For those companies who have entered into contracts under which they agree to reduce their use of electricity in return for payments from regional transmission operators and independent system operators (“RTOs/ISOs”), the recent split decision in Electric Power Supply Association v. FERC (No. 11- 1486, et. al., D.C. Cir. May 23, 2014) creates a great deal of uncertainty as to the legal validity of   these arrangements. RTOs/ISOs have relied on these “demand response” resource arrangements for some time to balance demand for power with available and planned generation and transmission capacity. The divided court’s decision vacates and remands rules adopted by the Federal Energy Regulatory Commission (“FERC”) in Order 745 that require payments for reductions in electric energy usage to be based on the locational marginal price (“LMP”) of such energy in organized wholesale electric power markets. Two of the three presiding judges held that rules were beyond FERC’s  statutory authority and, even if they were not, would be set aside as arbitrary.

The decision threatens demand response arrangements not only in organized wholesale energy   markets, but also in the more lucrative organized wholesale capacity markets. Based on the reasoning of this decision, a complaint has already been filed with FERC (Docket EL14-55-000) seeking to stay the effectiveness of an RTO’s capacity auction in which demand response resources participated, and to remove all of the RTO’s tariff provisions requiring or allowing demand response resources to be used as capacity resources in its wholesale market “with a refund effective date of May 23, 2014.”. Although it is too early to determine whether all wholesale market demand response programs will wither in the wake of the court’s decision, it is not too early to revisit the terms of demand response contracts in light of this decision, particularly those which relate to potential liability for refund obligations.

The Electric Power Decision

In March 2011, FERC issued Order 745 to establish rules for compensating demand response resources in jurisdictional wholesale electric energy markets operated under FERC tariffs by RTOs/ISOs. Such markets exist in most of the Northeast, Mideast, and Midwest regions of the country, as well as in California. (New England ISO, NYISO, PJM, MISO, and CAISO). Third-party demand response suppliers often contract with individual companies that use large amounts of electricity and are willing to reduce their demand for and consumption of energy from electric transmission grids at specific times for payments at market prices. These suppliers aggregate the contracts in order to create a significant amount of demand response resources to bid into organized wholesale electricity markets. Order 745 nominally dealt only with wholesale energy payments for demand response. But the court’s rationale for overturning Order 745 could extend to wholesale capacity markets as well.

A majority of the court in Electric Power Supply Association v. FERC held that the Federal Power Act unequivocally denied FERC the authority to adopt its Order 745 rules. In particular, the majority held that FERC could only regulate wholesale sales of electric energy in interstate commerce and that the rules in question regulated “non-sales” of electric energy. The majority further reasoned that demand response was entirely a function of the retail electricity market that is subject to exclusive state regulation, not FERC regulation. Assuming FERC nonetheless had the authority to regulate demand response, the court’s majority held that it would still set aside the rules as arbitrary because, among other things, FERC failed to justify its requirement that payments be made at LMP without subtracting the amount that a retail customer saved by reducing its consumption of electricity delivered by its  local utility.

In contrast, the dissenting judge in the case found that the Federal Power Act is ambiguous as to FERC’s jurisdiction over demand response resources. Under the Chevron doctrine, courts are required to defer to reasonable agency interpretations of ambiguous statutory authority, and the dissenting judge found FERC’s interpretation of the relevant parts of the statute to be reasonable. In addition, the dissenting judge found that FERC had adequately set forth a rational justification for the specific rules it adopted, including the LMP payment rule.

Based on the dissent, FERC may decide to seek rehearing of the majority’s decision by the full D.C. Circuit of Appeals. FERC’s rules remain effective until the court issues a mandate consistent with the majority decision in the case, which it has yet to do. If FERC seeks and the D.C. Circuit of Appeals agrees to a rehearing, issuance of the mandate would be automatically stayed until the rehearing is decided. Stay of the mandate could also result from an appeal of the court’s decision to the United States Supreme Court. So FERC’s rules could remain in effect through a period of further litigation, but uncertainty will remain with respect to the legality of demand response contractual arrangements until the issues surrounding FERC’s Order 745 are ultimately resolved in the courts and then attended to as necessary by FERC.

The decision at hand affects not only those who participate directly in wholesale electricity markets, but also downstream power purchasers and companies which participate in demand response programs. Each of these parties will need to consider the impact of this ruling on their current and prospective power purchase and sales arrangements, including in particular the terms and conditions of any  demand response contracts involved in those arrangements.