Today the United States Court of Appeals for the D.C. Circuit vacated in its entirety FERC’s controversial rule governing demand response resources in wholesale energy markets, known as “Order 745.”1  The majority (Judges Brown and Silberman) held that “[b]ecause FERC’s rule entails direct regulation of the retail market—a matter exclusively within state control—it exceeds the Commission’s authority.”  Even if FERC had statutory jurisdiction over demand response, “Order 745 would still fail because it was arbitrary and capricious.”  Judge Edwards dissented. 

Order 745

Order 745 directs ISOs and RTOs to pay demand response providers, including aggregators of retail customers, the full locational marginal price (LMP) that is used to compensate generators.  Demand response providers get to keep the savings from reducing their energy usage, and they also get paid (for their “negawatts”) the same price generators do for real megawatts.  Opponents of the rule have argued that FERC-mandated compensation levels are too high, and give demand response providers an unjust and unreasonable windfall.

Demand Response Is A Matter Exclusively Within State Control

FERC argued Sections 205 and 206 of the Federal Power Act (FPA) grant the agency authority over demand response resources in the wholesale market. Sections 205 and 206 task FERC with ensuring that “all rules and regulations affecting . . . rates” in connection with the wholesale sale of electric energy are “just and reasonable.”2  FERC argued that it has jurisdiction over demand response because it “directly affects wholesale rates.” 

The D.C. Circuit agreed that demand response compensation “affects” the wholesale market.  But the majority was troubled by the lack of any “limiting principle” in FERC’s argument. The majority observed that many other things that are unquestionably outside of FERC’s jurisdiction, such as “steel, fuel and labor,” also affect wholesale rates.  The majority stated that “[t]he commission’s authority must be cabined by something sturdier than creative characterizations,” and found that under the agency’s interpretation, “FERC’s authority regarding demand response would be almost limitless.”

The majority also rejected FERC’s argument that it has jurisdiction over demand response providers who are “direct participants” in the wholesale market. Since demand response resources participate in the wholesale market primarily because FERC lured them there with incentives, FERC cannot use their participation as an anchor for jurisdiction. The majority reasoned that directing an ISO to pay for demand response is essentially retail ratemaking, drawing a comparison between paying incentives for demand response service, and crediting the accounts of retail customers who reduced their energy consumption. FERC conceded that ordering such credits would be an impermissible intrusion into the retail market.

The majority held that “FERC can regulate practices affecting the wholesale market under [sections] 205 and 206 [of the FPA], provided the Commission is not directly regulating a matter subject to state control, such as the retail market.” The majority explained:

The limits of §§ 205 and 206 are best determined in the context of the overall statutory scheme. Congressional intent is clearly articulated in § 201’s text: FERC’s reach “extend[s] only to those matters which are not subject to regulation by the States.” States retain exclusive authority to regulate the retail market. Absent a “clear and specific grant of jurisdiction” elsewhere, the agency cannot regulate areas left to the states. The broad “affecting” language of §§ 205 and 206 does not erase the specific limits of § 201. (citations omitted)

Looking to the statutory scheme “as a whole,” the majority found that “demand response, while not necessarily a retail sale, is indeed part of the retail market, which, as the statute and case law confirm, is exclusively within the state’s jurisdiction.” The majority found that, under the Energy Policy Act of 2005, FERC’s authority over demand response resources is limited to “assist[ing] and advis[ing] state and regional programs.”

Order 745 Is Arbitrary and Capricious

The majority held that, even if FERC had statutory jurisdiction over demand response, “Order 745 would still fail because it was arbitrary and capricious.” The majority found that FERC “failed to properly consider—and engage—Commissioner Moeller’s reasonable (and persuasive) arguments” in his dissent from Order 745.3 Commissioner Moeller had argued that Order 745 “overcompensat[es]” demand response resources because it “requires that demand resource[s] be paid the full LMP plus be allowed to retain the savings associated with [the provider’s] avoided retail generation cost.” The Commission argued that demand response resources are comparable to generation resources and should therefore receive the same level of compensation, but the majority concluded that “comparable contributions cannot be the reason for equal compensation, when generation resources are incomparably saddled with generation costs.” The majority stated that “the potential windfall to demand response resources seems troubling,” and agreed with Commissioner Moeller that “overcompensation cannot be just and reasonable.”

What’s Next?

The D.C. Circuit, on its own motion, ordered that the Clerk withhold issuance of the mandate until seven days after disposition of any timely petition for rehearing or petition for rehearing en banc. Given the national significance of the case, it is likely that, following rehearing, an unsuccessful litigant will file a petition for a writ of certiorari to the U.S. Supreme Court.

In the meanwhile, it is not clear what impact today’s opinion will have on wholesale capacity markets. Order 745 addressed wholesale energy markets. While the D.C. Circuit does not explicitly address the rules under which demand response participates in wholesale capacity markets, those rules largely flowed from, and were a logical extension of, Order 745. It is probable that the rules under which demand response participates as a supplier in the wholesale capacity markets will come under renewed attack in light of today’s decision.

It is also unclear what steps, if any, state regulators will take to fill the space that was vacated today. It is widely agreed that some level of demand response is appropriate in a well functioning market. Order 745 describes evidence that energy savings alone may not be sufficient to incentivize demand response participation. Now it may fall to the states to provide whatever additional incentives are thought to be needed to achieve the desired level of demand response. Going forward, demand response could be addressed entirely at the retail level, with load-serving entities reporting reduced requirements to their ISO / RTOs to account for demand response resources under contract at the retail level.