By Robert Mullin

A FERC judge ruled last week that Shell Energy North America and Iberdrola Renewables saddled California consumers with $1.1 billion in excess energy costs at the height of the Western Energy Crisis.

The initial decision by Administrative Law Judge Steven Glazer said the Mobile-Sierra presumption of “justness and reasonableness” does not apply to overpriced long-term contracts the two companies signed with the California Department of Water Resources (CDWR) shortly before the crisis ended in 2001 (EL02-60-007, EL02-62-006).

By that time, CDWR had assumed the role of electricity buyer of last resort after widespread manipulation drove Pacific Gas and Electric and the now-defunct California Power Exchange into bankruptcy, while the state’s other two investor-owned utilities teetered on the brink of insolvency.

Glazer’s ruling also reinstated Iberdrola as a party to the proceedings, reversing a previous dismissal from the case.

The California Public Utilities Commission initiated the case to recover costs from the crisis. Shell and Iberdrola are the only suppliers not to have settled or renegotiated the terms of their contracts with CDWR, which expired in 2011 and 2012.

While the initial decision is subject to further review and modification by the full commission, Glazer’s opinion increases the likelihood that the two companies will be forced to disgorge at least some of the profits from the contracts. According to the ruling, the Shell and Iberdrola contracts strapped California consumers with an “excess burden” of $779 million and $371 million, respectively. Both estimates include interest accrued through April 2015.

“I am gratified that the ALJ agreed that FERC has a duty to vindicate the public interest and protect consumers from exorbitant overcharges that Shell and Iberdrola pocketed due to the worst electricity crisis and market meltdown in modern history,” PUC Commissioner Mike Florio said in a statement.

The state has obtained $7.7 billion in settlements over other long-term contracts. It also has received about $4 billion in settlements over short-term contracts, with complaints pending against 13 companies involved in short-term deals, according to Florio.

The public interest consideration was pivotal — but not decisive — in Glazer’s complex, 219-page decision to nullify the legal presumption of validity accorded to bilateral energy contracts.

Mobile-Sierra Reinterpreted

Grounded in Supreme Court precedent, the Mobile-Sierra doctrine holds that bilateral energy contracts can be voided only when a contract rate is shown to adversely affect the public interest. The burden of proof rests with the party seeking to break the contract, who must clearly show harm to the public. In 2003, FERC ruled that it was not in the public interest under the Mobile-Sierra rule to break CDWR’s contracts with Shell and Iberdrola. California appealed the ruling to the 9th U.S. Circuit Court of Appeals.

A 2008 Supreme Court decision in Morgan Stanley Capital Group Inc. v. Public Utility District No. 1 of Snohomish County would introduce a new dimension to the California proceeding, which was eventually sent back to FERC on remand. Based on Morgan Stanley, FERC now had to add an additional test to the Mobile-Sierra rule: whether the terms of a contract were the result of market manipulation.

In his ruling, Glazer spelled out that the “questions to be decided here focus on the Mobile-Sierra rule as reinterpreted by Morgan Stanley.”

“Specifically, those questions first ask whether the Mobile-Sierra-Morgan Stanley presumption of the justness and reasonableness of each of the contracts at issue is ‘avoided’ by reason of unlawful activity on the part of each wholesale marketer in making its contract with CDWR,” Glazer wrote. “Alternatively, the next question asks whether the Mobile-Sierra-Morgan Stanley presumption is ‘overcome’ by reason of the contract’s burden on consumers or other harm to the public interest.”

The decision to overturn California’s contracts with Shell and Iberdrola provided a mix of answers to both questions.

‘Avoided’ and ‘Overcome’

Glazer’s ruling against Shell rests on evidence that the company manipulated electricity spot prices during the crisis, employing many of the same strategies as Enron. The most harmful of those practices included false exports, false load scheduling and “anomalous” bidding strategies designed to drive up market clearing prices. The decision notes that Shell’s head of electricity trading joined the company after working at Enron.

Expert witnesses in the proceeding disagreed about the impact of spot market manipulation on the forward power prices underlying the contracts. Glazer agreed with California’s experts, who he said demonstrated that short-term prices affected forward prices in “a statistically significant manner.”

Glazer also found that Shell’s own trading activities contributed to the price spikes.

“Shell’s behavior in short-term trading with CDWR affected forward prices,” Glazer wrote. “Forward prices reflect expectations about future spot prices. Shell’s manipulative activity and that of other suppliers in spot markets elevated spot market prices and made them much more volatile.”

Shell’s culpability did not end there. Glazer noted that the Shell team negotiating the long-term contract with CDWR was in close contact with the company’s traders during the crisis and knew about the manipulative trading strategies in the spot market. He cited internal Shell emails showing that company negotiators understood the long-term contract was a “big bet” that the energy prices would eventually “tank.”

And tank they did, leaving California holding long-term contracts priced far higher than markets in subsequent years.

“The continuing decline of forward prices after the deal was signed proved to be costly to CDWR,” Glazer wrote. “It signaled that paying the high locked-in power prices of the Shell contract over the next two to three years would be more expensive for CDWR than acquiring power in the forward market would have been.”

The demonstration of those excess costs for the public, coupled with the illegal market activity producing them, laid the legal groundwork for Glazer’s decision: that the Mobile-Sierra presumption of justness and reasonableness was both “avoided” and “overcome” in the case of the Shell contract with CDWR — failing both tests established by Morgan Stanley.

Iberdrola Contract ‘Overcome’

In his decision to overturn Iberdrola’s contract, Glazer determined that while Mobile-Sierra was not “avoided,” the doctrine was “overcome” because of the long-term costs carried by the state of California, which was forced to issue bonds to fund the electricity and capacity purchases.

Glazer said Iberdrola’s power marketing unit engaged in manipulative practices during the crisis, including “parking” false exports of California power to be sold back into the state at elevated prices. And, as with Shell, Iberdrola employees negotiating with CDWR were shown to have coordinated their activities with the company’s electricity traders.

Still, Glazer found no evidence that CDWR actually relied on forward prices to evaluate the contracts, breaking a link in the chain tying the contracts to the spot markets. Iberdrola’s contract included a tolling arrangement by which CDWR controlled the dispatch of energy from its cogeneration facility in Klamath Falls, Ore.

“There are no records of CDWR modeling [Iberdrola’s] Klamath contract pricing against forward price curves and no testimony from any witness for the complainants that the evaluation was done,” Glazer said. “During the period it was negotiating long-term contracts, CDWR believed that forward price curves were an unreliable basis for setting prices for its long-term contract portfolio.”

Iberdrola and Shell could seek a settlement with California for a discount from the $1.1 billion rather than take their chances that the commission will reject the ALJ ruling.

“We take our business and compliance with regulations very seriously,” a Shell spokesman said in a statement. “As this is an ongoing legal matter, we will not be able to make any further comment at this time.”

Iberdrola expressed confidence it would prevail.

“We are currently reviewing the ALJ’s recommendation but continue to believe that the full commission will accept our arguments and those of FERC staff presented at the hearing,” an Iberdrola spokesperson told RTO Insider.

While the company declined to elaborate on that point, Glazer’s ruling does note that FERC staff believe Iberdrola’s contract did not pose a “down the line” burden on California consumers relative to the rates they could have obtained after elimination of the dysfunctional market, contrary to the ALJ’s own conclusions.