PSI Energy, Inc. v. Exxon Coal USA, Inc.

• Decision Date: 20 May 1993
• Docket Number: No. 93-1088,93-1088
• Citation: 991 F.2d 1265
• Parties: PSI ENERGY, INC., Plaintiff-Appellee, v. EXXON COAL USA, INC., and Exxon Corporation, Defendants-Appellants.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 1265

991 F.2d 1265

PSI ENERGY, INC., Plaintiff-Appellee, v. EXXON COAL USA, INC., and Exxon Corporation, Defendants-Appellants.

No. 93-1088.

United States Court of Appeals Seventh Circuit.

Argued March 31, 1993.

Decided April 15, 1993.

Rehearing Denied May 20, 1993.

Alan S. Brown, Robert F. Zoccola (argued), Thomas L. Davis, Locke, Reynolds, Boyd & Weisell, Indianapolis, IN, and Donald P. Bogard, Plainfield, IN, for plaintiff-appellee.

John D. Nell, William P. Wooden, Katherine L. Shelby, Mary L. Titsworth, Wooden, McLaughlin & Sterner, Indianapolis, IN, David J. Beck, Amy Murdock, Beck, Redden & Secrest, James K. Wilson, Exxon Coal and Minerals Co., Houston, TX, Robert Anthony Burgoyne, Keith A. Jones (argued), Fulbright & Jaworski, Washington, DC, and Richard J. Wilson, Fulbright & Jaworski, Houston, TX, Richard R. Wilson, Vuono, Lavelle & Gray, Pittsburgh, PA, for defendants-appellants.

Before BAUER, Chief Judge, EASTERBROOK, Circuit Judge, and REAVLEY, Senior Circuit Judge. ^*

EASTERBROOK, Circuit Judge.

PSI Energy burns coal to supply southern Indiana with electricity. Increasingly stringent environmental regulation requires PSI to limit the sulfur dioxide emitted from its plants. To do this PSI must install "scrubbers," large devices that precipitate the sulfur out of the stack gasses and leave a noxious slurry of sulfur and limestone. High costs of removing sulfur from coal after combustion give a competitive advantage to coal that contains less sulfur, and to plants situated in places where the EPA permits the emission of extra sulfur dioxide. Utilities that have not found the optimal mix of clean coal at low prices and pollution control technology have encountered pressure from regulatory agencies. See Northern Indiana Public Service Co. v. Colorado Westmoreland, Inc., 667 F.Supp. 613 (N.D.Ind.1987), affirmed mem., 845 F.2d 1024 (7th Cir.1988); Northern Indiana Public Service Co. v. Carbon County Coal Co., 799 F.2d 265 (7th Cir.1986).

Nineteen years ago PSI Energy contracted with a predecessor to Exxon Coal for a 29-year supply of high-sulfur coal, some 3 million tons per year. Exxon's coal is approximately 3.3% sulfur, leading to 6.2 pounds of sulfur dioxide per million Btu. The EPA has reduced allowable emissions at PSI's Gibson generating station (where it burns the coal Exxon supplies) to 3.57 pounds of SO sub2 per million Btu, and by 1995 PSI must cut these emissions to 2.5 pounds per million Btu. Complying with these rules requires additional scrubbers or reducing the sulfur content of the coal to be burned. Further reductions may lie in store, yet costly rules do not permit PSI to avoid its obligation. Under the agreement PSI must take the coal "regardless of conditions imposed by [environmental] laws, rules or regulations". Section 16.01. PSI would like to escape its commitment or drive down the price to recoup the cost of removing the sulfur from the coal Exxon delivers.

The contract provides a way to do just this. The price of coal is not fixed. It has several components: a "Base" defined as the price F.O.B. the customer's power plant (see U.C.C. § 2-319) and a table of adjustments called "Exhibit A". These adjustments produce changes in the effective price on account of changes in the cost of labor, transportation, and the value of money, among other items. Other clauses of the contract provide still more adjustments. Article III reduces the price if the coal has too much water or ash and imposes a penalty for sulfur exceeding a defined limit. Thus the delivered price changes frequently. But mechanical computations according to Exhibit A and other clauses do not necessarily track the market for coal. At five-year intervals, the parties may renegotiate the Base and the table of adjustments. Fresh negotiation ensures that the price in the long-term contract does not depart too far, or for too long, from the market price. Paul L. Joskow, Price Adjustment in Long-Term Contracts: The Case of Coal, 31 J.L. & Econ. 47 (1988); Victor P. Goldberg & John R. Erickson, Quantity and Price Adjustment in Long-Term Contracts: A Case Study of Petroleum Coke, 30 J.L. & Econ. 369 (1987). See generally Keith J. Crocker & Scott E. Masten, Pretia Ex Machina? Prices and Process in Long-Term Contracts, 34 J.L. & Econ. 69 (1991); Victor P. Goldberg, Price Adjustment in Long-Term Contracts, 1985 Wis.L.Rev. 527; Richard S. Lambert Long Term Contracts and Moral Hazard, 14 Bell J. Econ. 441 (1983). Rising costs of removing sulfur after combustion have led to a substantial fall in the market price of high-sulfur coal relative to low-sulfur coal. Falling prices of energy in general also have undercut the market position of firms holding reserves of high-sulfur coal. PSI hoped to take advantage of both effects in renegotiating with Exxon during 1991 and 1992 for the new price to take effect on January 1, 1993. Because the Exhibit A adjustments were increasing the delivered price of Exxon's coal during the 1980s, while the market price for high-sulfur coal was eroding, PSI anticipated a substantial savings.

An opportunity to renegotiate in mid-contract poses the question: what happens if the parties do not agree? If, for example, the seller's last offer prevails in the event of disagreement, then the seller has little reason to reduce its price to the current market. There is a similar, though reversed, problem if the buyer's last bid prevails. If inability to agree permits the parties to walk away from the deal, then the arrangement is not really a long-term contract after all. It becomes a five-year contract with a framework for renewal on mutual consent. Yet the parties may have strong reasons for preferring a genuine long-term contract. A long-term contract allows each side to make capital investments that facilitate performance, investments in goods whose useful life exceeds five years, and which therefore may be sensible (if they are specialized in some way to the other party's needs) only if they can be amortized over a longer period.

One way to drive the offers together during price renegotiation, while preserving the long-term nature of the arrangement, is to permit the buyer to obtain other bids while allowing the seller to "match" these. The possibility of a competitive offer, which defines the current market price, propels the parties toward agreement while ensuring that, as long as it charges no more than the current market price, the seller continues to receive the business. And this is what the Exxon-PSI contract provides. Section 7.03 reads:

Either party may require renegotiation of the Base by giving to the other, at any time in the first thirty (30) days of the fourth year of any contract period ..., written notice of its desire to do so. Promptly after the giving of such notice, the parties will commence negotiations to agree upon a new Base to be effective as of commencement of the next contract period. Each party covenants with the other to participate in such negotiations in a good faith effort to reach agreement. If the parties are unable to reach agreement, BUYER will accept SELLER's last offer or present SELLER with a firm, written offer which it has received from another supplier, which it is willing to accept, for the supply of coal called for under the remaining term of this Agreement (herein referred to as a "competitive offer"). It shall also provide SELLER with documentary proof of such offer, and permit SELLER to examine all supporting data and information submitted with the offer. SELLER shall have the right to meet such competitive offer.

If, by the one hundred and eightieth day preceding the end of the contract period in which notice of price negotiation was given, the parties have agreed upon a new Base, appropriate changes shall be made to the adjustment factors provided in Exhibit "A". The Price of coal effective at the commencement of the next contract period shall be computed from the new Base adjusted under the provisions of Exhibit "A" from the reference date of the new Base. If, by such time, the parties have not reached agreement upon a new Base and SELLER declines to meet a competitive offer submitted by BUYER pursuant to the above provisions, this Agreement shall terminate at the end of the contract period in which notice of price negotiation was given, or at BUYER's election, at the end of the temporary continuance of deliveries as provided for in Section 7.04.

Notice that the objective of the renegotiation is to update the Base in light of market conditions. The contract contemplates price negotiation for an identified product, not a bid for a different product or the reworking of the many other terms. Coal differs in multiple dimensions, including sulfur, ash, water, and heat content. Renegotiation or competitive bidding on a price per ton is futile unless these attributes of quality are held constant. To assure this, § 7.05 provides:

It is understood and agreed that the purpose and intent of Sections 7.01 to 7.04, inclusive, are only to provide for renegotiation of Base and Exhibit "A", and neither party shall inject into such negotiations, as a condition of agreement upon a new Price for the coal, any demand or request that other terms and conditions of this Agreement be altered.

Sections 7.03 and 7.05 need not mean that a competitive bid must duplicate the Exxon-PSI arrangement. Identical terms are impossible, given that Exxon supplies PSI with coal from a mine in Clinton County, Illinois. Rivals will offer deliveries from different places, and different coals necessarily will have different sulfur, ash, water, and heat contents. What §§ 7.03 and 7.05 make clear, however, is that Exxon can respond to competition by reducing its price without altering other features of the arrangement. This protects both sides from the expropriation of any relationship-specific capital investments. Exxon can't raise the price above market, and a competitive...