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February 10, 2015

Did Solicitor General Inadvertently Offer Creative Solution to FERC Demand Response Woes?

In Order No. 745,[1] the FERC sought to enhance competition in wholesale energy markets by setting rules to compensate “demand response” providers, i.e., users of electricity that offer to reduce their consumption when needed by wholesale market operators to balance marketplace supply and demand. In certain circumstances, it can be more cost-effective to achieve that balance by paying users to consume less rather than by paying generators to supply more. In Electric Power Supply Ass’n v. FERC, 753 F.3rd 216 (D.C. Cir. 2014), the DC Circuit sustained a challenge to those rules on the ground, inter alia, that demand response is a retail activity, which is exclusively a matter for state regulation and is beyond the FERC’s limited powers under the Federal Power Act (FPA) to regulate wholesale market activities.

On January 15, 2015, the Solicitor General (SG) filed a Petition for Certiorari urging the Supreme Court to review the DC Circuit decision. In addition to asserting that the DC Circuit misconstrued the FPA, the Petition contends that the matter warrants Supreme Court review to protect FERC’s authority to regulate demand response commitments, which are “critical in ensuring the efficiency and reliability of the Nation’s power markets.” Petition at p. 18. Ironically, however, the SG’s arguments on the merits appear to offer FERC an alternative path to encouraging reliance on cost-effective demand response in wholesale power markets even if the DC Circuit decision remains intact.

The SG claims that FERC’s conclusion that it has the authority to regulate compensation paid for demand response commitments is “the best and indeed the only sensible reading” of the FPA. This is so, it argues, because:

Under Section 824(b) [of Title 16 U.S.C.], FERC has jurisdiction over “the sale of electric energy at wholesale in interstate commerce”—i.e., the “interstate sale of electric energy to any person for resale.” 16 U.S.C.824(b) and (d). The auction markets run by wholesale-market operators establish the wholesale rates for electricity sold in each operator’s region. It is undisputed, therefore, that FERC must ensure that those rates are just and reasonable…

It follows that the rules that wholesale-market operators employ in their auction markets fall squarely within FERC’s statutory authority to regulate any “rule, regulation, practice or contract affecting [a wholesale] rate.”…

…[T[he methodology for compensating demand-response commitments bid into the wholesale market is a key determinant of the wholesale rate. The level of compensation controls which demand-response commitments the system will accept to balance supply and demand, which in turn determines the market-clearing price of wholesale electricity…Accordingly, like any other facet of the auction markets run by wholesale-market operators, the methodology for compensating demand-response commitments is a “rule, regulation [or] practice * * * affecting [a wholesale] rate”…. Simply put, FERC has plenary authority over the rules of the game in modern wholesale-electricity markets.

Petition at pp. 20-21.

As part of its argument, the SG posits a hypothetical to illustrate “why the contrary conclusion is untenable.” Petition at p. 21. “Suppose,” the SG asks, “that a wholesale-market operator was vastly overpaying for demand-response commitments, choosing to utilize them when it would be far more efficient to pay for additional generation instead”:

That overcompensation would inevitably result in a higher-than-optimal wholesale rate. Given that the FPA requires FERC to ensure that wholesale rates are just and reasonable, it is inconceivable that the Commission would lack authority to act in that situation. 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….in light of its important role in securing system reliability and efficient pricing…

Petition at pp. 21-22 (emphasis in original).

In saying that there is “no convincing basis” to distinguish the Commission’s decision to set compensation for demand-response commitments prospectively from its undisputed authority to set aside wholesale rates that reflect overcompensation for those commitments, the SG is obviously hoping to persuade the Supreme Court that the DC Circuit’s decision is logically flawed and must be reversed. Paradoxically, however, the SG’s reasoning suggests an alternative solution to FERC’s demand-response problem:

Based on the SG’s argument, FERC could simply accept that it lacks authority to set prospective compensation for demand-response commitments. Were it to do so, wholesale-market operators would be free to establish that compensation without direct intervention by FERC—that flows from the assumption in its hypothetical that the operator was “vastly overpaying for demand-response commitments.” But if FERC, by rule or adjudicated case, decreed that wholesale market operators could recover only reasonable costs of demand-response commitments in wholesale rates (in this case, the rates charged to load-serving entities for energy service), that would create a strong incentive for the operators not to overpay for those commitments. If wholesale-market operators were willing to continue accepting bids from demand-response providers, and had the incentive not to overcompensate successful bidders, demand-response would achieve much of the support that FERC sought to confer in Order No. 745.

If a wholesale-market operator is free to set compensation for demand-response  commitments without direct FERC oversight, does that leave the operator exposed to regulation by state PUCs? The SG Petition strongly suggests that the answer to that question is “no.” As an additional argument for the Supreme Court to grant certiorari, the SG contends that the DC Circuit decision “creates exactly the sort of regulatory gap that Congress sought to close when it enacted the FPA…” Petition at pp. 25-26. (The SG is referring the gap in federal oversight of interstate wholesale sales of electricity resulting from Public Utilities Commission v. Attleboro Steam & Elec. Co., 273 U.S. 83 (1927)). “Under settled FPA preemption principles,” the SG says, “States could not regulate the wholesale-market rules addressed in the Rule, because such regulation would directly alter the terms of wholesale transactions.” Petition at p. 27.

Another possible objection to wholesale-market operators setting compensation for demand-response commitments on a voluntary basis is that the DC Circuit decision might be read as forbidding FERC from approving tariffs that permit the use of those commitments in wholesale markets. While SG admits that this may have been the DC Circuit’s intent, it argues that that would be very bad policy and is certainly not compelled by the FPA itself:

If so, its ruling would be tremendously damaging to the electricity system, because demand-response providers play an increasingly important role in ensuring the efficiency and reliability of those markets…. Even the Rule’s challengers, after all, “agree[] that appropriate, economic and efficient participation by [demand-response] resources can provide efficiency benefits (both economic and operational) to wholesale electric markets.” … Nothing in the FPA, moreover, suggests that wholesale markets are barred from using demand-response commitments to set wholesale rates. If instead the court simply meant to hold that no regulatory body has authority to review demand-response compensation in wholesale markets, it restored exactly the sort of regulatory vacuum the FPA was designed to eliminate.

Petition at pp. 27-28.

Even if the DC Circuit decision does not bar wholesale-market operators from accepting and paying for demand-response commitments on a non-regulated basis, that does not ensure that they would do so. There still could be questions as to whether their Boards or stakeholders would endorse such action, and it is not clear whether their internal procedures currently accommodate non-regulated  auction features. Nonetheless, it is possible that those obstacles could be overcome, especially if states took the initiative to bring that about.

It is also possible that the Supreme Court will grant certiorari and reverse the DC Circuit decision, rendering this issue moot. If not, however, the SG’s Petition may provide a roadmap for those seeking a continued role for demand-response in wholesale energy markets.

[1] Demand Response Compensation in Organized Wholesale Energy Mkts., Order No. 745, FERC Stats. & Regs. ¶ 31,322, on reh’g, Order No. 745-A, 137 FERC ¶ 61,215 (2011), reh’g denied, Order No. 745-B, 138 FERC ¶ 61,148 (2012).

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