Week Ending January 29, 2016

Supreme Court Affirms FERC’s Authority To Regulate Demand Response Programs

This Article Appears as Published in Foster Report No 3084
Supreme Court Affirms FERC’s Authority To Regulate Demand Response Programs

On January 25, reversing a controversial 2014 decision of the D.C. Court of Appeals, the U.S. Supreme Court handed down a 6-2 ruling in support of FERC’s jurisdiction to regulate demand response (DR) programs administered by the nation’s independent electric system operators (ISOs or RTOs).[1]  The holding in FERC v. Electric Power Supply Association (EPSA), et al. (No. 14-840) represents a major victory for RTO market design and FERC’s use of its “wholesale” market-regulating authority to counteract the pricing power of generators in periods of peak demand – in this case by maximizing the potential contribution from DR.  Justices Scalia and Thomas dissented, while Justice Alito did not participate in the decision.

The challenge to FERC’s jurisdiction over RTO DR programs, which had been brought by independent power producers led by EPSA,[2]  pitted two economic interest groups against each other:  the merchant generators versus aggregators and direct large-load suppliers of DR.  The spark for the litigation was FERC’s Order No. 745, which obligated all RTOs to pay offerors of DR the full “locational marginal price” (LMP) for the units of electricity they bid into the market through their willingness to forego regular consumption.  FERC’s LMP pricing rule was also subject to a “net benefits” test, to ensure that in each instance where generator bids were displaced by DR offers, lower costs would result to customers.

The D.C. Circuit Court of Appeals had two fundamental problems with Order 745, one jurisdictional and the other a matter of administrative law.  As to the first, the D.C. Circuit thought that RTO-administered wholesale DR programs, by “luring…retail customers” into the wholesale market, caused them to reduce their consumption of energy in the retail market and thus, in effect, amounted to FERC’s “direct regulation of the retail market,” in violation of the statute.  As to the second, the D.C. Circuit found Order 745 “arbitrary and capricious” because it failed to adequately explain why paying full LMP to DR providers “results in just compensation.”[3]  The Supreme Court, in reversing the lower court, had to discredit both of these findings.[4]

Apart from the jurisdictional question, the main economic policy debate in Order 745 concerned whether DR suppliers should get just as much payment per unit of energy for reducing load as do traditional suppliers for producing energy – or, in the alternative, whether they should receive some lesser amount.  By mandating a “full LMP” payment policy, Order 745 came down squarely in favor of maximizing the monetary incentive to pull the most DR possible into the market.  This solution, FERC believed, would enhance elasticity of demand in the hourly spot market when supply is tight and power gets the priciest, enabling “conservation” to compete on a par with generation bid into the same markets.[5]  In contrast, generators favored a DR compensation rate below “full LMP.”[6]

Different Takes On Where FERC Jurisdiction Ends and the State’s Begins.  The court of appeals concluded that Order 745 exceeded FERC’s boundaries under the Federal Power Act (FPA) to regulate interstate transmission and wholesale power markets because, in that court’s view, regulating DR offered by end users (whether through aggregators or directly) interfered with the state’s exclusive right to regulate retail electricity markets under division of jurisdiction set forth in the FPA.  But the Supreme Court majority perceived FERC’s regulation of DR programs run under the auspices of RTOs as clearly falling within the FPA’s jurisdictional grant to FERC to regulate “practices” that “directly affect” wholesale rates.  Holding to the contrary, added the Court, would “conflict with the FPA’s core purposes.”

The Court’s opinion acknowledged that when FERC regulates transactions in the wholesale market it frequently has an impact at the retail level; but this is “no matter,” said the Court, and “imposes no bar” on the Commission’s responsibility.  It underscored that “every aspect of FERC’s regulatory plan” in Order 745 and its mandate to RTOs “happens exclusively on the wholesale market and governs exclusively that market’s rules.”

The Court derided EPSA’s position as “subverting” the FPA.  By arguing that wholesale DR programs fall outside FERC’s authority to regulate but also conceding that the states lack authority to regulate such programs, EPSA, the Court maintained, would “flout” the FPA’s core purpose of protecting against “excessive prices” and ensuring “effective transmission” – the two major goals of wholesale DR programs – and “halt a practice that so evidently enables” the Commission to fulfill its duties.

Supreme Court Majority View.  The Court’s majority had no difficulty in placing wholesale DR programs in an entirely different context from the D.C. Circuit’s analysis.  “Wholesale demand response,” it observed, is “all about reducing wholesale rates,” as is framing “the rules and practices that determine how those programs operate.”  This was “particularly true of the formula that [market] operators use to compensate demand response providers,” the Court continued; the more demand response is elicited by increasing the incentive payment, the more “’downward pressure’ on generators’ own bids.”  This in turn “ratchets down” the wholesale price for power paid by consumers.  Indeed, the Court remarked that “it is hard to think of a practice” that does more to affect wholesale prices.

It is inevitable, the Court observed, that wholesale markets have impacts in the retail markets they serve, given their interconnectedness.  In the case before it, setting demand response rules in the wholesale market was “all FERC has done”; the effects on the retail market, while not insignificant, were incidental to “improving the wholesale market.”

FERC’s actions through Order 745 did not purport to set retail rates, nor does it, the Court noted.  While EPSA, in the Court’s view, had advanced an argument that FERC’s regulation of the wholesale DR market “effectively” sets retail rates, the majority opinion mused that “the modifier ‘effective’ is doing quite a lot of work – more than any conventional understanding of rate-setting allows.”  The rate, stressed the court, is “the price paid, not the price paid plus the cost of a foregone economic opportunity.”[7]

The Court was even more dismissive of EPSA’s argument that FERC’s agenda in issuing Order 745 was to disrupt state policies favoring “stable” hourly electric rates.  The Court found this argument dubious because the Commission’s rule, in deference to state preferences, allows state regulatory commissions to prohibit retail customers from making any DR bids into the wholesale market.

FERC’s Rationale For “Full LMP.”  The Court then turned to the lower court’s alternative holding against FERC – that Order 745 was “arbitrary and capricious” because the Commission had failed to furnish a coherent rationale for its requirement that providers of DR be paid the “full LMP.”   In approaching this question, the Court underscored that its task on review is not to determine whether FERC’s policy choice was “the best one possible” among the alternatives, but only whether the Commission supplied a “satisfactory explanation,” one that logically connected the facts found to the choice made.  Moreover, the Court was inclined to show “great deference” to FERC in “a technical area like electricity rate design.”

In this case, the Court found that FERC had given “a detailed explanation” relying on the input of an “eminent regulatory economist,” Dr. Alfred Kahn, for the view that suppliers of DR should receive the same monetary compensation as a supplier of electric energy for a given unit of energy because they provide the “same value” to the wholesale market.  That principle of payment parity was reinforced, noted the Court, by Order 745’s “net benefits” screen, which weeds out those instances where a lower wholesale market-clearing price made possible by a DR bid may not deliver lower actual costs paid by customers.

As to the “double-payment” argument EPSA had posed, FERC had countered in Order 745 that an RTO does not enquire into the profits or secondary benefits of generators either, when it accepts their bids.  It is only focused on the bid itself, and the same logic should hold true for DR bids.[8]    In addition, FERC had found that paying a full LMP would help DR providers overcome initial barriers to participation, such as new metering and energy management systems.

In sum, held the Court, FERC “seriously and carefully” addressed a “disputed question [involving] both technical understanding and policy judgment.”  Without “discounting the cogency” of EPSA’s arguments or deciding whether FERC made “the better call,” the Court concluded that FERC had satisfied the traditional standard of judicial review by having “engaged in reasoned decision making.”

Justice Scalia’s Dissent.  The dissent of Justice Antonin Scalia, joined by Justice Clarence Thomas, attacked the majority’s reading of FERC’s fundamental jurisdictional grant under the FPA.  Scalia would impose a strict reading of the Commission’s jurisdiction under the FPA to regulate only transmission and “sale of electric energy at wholesale.”  The majority, he suggests, devised an alternative test for Commission assertions of authority:  whether the regulation at issue regulates retail rates.  This test, Scalia believes, subverts the structure of the FPA, which makes the state the “default” regulator except insofar as the law expressly confers jurisdiction on FERC for particular types of transactions.

Scalia’s analysis thereupon turns on his view that DR providers are consumers of energy, not “sellers for resale.”  He concludes:  “The demand response bidders here indisputably do not resell energy to other customers.  It follows that the rule does not regulate electric-energy sales ‘at wholesale’ and [the statute] therefore forbids FERC to regulate these demand-response transactions.”

Furthermore, the dissent concluded that the DR program at issue does regulate retail rates, in violation of the FPA.  In so concluding, Scalia adopted the EPSA argument (discussed above) that the prospect of incentive payments for reducing one’s purchase of energy (whether this incentive is accepted or foregone) becomes, in effect, an element of the retail price, in the form of an “opportunity cost.”[9]

Scalia also scoffed at the majority’s theory that invalidating FERC’s Order 745 would sound a death knell for effective DR programs.  He came at this question from two directions:  first, he said that nothing prevents FERC from “tweaking” its program to require incentive payments only to wholesale customers; second, he reads Congress’s encouragement of demand response programs in EPAct 2005 (which the majority also cited to support its holding) as aimed at state-driven DR programs.[10]  Thus, in Scalia’s view of what the FPA does and does not permit, DR programs should be largely the province of state regulation.

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[1]   For convenience, we will refer to these organized market administrators as “RTOs” hereafter.

[2]   The Supreme Court ruling also encompassed No. 14-841, EnerNOC Inc. v. EPSA, et al, on certiorari from the same court of appeals.

[3]   The D.C. Circuit thus agreed with dissenting FERC Commissioner Moeller that paying “full LMP,” without a deduction for costs avoided by not purchasing electricity from the retail provider, resulted in a “windfall” to the provider.

[4]   The Court noted that the D.C. Circuit panel was itself divided, with Judge Edwards dissenting from the majority opinion that FERC had exceeded its jurisdiction and had failed to adequately explain why “full LMP” was just compensation.

[5]   The last bid accepted to clear the market (by definition, the highest-priced bid of needed energy or DR) is paid to all providers of supply or DR under the structure and rules of RTO hourly markets.  Therefore, accepting a lower DR bid to clear the market versus a higher conventional energy generation bid has a profound effect on the aggregate payments to all suppliers – and hence on the costs consumers of electricity are allocated.

[6]   Believing that “full LMP” overcompensates suppliers of DR, generators advocated a deduction to the LMP payment to reflect out-of-pocket savings from not buying electricity during a load reduction.  Otherwise, DR providers would in effect receive a “double payment,” these commenters argued.  One dissenting FERC commissioner agreed with this position in Order 745.

[7]   EPSA had argued that the retail customer must, if eligible for a wholesale DR incentive program, make a calculation not only of the rate it pays directly to the local electric utility, but also of the “cost of foregoing a possible demand response payment,” as an add-on to its effective retail “rate.”

[8]   FERC recognized that a supplier of DR not only captures the benefit of a reduction in the cost is would pay to its retail electric provider, but also costs from deferring the purchase of electricity for its operations.  But neither the market operator nor FERC should delve into those ancillary costs and benefits.

[9]   Scalia recalls that, in the court below, FERC “conceded” that offering credits to retail customers for reducing their electric purchases would be “an impermissible intrusion into the retail market”; he then submits that the demand-response incentive payments are “identical in substance.”

[10] Scalia for the most part leaves alone the question of whether the policy choice of Order 745 was “arbitrary and capricious.”  He remarks “there are strong arguments” that it is; but finds this analysis unnecessary because of the jurisdictional bar he posits in his dissent.

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Copyright © 2016 by Concentric Energy Publications, Inc.  All rights reserved.

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