FERC’s Demand Response Strategy Hits a Snag: D.C. Circuit Vacates Order 745 in Electric Power Supply Association v. FERC

• I am delighted to welcome guest blogger Sharon Jacobs. Sharon was my colleague at Harvard Law School and will be an Associate Professor at Colorado Law beginning this summer.  Sharon’s scholarship focuses on administrative, energy and environmental law and she has a forthcoming article on federalism and demand response programs, so she is the perfect person to discuss the D.C. Circuit’s recent decision in Electric Power Supply Association v. FERC, which invalidated a federal order designed to encourage demand response. -James Coleman

By Sharon B. Jacobs

It is a poorly kept secret that D.C. Circuit judges do not exactly clamor to be assigned Federal Energy Regulatory Commission (FERC) cases. The notable exception is now-Senior Judge Stephen Williams, who loves them. His grasp of the intricacies of energy regulation is unparalleled on any court in the country. It is unfortunate, therefore, that Judge Williams was not assigned to the D.C. Circuit panel that recently handed down Electric Power Supply Association v. FERC. In a 2-1 opinion authored by Judge Janice Rogers Brown and joined by Judge Laurence Silberman, the panel vacated FERC’s final rule on compensation for demand response resources in wholesale energy markets. Judge Harry Edwards offered a well-reasoned and ultimately more persuasive dissent.

Demand response is the reduction of electricity use in response to a price signal. In other words, customers are paid not to consume energy. Demand response has been called the sale of “negawatts,” although the phrase is an imperfect description of the actual transaction. Where demand response bids are accepted, market administrators need not purchase as much generation (supply) to meet aggregate demand. Because the cost of electricity goes up as demand increases, especially at times of peak consumption, demand response can lead to significant savings.

Electricity markets are divided into two spheres: retail (sales to end-use customers) and wholesale (sales for resale). For the most part, states regulate the former, while FERC controls the latter. FERC’s demand response strategy affects both markets. In an earlier order, FERC allowed aggregating companies to bid retail customers’ demand response commitments directly into wholesale markets. In the rule challenged in this case, Order 745, FERC sought to further eliminate barriers to demand response participation in wholesale markets by requiring market administrators to pay demand resources the “locational marginal price” or “LMP” for each megawatt not consumed. The locational marginal price is the same price that generators receive when they bid their megawatts of power into wholesale markets. It reflects the value of energy at a specific location at the time of delivery. PJM, the market administrator for the mid-Atlantic region, explains that the LMP fluctuates like taxi fares—lighter electricity traffic yields a lower, steadier fare, whereas congestion on the wires causes the fare to rise. FERC included a caveat in its rule: demand response resources would only receive the LMP when their participation in wholesale markets would be cost effective, as determined by a specified “net benefits” test.

The bulk of the opinion concerned a threshold question: whether FERC acted within the scope of its jurisdiction under the Federal Power Act when it established compensation and other rules for retail demand response resources participating in wholesale markets. Under the Act, FERC has clear jurisdiction over rates for wholesale sales of electric energy in interstate commerce as well as rules, regulations and practices affecting those rates. FERC argued that it could set wholesale rates and other rules for demand response in wholesale markets because they were practices “directly affecting” wholesale sales. The panel majority disagreed, instead characterizing what FERC did as indirect regulation of the retail market for electricity.

There were three major problems with the opinion.  First, the majority found the Federal Power Act’s jurisdictional provisions much clearer than they are in fact.  It applied the normally deferential Chevron test, under which the court will defer to the agency’s reasonable interpretation of an ambiguous statutory provision it is authorized to administer, to FERC’s jurisdictional claims. Though some have argued that allowing the agency to determine the scope of its own jurisdiction when statutory language is ambiguous is analogous to permitting the fox to guard the henhouse, the Supreme Court recently affirmed the propriety of this practice in City of Arlington v. FCC. The Federal Power Act’s grants of jurisdiction did not anticipate demand response and the statute’s application to the phenomenon, as the dissent recognized, is unclear. In other words, the statutory provisions at issue, as applied to demand response, are ambiguous. Thus, the court should have deferred to FERC’s reasonable interpretation of those provisions at Chevron step two.

Second, Judge Brown found that the Federal Power Act foreclosed FERC’s reading because the Commission’s interpretation “has no limiting principle.” In an argument reminiscent of Justice Scalia’s warning in his Massachusetts v. EPA dissent that Frisbees and flatulence could be regulated under EPA’s capacious definition of “air pollutant,” Judge Brown warned that FERC’s interpretation of its “affecting” jurisdiction would authorize it to regulate “steel, fuel, and labor markets.” As the dissent pointed out, however, the limiting principle could not be clearer. Under the D.C. Circuit’s own holding in CAISO v. FERC, FERC may only regulate practices that “directly affect” wholesale rates or are “closely related” to those rates, “not all those remote things beyond the rate structure that might in some sense indirectly or ultimately do so.” As Judge Edwards pointed out in his dissent, this language clearly precludes regulation of “steel, fuel, and labor markets.”

Third, to the extent that the true motivation for the decision was general unease about federal encroachment on traditional areas of state regulatory power, the decision overlooked a key aspect of FERC’s demand response rules that mitigate any unwanted impact on state authority. An earlier FERC order, Order 719, offered state and local regulatory authorities an “opt-out”: those who did not want their retail customers participating in wholesale markets for demand response could prohibit them from doing so via legislation or regulation. Order 745’s pricing scheme was layered on top of this jurisdictional compromise. In Judge Edwards’s words, “[t]his is hardly the stuff of grand agency overreach.”

The most controversial part of Order 745, and the real reason the rule was the subject of such concerted opposition, got the least airtime in the opinion. In what was billed as an alternate holding in Part IV (but felt more like dicta), the panel found that Order 745’s locational marginal pricing scheme was arbitrary and capricious. In under two pages of text, the opinion declined to “delve now into the dispute among experts” yet asserted that the Commission had not “adequately explained how their system results in just compensation.” “If FERC thinks its jurisdictional struggles are its only concern with Order 745,” the opinion cautioned, “it is mistaken.” In a much more nuanced discussion of the Commission’s choice and the deference due to FERC “in light of the highly technical regulatory landscape that is its purview,” Judge Edwards concluded that the Commission provided a “thorough explanation” for selecting the locational marginal price as the appropriate level of compensation. In a nutshell, FERC’s argument was that the compensation level was necessary to overcome barriers to participation by demand response resources in wholesale markets and that it accurately reflected the value demand response provided to those markets.

Prior to this ruling, FERC had been successfully pursuing a policy of what I call, in a forthcoming article, “bypassing federalism”:  working a de facto rather than a de jure reallocation of regulatory power by extending its influence through the expansion of wholesale markets. In the context of demand response, that strategy was undermined by the Commission’s aggressive posture on pricing in Order 745. It was the idea that demand response resources would be paid the LMP for their “negawatts,” thereby competing directly with generation in wholesale markets, that triggered the groundswell of opposition from generation resources. The decision will not go into effect until seven days after the disposition of any motion for rehearing, and FERC is still considering its options as well as the decision’s impact on its rules and related programs. The panel’s decision may yet be reversed by the D.C. Circuit en banc or by the Supreme Court. But, as a policy matter, the Commission might have avoided a direct confrontation over its demand response rules by moving more deliberately on the pricing question.  As I have written elsewhere, for agencies whose regulatory schemes face concerted opposition, discretion is sometimes the better part of valor.