The Indust v. FERC

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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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 cash-
out 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

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.
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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 cash-
out 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 happy-
medium 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.