change on the theory that, as
shippers, they entered long term, modified f/v contracts in
reliance on Optional Certificate procedures under NGA s 7,
and that the switch to straight f/v arbitrarily altered the
carefully negotiated risk allocation embodied in those con-
tracts. They claim that FERC did not provide a reasoned
explanation for its change, and that Kern River has reaped
unearned benefits by the lessening of its share of the econom-
ic risk of the pipeline.

In an order granting an Optional Certificate to one of Kern
River's competitors, FERC stated:

Although we cannot bind the actions of future Commis-
sions, it is our intent that the negotiated rate design
would not be subject to change in a future section 4 or
section 5 rate proceeding, either by the applicant or by
the Commission, because that rate design reflects the
assessment of risk agreed to by the parties in order to
construct the project.

45 FERC p 61,234, 61,678 (1988). In the first Kern River
order, FERC acknowledged that "the intent and anticipation
of the Commission's original order issuing the Kern River
[optional] certificates was to be consistent with [this lan-
guage]." 62 FERC at 62,257.

Petitioners and Kern River probably did intend to negoti-
ate risk allocation when they entered the long term contracts
at issue here. It is also likely that they did not specifically
anticipate FERC Order No. 636 and the resulting change
from modified f/v, on which they relied, to straight f/v. Kern
River may well have incurred some unexpected benefits as a
result of the change, as Petitioners have incurred unexpected

costs. Kern River now shoulders less of the risk of the
pipeline, since it can recover return on equity and taxes
through reservation charges, which it could not do under the
original contracts; Petitioners now shoulder more of the risk.

Even assuming the correctness of all Petitioners' factual
claims, however, it does not follow that FERC's orders were
arbitrary and capricious. This case presents a paradigmatic
example of an agency reasonably changing its policies, and
implementing the consequences of those changes to the detri-
ment of some parties and the benefit of others. Policy
changes sometimes have distributive effects that may appear
arbitrary from the perspective of their corporate victims, but
in fact proceed logically from the reasoned premises underly-
ing the changes. The policy changes may even have the
effect of unsettling other policies that the agency has pursued
or continues to pursue; but this is occasionally inevitable
given the complexity of economic relations and administrative
intervention. The problem of unsettling existing agency poli-
cies counsels caution, but does not bar policy changes. By
formulating its policy in a reasoned fashion, FERC acted in a
non-arbitrary manner; by justifying its decision to apply
straight f/v to Kern River on the basis of promoting market
efficiency, FERC satisfied its burden of providing reasoned
explanation for its change in policy.

FERC's formulation and structuring of its policies from the
outset acknowledged the possibility of policy change.
FERC's statement of its future intent, supra, began with the
caveat that FERC, like a legislature, cannot bind itself with
respect to future policy changes. See 45 FERC at 61,678.
Because of the possibility of future changes, the Optional
Certificate regulations, which are still in effect, do not formal-
ly require that FERC maintain the rate structures negotiated
by parties in their initial agreements. Instead, the Optional
Certificate regulations require a pipeline to abide by all
operative FERC regulations. The Optional Certificate regu-
lations permit a reservation charge "consistent with the con-
ditions in [18 C.F.R.] s 284.8(d)." 18 C.F.R. s 157.103(d)(3).

Order No. 636 changed the content of 18 C.F.R. s 284.8(d)
from a modified f/v design to a straight f/v design. The
Optional Certificate regulations continued to incorporate by
reference the changed rate design.

No doubt, the possibility of FERC intervention in rate
design makes it more difficult for the parties to allocate risk
by means of contracts adopted pursuant to the Optional
Certificate procedures. No rational corporation would, with-
out some trepidation, enter a long term contract whose terms
might be altered by highly unpredictable government inter-
vention. The possibility of FERC intervention makes risk
allocation difficult. Indeed, the Kern River orders conceiv-
ably could have the effect of chilling future Optional Certifi-
cate contracts, to the extent that pipeline builders and ship-
pers may believe that significant shifts in their bargained-for
risk allocations can and sometimes do occur. However, this
possibility of future chilling belongs as one among the various
factors that FERC could consider in exercising its adminis-
trative discretion. The one dissenting Commissioner in the
Kern River rehearing order raised the issue of regulatory
certainty as a concern, and justly so. 64 FERC at 61,436.
Yet this concern, appropriate for FERC itself, does not
establish arbitrariness for the purposes of this court.

In the first Kern River order, FERC justified its applica-
tion of straight f/v to Kern River in terms of the broad policy
change of Order No. 636 under which straight f/v became the
rate design for the entire natural gas industry. First sketch-
ing the goal of competition at the wellhead, FERC pointed
out that Kern River's usage rates under modified f/v of either
$0.1852 or $0.2502 per thousand cubic feet ("Mcf") would
drastically exceed its competitors' straight f/v charges of
$0.0165 and $0.00478 per Mcf. 62 FERC at 62,258. If Kern
River kept modified f/v, "the competitive distortion which the
Commission has tried to prevent could occur." Id. Price
disparity in the new competitive environment, FERC further
argued, could put Kern River at a significant disadvantage
vis--vis its competitors, and might even put it at risk of not
recovering its fixed costs. FERC concluded:

On balance, we believe that the fundamental changes
that are to occur in the natural gas industry under
restructuring greatly outweigh the anticipation of the
parties and the Commission when Kern River's original
certificate authorization was being considered that the
MFV methodology would not change.... Kern River's
customers are in essentially no different a position now
than the customers of any other pipeline who, in the past
expected the Commission's former policy favoring MFV
to continue.

Id. FERC's explanation for its decision sufficiently articulat-
ed the basis for its actions: the purposes of straight f/v
"greatly outweigh" whatever harm might befall the parties as
the result of a change in their initial expectations. Similar
harms affected all natural gas customers who relied on the
continuity of modified f/v, yet the court found the change
from modified f/v to straight f/v to be permissible in United
Distrib. Cos., 88 F.3d at 1161-76.

In its second, clarificatory order on rehearing, FERC
explained once more that, by implementing straight f/v, it
intended to serve the general policy aim of Order No. 636:
facilitating competition at the wellhead for natural gas sales.
Noting the usage rate disparity between Kern River and its
competitors that would result from allowing Kern River to
maintain modified f/v, FERC observed:

Shippers with different supply options would look to the
usage charges of the competing pipelines to make market
decisions. Therefore, Kern River's usage charge would
cause distortions in the wellhead markets where mer-
chants purchase gas for sale in the California market.

64 FERC at 61,407-08. In this second order, FERC ac-
knowledged that imposing straight f/v shifted risk away from
Kern River. "However," it reasoned, "the need to accomplish
the important national policy goals established by Order No.
636 outweighs any adverse effects of a change in the alloca-
tion of the risk of the Kern River project." Id. at 61,408.
Finally, FERC explained in some detail that requiring Kern

River to keep modified f/v while its competitors used straight
f/v might have the effect of making it difficult for Kern River
to recover its fixed costs because Kern River's services would
be less attractive than those of its competitors. Id.

Thus, in both Kern River orders, FERC provided reasoned
explanation for its decision to impose straight f/v. This
decision resulted from the broad policy reorientation that
favored creating competition at the wellhead by making gas
prices reflect only the marginal cost of extraction and trans-
portation, and not any fixed pipeline costs. Applying this
policy generally meant that if Kern River, and none of its
competitors, used modified f/v, the goal of price transparency
and comparability would not be achieved in its market. It
thus made regulatory sense to require Kern River to use
straight f/v, even though the consequence of this decision was
to reallocate risk that Kern River and Petitioners had already
allocated. This was a reasoned trade-off, not an arbitrary
decision, and lay within FERC's discretion.

C. Subsequently Granted FERC Exceptions

Since the time when the Kern River orders were issued,
FERC has permitted exceptions to its straight f/v rate re-
quirement in several cases, including those of two of Kern
River's competitors. Joint Initial Brief of Petitioners 34-36;
Joint Reply Brief of Petitioners 20-21. Because these excep-
tions occurred after the orders under review, they play no
role in our determination of the orders' legality. Although we
may remand where FERC has formally altered its policy
after issuing an order challenged before us, see, e.g., Panhan-
dle E. Pipe Line v. F.E.R.C., 890 F.2d 435, 438 (D.C. Cir.
1989), here Order No. 636 remains in place, and straight f/v
remains the FERC-required default rate structure. Petition-
ers have the option to encourage Kern River to request a
waiver of the straight f/v requirement similar to that obtained
by its competitors. Although straight f/v benefits Kern Riv-
er, the bargaining power of Kern River's customers is hardly
negligible in light of the ongoing relationship and long term
interests of pipeline and customers alike.

D. Factual Hearing Request

Petitioners requested a hearing before FERC to determine
whether justification existed for an exception to the straight
f/v requirement, and now ask this court to remand for a
hearing on the question because cost allocation "involves
judgment on a myriad of facts." United Distrib. Cos., 88
F.3d at 1167. This observation does not suffice to require a
trial-type hearing where, as here, no material disputes exist-
ed. See Moreau v. F.E.R.C., 982 F.2d 556, 568 (D.C. Cir.
1993). FERC may resolve factual issues on a written record
unless motive, intent, or credibility are at issue or there is a
dispute over a past event. Louisiana Ass'n of Indep. Pro-
ducers & Royalty Owners v. F.E.R.C., 958 F.2d 1101, 1113
(D.C. Cir. 1992). A trial-type hearing would not have facili-
tated what was at bottom a policy determination as to the
relative importance of facilitating wellhead competition and
preserving parties' risk allocation.

III. Conclusion

FERC's orders reasonably instituted policy decisions
whose distributive effects disadvantaged Petitioners. The
orders were not arbitrary, capricious, or otherwise in violation
of law, and they were adequately explained by FERC. The
petition for review is denied.

So ordered.