National Fuel Gas Supply Corp. v. Federal Energy Regulatory Commission

United States Court of Appeals
FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued September 11, 2006 Decided November 17, 2006

No. 04-1183

NATIONAL FUEL GAS SUPPLY CORPORATION,
PETITIONER

v.

FEDERAL ENERGY REGULATORY COMMISSION,
RESPONDENT

PUBLIC SERVICE COMMISSION OF THE STATE OF NEW YORK,
ET AL.,
INTERVENORS

Consolidated with
04-1302, 04-1318, 04-1338, 05-1042, 05-1048, 05-1051,
05-1052, 05-1055

On Petitions for Review of Orders of the
Federal Energy Regulatory Commission

Howard L. Nelson argued the cause for Interstate Gas
Pipeline Company Petitioners. With him on the briefs were
Joan Dreskin, Timm Abendroth, Janice A. Alperin, Mark C.
Schroeder, David W. Reitz, and Kenneth B. Driver. Richard D.
Avil, Jr. entered an appearance.
 2

Christopher J. Barr argued the cause for Local Distribution
Company Petitioners. With him on the briefs were Anne K.
Kyzmir, Jeffrey M. Petrash, William A. Williams, and David W.
Reitz. Michael A. Reville entered an appearance.

Lawrence G. Acker argued the cause for petitioner Calypso
U.S. Pipeline, LLC. With him on the briefs was Brett A. Snyder.

Samuel Soopper, Attorney, Federal Energy Regulatory
Commission, argued the cause for respondent. With him on the
brief were John S. Moot, General Counsel, and Robert H.
Solomon, Solicitor.

Before: GINSBURG, Chief Judge, and GRIFFITH and
KAVANAUGH, Circuit Judges.

Opinion for the Court filed by Circuit Judge KAVANAUGH.

KAVANAUGH, Circuit Judge: The Natural Gas Act of 1938
provides that “[n]o natural-gas company shall, with respect to
any transportation or sale of natural gas . . . make or grant any
undue preference or advantage to any person or subject any
person to any undue prejudice or disadvantage.” 15 U.S.C.
§ 717c(b)(1). The Act’s fundamental purpose is to protect
natural gas consumers from the monopoly power of natural gas
pipelines. See Associated Gas Distribs. v. FERC, 824 F.2d 981,
995 (D.C. Cir. 1987). Congress has directed the Federal Energy
Regulatory Commission to enforce the statute and regulate the
pipelines. Since the 1980s, FERC has done so primarily through
open-access rules that require pipelines to carry gas on equal
terms and not to grant undue preferences or discriminate in favor
of gas sold by the pipeline itself. See id. at 996; United
Distribution Cos. v. FERC, 88 F.3d 1105, 1123-27 (D.C. Cir.
1996).
 3

In 1988, acting pursuant to its statutory authority, FERC
issued Standards of Conduct to regulate natural gas pipelines’
interactions with their “marketing affiliates.” (Marketing
affiliates are the separate affiliates of pipelines that sell natural
gas; the affiliates arrange to purchase gas at the wellhead and to
transport and distribute it to buyers.) The Standards required
pipelines and their marketing affiliates to function independently
and imposed restrictions on the sharing of information between
them. FERC promulgated those rules because of (i) the
theoretical threat that pipelines would favor their marketing
affiliates by selectively divulging information about pipeline
operations, thereby impeding market competition; and (ii) a
factual record consisting of complaints by other sellers who
were competing with pipelines’ marketing affiliates and of
documented abuses by pipelines and their marketing affiliates.

The pipelines petitioned for review, but we denied the
petition in relevant part. We recognized that FERC must take
into account the substantial efficiencies and benefits of vertical
integration. We nonetheless upheld the Order because FERC
had sufficiently demonstrated both a theoretical threat of
pipelines granting undue preferences to their marketing affiliates
and substantial record evidence of actual abuse. See Tenneco
Gas v. FERC, 969 F.2d 1187, 1197 (D.C. Cir. 1992).

In 2004, FERC significantly revised and extended the
Standards so that they would apply to pipelines’ relationships
not only with marketing affiliates but also with other entities in
the industry (such as producers, gatherers, processors, and
traders) that are affiliated with pipelines. In vastly expanding
the reach of the Standards, FERC again relied on both a claimed
theoretical threat – this time, of pipelines granting undue
preferences to those non-marketing affiliates – and record
evidence that, according to FERC, indicated that abuse by
pipelines and non-marketing affiliates was a real problem in the
 4

industry. The two dissenting FERC Commissioners objected,
however, that the factual record on which FERC relied was
barren and did not contain a single example of abuse involving
non-marketing affiliates, much less evidence of an industry-wide
problem.

Several pipelines petitioned for review in this court. We
conclude that FERC’s asserted factual premises do not withstand
scrutiny and that the Order does not reflect the reasoned
decisionmaking required by the Administrative Procedure Act.
We therefore hold that the Order is arbitrary and capricious as
applied to natural gas pipelines. We will grant the petition,
vacate the Order as applied to natural gas pipelines, and remand.
Because of our disposition, we need not consider the separate
arguments against the Order raised by Calypso U.S. Pipeline and
the local natural gas distribution companies.

I

1. The natural gas supply chain consists of a variety of
entities. Some of them, such as producers, gatherers, processors,
pipelines, and local distribution companies, perform the physical
processes required to extract, refine, transport, and distribute
gas. Other entities, such as marketers and traders, operate on the
financial side, coordinating sales and trading in the natural gas
commodity market.

Producers establish new wells and extract natural gas from
the ground. Gatherers transport the gas from the wellhead to a
processing plant. From there, processors distill “pipeline
quality” natural gas by removing various hydrocarbons and
fluids (some processing is done initially at the wellhead or later
in the supply chain). Natural gas pipelines (either intrastate or
interstate) carry gas to local distribution companies and to large
industrial and commercial customers. Finally, local distribution
 5

companies deliver gas to retail consumers, subject to price
regulation by state utility commissions.

Natural gas marketers sell natural gas and oversee the steps
needed to arrange transportation of gas from the wellhead to the
end-user. Frequently affiliated with another entity (such as a
producer or pipeline), marketers identify customers, arrange gas
transportation and storage, and ensure that adequate supplies are
available to satisfy the purchasers’ demand.

In recent years, entities referred to as natural gas traders
have actively participated in the natural gas spot market and the
natural gas derivatives market. In the spot (or physical) market,
traders enter into contracts for the near-term delivery of natural
gas. In the derivatives market, traders buy and sell derivative
instruments like futures that are based on the underlying natural
gas commodity. Traders participate in those markets primarily
to hedge against risk or to profit from speculation on future price
changes.

2. Like railroads, water pipelines, cable television lines,
and telephone lines, natural gas pipelines traditionally have been
considered natural monopolies. In other words, the costs of
entering the market are so high (because of the large fixed cost
of building a pipeline) that it is most efficient for only one firm
to serve a given geographical region. See RICHARD A. POSNER,
ECONOMIC ANALYSIS OF LAW § 12.1, at 343-46 (4th ed. 1992);
see also United Distribution Cos. v. FERC, 88 F.3d 1105, 1122
& n.4 (D.C. Cir. 1996); Associated Gas Distribs. v. FERC, 824
F.2d 981, 1010 (D.C. Cir. 1987). As natural monopolies,
pipelines if unregulated would possess the ability to engage in
monopolistic pricing for transportation services and discriminate
against unaffiliated entities that seek to transport gas.
 6

As this court has explained, federal regulation of the natural
gas industry is “designed to curb pipelines’ potential monopoly
power over gas transportation.” United Distribution Cos., 88
F.3d at 1122. Federal regulation began in 1938 after Congress
passed and President Franklin Roosevelt signed the Natural Gas
Act. 52 Stat. 821 (codified as amended at 15 U.S.C. §§ 717 et
seq.). That Act conferred jurisdiction on FERC’s predecessor,
the Federal Power Commission, to regulate the interstate
transportation and sale of natural gas. See 15 U.S.C. §§ 717(b),
717d(a). The Act also established a certification system and
required the Commission to ensure that all rates were “just and
reasonable” and that natural gas companies did not grant “undue
preference[s].” See id. §§ 717c, 717d, 717f(c)(1)(a). Under this
system, the Commission for decades regulated both the wellhead
price and the “city gate price” (the price charged by pipelines to
end-users and local distribution companies). See generally
STEPHEN G. BREYER & PAUL W. MACAVOY, ENERGY
REGULATION BY THE FEDERAL POWER COMMISSION 56-88
(1974).

In 1978, Congress passed and President Carter signed the
Natural Gas Policy Act, Pub. L. No. 95-621, 92 Stat. 3350. That
Act began the gradual deregulation of prices at the wellhead. In
the aftermath of the Act and as a result of other legal and
economic developments in the early 1980s, FERC launched a
new regulatory approach. The Commission concluded that it
could best fulfill the statutory purposes by allowing customers
to purchase gas at the wellhead free from regulation and by
preventing pipelines from abusing their monopoly power over
the transportation of gas. At the time, pipelines served not just
as transporters of gas but also as the primary gas marketers:
They would purchase gas at the wellhead themselves, transport
it over their systems, and sell it to local distribution companies
or other end-users. See Associated Gas Distribs., 824 F.2d at
993. The problem was that pipelines could exclude third parties
 7

from using the transmission facilities when pipelines wanted to
favor the pipelines’ own sales. See id.

To achieve its regulatory goals, FERC issued its landmark
Order 436 in 1985. See Regulation of Natural Gas Pipelines
After Partial Wellhead Decontrol, Order No. 436, F.E.R.C.
Stats. & Regs. ¶ 30,665, 50 Fed. Reg. 42,408 (1985) (rehearing
orders omitted). Order 436 declared the bundling of
transportation and marketing services “unduly discriminatory”
and conditioned “blanket certification” (which allowed pipelines
to avoid costly individual certifications) on non-discriminatory
“open access” to pipelines’ transmission facilities. The Order
served to help deregulate the sales market, where there are no
natural barriers to market competition, while simultaneously
preventing anti-competitive activity by the monopolistic
pipelines in the transportation market. This court upheld the
regulatory scheme as consistent with FERC’s authority to
prevent natural gas companies from granting undue preferences.
See Associated Gas Distribs., 824 F.2d at 1044 (approving bulk
of Order); Regulation of Natural Gas Pipelines After Partial
Wellhead Decontrol, Order No. 500, F.E.R.C. Stats. & Regs.
¶ 30,761, 52 Fed. Reg. 30,334 (1987) (readopting in large part
Order 436); Am. Gas Ass’n v. FERC, 888 F.2d 136, 153 (D.C.
Cir. 1989) (remanding record of Order 500); Am. Gas Ass’n v.
FERC, 912 F.2d 1496, 1503, 1520 (D.C. Cir. 1990) (largely
upholding additional Orders 500-H and 500-I).

In 1992, FERC followed up on Order 436 by issuing Order
636, which fully mandated the unbundling of transportation and
marketing by directly requiring pipelines to offer transportation
service on a non-discriminatory basis. See Pipeline Service
Obligations and Revisions to Regulations Governing Self-
Implementing Transportation; and Regulation of Natural Gas
Pipelines After Wellhead Decontrol, Order No. 636, F.E.R.C.
Stats. & Regs. ¶ 30,939, 57 Fed. Reg. 13,267 (1992) (rehearing
 8

orders omitted). We upheld that Order in large part. See United
Distribution Cos., 88 F.3d at 1191.

3. In the 1980s, as FERC unbundled interstate pipelines’
marketing and transportation functions by requiring pipelines to
transport gas on equal terms, pipelines began to withdraw from
the sales market for a variety of legal and economic reasons.
See Tenneco Gas v. FERC, 969 F.2d 1187, 1193 (D.C. Cir.
1992). Instead of selling gas directly, pipelines established
marketing affiliates that would sell gas in a competitive market
free from regulation. Before long, however, non-affiliated
marketers objected that pipelines – while providing equal and
open access to sellers – were violating that principle in spirit by
granting their marketing affiliates undue preferences, such as by
divulging inside information regarding future capacity that
would provide competitive benefits to pipelines’ affiliates. See
id. at 1194.

In response to pipelines’ undue favoritism toward their
marketing affiliates, FERC promulgated Order 497, which set
out Standards of Conduct to govern the relationship between
pipelines and their marketing affiliates. See Inquiry Into
Alleged Anticompetitive Practices Related to Marketing
Affiliates of Interstate Pipelines, Order No. 497, F.E.R.C. Stats.
& Regs. ¶ 30,820, 53 Fed. Reg. 22,139 (1988) (rehearing orders
omitted). Order 497 required pipelines to provide equal
treatment to sellers in areas such as scheduling, transportation,
and speed of service; ordered contemporaneous disclosure of
transportation information to all potential shippers if disclosed
to an affiliate; and required independent functioning of pipeline
and marketing affiliate employees. See Tenneco, 969 F.2d at
1194-95.

Order 497 was narrowly targeted in certain important
respects. First, FERC chose not to extend the Standards to
 9

relationships with non-marketing affiliates, such as producers,
gatherers, and processors. FERC concluded that imposing the
Standards on relationships with non-marketing affiliates was
unnecessary because of “the absence of evidence of abusive
practices” between pipelines and non-marketing affiliates and
“in light of the availability of complaint procedures for
aggrieved persons.” Order 497, at 31,130. Second, the Order
did not apply to pipelines that do not conduct any transactions
with their marketing affiliates. FERC found that “there is no
possibility for abuse of the pipeline-marketing affiliate
relationship where the pipeline and marketing affiliate do not
conduct any transactions with each other.” Id. at 33,131.

Pipelines and other entities filed petitions in this court
challenging the contemporaneous disclosure and independent
functioning requirements of Order 497. See Tenneco, 969 F.2d
at 1195-96. We began by stating that vertical integration in the
natural gas industry produces benefits for consumers and that
FERC must take those benefits into account when regulating the
pipelines. See id. at 1197-99. We nonetheless upheld the
contemporaneous disclosure requirement with respect to
transportation information because the record demonstrated both
a straightforward theoretical threat of abuse and substantial
record evidence that pipelines had been granting their marketing
affiliates undue preferences. See id. In light of the theoretical
threat and the record of abuse, we also upheld the independent
functioning requirement, noting that it preserved some benefits
of vertical integration, particularly in contrast to the more
draconian possibilities of complete physical separation,
divorcement, or divestiture. Id. at 1204, 1209.

4. Some nine years later, in 2001, FERC considered
taking a step it had rejected in Order 497. FERC issued a notice
of proposed rulemaking announcing its plan to broaden “the
definition of an affiliate covered by the standards of conduct” to
 10

include non-marketing affiliates. See Notice of Proposed
Rulemaking, Standards of Conduct for Transmission Providers,
F.E.R.C. Stats. & Regs. ¶ 32,555, at 34,079, 66 Fed. Reg. 50,919
(Sept. 27, 2001); id. at 34,090. FERC cited its concern “that a
transmission provider’s market power could be transferred to its
affiliated businesses because the existing rules do not cover all
affiliate relationships” and pointed to “[s]ignificant changes” in
the range of services offered by various companies in the natural
gas industry. Id. at 34,081-34,082. The notice of proposed
rulemaking indicated that the industry-wide costs of compliance
with the Standards could be $240 million per year – a cost that
eventually would be borne in part by consumers. See id. at
34,090.

In their comments, the pipelines suggested that the proposal
was “perhaps a solution in search of a problem.” Comments of
Interstate Natural Gas Association of America (Dec. 20, 2001)
at 1. After receiving input from the pipelines, other industry
participants, and various organizations, FERC went ahead and
promulgated Order 2004 in November 2003. See Standards of
Conduct for Transmission Providers, Order No. 2004, F.E.R.C.
Stats. & Regs. ¶ 31,155, 68 Fed. Reg. 69,134 (Nov. 25, 2003).
FERC conducted four more rounds of notice and comment to
clarify various aspects of the new regulations. See Order No.
2004-A, F.E.R.C. Stats. & Regs. ¶ 31,161, 69 Fed. Reg. 23,562
(Apr. 16, 2004); Order No. 2004-B, F.E.R.C. Stats. & Regs.
¶ 31,166, 69 Fed. Reg. 48,371 (Aug. 2, 2004); Order No.
2004-C, F.E.R.C. Stats. & Regs. ¶ 31,172, 70 Fed. Reg. 284
(Dec. 21, 2004); Order No. 2004-D, 110 FERC ¶ 61,320 (Mar.
23, 2005). (For ease of reference, we will refer to these Orders
collectively as “Order 2004.”)

FERC based the new Standards on the same principles of
non-discrimination and independent functioning as the old
Standards. See Standards of Conduct for Transmission
 11

Providers, 18 C.F.R. § 358.2 (2006); Tenneco, 969 F.2d at 1194-
95. The central provisions are:

(a) Independent Functioning. A pipeline’s employees who
engage in transmission operations ordinarily “must function
independently of [its] Marketing or Energy Affiliates’
employees,” with an exception for “emergency circumstances.”
18 C.F.R. § 358.4(a)(1)-(2). Further, a pipeline generally may
not permit its affiliates’ employees to engage in transmission
system operations or reliability functions or to access the system
control center. Id. § 358.4(a)(3)(i)-(ii).

(b) Non-discrimination. A pipeline must ensure that its
affiliates’ employees have access only to the information
available to all transmission customers and that such employees
are prevented from obtaining non-public information about the
pipeline’s transmission system. Id. § 358.5(a).

(c) Posting Requirements. A pipeline must post online such
information as the names and addresses of its affiliates, the
organizational structure of its parent corporation, a list of
facilities shared with affiliates, a list of business units and job
descriptions, a schedule for implementing the Standards, and a
written log “detailing the circumstances and manner in which
[the pipeline] exercised its discretion under any terms of [its]
tariff.” Id. §§ 358.4(b)(1)-(3), (e)(1), 358.5(c)(4).

Order 2004 ushers in two fundamental changes from Order
497. First, it extends the Standards beyond pipelines’
relationships with their marketing affiliates to govern also
pipelines’ relationships with numerous non-marketing affiliates
– processors, gatherers, producers, local distribution companies,
and traders. See Order 2004, at 30,825-30,827. The Order
includes a broad, multipart definition of Energy Affiliate as an
affiliate that “(1) Engages in or is involved in transmission
 12

transactions in U.S. energy or transmission markets; or (2)
Manages or controls transmission capacity of a Transmission
Provider in U.S. energy or transmission markets; or (3) Buys,
sells, trades or administers natural gas or electric energy in U.S.
energy or transmission markets; or (4) Engages in financial
transactions relating to the sale or transmission of natural gas or
electric energy in U.S. energy or transmission markets.” 18
C.F.R. § 358.3(d)(1)-(4). The definition also includes local
distribution companies, other than those that make only on-
system sales (where the point of delivery is on or directly
interconnected with the local distribution company’s distribution
system). Id. § 358.3(d)(5), (d)(6)(v).

Second, the new Standards cover a pipeline’s relationships
even with those affiliates that do not hold or control any
capacity on the pipeline. See id. §§ 358.1(a), 358.3(d). For
example, a pipeline is subject to the Standards in its relationship
with an affiliated producer that transports gas only on other
pipelines. FERC’s apparent rationale was that pipelines could
communicate information to affiliates who in turn could profit
in the natural gas financial markets. FERC believed that a
pipeline could, for instance, inform its affiliate of an upcoming
transmission constraint that would affect the price of the
commodity in the New York Mercantile Exchange, enabling the
affiliate to enter into a profitable futures contract and gain a
competitive advantage. See Order 2004, at 30,827-30,828.

Two FERC Commissioners strongly disagreed with
FERC’s new intervention in the natural gas market.
Commissioner Kelliher stated that “the flaw in the Standards of
Conduct Final Rule is the lack of record evidence to support
expanding the scope beyond Marketing Affiliates.” Order 2004-
A, at 31,225 (statement of Kelliher, Comm’r, dissenting in part).
In his view, “suspicion is not a sufficient basis for expanding the
scope of Standards of Conduct beyond Marketing Affiliates.”
 13

Id. He explained that the record evidence of abuse related to
marketing affiliates, not non-marketing affiliates, and stated: “I
do not see how a record of affiliate abuse limited to Marketing
Affiliates argues in favor of expanding the scope of the rule
beyond Marketing Affiliates. To my mind, it argues in favor of
keeping the scope of the rule where it was. Indeed, there
appears to be no factual basis to support expanding the scope
beyond Marketing Affiliates.” Id. Finally, citing this court’s
decision in Dominion Resources, Inc. v. FERC, 286 F.3d 586
(D.C. Cir. 2002), Commissioner Kelliher expressed his concern
that the Order would diminish industry efficiencies without
advancing the FERC policy of preventing unduly discriminatory
behavior. Order 2004-A, at 31,226 (statement of Kelliher,
Comm’r, dissenting in part). Commissioner Brownell also
dissented. She stated that there was “insufficient evidence to
support eliminating the exemption for affiliated producers,
gatherers, and processors.” Order 2004, at 30,860 (statement of
Brownell, Comm’r, dissenting in part).

Several entities timely filed petitions for review in this
court. They include the Interstate Natural Gas Association of
America, a trade group that represents interstate pipelines. (No
electric utilities petitioned for review of the Standards as applied
to them.) Invoking the standards in the Administrative
Procedure Act, 5 U.S.C. §§ 701 et seq., the petitioners challenge
multiple aspects of the Orders: (1) the extension of the Standards
to non-marketing affiliates; (2) the extension of the Standards to
entities that do not hold or control capacity on their affiliated
pipelines, including the elimination of the exemption for local
distribution companies that make off-system sales only on
non-affiliated pipelines; (3) the favorable treatment of local
distribution companies as compared to producers, gatherers, and
processors with respect to the exemption for local distribution
companies that make only on-system sales; (4) the restriction of
the activities of risk management employees and lawyers; and
 14

(5) the waiver log requirement. In addition, petitioner Calypso
U.S. Pipeline challenges the application of the Standards to a
certificate holder that has not commenced the transportation of
natural gas but has begun soliciting business. We have
jurisdiction under 15 U.S.C. § 717r(b).

II

1. The Administrative Procedure Act governs our analysis.
We review FERC’s Order to determine whether it is “arbitrary,
capricious, an abuse of discretion, or otherwise not in
accordance with law.” 5 U.S.C. § 706(2)(A). An agency’s
“policy decisions are entitled to deference so long as they are
reasonably explained.” Covad Communications Co. v. FCC,
450 F.3d 528, 539 n.6 (D.C. Cir. 2006). Under the arbitrary and
capricious prong of the standard, we must ensure that FERC has
“examine[d] the relevant data and articulate[d] a satisfactory
explanation for its action including a rational connection
between the facts found and the choice made.” Motor Vehicle
Mfrs. Ass’n of U.S. v. State Farm Mut. Auto. Ins. Co., 463 U.S.
29, 43 (1983) (internal quotation marks omitted). “Normally, an
agency rule would be arbitrary and capricious if the agency has
. . . offered an explanation for its decision that runs counter to
the evidence before the agency.” Id. The APA “establishes a
scheme of ‘reasoned decisionmaking.’” Allentown Mack Sales
& Serv., Inc. v. NLRB, 522 U.S. 359, 374 (1998) (quoting State
Farm, 463 U.S. at 52).

We also adhere to the principle set out in SEC v. Chenery
Corp., 318 U.S. 80, 95 (1943): “[A]n administrative order
cannot be upheld unless the grounds upon which the agency
acted in exercising its powers were those upon which its action
can be sustained.” See also La. Pub. Serv. Comm’n v. FERC,
184 F.3d 892, 898 (D.C. Cir. 1999); Consol. Edison Co. of N.Y.
v. FERC, 823 F.2d 630, 641 (D.C. Cir. 1987). We will neither
 15

supply our own justifications for an order nor uphold an order
based on FERC’s post hoc rationalizations. See EchoStar
Satellite, L.L.C. v. FCC, 457 F.3d 31, 36 (D.C. Cir. 2006). An
important corollary is that where FERC has relied on multiple
rationales (and has not done so in the alternative), and we
conclude that at least one of the rationales is deficient, we will
ordinarily vacate the order unless we are certain that FERC
would have adopted it even absent the flawed rationale. See
Consol. Edison Co. of N.Y., 823 F.2d at 641-42; Allied-Signal,
Inc. v. U.S. Nuclear Regulatory Comm’n, 988 F.2d 146, 150-51
(D.C. Cir. 1993).

To justify Order 2004, FERC has relied on both an asserted
theoretical threat of undue preferences and a claimed record of
abuse. The Commission did not seek to justify the Order based
solely on the theoretical danger. Therefore, if we find that the
claimed record evidence does not support the Order, we cannot
uphold it. See Chenery, 318 U.S. at 95.

2. In Tenneco, we carefully examined FERC’s adoption of
Standards of Conduct to govern relationships between pipelines
and their marketing affiliates. Our analysis in that case guides
our evaluation of Order 2004’s extension of the Standards of
Conduct to relationships between pipelines and their non-
marketing affiliates.

We began by emphasizing that vertical integration creates
efficiencies for consumers. See Tenneco Gas v. FERC, 969 F.2d
1187, 1197 (D.C. Cir. 1992) (“In a competitive market, the
efficiencies of the pipeline-affiliate relationship should produce
benefits for consumers.”) (citing 3 P. AREEDA & D. TURNER,
ANTITRUST LAW ¶ 725d, at 201 (1978)). See generally ROBERT
H. BORK, THE ANTITRUST PARADOX 225-31 (2d ed. 1993). As
to vertical information sharing, we stated that “the sharing of
information between pipelines and their marketing affiliates has
 16

efficiency benefits.” 969 F.2d at 1197. In considering structural
separation requirements, we similarly recognized that “there are
efficiencies to be derived from such integration and any
separation reduces those benefits to some extent.” Id. at 1205.

We pointed out that the Commission, by contrast,
“appear[ed] to believe that any advantage a pipeline gives its
marketing affiliate is improper.” Id. at 1201. We rejected this
theory and explained that “advantages a pipeline gives its
affiliate are improper only to the extent that they flow from the
pipeline’s anti-competitive market power. Otherwise vertical
integration produces permissible efficiencies that ‘cannot by
themselves be considered uses of monopoly power.’” Id.
(quoting Berkey Photo, Inc. v. Eastman Kodak Co., 603 F.2d
263, 276 (2d Cir. 1979)).

Tenneco thus stands for the proposition that FERC cannot
impede vertical integration between a pipeline and its affiliates
without “adequate justification.” See 969 F.2d at 1199. We
upheld Order 497 in relevant part because FERC presented an
adequate justification – by advancing both (i) a plausible
theoretical threat of anti-competitive information-sharing
between pipelines and their marketing affiliates and (ii) vast
record evidence of abuse.

As to the theoretical threat, we accepted FERC’s
explanation “that there is at least a theoretical danger that
pipelines will favor their marketing affiliates in providing
information, and that the result would be anti-competitive.” Id.
at 1197. FERC had relied on a Department of Justice report that
stated: “The affiliate relationship . . . creates an incentive for the
pipeline to withhold information that otherwise would be made
available to the affiliate’s competitors. Withholding this
information from non-affiliated shippers reduces their ability to
arrange transactions efficiently.” Id. (quoting Comments of the
 17

United States Department of Justice in Response to the Notice
of Inquiry (Dec. 29, 1986) at 15). The threat of pipelines
enabling their affiliates to secure capacity sooner than their
competitors or otherwise to benefit from non-public knowledge
about the transmission system was readily apparent – and this
threat stemmed from the pipelines’ monopoly position.

As to record evidence, we explained that “[t]he record also
contains evidence that the discriminatory and anti-competitive
distribution of information is not just a theoretical danger, but a
real one.” Id. at 1197 (emphasis added); see also id. (recounting
representative example of non-affiliated marketer that lost out
on capacity when pipeline apprised affiliate of availability of
capacity before disclosing that information to affiliate’s rivals);
id. (citing pipeline’s disclosure in record that it had provided
information to its marketing affiliate, which may have allowed
the affiliate to displace existing sales). The rulemaking had
been prompted by “unaffiliated marketers [that] complained to
FERC that pipelines were granting unfair preferences to their
affiliates by, among other things, providing inside information
on pipeline capacity.” Id. at 1194. Order 497 also relied upon
“instances of abuse actually adjudicated by the Commission.”
Order 497, at 31,128.

3. In issuing Order 2004, as well as in defending that Order
before this court, FERC has relied on what it asserts is a record
of abuse between pipelines and their non-marketing affiliates.
FERC has asserted that the record here is similar to the record
of abuse found in Order 497 between pipelines and their
marketing affiliates. See Order 2004, at 30,821 (responding to
comments arguing that there have been few cases of abuse by
citing agency investigations uncovering unfairly preferential
treatment toward marketing affiliates); Order No. 2004-A, at
31,179 (“In the past, agency arrangements have been abused.”);
id. at 31,181 (“Unduly preferential behavior can and does harm
 18

customers.”); Respondent’s Br. at 27 (“[The] suggestion that the
Commission in this proceeding based its Energy Affiliate rule
on mere conjecture [is] totally unfounded. In fact, the record
contains numerous supporting comments . . . identifying affiliate
relationships with natural gas pipelines as a breeding ground for
undue discrimination.”); id. at 8 (“The Standards of Conduct
proposed by the Commission in 2001 relied on the same general
principles as those upheld by this court in Tenneco.”); id. at 16
(asserting that Order 2004 is based on “substantial evidence in
the record”); id. at 20 (Order 2004 must be and is “based upon
the record” and supported by “substantial evidence.”).

At the outset, we take note of the assessment of the two
dissenting FERC Commissioners. They claimed that FERC was
relying on a record of abuse that in fact did not exist.
Commissioner Kelliher stated that “the flaw . . . is the lack of
record evidence to support expanding the scope beyond
Marketing Affiliates.” Order 2004-A, at 31,225 (statement of
Kelliher, Comm’r, dissenting in part). He added: “I do not see
how a record of affiliate abuse limited to Marketing Affiliates
argues in favor of expanding the scope of the rule beyond
Marketing Affiliates. To my mind, it argues in favor of keeping
the scope of the rule where it was. Indeed, there appears to be
no factual basis to support expanding the scope beyond
Marketing Affiliates.” Id. Commissioner Brownell similarly
stated that there was “insufficient evidence to support
eliminating the exemption for affiliated producers, gatherers,
and processors.” Order 2004, at 30,860 (statement of Brownell,
Comm’r, dissenting in part).

Our review of the record on which FERC relied reveals that
Commissioners Kelliher and Brownell were plainly correct:
Unlike in Order 497, FERC here has provided no evidence of a
real problem with respect to pipelines’ relationships with non-
marketing affiliates. Indeed, Order 2004 does not include a
 19

single example of abuse by non-marketing affiliates. Nor does
the record disclose complaints from competitors of pipelines’
non-marketing affiliates. Rather, FERC relied on either
examples of abuse by marketing affiliates (already covered by
the old Standards) or comments from the rulemaking that merely
reiterated a theoretical potential for abuse.

A review of some of the primary evidence cited by FERC
helps demonstrate the flaws in its reasoning.

• FERC explained that the Enforcement Division of its
Office of Market Oversight and Investigations had “uncovered
affiliate abuse activity that reveals that some Transmission
Providers are giving their affiliates undue preferences and
violating the standards of conduct.” Order 2004, at 30,821; see
also Order 2004-A, at 31,179-31,180. That supposed “activity”
provides no support for Order 2004 for the simple reason that all
of the cases listed addressed undue preferences granted to
marketing affiliates. See Transcon. Gas Pipe Line Corp., 102
FERC ¶ 61,302 (2003); Nat’l Fuel Gas Supply Corp., 103 FERC
¶ 61,192 (2003); Idaho Power Corp., 103 FERC ¶ 61,182
(2003); Cleco Corp., 104 FERC ¶ 61,125 (2003). Those
decisions have no bearing on whether the Standards should be
extended to relationships with non-marketing affiliates. Like
Commissioner Kelliher, we do not see how “a record of affiliate
abuse limited to Marketing Affiliates argues in favor of
expanding the scope of the rule beyond Marketing Affiliates.”
Order 2004-A, at 31,225 (statement of Kelliher, Comm’r,
dissenting in part).

• The Commission identified one case involving a
non-marketing affiliate (a gatherer). See Order 2004, at 30,832
& n.33 (citing Shell Offshore Inc. v. Transcon. Gas Pipe Line
Corp., 100 FERC ¶ 61,254 (2002)). But that evidence does not
help FERC: This court’s subsequent review of that proceeding
 20

expressly rejected the contention that the affiliate relationship
between the gatherer and a pipeline was related to the alleged
abuse. See Williams Gas Processing – Gulf Coast Co., L.P. v.
FERC, 373 F.3d 1335, 1342-43 (D.C. Cir. 2004).

• FERC cited comments from the California Public
Utilities Commission (CPUC). The CPUC, however, did not
identify any actual examples of wrongdoing. The CPUC stated
that pipelines with affiliates are subject “to criticism as serving
not the public interest of providing competitive, open-access
transportation services . . . .” Comments of the California Public
Utilities Commission (Dec. 21, 2001) at 10. It also claimed that
it had “learned of numerous methods by which a pipeline and
affiliate can work in concert to benefit the common goal of their
parent corporation.” Id. But those remarks are mere
restatements of the theoretical threat; they do not constitute
record evidence of abuse by pipelines and their non-marketing
affiliates. The CPUC did note one complaint, but that incident
concerned a marketing affiliate. See id. at 11 (referring to a
complaint filed in Public Utilities Commission of the State of
California v. El Paso Natural Gas Co., 91 FERC ¶ 61,312 (June
28, 2000), a case that involved El Paso Natural Gas Company,
El Paso Merchant Energy-Gas, L.P., and El Paso Merchant
Energy Co.).

• FERC pointed to comments from the Illinois Commerce
Commission, which “applauded” FERC’s approach. But the
Illinois commission similarly did not provide any examples of
misconduct with respect to non-marketing affiliates. It restated
the potential threat of abuse by marketing affiliates: “Indeed, as
a theoretical matter, an even greater degree of independence
between the transmission function and market participant
activities of the merchant function than that proposed . . . could
foster more vibrant wholesale and retail competition . . . .”
 21

Comments of the Illinois Commerce Commission (Dec. 20,
2001) at 8.

• FERC cited the submission of the National Association
of State Utility Consumer Advocates (NASUCA). But that
group simply explained that “[t]he relatively small number of
formal complaints that have been brought before [FERC] does
not necessarily indicate that there are few anti-competitive
transactions between interstate transmission providers and their
affiliates.” Comments of the National Association of State
Utility Consumer Advocates (Dec. 20, 2001) at 2. The
NASUCA mentioned state proceedings involving retail rates,
but it acknowledged that they did not “bear directly” on Order
2004 and alleged only that affiliate relationships “may have had
anti-competitive impacts in the wholesale gas and electric
markets.” Id. at 1-2 (emphasis added). The NASUCA
concluded that there exists “the potential for interstate pipelines
to engage in anti-competitive behavior” with non-marketing
affiliates and “[s]uch activities may have anti-competitive
implications for the interstate market . . . .” Id. at 4-5 (emphases
added).

• FERC referred to comments from the Federal Trade
Commission’s Bureau of Economics and Office of the General
Counsel. But those comments offered no examples or factual
evidence; they noted only that “it is possible that a transmission
provider’s market power . . . could be transferred to and
exercised by its affiliated businesses . . . .” Comments of the
Staff of the Federal Trade Commission (Dec. 20, 2001) at 3
(emphasis added). What is more, the report cited by the FTC
Staff addressed the electric power industry – not the natural gas
industry – and relied largely on FERC’s assertions, not the
FTC’s independent examination of the industry. See id. at 2-3
& nn.4-5 (citing FTC Staff Report: Competition and Consumer
Protection Perspectives on Electric Power Regulatory Reform,
 22

Focus on Retail Competition (Sept. 2001) at 13, available at
http://www.ftc.gov/reports/index.htm).

• FERC referenced the comments of the American
Antitrust Institute. That organization, however, did not provide
any examples of pipelines granting undue preferences to their
non-marketing affiliates by divulging information about
transmission systems. It simply stated that “[s]uch information
sharing, if unimpeded, could allow the transmission company to
potentially frustrate or preclude its existing or prospective
downstream rivals’ access to the network.” Comments of the
American Antitrust Institute (Dec. 20, 2001) at 2 (emphases
added). Moreover, the Institute actually urged FERC to
consider more carefully the costs of the Standards: “Given the
importance of efficiencies generated by vertical integration, AAI
believes it is appropriate for FERC to make at least a cursory
attempt to scope out the costs and benefits of uniform imposition
of standards of conduct.” Id. at 4.

• FERC cited the comments of the Natural Gas Supply
Association, an organization that represents independent gas
producers and marketers. Those comments likewise did not
point to any examples of abuse involving non-marketing
affiliates. Comments of the Natural Gas Supply Association
(Dec. 20, 2001) at 5.

4. As the dissenting Commissioners explained, FERC was
wrong to conclude that the evidence supporting Order 2004 is
similar to the evidence that supported Order 497. In Tenneco,
FERC pointed to numerous complaints by competitors and many
documented instances of abuse between pipelines and their
marketing affiliates. See 969 F.2d at 1197-98; cf. Chamber of
Commerce v. SEC, 412 F.3d 133, 140-42 (D.C. Cir. 2005)
(explaining that the SEC identified significant abuses in the
mutual fund industry and adopted rules to prevent them). We
 23

relied on that record evidence in upholding FERC’s Order.
Here, by contrast, FERC has cited no complaints and provided
zero evidence of actual abuse between pipelines and their
non-marketing affiliates. FERC staked its rationale in part on a
record of abuse, but that record is non-existent. Professing that
an order ameliorates a real industry problem but then citing no
evidence demonstrating that there is in fact an industry problem
is not reasoned decisionmaking. See State Farm, 463 U.S. at 42-
43.

Perhaps recognizing the deficiency of the record evidence,
FERC’s attorneys have defended the Order before this court in
part by attempting to explain away the insubstantial nature of the
record evidence. Of course, FERC’s Order relied in part on
record evidence of abuse, so explaining away the absence of
such evidence merely underscores the need to vacate the Order
and remand. In any event, even on their own terms, the
explanations do not hold water. FERC’s brief claims, for
example, that there may have been little evidence because “the
affiliate activity in question was not yet covered by [the]
Standards of Conduct.” Respondent’s Br. at 28. But that was
also true at the time of Order 497, yet FERC had received
numerous complaints and amassed substantial evidence of abuse
arising from the relationship between pipelines and their
marketing affiliates. If abuse arising from the relationship
between pipelines and non-marketing affiliates were similarly
rampant, FERC likely would have been inundated with
complaints and evidence, as it was before issuing Order 497.
See Tenneco, 969 F.2d at 1194.

In a separate effort to justify the absence of evidence,
FERC’s brief also resorts to a claim that “the absence of specific
documented instances of abuse by non-marketing Energy
Affiliates does not mean they have not occurred.” Respondent’s
Br. at 29. The Administrative Procedure Act does not tolerate
 24

that kind of truism as the basis for the administrative action
here.

III

On remand, FERC may decide not to proceed with rules in
this area. Alternatively, it may seek to develop a factual record
that could fully satisfy the standard of Tenneco.

In the absence of factual evidence that satisfies Tenneco,
FERC may try to support the Standards by setting out its best
case for relying solely on a theoretical threat of abuse. In
Tenneco, of course, FERC presented both a theoretical threat
and actual evidence of abuse to justify adopting the Standards
for marketing affiliates; we express no view here whether a
theoretical threat alone would be sufficient to justify an order
extending the Standards to non-marketing affiliates.

In Tenneco, in remanding certain provisions of Order 497,
this court provided specific guidance to FERC on what it could
do on remand if it chose to re-promulgate those provisions. See
Tenneco Gas v. FERC, 969 F.2d 1187, 1199, 1201 (D.C. Cir.
1992). We provide similar guidance here. If FERC chooses to
rely solely on a theoretical threat, it will need to explain how the
potential danger of improper communications between pipelines
and their non-marketing affiliates, unsupported by a record of
abuse, justifies such costly prophylactic rules. FERC would
need to explain why the individual complaint procedure under
Section 5 of the Natural Gas Act does not suffice to ensure that
pipelines are not abusing their relationships with non-marketing
affiliates. See 15 U.S.C. § 717d(a); cf. Order 497, at 31,130
(relying in part on complaint procedure in declining to extend
Standards to non-marketing affiliates). If FERC believes that
the nature of the alleged misconduct renders it undetectable
through normal reporting mechanisms, FERC would have to
 25

say, for example, why such evidence of abuse was detected
before it adopted Order 497. If FERC points to the number of
mergers between gas and electric companies in recent years, it
must address our decision in Dominion Resources, Inc. v. FERC,
286 F.3d 586 (D.C. Cir. 2002), where we stated that “the logic
of correcting anticompetitive hazards posed by a merger
implicitly suggests remedies only between the merging
companies,” not within pre-existing entities. Id. at 593. If
FERC cites the rise of a variety of new services, mostly relating
to the commodity market, it will need to elucidate how those
developments relate to and justify the promulgation of costly
prophylactic rules governing pipelines’ relationships with their
non-marketing affiliates. If FERC relies on an increase in the
amount of pipeline capacity held by non-marketing affiliates, it
must explain how that poses a threat of actual abuse by pipelines
and their non-marketing affiliates (and why the rule should also
apply to affiliates that do not ship on their affiliated pipelines).
If FERC chooses to extend the Standards to entities that do not
hold or control capacity, the Commission would need to justify
such an extension given that a stronger theoretical threat exists
with respect to affiliates that hold or control capacity on
affiliated pipelines than to affiliates that do not hold or control
such capacity. See Comments of the Staff of the Federal Trade
Commission (Dec. 20, 2001) at 4 n.8. We cannot say that any
of these theoretical rationales, alone or in combination, would
justify adoption of the Standards of Conduct under the Tenneco
standard; they merely illustrate the kind of analysis FERC would
need to undertake if it attempts to support the Order based solely
on a theoretical threat (that is, absent record evidence of abuse).

IV

We grant the pipelines’ petition, vacate Orders 2004,
2004-A, 2004-B, 2004-C, and 2004-D as applied to natural gas
 26

pipelines, and remand to the Federal Energy Regulatory
Commission.

So ordered.