Under the Federal Power Act, the federal government (through the Federal Electricity Regulatory Commission, or FERC) regulates the interstate wholesale market in electricity, while state utility commissions regulate intrastate retail markets in electricity. This division of regulatory authority is cleaner in theory than in practice, because, as the U.S. Supreme Court recognized in a highly anticipated decision released Monday, “in point of fact if not in law[,] the wholesale and retail markets in electricity are inextricably linked.” FERC v. Electric Power Supply Ass’n, No. 14-840, slip op. at 1 (U.S. Jan. 25, 2016). Observing that “transactions that occur on the wholesale market have natural consequences on the retail level,” id. at 18, the Court rejected arguments that FERC exceeded its legal authority by adopting a 2011 regulation requiring the operators of interstate wholesale markets to pay the same price to large users that offer to conserve energy during periods of peak usage as they pay to generators that offer to produce more electricity to meet demand during those peaks.
The FERC rule at issue regulates a practice known as “demand response.” Interstate wholesale electricity markets operate on an auction model. Electricity suppliers offer to sell electricity into the market at a certain price. Utility companies submit bids to buy electricity from the grid to meet customer demand. The offers and bids are matched and balanced over multistate areas through wholesale markets operated by regional transmission organizations, or RTOS. The RTO for Wisconsin is the Midcontinent Independent System Operator, or MISO. RTOs like MISO match utility bids with the lowest-price offers available. As demand increases—due to a summer heat wave, for example—so too does the price of wholesale electricity at the auction.
In a typical market, as price increases, demand softens in response. But that kind of self-correction is largely absent in the wholesale electricity market. There are several reasons for this, including the need for electricity (which is not easily met by a substitute product) and lack of transparency to consumers (largely caused by state regulation of retail electric markets that insulates consumers from short-term fluctuations in the price of wholesale electricity). Nor are price spikes on wholesale markets the only consequence from periods of extreme demand for electricity. As the amount of electricity being transmitted over the electrical grid increases, so too do risks to reliability. Periods of intense demand threaten to overload transmission lines, which can lead to service disruptions.
Demand response improves both the price-efficiency of wholesale electricity markets and the reliability of the electric grid. The idea is that, in addition to offers from electricity suppliers and bids from utilities, the wholesale auction model should also factor in “demand response commitments,” through which consumers (whether “large-scale individual users like factories” or “[a]ggregators of multiple users of electricity”) can promise to reduce consumption during periods of peak demand. Id. at 7. The consumers promise to reduce the amount of electricity they use at a certain time by a certain amount for some set price. RTOs can then balance their markets through a combination of supply offers, which build toward the amount of electricity sought by utilities, and demand response commitments, which lower the overall amount of electricity the utilities actually need.
RTOs sought FERC approval to incorporate demand response commitments into their wholesale markets. In 2008, FERC responded with Order No. 719. That Order required wholesale market operators to accept demand response commitments, except from consumers located in states whose regulators forbade demand response participation. In 2011, FERC adopted an additional rule, requiring that, where appropriate, demand response commitments that are accepted on interstate wholesale markets be compensated at the same level as accepted offers for electricity generation. The FERC regulations on demand response sought to make sure that commitments to reduce consumption are accepted and compensated in circumstances where “acceptance will result in actual savings to wholesale purchasers (along with more reliable service to end users).”
Though no one had challenged Rule 719 when it was put into effect, some participants in the energy market challenged the 2011 FERC regulation. Those challengers raised two primary arguments. First, because demand response affects electricity prices on intrastate retail markets as well as on interstate wholesale markets, regulations of the practice exceed FERC’s authority under federal law. Second, in adopting the 2011 regulation, FERC failed to explain why requiring equivalent payment to demand response providers as to electricity suppliers leads to just compensation of the participants in interstate wholesale electricity markets. The U.S. Court of Appeals for the D.C. Circuit accepted both arguments and held the FERC regulations invalid. See Electric Power Supply Ass’n v. FERC, 753 F.3d 216 (D.C. Cir. 2014).
The Supreme Court, by a 6-2 vote (Justice Alito did not participate in the case), reversed and upheld the FERC regulations. On the issue of FERC’s authority, the Court’s reasoning had three primary steps:
First, the Court held that the regulation of demand response directly affects rates on wholesale electricity markets. “FERC has the authority—and, indeed, the duty, to ensure that rules or practices ‘affecting’ wholesale rates are just and reasonable.” Slip op. at 15. While wholesale electricity prices can be influenced by myriad factors, including any input that could move the expense of generating electricity and any circumstance that could influence the amount of electricity demanded , the scope of FERC’s authority is not so broad as to allow regulation over all of those factors. Instead, FERC has jurisdiction to issue rules that directly affect wholesale rates. Since “demand response, in short, is all about reducing wholesale rates,” the Court held, “the rules governing wholesale demand response programs meet that standard with room to spare.” Id. at 16.
Second, FERC’s regulation of demand response is not a regulation of retail sales. The Court recognized that “no matter how direct, or dramatic, its impact on wholesale rates” might be, FERC cannot take any action that violates the Federal Power Act’s prohibition on federal regulation of intrastate retail electricity markets. Id. at 17. Yet, the Court also explained that, when FERC acts in its capacity to regulate the wholesale market “as part of carrying out its charge to improve how that market runs, then no matter the effect on retail rates, [the Federal Power Act] imposes no bar.” Id. at 19. The veto power that state regulators have over their regulated consumers participating in wholesale demand response is illustrative here. Because FERC implemented wholesale demand response as “a program of cooperative federalism, in which the States retain the last word,” there can be no “conceivable doubt as to its compliance with [the Federal Power Act’s] allocation of federal and state authority.” Id. at 25.
Third, the Court concluded that a ruling invalidating FERC’s regulation of demand response because that program has trickle-down effects on retail prices would upset the entire regulatory scheme under the Federal Power Act. The purpose of that statute is to provide comprehensive regulation, divided among federal and state authorities. If FERC cannot regulate demand response because the program affects retail prices, state regulators could not govern a similar program because doing so would affect wholesale prices. Thus, demand response would fall in a gap between regulators. Under the Federal Power Act, the Court explains, “no electricity transaction can proceed unless it is regulable by someone.” Thus, the challenge to the FERC regulations is essentially a challenge to the notion of demand response. And since demand response was developed to improve efficiency of intrastate wholesale electricity markets and performance of the electricity grid, and since Congress specifically encouraged greater utilization of demand response in wholesale markets in the Energy Policy Act of 2005, prohibiting its use “would flout the FPA’s core objects.” Id. at 28.
The Court then turned to the contention that FERC had acted arbitrarily and capriciously in adopting the 2011 regulation. The Court held that FERC had provided adequate explanation of its reasoning and “responded at length” to feedback received during notice-and-comment rulemaking that the regulation would “overcompensate demand response providers.” See id. at 31. Because FERC “addressed that issue seriously and carefully, providing reasons in support of its position and responding to the principal alternative advanced,” it “engaged in reasoned decisionmaking.” Id. at 33.
In dissent, Justice Scalia (joined by Justice Thomas) argued that FERC had indeed exceeded the scope of its authority. The primary fact, in the dissent’s view, is that demand response involves parties (the consumers committing to reduce consumption) that “indisputably do not resell energy to other customers.” Dissent at 4. Because the Federal Power Act defines a sale “‘at wholesale’” as a sale “‘for resale,’” the dissent argues, FERC’s rules for demand response do not regulate wholesale transactions. See id. at 3-4 (quoting 16 U.S.C. §824(d)). Second, even overlooking the definition of wholesale sales, the dissent argues, demand response is designed “to induce a reduction in retail electricity sales—by offering incentive payments to those customers” willing to reduce their usage. Id. at 4-5 (internal quotation marks omitted; emphasis in original). To the dissent, “fiddling with the effective retail prce of electric energy, be in through incentive payments or hypothetical credits, regulates retail sales of electric energy no less than does direct ratesetting.” Id. at 6 (emphasis in original). Finally, the dissent rejects the contention that the Federal Power Act created a comprehensive regulatory scheme under which any regulatory program must be available to FERC or to state regulators. See id. at 6-10.
The ruling is a victory for FERC and for those submitting demand response offers into wholesale markets. Depending on your perspective, the ruling either preserves or expands FERC’s authority to set the rules for demand response and other novel forms of demand-dampening offerings in wholesale electricity markets. The opinion clearly forbids FERC from regulating retail markets itself, but it also clearly sets out a touchstone for determining what directly affects wholesale markets within FERC’s purview and grants FERC free rein to act within that sphere “no matter the effect on retail rates.” Slip op. at 19. That allowance will likely be central to future challenges to FERC actions.