Ensuring the reliability of the electric power grid in times of extreme weather and other times of peak usage is critical to avoid interruptions in power and black outs. Reflecting on the 2014 Polar Vortex, the paramount importance of a secure and reliable grid is made abundantly clear. Balancing the supply of electricity with fluctuating demand takes place in the wholesale electricity markets on a real-time and day-ahead basis, using supply-side initiatives as well as demand-side initiatives. “Demand response” is a demand-side initiative under which electricity users are paid to reduce their usage of power at particular times, instead of increasing the supply of electricity to meet increasing demand. Demand response initiatives are operated in both the wholesale and retail electricity markets, and have been credited with enhancing the reliability of the grid by lowering the power necessary to meet demand, preventing spikes in electricity prices and, in some cases, as possibly the only option for avoiding power interruptions in certain regions. On October 14, 2015, the U.S. Supreme Court heard oral argument in two consolidated cases that call into question the Federal Energy Regulatory Commission’s (“FERC”) authority to regulate the methodology for determining the compensation paid to demand response participants in the wholesale electricity markets and the viability of the methodology that FERC did establish, assuming the agency does have jurisdiction.
The Challenge to FERC’s Order No. 745
The cases under review, FERC v. Electric Power Supply Association, et.al (14-840) and EnerNOC, Inc., et al. v. Electric Power Supply Association, et al. (14-841), challenge a 2014 decision by the D.C. Circuit Court of Appeals that invalidated FERC’s rule requiring wholesale market operators to use the same methodology to determine compensation for demand response participants as they use to compensate power generators that supply electricity to the wholesale market. In a challenge to the rule led by the Electric Power Supply Association (“EPSA”), the national trade association representing competitive power suppliers, including generators and marketers, the D.C. Circuit held that demand response is part of the retail electricity market that is regulated by the States, and therefore outside of FERC’s jurisdiction. The appellate court alternatively held that, even if FERC had authority to issue the rule, the rule established by Order No. 745 – Demand Response Compensation in Organized Whole-sale Energy Markets was arbitrary and capricious due to FERC’s failure to consider alternative methodologies adequately during the rulemaking process.
The Supreme Court certified two questions for review, which were guided by the two-step Chevron analysis applied to challenges to agency decisions: 1) Whether the Federal Energy Regulatory Commission reasonably concluded that it has authority under the Federal Power Act, 16 U. S. C. 791a et seq., to regulate the rules used by operators of wholesale electricity markets to pay for reductions in electricity consumption and to recoup those payments through adjustments to wholesale rates, and 2) Whether the Court of Appeals erred in holding that the rule issued by the Federal Energy Regulatory Commission is arbitrary and capricious. Key points of contention raised during Wednesday’s oral arguments indicate that the Supreme Court Justices seem to diverge on the question of whether FERC overstepped its bounds and encroached upon an area of regulation that is wholly within the purview of the States.
Demand Response as a Resource
FERC rests its position on the express authorization under the Federal Power Act to regulate the process that sets electricity wholesale rates. As described by FERC, wholesale demand response operates as follows: “third-party aggregators of electricity users, as well as local utilities and large individual users like factories, ‘bid’ demand-response commitments into the wholesale markets, specifying the hours, number of megawatts and price at which they are willing to curtail. The market operators then treat those commitments like bids from generators, accepting them if the price is right in light of the level of demand and all other bids.” FERC views demand response as a resource that is bid into the wholesale auction, relied upon by market operators to balance wholesale supply and demand, set wholesale rates, and mitigate spikes in prices and power interruption. Accordingly, FERC believes that all of the demand response related conduct regulated by Order No. 745 falls within the wholesale market and its jurisdiction.
In its briefing, FERC urged the High Court to consider the opposite scenario – what if a wholesale market operator was overpaying demand response participants and using demand response to balance supply/demand when it would be more efficient to pay for additional generation? As demand response payments are recouped through wholesale rates, this would lead to a higher than optimal wholesale rate. Is there really any doubt that FERC would have authority to address the situation, given the Federal Power Act requires FERC to ensure that wholesale rates are just and reasonable? “And if that is so, no convincing basis exists to distinguish the Commission’s decision here to set the compensation level for demand-response commitments prospectively to ensure that demand response is neither overused nor underused—and neither overpaid nor underpaid—in light of its important role in securing system reliability and efficient pricing.”
Economics 101 – What is the Limiting Principle?
During arguments, Justice Kennedy and Chief Justice Roberts pushed FERC to define the limitation on its authority to regulate practices within the wholesale markets that indeed impact retail market pricing. Where is the line drawn under the law, considering the interrelated nature of the wholesale and retail markets:
JUSTICE KENNEDY: If there were a student in Economics I, it seems to me that he would conclude and his professor would conclude that wholesale affects retail, retail affects wholesale, they’re interlinked, which means you win the case, except that the statute makes a distinction. We have to make a distinction. Can you tell us what the distinction is that marks the end of Federal power and the beginning of local power?
CHIEF JUSTICE ROBERTS: And there’s just no doubt given that all of the practices FERC is regulating occur in the wholesale auction. They’re all embedded in the wholesale auction…. obviously, that’s true. But it’s just as obvious, it seems to me, that you have to have some sort of limiting principle, otherwise FERC can do whatever it wants. So what is the limiting principle that you would suggest to us?
The limiting principle offered by FERC and the private parties in the case is based on tracing the direct effects of the regulation. They proffered that FERC’s rule has a direct effect on wholesale rates because there’s “an absolute one-to-one relationship….If I…reduce a unit of demand, I don’t need as much supply, and that affects the price directly. And that’s the direct relationship that derives from the economic principles.” Then the question is not “[d]oes it affect the retail rate?” in their view. “Clearly it will. The question is: Did what FERC do here in the order directly affect the wholesale rate? And on that score, it seems…there’s no question.”
Is the Central Conduct Regulated Retail or Wholesale?
Despite Chief Justice Roberts’ statement of the obvious, not all of the Justices viewed the conduct impacted by FERC’s rule as obviously occurring in the wholesale auction. Indeed, Justice Scalia described the central conduct at issue as “the refusal to buy power during peak hours,” which takes place in the retail market. From that premise, Justice Scalia questioned why demand response has a direct effect on the wholesale market: “what you’re telling people is, if you agree not to buy power at retail during certain hours, we’re going to pay you….that seems to me an indirect effect, not a direct effect.”
The EPSA and other respondents similarly asserted that FERC really was trying “to reduce retail demand by providing payments to retail customers on an otherwise wholesale market in an effort to change the effective price for retail sales.” But, they were met with swift rebuke by Justice Sotomayor: “Where is that…written anywhere that that was their goal? That’s how you’ve characterized that goal. But what I’ve heard them say is, we’re trying to lower the price of wholesale to a more just amount. That’s what’s in anything I’ve seen written. You’ve recharacterized it.”
FERC maintained that the conduct the rule reaches is all occurring within the context of the wholesale auction. FERC also noted that retail customers who want to participate as demand response entities in the wholesale market can only do so if their State law permits it, just like large customers who want to buy electricity directly. Therefore, FERC maintained, their participation in the wholesale market as demand response entities is not inappropriate and no different from what has occurred in the markets for quite some time.
An Odd Result – Is Deference Due?
Justice Kagan posited that depriving FERC of the authority to regulate demand response does not seem to follow from stated energy policy: “it is an odd result, given this Energy Policy Act which made it so clear that Congress liked demand response that it wanted FERC to lower barriers to demand response, to then say, well, FERC has no jurisdiction to do exactly what the policy that Congress articulated is.” Justice Breyer similarly looked to the law, stating: “I do not see any law that prevents them from raising or lowering wholesale price despite the fact that that affects retail price.” Respondents found support in Justice Scalia’s line of questioning to stand their ground, arguing that “when you regulate wholesale prices, essentially as Justice Scalia suggested, through the retail market…that crosses a very important boundary in the Federal Power Act.”
FERC has argued that if there is ambiguity in its statutory authority, deference is due to the agency’s determination under Chevron analysis. FERC reasons that demand response in the wholesale market can be viewed at most as a “hybrid” impacting both wholesale and retail, since “wholesale purchasers of power are charged, as part of the wholesale rate, to incentivize retail end-users not to consume power.” The agency acknowledged that “the court was correct that demand response ‘involves retail customers, their decision whether to purchase at retail, and the levels of retail electricity consumption,’” however FERC urges that “it is equally true that the Rule governs only payments made by wholesale power purchasers for demand-response commitments used by wholesale-market operators to set the wholesale price.”
The parties and Justices also discussed whether FERC’s decision to require the methodology it selected was arbitrary and capricious, given objections raised to the methodology during the rule making process. It remains to be seen whether FERC’s authority to regulate demand response will be validated, and whether Order No. 745 will survive even if it is. Only eight Justices will be considering the case, as Justice Alito did not participate. An even split would leave the D.C. Circuit’s ruling intact.