Energy Commodities: The Netherworld Between FERC And CFTC Jurisdiction

Article by Terence T. Healey , Joseph B. Williams and Paul J. Pantano, Jr. 1

INTRODUCTION

Midway upon the journey of our life I found myself within a forest dark, For the straightforward pathway had been lost.2

In 1999, we wrote an article about managing legal risk in the electric power market, which at the time was a new competitive wholesale commodity market subject primarily to the jurisdiction of the Federal Energy Regulatory Commission ("FERC"). A lot has happened in the energy commodity markets and the regulatory environment since 1999. It would be hard, however, to describe intervening events as progress, particularly when it comes to the "lines" between FERC and Commodity Futures Trading Commission ("CFTC") jurisdiction. This article describes the evolution in the regulation of the energy markets from 1999 to the framework that exists today.

As the great philosopher, Yogi Berra, once said: "This is like déjà vu all over again." In 1999, lawyers and market participants spent a fair amount of time worrying about whether electricity and natural gas forward contracts with embedded bells and whistles were really forward contracts, excluded from the CFTC's jurisdiction and, possibly, within the FERC's jurisdiction, or instead were illegal off-exchange futures contracts, squarely within the CFTC's jurisdiction and surely not within the FERC's jurisdiction. Commodity options raised similar transaction characterization issues. Then, in 2000, we achieved legal Nirvana: Congress passed the Commodity Futures Modernization Act ("CFMA"). The industry no longer had to worry about whether contracts between sophisticated commercial parties had attributes that converted them, metaphysically, from lawful forward contracts into illegal futures contracts. Lawyers were able to spend their time on more productive activities, such as getting deals done, or resolving industry-wide disputes, such as those following the California energy crisis.

In 2010, Congress decided that commodity and derivatives lawyers had spent too much time in legal Nirvana. Instead, Congress determined that lawyers should descend into nine levels of legal hell. And, while Congress debated the Dodd- Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act"), the FERC and CFTC engaged in hand-to-hand combat over the "lines" between their respective jurisdictions. They both lost. In the true spirit of regulatory bipartisanship, Congress punted—drawing clear lines is not its specialty. Instead, Congress resorted to jurisdictional savings clauses and exemptive authority, and it told the agencies and market participants to duke it out in the regulatory arena.

In a statute with no definition of futures contract or forward contract, Congress added a six-part (with 22 subparts) definition of swap. The definition is so broad that almost every possible energy contract that is settled in cash, rather than with a physical delivery, arguably is a swap. Congress also introduced the subjective concept of "intent" to physically settle into commercial contracts (forwards and options) that already have binding delivery obligations. Not to be outdone by Congress, the FERC in an important administrative decision added an intent element to the determination of whether electricity transactions are within the scope of its jurisdiction. And the CFTC, not to be outdone by either Congress or the FERC, has introduced multiple tests (some with three, five and seven parts!) for determining whether commodity transactions of all types are in, half in, or out of its jurisdiction. All of these legal brain teasers are enough to make an energy lawyer nostalgic for the "painful" days before the CFMA. When descending into the nine circles of legal hell, all pain is relative.

In our 1999 article, we mentioned the transformation of the wholesale electric power market from a heavily regulated market into a competitive one.3 What we have learned in the intervening 14 years is that the regulatory maze faced by the industry has become much more, not less, complex. Regrettably, market participants face more legal and regulatory risk than ever. This article updates the discussion of legal and regulatory risks faced by industry participants.

FENCING OVER JURISDICTION CONTINUES

Both physical and financial transactions in the wholesale power and gas industries are the subject of considerable regulation by the CFTC and FERC—and sometimes both. Congress has not alleviated the legal headaches that market participants and the legal community face from the CFTC's and FERC's sometimes overlapping jurisdiction (and the agencies' differing views of their jurisdiction).

CFTC Jurisdiction

The CFTC has "exclusive" jurisdiction over "accounts, agreements (including ... options) ... and transactions involving swaps or contracts of sale of a commodity for future delivery."4 To be legal and enforceable, futures contracts must be traded on a commodity exchange that has been designated as a contract market ("DCM") by the CFTC.5 Under the Commodity Exchange Act ("CEA"), as amended by the Dodd-Frank Act, swaps subject to mandatory clearing must be traded on a swap execution facility ("SEF") or a DCM. Swaps used by a company to manage the commercial risks associated with its business are exempt from the mandatory clearing requirement and may be executed bilaterally in the over-the-counter ("OTC") market.

The CEA does not define the elements of a "futures contract." Nevertheless, to ensure that the CEA does not apply to commercial contracts for the delivery of a commodity, the CEA provides that the "term 'future delivery' does not include any sale of any cash commodity for deferred shipment or delivery."6 Such deferred delivery or "forward contracts" are excluded from the provisions of the CEA and the CFTC's regulations. Ironically, even though the CEA, as amended by the Dodd-Frank Act, still does not define a "futures contract," it now contains a six-prong definition (with multiple subparts) of "swap." Similar, but not identical, to the exclusion from "future delivery," Congress excluded from the term "swap" "any sale of a nonfinancial commodity . . . for deferred shipment or delivery, so long as the transaction is intended to be physically settled."7 More on this topic later.

"Spot" or "cash" contracts for the immediate sale and delivery of a commodity also are outside of the CFTC's jurisdiction.8 The CFTC defines the spot or cash market for a commodity by reference to commercial practices in the market for that commodity.9 Options "involving any commodity regulated" under the CEA, which previously could only be offered and sold in accordance with the terms and conditions in the CFTC's options regulations, now are subject to the same regulations as swaps except for "trade options," which generally are OTC commodity options offered to commercial parties for hedging or inventory management purposes that, if exercised, are intended to be physically settled.10

FERC Jurisdiction

The FERC is an independent regulatory agency within the Department of Energy.11 Under the Federal Power Act ("FPA"), the FERC has jurisdiction over the interstate transmission of electric energy and the interstate sale of electric energy at wholesale, i.e., the sale of power to any person for resale.12 The FERC's authority includes "the establishment, review, and enforcement of rates and charges for the transmission and sale of electric energy ... and the interconnection of facilities for the generation, transmission, and sale of electric energy."13 The FERC has jurisdiction over all facilities for the transmission and sale of electricity in interstate commerce. The FERC is also responsible for overseeing the reliability of the nation's electricity transmission grid.14 In addition, the FERC reviews and, in certain cases must approve, various corporate activities and transactions by public utilities, such as mergers, securities issuances and interlocking directorates.15

All public utilities must file with the FERC schedules of their rates and charges for the interstate transmission and wholesale sale of electricity. 16 Those rates and charges must be "just and reasonable."17 Any rate or charge that is not just and reasonable is unlawful.18 In addition, the rates and charges of public utilities for services within the FERC's jurisdiction must not give undue preference to any person, or unreasonably discriminate between classes of service.19

In New York Mercantile Exchange, the FERC disclaimed rate jurisdiction over an electricity futures contract unless it results in physical delivery.20 Interestingly, the FERC reserved decision on whether it had "jurisdiction over other types of risk management instruments; e.g., options contracts, forwards contracts, or swap agreements."21 In Puget Sound Energy, Inc., a FERC administrative law judge reasoned that because book-out transactions do not result in the physical delivery of electricity, such transactions are "... not subject to the Federal Power Act in the first instance."22 The FERC did not address that particular ALJ decision.23 In a later, unrelated order, the FERC declined to address whether the transactions underlying book-outs are in fact jurisdictional.24 It did, however, order public utilities to report book-outs of any power sales contracts that provide for physical delivery but not "purely financial transactions."25 In a more recent case, DC Energy, LLC v. PJM, the FERC determined that DC Energy's transactions with an affiliate that were documented with an ISDA (with power annex) constituted a financial transaction and, therefore, did not satisfy a PJM tariff provision requiring that internal bilateral transactions "contemplate[] the physical transfer of energy."26 In a finding that tracks the forward contract exclusion from the definition of swap under the CEA, the FERC concluded that DC Energy had no way to physically deliver electricity and, instead, intended for...