DC Circuit: FERC’s “Demand Response” Scheme to Pay Retail Customers Not to Use Electricity Illegally Exceeds its Powers to Set Wholesale Electric Rates

The Court of Appeals for the District of Columbia issued a  May 23, 2014 opinion in EPSA v FERC spiking FERC Order 745, the “demand response” element  of FERC’s extra-statutory effort to adopt a market rate system for setting wholesale electric rates.  See E&E Greenwire, Appeals court throws out FERC’s demand-response order, May 23, 2014. APPA, the Electric Power Supply Association, National Rural Electric Cooperative Association, Old Dominion Electric Cooperative and Edison Electric Institute had filed a joint brief in the case arguing that the demand response tariff should be overturned.

This has major implications and may require a change in priorities to deal with high and spiking NYISO prices that earlier in 2014 abruptly may have raised New York state consumers’ electric bills by up to $2 Billion.

Background 

The Federal Power Act. 

The Federal Power Act requires advance public filing of wholesale interstate electric rates and rate changes, giving an opportunity for FERC to revise them for reasonableness before they take effect. The basic statutory scheme, as described by the Supreme Court, is below:

 “The Federal Power Act (FPA), 41 Stat. 1063, as amended, gives the Commission[fn1] the authority to regulate the sale of electricity in interstate commerce — a market historically characterized by natural monopoly and therefore subject to abuses of market power. See 16 U. S. C. § 824et seq. (2000 ed. and Supp. V). Modeled on the Interstate Commerce Act, the FPA requires regulated utilities to file [**2738] compilations of their rate schedules, or “tariffs,” with the Commission, and to provide service to electricity purchasers on the terms and prices there set forth. § 824d(c). Utilities wishing to change their tariffs must notify the Commission 60 days before the change is to go into effect. § 824d(d). Unlike the Interstate Commerce Act, however, the FPA also permits utilities to set rates with individual electricity purchasers through bilateral contracts. § 824d(c), (d). As we have explained elsewhere, the FPA “departed from the scheme of purely tariff-based regulation and acknowledged that contracts between commercial buyers and sellers could be used in ratesetting.” Verizon Communications Inc. v. FCC, 535 U. S. 467, 479 (2002). Like tariffs, contracts must be filed with the Commission before they go into effect. 16 U. S. C. § 824d(c), (d).

The FPA requires all wholesale-electricity rates to be “just and reasonable.” § 824d(a). When a utility files a new [*532] rate with the Commission, through a change to its tariff or a new contract, the Commission may suspend the rate for up to five months while it investigates whether the rate is just and reasonable. § 824d(e). The Commission may, however, decline to investigate and permit the rate to go into effect — which does not amount to a determination that the rate is “just and reasonable.” See 18 CFR § 35.4 (2007). After a rate goes into effect, whether or not the Commission deemed it just and reasonable when filed, the Commission may conclude, in response to a complaint or on its own motion, that the rate is not just and reasonable and replace it with a lawful rate. 16 U. S. C. § 824e(a) (2000 ed., Supp. V).” 

Once set under federal law, wholesale rates cannot be modified by states and are passed through to consumers by their retail utilities. The statutory scheme, requiring advance public filing of rate changes, making rates reviewable and subject to refund if  questioned, is anathema to promoters of deregulation and private rate setting.  

FERC’s Market-Based Rate Scheme.

Through a series of Orders over the years FERC gradually created an extra-statutory system of market based rates, heavily influenced by the prices set in the short term (daily and real time) spot markets run by grid operator utilities, like the NYISO and PJM.  In the 15 states like New York where utilities sold their power plants to new owners with market rate permission from FERC, electricity must be bought at market prices set in the wholesale markets (rather than produced at cost by the utility).  Thus, in contrast to the plain language of the FPA establishing a public filed rate regulation scheme, FERC  has allowed the private setting of wholesale electric rates under secret unfiled contracts and in short term spot markets operated by regional transmission organizations, where sellers bids are secret and the same clearing price is paid to all sellers.  

FERC allows utilities to sell at market rates under an assumption that if a single seller lacks power to drive up prices, the rates it demands and charges will satisfy the “just and reasonable” requirement of the  Federal Power Act.  In Morgan Stanley Capital Gropu v. P.U.D. No. 1, where  parties in a case involving a dispute over a market based rate had not raised the issue whether market rates were legal, the Supreme Court did not rule on market rate legality, but pointedly said it has never approved the market rate scheme and further opined that FERC’s belief that its market power test assures reasonable rates is “metaphysical”.  As a consequence, as Scotusblog  observed, “the Court has explicitly left open the possibility of future challenges to the lawfulness of FERC’s entire market-based-tariff system.”  (The Utility Project submitted an amicus brief to the Supreme Court in the Morgan Stanley Capital Group case, arguing that FERC’ lacks any statutory authority to depart from the filed rate regulation system).  In an analogous situation involving the FCC’s attempt to deregulate phone service, the Supreme Court invalidated the agency effort to deregulate without statutory authoriity adding impetus to the eventual enactment of the Telecommunications Act of 1996 which allowed more competition but included new benefits and protections for consumers.

In the 15 states and District of Columbia where utilities sold off their power plants to new owners who have FERC permission to sell at market rates,  ISO and RTO spot markets now have inordinate influence in setting the price for all electricity, reducing the role of long term contracts. As a consequence, the spot markets often yield unpredictably high and spiking prices. This has spawned a murky financial derivatives market, market gaming, and exploitation of consumers when artificially high wholesale prices are passed through to be paid by retail customers.  The main response of FERC to malfunction of its market rate scheme was not to correct the rates charged, but to rely on a new market scheme, “demand response” to tame the wilder prices in the spot markets.

The “Demand Response” to Spot Market Price Extremes.

In response to the spot market gyrations, FERC did not take steps sufficient to halt economic withholding or market gaming or revitalize the long term contract markets.  Instead, following market dogma, it perceived the excessive and spiking spot market rate problem as one that could be solved if consumers respond quickly by reducing their usage.  Rather than fix unreasonable rates so that consumers could use electricity when they wanted it, FERC encouraged flowing spiking spot market prices through to customers and encouraging them to make a market response, i.e., to refuse to buy.  The theory was that by reducing demand, the hours in which peak prices are set in the spot markets would be reduced. To entice customers to provide this “demand response”, large customers are paid high prices to shut down their usage, in some cases closing operations on hot days and sending workers home, because they would be paid more by the ISO/RTO than they would make running their ordinary business.

At the NYISO, there is now a group of companies, demand response providers,  that arrange with big retail customers to cut load, and they can receive payments for not using electricity, the cost of which is charged eventually to consumers.  The NYISO has four demand response programs.

In practice, the theory is riddled with flaws, including the questionable assumption that the spot markets are competitive and that a demand reduction program would over time lower prices, and that a competitive market price is always just and reasonable.  (See Energy Market Regulation and the Problem of Market Power, 53 Boston College Law Review 131 (2012)).  In actuality, the demand response efforts, made at great expense, may in theory and perhaps in the short term lower prices, but they may be countered over time simply by more economic or physical withholding of generation, so that the peak prices can be maintained.  In the recent New York price spikes, a considerable number of generation units were not running, forcing reliance on peaker plants that buy fuel in the next day markets, which were also spiking, driving prices higher for all sellers.

An association of power producers (EPSA) objected to FERC about the demand response program created in Order 745, which, however ineffective, is directly intended to reduce the prices paid to EPSA’s members.  In a divided opinion, FERC upheld the tariffs of the ISO/RTO utilities that provide for payments to retail customers for “demand response.”   EPSA then sought judicial review, arguing to the DC Circuit that in approving ISO and RTO rates that pay retail customers for not using electricity, FERC went beyond its statutory powers, which in this area are limited to setting rates for sales of wholesale electricity.

The DC Circuit Court Invalidates the FERC  Demand Response Order.

The DC Circuit held that FERC has no statutory authority to require payments to retail customers in its Demand Response program, stating:

“Demand response resources do not actually sell into the market. Demand response does not involve a sale, and the resources “participate” only by declining to act.  As noted, and as the Commission concedes, demand response is not a wholesale sale of electricity; in fact, it is not
a sale at all.  * * * * FERC can regulate practices affecting the wholesale market under §§ 205 and 206, provided the Commission is not directly regulating a matter subject to state control, such as the retail market. * * * * The fact that the Commission is only “luring” the resource to enter the market instead of requiring entry does not undercut the force of Petitioners’ challenge. The lure is change of the retail rate. Demand response—simply put—is part of the retail market. It involves retail customers, their decision whether to purchase at retail, and the levels of retail electricity consumption. If FERC had directed ISOs to give a credit to any consumer who reduced its expected use of retail electricity, FERC would be directly regulating the retail rate. At oral argument, the Commission conceded crediting would be an impermissible intrusion into the retail market. See Oral Arg. Tape, at 27:15. Ordering an ISO to compensate a consumer for reducing its demand is the same in substance and effect as issuing a credit.3 Thus, while it is true demand response can occur in two ways—through a response to either price change or incentive payments—nothing about the latter makes it “wholesale.” A buyer is a buyer, but a reduction in consumption cannot be a “wholesale sale.” FERC’s metaphysical distinction between price-responsive demand and incentive-based demand cannot solve its jurisdictional quandary”

In conclusion, the court said, “[u]ltimately, given Order 745’s direct regulation of the retail market, we vacate the rule in its entirety as ultra vires agency action.”  The Court also held that FERC had not made a reasoned decision in adopting Order 745 because it gave short shrift to the argument of Commissioner Moeller that the scheme overcompensates “demand response” by paying for it the same price paid for power generation, even though the demand response entailed no generation expense. Because an alternate basis for invalidation exists, it may be difficult for demand response program supporters to get Supreme Court review, though they surely will attempt it.

There is little doubt that FERC and supporters of “demand response” will try to win reversal of the DC Circuit decision by appealing to the Supreme Court.  Predictably, they are claiming that prices will go up or energy conservation will be frustrated if demand response is not restored.  Given the long history of Supreme Court precedents holding that regulatory agencies charged by statute must actually regulate even if they have been persuaded not to by market rate proponents,  the language of the statute defining FERC’s limited powers is likely to be determinative.  They will have an uphill fight.

As a practical matter, we doubt that demand response by reducing peak load or shifting load to off-peak hours is a viable means to achieve lasting wholesale electricity price reductions.  It certainly hasn’t prevented price spikes that harm consumers, drive up the cost of small businesses, and sap local economies while enriching energy traders and hedge funds.  The structure of the flawed markets is such that, if demand response worked to reduce the number of hours that peaker plants set high spot market clearing prices, there eventually would be a “supply response”, i.e., the mothballing of generation, or more economic withholding, so that over time, high prices and the number of peak hours will be maintained.  The reduction of supply is a reality — much generation in New York has shut down in recent years.  Also, see WAS HEDGE FUND SHUTDOWN OF MA POWER PLANT PART OF A WITHHOLDING STRATEGY TO DRIVE UP NE-ISO CAPACITY MARKET PRICES?

A better response would be for FERC to reverse its abdication of regulation and fix reasonable prices, and enforce the just and reasonable rate requirements of the FPA to curb excessive rates and market gaming.  FERC  could also take steps to rejuvenate the long term contract markets for wholesale electricity, and adjudicate whether sellers are making unreasonable price demands far in excess of a reasonable profit.  State regulators could require diverse supply portfolios for the utilities and reduce their reliance upon the  high and spiking NYISO and RTO spot market prices.  Utilities, instead of mindlessly buying electricity in the short term spot markets, should battle with producers over prices in long term contracts. Efficiency and conservation is still a viable course of action for consumers to reduce their bills.  

Perhaps a lesson of the case is that advocates of demand response and market nostrums should have convinced legislators to change the law instead of administratively jettisoning the statutory paradigm to experiment with the  market rate system.  Instead, the recklessly deregulated wholesale prices are inflicting harsh and unreasonably high and spiking prices upon vulnerable customers.  A new legislative push by market enthusiasts to ratify the market rate system and restore demand response is likely.  But  before rushing to fix the gap in FERC’s statutory powers, legislators should  think twice about regularizing  FERC’s flawed deregulation scheme, and heed consumer groups and others who have protested the FERC “market based rate” regime.  At a minimum, regulators and legislators should at least take steps to better protect customers, which the private market operators, utilities and state and federal regulators have failed to do.  After the Supreme Court invalidated the FCC’s effort to deregulate telecommunications without statutory authorization to depart from the filed rate regulation system, Congress responded in the Telecom Act of 1996 with a revised regulatory paradigm that included efforts to protect consumers, Lifeline rates for low income customers in all states, advanced services for schools and libraries, and equity between rural and urban areas.  

Another possibility is that proponents of “demand response” schemes to pay customers not to use electricity will shift their justification from reducing peak prices to reliability, claiming it is necessary to assure continuous and adequate service.  A problem with that is that the bulk power grid rules currently have ample reserves and operating rules so that situations where the grid operator really needs to  call upon customers not to use electricity and pay them handsomely, are quite rare.

Gerald A. Norlander

Updates

Ehren Goossens, Mark Chediak and Jim Polson, Blackstone Unit Foreshadows Google Path to Power Company, Washington Post, May 29, 2014:

“Although a U.S. appeals court ruled last week that utilities aren’t required to pay industrial customers a rate for demand response equal to the cost of power generation, the ruling doesn’t kill the demand-response market or prevent aggregators from selling their energy savings. More likely, it will shift the issue of how much this aggregated conservation is worth to state utility regulators.”

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