More than 50 years ago, the Supreme Court described the Federal Power Act's (FPA) division of federal and state jurisdiction over electric energy transactions as a "bright line, easily ascertained . . . ." Federal Power Commission v. Southern California Edison Company, 376 U.S. 205 (1964). In recent decades, as the electric industry has evolved from one dominated by localized, vertically integrated utilities to one characterized by open-access transmission, Regional Transmission Organizations (RTOs), Independent System Operators (ISOs), organized electricity markets, merchant generators, and (in more recent years) an increased use of distributed resources, that "bright line" has become less clear. While the Federal Power Act (FPA or Act) gives the Federal Energy Regulatory Commission (FERC or Commission) responsibility over transmission and wholesale sales of electric energy in interstate commerce, and reserves jurisdiction over retail sales to the states, recent initiatives involving demand response and state-driven generator development have raised questions about the location of that dividing line, and the nature of the federal-state relationship in electricity regulation.
In its Monday decision in Federal Energy Regulatory Commission v. Electric Power Supply Association, 577 U.S. ___ (2016) (EPSA) the Supreme Court addressed that question in the context of FERC's jurisdiction over demand response in organized wholesale electricity markets. That decision, which held that FERC has authority to issue rules and regulations for the participation of demand response in organized wholesale electricity markets, is notable not only for its larger-than-expected majority, but also for its enunciation of a fairly expansive view of federal power, and the federal role in regulating U.S. electricity markets.
The Backdrop
Sections 201, 205, and 206 of the FPA give FERC the power to regulate rates, terms, and conditions of wholesale sales of electric energy in interstate commerce, including all practices "affecting" such rates, terms, and conditions. At the same time, Section 201(b) of the FPA prohibits FERC from regulating "any other sale" (i.e., retail sales) of electric energy, and reserves regulatory authority over those "other sale[s]" to the states.
This dividing line between federal and state jurisdiction, based on the industry structure of 80 years ago (the relevant provisions of the FPA were passed into law in 1935), applies cleanly to bilateral sales of electricity from one public utility to another. However, market structures have evolved substantially in the last few decades, particularly with the advent of RTOs and ISOs in the late 1990s. These entities manage the economic benefit of transmission capacity by operating day-ahead and real-time markets for electricity in which the RTO or ISO calculates clearing prices for different physical locations based on the extent of constraints between those locations. These location-based clearing prices – known in the industry generally as Locational Marginal Prices or LMPs – are calculated for each hour in the day-ahead markets, and sub-hourly in the real-time markets, and are used to compensate generators selling power in these markets. The organized markets operated by RTOs and ISOs are wholesale markets, so FERC's authority over sales of energy in these markets is clear and unequivocal.
One of the challenges with organized wholesale markets, and with electric markets generally, is that demand tends to be fairly inelastic. This is due partly to the nature of the underlying product (electricity is a necessity of modern life), and partly to the fact that end users of electricity tend to be shielded by their own state regulators from the impact of price spikes on high-demand days. RTOs and ISOs have long sought to encourage demand response – that is, deliberately forgoing electricity use that otherwise would be undertaken – in the operations of their markets, to facilitate the balance of generation and load, and to moderate price spikes.
FERC's leadership has been an enthusiastic promoter of demand response, particularly in recent years, and the Commission has issued a series of rulemakings governing the participation of demand response in organized wholesale markets. The latest of these, Order No. 745, is the one at issue in EPSA. That rule mandates that demand response be permitted to bid in RTO/ISO organized markets, and that it be compensated at the LMP, as long as (1) it is capable of supplying the reduction in demand, (2) it passes a net benefits test, and (3) the applicable state regulatory commission permits the bidding of the demand in an organized wholesale market.
The incorporation of demand response into wholesale electric markets engenders no small amount of controversy because it has a tendency to drive down prices in those markets, while also displacing "steel in the ground" projects. EPSA and a series of other parties challenged Order No. 745 on the ground that it exceeded FERC's regulatory authority under the FPA, and that argument found a receptive audience at the U.S. Court of Appeals for the District of Columbia Circuit (D.C. Circuit). In a 2-1 decision, the D.C. Circuit held that Order No. 745 contravened the FPA's jurisdictional limitation by "luring" retail customers into the wholesale market and causing them to reduce their retail electric consumption, thereby engaging in "direct regulation of the retail market," in contravention of the prohibition on such regulation in FPA Section 201(b). Electric Power Supply Association v. FERC.
FERC v. EPSA
The Supreme Court reversed the D.C. Circuit's decision. The Court began its analysis with the language of the statute, particularly the language of Section 201(b) of the FPA providing that FERC has the authority to regulate "the sale of electric energy at wholesale in interstate commerce," and the language in Sections 205 and 206 of the FPA giving FERC authority over rules or practices "affecting" rates for interstate wholesale sales. The Court also focused on the language from Section 201(b) prohibiting FERC from exercising jurisdiction over "any other sales" (i.e., retail sales).
Turning first to the most straightforward aspect of the analysis, the Court held that demand response bids in organized wholesale markets substantially affect rates for electric energy in interstate commerce, and thus fall within the ambit of the "affecting" language in Sections 205 and 206. The Court noted that the FPA's grant of authority to regulate practices "affecting" rates for interstate wholesale electricity transactions, taken to its logical conclusion, could potentially encompass all kinds of practices, including those only tangentially related to the supply of electricity. Thus, the Court established a limiting principle, adopting the formulation from an earlier D.C. Circuit decision that a practice must "directly affect" the wholesale rate in order to fall within FERC's jurisdiction under the "affecting" language in FPA Sections 205 and 206. Slip op. at 15. The Court determined that "the rules governing wholesale demand response programs meet that standard with room to spare." Id. at 16.
The Court turned next to the thorny question at the center of the case – whether allowing FERC to establish the rules governing the participation of demand response in organized wholesale markets constitutes impermissible regulation of retail electric rates under FPA Section 201(b). The Court rejected the argument that the demand response rule involved regulation of retail rates because it (in the words of the D.C. Circuit) "lured" retail customers into the wholesale markets, and thus directly influenced quantities and prices paid at retail. The Court held that "a FERC regulation does not run afoul of [§201(b)'s] proscription just because it affects – even substantially – the quantity or terms of retail sales." Slip op. at 18. The Court emphasized that, "whatever the effects at the retail level, every aspect of the [demand response] regulatory plan happens exclusively on the wholesale market and governs exclusively that market's rules." Id. at 20. The Court found further that "the Commission's justifications for regulating demand response are all about, and only about, improving the wholesale market." Id. Thus, the Court determined that, although it may have substantial effects on the retail market, the Commission's demand response rule does not contravene the prohibition in FPA Section 201(b) on regulation of retail electric sales.
The Court ended its analysis of the jurisdictional issue by asserting that EPSA's position would subvert the purposes of the FPA by rendering demand response programs beyond the regulatory reach of either FERC or the states. The Court observed that EPSA's position would place demand response beyond FERC's regulatory reach and – in language that could serve to foreshadow the outcome of the upcoming cases on state-driven generator development – posited that organized demand response programs are outside of state jurisdiction because the "FPA leaves no room either for direct state regulation of the prices of interstate wholesales or for regulation that would indirectly achieve the same result." Slip op. at 26 (internal citations omitted). In the Court's view, this outcome would contravene the whole regulatory structure set up by the FPA, which "makes federal and state powers 'complementary' and 'comprehensive,' so that 'there [will] be no "gaps" for private interests to subvert the public welfare.'" Id. at 26-27 (internal citations omitted). The Court posited that demand response in organized markets would not be able to move forward under such an outcome because it would lie beyond the regulatory authority of either the federal or state government.
The Court concluded its decision by rejecting the argument that the decision in Order No. 745 to pay full LMPs to demand response providers constitutes arbitrary and capricious decision making. Citing its decision in Motor Vehicle Mfrs. Assn. of United States, Inc. v. State Farm Mut. Automobile Ins. Co., the Court emphasized the limited nature of its role in reviewing FERC rate decisions, stating that a "court is not to ask whether a regulatory decision is the best one possible or even whether it is better than the alternatives[,]" but instead must limit its review to whether the agency reviewed all salient considerations and articulated a satisfactory explanation for its decision. Slip op. at 30 (internal citations omitted). Using that standard, the Court found that FERC's decision to allow demand response providers had been fully explained after consideration of all competing views, and therefore was not arbitrary and capricious.
Implications for the Future
The Court's decision in EPSA reinforces a fairly broad conception of FERC jurisdiction, holding that as long as the Commission's actions involve the operations of wholesale markets and directly affect prices in those markets, those actions are jurisdictional under Section 201(b) of the FPA, even if they otherwise substantially impact retail markets. For supporters of demand response, and of a broader federal role in the operations of national electricity markets, this is obviously a desired outcome. Indeed, it may well allow FERC to play more of a role in the ongoing efforts to comply with the terms of the Environmental Protection Agency's Clean Power Plan (CPP) if that rule survives judicial review, although given the CPP's emphasis on state-developed implementation plans (an emphasis that derives from the Clean Air Act itself), the Court's relatively broad reading of FERC's regulatory authority in EPSA could lead to federal-state clashes in the future.
Furthermore, the Court's decision will almost certainly have an impact on the upcoming cases regarding states' authority to contract directly with generators that participate in organized wholesale markets. The question in those cases is the extent to which state actions in the retail market are allowed to impinge on or affect FERC-jurisdictional wholesale markets, and the resolution of this issue will turn, in large measure, on how broadly or narrowly the Court construes its admonition (in EPSA) that the "FPA leaves no room either for direct state regulation of the prices of interstate wholesales or for regulation that would indirectly achieve the same result."