In a June 29 order, the Federal Energy Regulatory Commission (FERC) found that the PJM Interconnection, L.L.C. (PJM) Tariff was unjust and unreasonable because it failed to address the impact of subsidized generation resources on capacity auction prices. FERC noted that state programs originally providing limited support for relatively small renewable resources have “evolved into support for thousands of megawatts (MWs) of resources ranging from small solar and wind facilities to large nuclear plants.” According to FERC, those programs are causing price distortions and costs shifts in wholesale markets. FERC took particular aim at two forms of state “out-of-market support” for generation resources: zero emission credits (ZECs), designed to compensate nuclear plants for generating power without producing carbon dioxide, and state renewable portfolio standards (RPS).

With its order, issued over the protests of two commissioners, FERC initiated an investigation into PJM’s capacity rules and set deadlines for an accelerated paper hearing. At the conclusion of the process, FERC will establish a replacement rate for PJM’s capacity auctions. Judging by the June 29 order, the rate ultimately adopted by FERC will attempt to fully offset the effect of state subsidies on auction prices in PJM’s capacity markets.

FERC’s order is likely not subject to immediate judicial review, as FERC has not issued a final order and instead has set the issue for hearing. FERC could also soften its position when it issues a final order, particularly since one of the three commissioners who voted in favor of the June 29 order is leaving the agency next month. But assuming FERC sticks to its guns, the final order will almost certainly be attacked in a federal court of appeals.

Would a FERC order purporting to mitigate the effect of state subsidy programs on wholesale energy markets withstand a judicial challenge? This may be a closer call than either side would care to admit, as it would force a court to delineate the currently-blurry line between federal jurisdiction over wholesale energy markets and state jurisdiction over local generation resources.

Any challenger to FERC’s ultimate rule will note, as did one dissenting commissioner, that the Federal Power Act reserves to the states exclusive jurisdiction over “facilities used for the generation of electric energy.” Although the June 29 order promises states that they “may continue to support their preferred types of resources in pursuit of state policy goals,” states may view FERC as impeding that pursuit by reducing the economic attractiveness of the preferred resources. And the impact on state subsidies is neither incidental nor indirect; FERC is openly trying to negate the impact of state programs on wholesale capacity prices.

A court could also view FERC’s selection of targets as arbitrary and capricious. As one commissioner pointed out, FERC is choosing to mitigate only two forms of subsidies: ZEC and RPS programs. Government subsidies that other generation resources receive evidently will remain unmitigated. A court may also be uneasy with FERC’s decision to treat ZEC and RPS programs as equally distortive of wholesale energy markets. A reviewing court may agree with another dissenting commissioner that RPS programs “are not intended to prop up specific uneconomic units that would otherwise leave the market, but rather to help shape a state’s resource mix over time through competitive procurements.”

Complicating FERC’s position is that it has consistently described renewable energy credits as not directly affecting wholesale energy rates when they are sold separately from energy. FERC took the same position with respect to ZECs in an amicus brief FERC and the Department of Justice recently filed with the Seventh Circuit in a case challenging whether Illinois’ ZEC program is preempted by the Federal Power Act. A court may wonder why FERC has declared that the financial incentives in the ZEC and RPS programs are sufficiently distant from wholesale energy markets to avoid preemption but have enough of an impact on energy markets to cause “price distortions” that must mitigated.

In defense of its order, FERC undoubtedly would point to (1) its statutory duty to ensure that wholesale energy rates are just and reasonable and (2) the deference that courts traditionally have accorded FERC in ratemaking matters. FERC would also rely on the Supreme Court’s decisions in FERC v. Elec. Power Supply Ass’n, 136 S. Ct. 760 (2016) and Hughes v. Talen Energy Mktg., 136 S. Ct. 1288 (2016). In Hughes, the Supreme Court found a Maryland subsidy for new generation to be preempted by the Federal Power Act because it interfered with the PJM capacity markets. The court noted that “FERC extensively regulates the structure of the PJM capacity auction to ensure that it efficiently balances supply and demand, producing a just and reasonable clearing price.” In EPSA, the Supreme Court held that FERC had the power to set wholesale prices for electric demand response offers, despite the states’ rights to regulate retail electric rates. The court found that FERC could regulate demand response programs in an effort to enhance wholesale markets, even if increased use of demand response would inhibit retail sales otherwise subject to state control.

Nevertheless, there is a word of caution in EPSA. The Supreme Court pointed out that FERC’s demand response program gave states a veto power, as it allowed state regulators to prohibit their consumers from making demand response bids in the wholesale market. The court characterized wholesale demand response as implemented by FERC “a program of cooperative federalism, in which the States retain the last word.”

By contrast, FERC’s June 29 order does not contemplate giving any state the last word on subsidies. FERC would likely note in response, however, that generation resources are not required to participate in wholesale markets. Indeed, the June 29 order contemplates that resources could opt out from participation in capacity auctions.

When defending its order, FERC assuredly will claim that it has the statutory duty to ensure the smooth functioning of the wholesale markets, a function blessed by the Supreme Court in Hughes. At least one federal court has noted that FERC has the power to address market distortions caused by state ZEC programs. FERC will further point out that its action is narrowly directed at mitigating the effect of state subsidies on wholesale markets. The agency is not seeking to invalidate the subsidies altogether. FERC will similarly state that it has defended the state programs from preemption claims while reserving the right to rectify the impact of the programs on wholesale markets.

As these points illustrate, a court faced with a petition seeking review of FERC’s order will struggle with delineating the intersection of FERC’s statutory jurisdiction over wholesale energy markets and state jurisdiction over generation resources. And the issues in the legal fight could change. Although the battle lines have been partially drawn, no complaint has been filed, and the order that FERC ultimately issues may contain safeguards or features not contemplated in the June 29 order. But keep the popcorn handy—it likely will be a dandy of a legal fight.