June 13, 2014.  The Court of Appeals for the District of Columbia Circuit (Court), in a 2 to 1 decision in Electric Power Supply Ass’n v. FERC et al.,[1] vacated the Federal Energy Regulatory Commission’s (FERC) Order 745 in its entirety on May 23, 2014.  Order 745 standardized compensation paid to demand response providers in Regional Transmission Organization (RTO) and Independent System Operator (ISO) wholesale energy markets.  The rule requires RTOs/ISOs to pay demand response providers the locational marginal price (LMP) under certain circumstances. The Court’s majority opinion is sweeping in scope and has implications that go beyond the price paid for demand response in RTO/ISO markets.  FERC recently indicated that it will ask the full Court of Appeals for an en banc review of the decision.  The decision can be found here.

The Decision.  The majority opinion finds that demand response is not a wholesale sale of electricity and is, in fact, not a “sale” at all.  The majority states that “[d]emand 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.”[2]  Due to the regulation of the retail market, the majority vacated Order No. 745 in its entirety as ultra vires agency action.

Given the characterization of demand response as a non-sale, the Court says FERC was astute not to rely exclusively on its jurisdiction over wholesale sales of electricity under § 201(b)(1) of the Federal Power Act (FPA).  FERC also relied on sections 205 and 206 of the FPA which include ensuring that all classifications, practices and regulations affectingwholesale rates for jurisdictional services are just and reasonable.  While the Court agreed that demand response “affects” the wholesale market, it finds that FERC’s authority under FPA § 201(b) extends only to those matters which are not subject to regulation by the States and that the FERC’s “affecting” jurisdiction cannot trump the express statutory restriction on FERC regulating non-wholesale sales.[3]

Stated in terms of the Chevron doctrine,[4] the majority decided that FERC failed the first step of the two-step Chevron analysis because FERC’s assertion of authority in Order 745 was contrary to the express or unambiguous text of the FPA.  According to the majority, FERC can regulate practices affecting the wholesale market under FPA §§ 205 and 206 provided that it is not directly regulating matters subject to state control such as the retail market.

Furthermore, even if it were to assume the FPA was ambiguous (i.e., even if it were to reach step two of the Chevron analysis), the majority stated that it would still hold FERC’s construction of the statute as unreasonable because Order 745 “entails direct regulation of the retail market – a matter exclusively within state control – [and] exceeds the [FERC’s] authority.”[5]

The majority went further and indicated that even if the Court were to assume FERC had the statutory authority to issue the rule, they would still find FERC’s actions arbitrary and capricious for failing to address the concerns of dissenting FERC Commissioner Moeller.[6] Commission Moeller’s concerns were that awarding the full LMP over compensates demand response providers and that the “net benefits test” is unduly discriminatory.

The Dissenting Opinion.  In his 28 page dissent, Judge Edwards says that the statutory question was a straightforward one: “whether a promise to forgo consumption of electricity that would have been purchased in a retail electricity market unambiguously constitutes a “sale of electric energy” under [FPA] § 201(b)(1).”[7]  Judge Edwards finds that demand response is not unambiguously a “sale” of electric energy under the FPA§ 201(b).  Furthermore, because of this ambiguity, Judge Edwards says it also is ambiguous whether the compensation paid to demand response providers in wholesale markets is “direct regulation” of retail sales that would violate FPA § 201(b).[8]  Therefore, FERC was reasonable to use its “affecting” jurisdiction to issue Order 745 according to Judge Edwards.  Absent a limitation FPA § 201, Judge Edwards says there is no doubt that demand response in wholesale markets (and the RTO/ISO rules concerning such participation) constitute practices affecting rates under FPA § 206.[9]

Looking at the reasonableness of FERC’s actions, Judge Edwards says the benefits of demand response participating in wholesale markets are beyond reproach; wholesale supply and demand can be brought into balance by increasing supply or by decreasing demand and there functionally is little difference to the RTOs/ISOs charged with maintaining this balance.[10]  Regarding the argument that Order 745 requires RTOs/ISOs to pay retail customers for reducing their retail purchases, Judge Edwards says the argument mischaracterizes the rule because its provisions are inapplicable if demand response is “not permitted by the laws or regulations of the relevant retail regulatory authority.”[11]  According to Judge Edwards, Order 745 preserves State regulation of retail markets.  Order 745 does not constitute the type of “direct regulation” that would violate FPA § 201 because the rule requires nothing of retail electricity consumers and the States have the discretion whether to permit demand response.[12]

Highlighting that the rule was tailored appropriately, Judge Edwards notes that the rule requires four separate conditions to occur before demand response can be paid the LMP: (1) the State’s laws must permit demand response to be bid in to the electricity markets, (2) a demand response provider must decide to participate in the electricity markets, (3) the demand response bid must help the RTO/ISO balance wholesale supply and demand, and (4) the demand response bid must pass the net benefits test.  Last, regarding the specific use of the full LMP to compensate demand response providers, Judge Edwards says the Court has no reason to second-guess FERC’s judgment, which was supported by a reasonable, multi-step explanation.[13]

Analysis.  As noted above, the majority opinion is sweeping in scope and its implications go beyond standardizing compensation for demand response providers in RTO/ISO markets.  The opinion itself notes that FERC has permitted demand response to participate in RTO/ISO markets for more than a decade (often using different terms, e.g., “participating load”).  Due to the scope of the opinion, all of the current RTO/ISO mechanisms where load is allowed to participate like a generator in energy markets in order to balance the system are at risk if the decision stands.  Moreover, the notion that the non-consumption of energy (like the consumption of energy) is a retail activity means that the decision also can impact RTO/ISO ancillary service markets and forward capacity markets where FERC currently allows demand response to provide certain ancillary services on a basis comparable to other resources and to participate in forward capacity markets, respectively.

If the decision stands and energy consumption and non-consumption are both retail activities beyond FERC’s authority, it seems clear that energy and capacity prices will be higher than they otherwise would be without the participation of demand response.  In other words, the market will clear higher on the demand curve than it otherwise would (with a resulting higher price) due to the absence of participation by demand response providers.  In addition, concerns about buyer market power and minimum price offer rules in wholesale forward capacity markets will be much smaller concerns.

There are limits to the concerns regarding the decision.  For example, the notion of energy consumption itself (or demand or load) being a retail activity is unlikely to put all RTO/ISO markets at risk.  The reason is that the load in the ISO/RTO markets is bid-in by Load-Serving Entities (LSEs) and not the consumers themselves.  Interspersing the LSEs between the generators and the consuming public makes the activities wholesale sales of energy that fall squarely within FERC’s jurisdiction.  Similarly, it is reasonable to ask of the Court’s decision why an aggregator or provider of demand response doesn’t serve the same function as an LSE in RTO/ISO markets.  In other words, doesn’t interspersing a demand response provider between the non-consuming entities themselves and the load bid-in to the RTO/ISO markets make the demand response activity a wholesale one (and as Judge Edwards stated, an activity that directly affects FERC jurisdictional wholesale sales of energy)?

As noted at the outset, there is more to come regarding the decision, FERC indicated on June 11, 2014 (http://ferc.gov/media/news-releases/2014/2014-2/06-11-14.asp) that it will ask the full Court of Appeals for an en banc review of the decision.  FERC’s request is due on July 7, 2014.  Due to the wide ranging effect of the decision on the nation’s energy markets, if the reconsideration were to be denied by the Court of Appeals there is a good chance FERC will petition the Supreme Court for review.