Energy Reserves Group v. Kansas Power and Light

459 U.S. 400

Case Year: 1983

Case Ruling: 9-0, Affirmed

Opinion Justice: Blackmun

FACTS

In 1975 Kansas Power and Light Company (KPL), a public utility, and Energy Reserves Group, Inc. (ERG), a natural gas producer, entered into two natural gas supply contracts. The contracts called for KPL to purchase natural gas from ERG’s wells in southern Kansas. The original contract price was $1.50 per thousand cubic feet (Mcf) of gas. The contracts were to continue for the life of the gas field or the life of the processing plants associated with the field.

The contracts included two price escalator clauses. The first called for the price to be increased in the event that any government authority fixed the price for natural gas higher than the contract price. The second gave ERG the option to have the contract price redetermined, but such revision in the price was to occur no more than once every two years. The redetermined price was to be set by averaging the prices being paid under three other gas contracts chosen by the parties.

When a price increase occurred pursuant to either clause, KPL was required to seek permission from the Kansas Corporation Commission to pass the increase along to consumers. If the commission refused to permit the pass-through and KPL refused to pay the increased price, ERG had the option of terminating the agreement on thirty days’ notice.

The contracts stated that the purpose of the price escalator clauses was “solely” to compensate ERG for “anticipated” increases in its operating costs and the value of its gas. The contracts also stipulated that neither party would be held in default for failure to comply with the contract if noncompliance was due to state or federal laws.

The federal Natural Gas Policy Act went into effect in 1978. This legislation set new federal price controls for natural gas along with inflation escalators. The purpose of the law was to deregulate gas prices gradually and to encourage new exploration and development of gas resources. The law also gave the states the right to set certain price limits on gas sales. The purpose of this provision was to allow the states to coordinate the prices of intrastate gas with changes in the interstate market.

In direct response to this legislation, the Kansas legislature imposed price controls on the intrastate gas market (the Kansas Natural Gas Price Protection Act of 1979). Among its other provisions, the Kansas law prohibited the use of government escalation clauses and price redetermination clauses in setting gas prices.

In June 1979 ERG notified KPL that it was terminating its sales contracts with the utility because KPL had failed to seek timely approval of a pass-through of price increases, prompted by the government escalator clause, that ERG had invoked in late 1978. Furthermore, KPL declined to pay the increased price. In July 1979, after KPL refused to terminate the agreement, ERG requested an additional increase in gas prices, based again on the government price escalator clause. KPL refused to agree to the price increase, claiming that the government price escalator clause was no longer valid under the Kansas Natural Gas Protection Act. ERG and KPL sued each other to resolve their differences.

Among other issues involved in their dispute, ERG claimed that the application of the Kansas act to its previously agreed-upon contract with KPL was a violation of the Contract Clause of the Constitution. The Kansas trial court held that the Contract Clause was not violated, reasoning that the state had a legitimate interest in addressing and controlling the serious economic dislocations that sudden increases in gas prices would cause. The state supreme court affirmed.

JUSTICE BLACKMUN DELIVERED THE OPINION OF THE COURT.

... The constitutional issue is whether the Kansas Act impairs ERG’s contracts with KPL in violation of the Contract Clause, U.S. Const., Art. I, 10, cl. 1. 9....

Although the language of the Contract Clause is facially absolute, its prohibition must be accommodated to the inherent police power of the State “to safeguard the vital interests of its people.” Home Bldg. & Loan Assn. v. Blaisdell (1934). InBlaisdell, the Court approved a Minnesota mortgage moratorium statute, even though the statute retroactively impaired contract rights. The Court balanced the language of the Contract Clause against the State’s interest in exercising its police power, and concluded that the statute was justified.

The Court in two recent cases has addressed Contract Clause claims. In United States Trust Co. v. New Jersey (1977), the Court held that New Jersey could not retroactively alter a statutory bond covenant relied upon by bond purchasers. One year later, in Allied Structural Steel Co. v. Spannaus (1978), the Court invalidated a Minnesota statute that required an employer who closed its office in the State to pay a “pension funding charge” if its pension fund at the time was insufficient to provide full benefits for all employees with at least 10 years’ seniority. Although the legal issues and facts in these two cases differ in certain ways, they clarify the appropriate Contract Clause standard.

The threshold inquiry is “whether the state law has, in fact, operated as a substantial impairment of a contractual relationship.” Allied Structural Steel Co. The severity of the impairment is said to increase the level of scrutiny to which the legislation will be subjected. vAllied Structural Steel Co. Total destruction of contractual expectations is not necessary for a finding of substantial impairment. United States Trust Co. On the other hand, state regulation that restricts a party to gains it reasonably expected from the contract does not necessarily constitute a substantial impairment. In determining the extent of the impairment, we are to consider whether the industry the complaining party has entered has been regulated in the past. Allied Structural Steel Co. The Court long ago observed: “One whose rights, such as they are, are subject to state restriction, cannot remove them from the power of the State by making a contract about them.” Hudson Water Co. v. McCarter (1908).

If the state regulation constitutes a substantial impairment, the State, in justification, must have a significant and legitimate public purpose behind the regulation, United States Trust Co., such as the remedying of a broad and general social or economic problem. Allied Structural Steel Co. Furthermore, since Blaisdell, the Court has indicated that the public purpose need not be addressed to an emergency or temporary situation. One legitimate state interest is the elimination of unforeseen windfall profits. United States Trust Co. The requirement of a legitimate public purpose guarantees that the State is exercising its police power, rather than providing a benefit to special interests.

Once a legitimate public purpose has been identified, the next inquiry is whether the adjustment of “the rights and responsibilities of contracting parties [is based] upon reasonable conditions and [is] of a character appropriate to the public purpose justifying [the legislation’s] adoption.” United States Trust Co. Unless the State itself is a contracting party “[a]s is customary in reviewing economic and social regulation, ... courts properly defer to legislative judgment as to the necessity and reasonableness of a particular measure.”

The threshold determination is whether the Kansas Act has impaired substantially ERG’s contractual rights. Significant here is the fact that the parties are operating in a heavily regulated industry. State authority to regulate natural gas prices is well established. At the time of the execution of these contracts, Kansas did not regulate natural gas prices specifically, but its supervision of the industry was extensive and intrusive. Moreover, under the authority of 5(a) of the 1938 Natural Gas Act, the Federal Power Commission (FPC) set “just and reasonable” rates for prices of gas both at the wellhead and in pipelines. Although prices in the intrastate market have diverged somewhat from those in the interstate market due to the recent shortage of natural gas, the regulation of interstate prices effectively limits intrastate price increases.

It is in this context that the indefinite escalator clauses at issue here are to be viewed. In drafting each of the contracts, the parties included a statement of intent, which made clear that the escalator clause was designed to guarantee price increases consistent with anticipated increases in the value of ERG’s gas. While it is not entirely inconceivable that ERG in September 1975 anticipated the deregulation of gas prices introduced by the Act in 1978, we think this is highly unlikely, and we read the statement of intent to refer to nothing more than changes in value resulting from changes in the federal regulator’s “just and reasonable” rates. In exchange for these anticipated increases, KPL agreed to accept gas from the Spivey-Grabs field for the lifetime of that field. Thus, at the time of the execution of the contracts, ERG did not expect to receive deregulated prices. The very existence of the governmental price escalator clause and the price redetermination clause indicates that the contracts were structured against the background of regulated gas prices. If deregulation had not occurred, the contracts undoubtedly would have called for a much smaller price increase than that provided by the Kansas Act....

Moreover, the contracts expressly recognize the existence of extensive regulation by providing that any contractual terms are subject to relevant present and future state and federal law. This latter provision could be interpreted to incorporate all future state price regulation, and thus dispose of the Contract Clause claim. Regardless of whether this interpretation is correct, the provision does suggest that ERG knew its contractual rights were subject to alteration by state price regulation. Price regulation existed and was foreseeable as the type of law that would alter contract obligations. Reading the Contract Clause as ERG does would mean that indefinite price escalator clauses could exempt ERG from any regulatory limitation of prices whatsoever. Such a result cannot be permitted. In short, ERG’s reasonable expectations have not been impaired by the Kansas Act.

To the extent, if any, the Kansas Act impairs ERG’s contractual interests, the Kansas Act rests on, and is prompted by, significant and legitimate state interests. Kansas has exercised its police power to protect consumers from the escalation of natural gas prices caused by deregulation. The State reasonably could find that higher gas prices have caused and will cause hardship among those who use gas heat but must exist on limited fixed incomes.

The State also has a legitimate interest in correcting the imbalance between the interstate and intrastate markets.... By slowly deregulating interstate prices, the Act took the cap off intrastate prices as well. The Kansas Act attempts to coordinate the intrastate and interstate prices by supplementing the federal Act’s regulation of intrastate gas. Congress specifically contemplated such action....

There can be little doubt about the legitimate public purpose behind the Act.

Nor are the means chosen to implement these purposes deficient, particularly in light of the deference to which the Kansas Legislature’s judgment is entitled....

The Kansas Act also rationally exempts the types of new gas the production of which Congress sought to encourage through the higher ... prices. Finally, the Act is a temporary measure that expires when federal price regulation of certain categories of gas terminates. The Kansas statute completes the regulation of the gas market by imposing gradual escalation mechanisms on the intrastate market, consistent with the new national policy toward gas regulation.

We thus resolve the constitutional issue against ERG....

The regulation of energy production and use is a matter of national concern. Congress set out on a new path with the Natural Gas Policy Act of 1978. In pursuing this path, Congress explicitly envisioned that the States would regulate intrastate markets in accordance with the overall national policy. The Kansas Natural Gas Price Protection Act is one State’s effort to balance the need to provide incentives for the production of gas against the need to protect consumers from hardships brought on by deregulation of a traditionally regulated commodity. We see no constitutional or statutory infirmity in Kansas’ attempt. The judgment of the Supreme Court of Kansas is therefore Affirmed.