On May 23, 2014, the U.S. Court of Appeals for the District of Columbia Circuit (“D.C. Circuit”), in a 2-1 decision, vacated in its entirety and remanded Order No. 745 of the Federal Energy Regulatory Commission (“FERC” or the “Commission”).  FERC Order No. 745 requires independent system operators and regional transmission organizations (“ISOs/RTOs”) to compensate, in certain circumstances, demand response providers at market prices, i.e., locational marginal price (“LMP”).1  The D.C. Circuit invalidated FERC Order No. 745 on the grounds that, despite congressional policy in the Energy Policy Act of 2005 (“EPAct 2005”) to encourage demand response, FERC acted: (1) beyond its jurisdictional authority because Order No. 745 infringed on the exclusive jurisdiction of the states to regulate the retail electricity market unambiguously set in the Federal Power Act (“FPA”); and, alternatively, (2) arbitrarily and capriciously by implementing Order No. 745 without responding to arguments that such compensation would result in “unjust and discriminatory rates.”2

Application of the court’s opinion to demand response participation in the capacity and ancillary services markets will prove complex for several reasons.  In the near-term, at least, the opinion itself is not yet effective and the court on its own motion has withheld issuance of its mandate until seven days after disposition of any timely petition for rehearing, which is due 45 days from the date of the court’s decision.  In addition, the vigorous dissent offered by Judge Edwards raises substantive issues that portend a further challenge by FERC – either reconsideration by this panel or rehearing en banc (full court), and perhaps further challenge to the Supreme Court. 

In immediate reaction to the opinion, FirstEnergy Service Company filed a “fast track” complaint at FERC to remove demand response requirements from PJM Interconnection, L.L.C.’s (“PJM”) tariff, set a refund effective date, and nullify the results of the most recent capacity auction that included demand response resources.  We anticipate that if demand response providers do not participate in forthcoming PJM capacity auctions, then prices will clear materially higher.  Accordingly, we would not expect FERC to grant the complaint.  Instead, we look for the D.C. Circuit to withhold its mandate pending further appeals, which FERC likely will pursue given the scope of the dissent.

Demand Response Programs and FERC Order No. 745  

Order No. 745 marked a seminal event for the chairmanship of Jon Wellinghoff.  During his tenure, Chairman Wellinghoff described his battle to support demand response as an epic struggle, pitted against entrenched views.  Pursuant to ISO/RTO demand response programs, consumers reduce electricity intake in reaction to price signals by serving “as a resource in organized wholesale energy markets to balance supply and demand.”3  FERC Order No. 745 requires ISOs/RTOs to compensate demand response resources at LMP, as if the demand response resource had generated that amount of energy.  In Order No. 745, FERC explained that it sought

to ensure that when a demand response resource participating in an organized wholesale energy market administered by [an ISO/RTO] has the capability to balance supply and demand as an alternative to a generation resource and when dispatch of that demand response resource is cost-effective as determined by the net benefits test described in th[e] rule, that demand response resource must be compensated for the service it provides to the energy market at the market price for energy.4

The D.C. Circuit’s Decision  

FERC Lacked Jurisdiction  

The D.C. Circuit held that FERC’s jurisdiction is limited to regulating the wholesaleenergy market.5  Meanwhile, the retail energy market is within the exclusive jurisdiction of the states.6  FERC conceded that “demand response is not a wholesale sale of electricity . . . it is not a sale at all” – it is a decision not to act – and, therefore, FERC lacked jurisdiction under Section 201(b)(1) of the FPA on that basis.7  Instead, in order to regulate demand response programs, FERC relied on Sections 205 and 206 of the FPA for its grant of jurisdiction.8  These provisions of the FPA charge FERC with certifying that “‘all rules and regulations affecting . . . rates’ in connection with the wholesale sale of electric energy are ‘just and reasonable.’”9  In Order No. 745, FERC asserted that demand response, by reducing retail consumption incentivized by LMP payments, “directly affects wholesale rates.”10

The majority sharply rejected FERC’s position by declaring: “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.”11  FERC cannot regulate areas left to the states, and although demand response is “not necessarily a retail sale, [it] is indeed part of the retail market, which . . . is exclusively within the state’s jurisdiction.”12  Apparently looking past the role of “aggregators” through which many demand response resources seek to participate in the wholesale market, the majority stated that the LMP payments lured “non-jurisdictional resources into the wholesale market . . . to create jurisdiction.”13  The court stated that FERC’s rationale “has no limiting principle” and its “affecting” jurisdiction, without limitations, could be justification to regulate vast areas of the economy such as “steel, fuel, and labor.”14  To accept the Commission’s broad interpretation of Sections 205 and 206 would, according to the majority, drastically alter the scope of activities within the Commission’s jurisdiction.15

The majority sought to distinguish the D.C. Circuit’s prior holding in Connecticut Department of Public Utility Control v. FERC, by explaining that, in that case, FERC’s regulation of the installed capacity market only “incidentally” affected an area subject to the exclusive jurisdiction of the states.16  By comparison, here, the majority asserts, “FERC’s incentive is not merely a logical byproduct of the rule; it is the rule.”17

The court also rejected FERC’s reliance on Section 1252(f) of the EPAct 2005 on the grounds that statements of policy are not sufficient stand-alone sources of authority.18  The court emphasized that Section 1252(f) “dictates demand response is to be ‘encouraged’ and ‘facilitated,’ not directly regulated as Order 745 proposes.”19  According to the court, encouraging is not the same as regulating.20

“Because the [FPA] unambiguously restricts FERC from regulating the retail market,” the court determined that it did not need to defer under the Chevron doctrine to FERC’s interpretation of the FPA if reasonable.21

FERC Acted in an Arbitrary and Capricious Manner  

To buttress its decision, the majority went on to consider whether, assuming that FERC had jurisdiction, Order No. 745 was nevertheless arbitrary and capricious.22  Applying aChevron formulation that some may consider not aligned with precedent, the majority took FERC to task for failing to consider the arguments presented against FERC’s regulation of demand response programs.23  Namely, the majority asserted that FERC failed to address properly Commissioner Moeller’s arguments that the Commission’s regulation of demand response programs would lead to the implementation of “unjust and discriminatory rates.”24  Commissioner Moeller contended that Order No. 745 would overcompensate parties who chose to take advantage of its provisions because they would be paid LMP and still avoid the costs of generation, while generators could not avoid the cost of producing electricity.25  In the absence of a direct response to these arguments, the majority concluded that Order No. 745 also should be struck down as arbitrary and capricious, even if FERC had the jurisdictional authority to act, which it did not.26

The Dissent  

Senior Circuit Judge Edwards disagreed with the majority on the jurisdictional issue as well as on the merits.27  As to jurisdiction, the dissent argued: (1) that the FPA is ambiguous regarding “whether demand response is a retail ‘sale;’” and (2) that the narrow application of Order No. 745 allows it to “fall[ ] squarely within the Commission’s ‘affecting’ jurisdiction.”28  Regarding the merits, the dissent argued that FERC’s decision as to the compensation scheme should be given deference by the court because it was thoroughly explained.29

Practical Implications and Next Steps  

The court’s majority opinion could have found that this particular, mandatory demand response LMP compensation scheme was arbitrary and capricious and remanded the issue back to FERC.  Instead, the majority vacated Order No. 745 on jurisdictional grounds.  This comes on the heels of other decisions that serve to limit FERC’s jurisdiction,30 and bears witness to a complicated analysis that denotes the messy line between federal and state authority as concerns the electricity market.31

Application of the majority opinion as well as efforts to extend it to demand response participation in the capacity and ancillary services markets may be difficult in the near-term.  This is because: (1) the opinion itself is not yet effective and likely will be the subject of further review by the D.C. Circuit and, possibly, the U.S. Supreme Court; (2) there is a vigorous dissent by Senior Circuit Judge Edwards that raises substantive issues; and (3) the majority opinion did not adequately address other FERC precedent that allows broader demand response participation in the wholesale market, including as capacity and ancillary services products.

As a matter of procedure, FERC has 45 days from the date of this judgment to file a petition for rehearing and en banc review.32  The court has substantial flexibility in determining how and when any requested rehearing is completed.33  FERC could also, or later, file a writ of certiorari to the U.S. Supreme Court, within 90 days of the entry of judgment.34

Substantively speaking, the D.C. Circuit’s ruling likely is to be challenged for two reasons: (1) because Judge Edwards offers a convincing dissent; and (2) because the majority fails to adequately distinguish their decision from Connecticut.35

As to the first point, Judge Edwards argued that Order No. 745 was within FERC’s jurisdiction and did not “purport to regulate demand response writ large.”36  He further argued that FERC’s determination as to the level of compensation to demand response resources is owed deference under the Chevron doctrine and should be upheld.37  Judge Edwards stated: “[t]his court has no business second-guessing the Commission’s judgment on the level of compensation.”38

As to the second point, in Connecticut, the D.C. Circuit held that FERC was within its power and authority, under its “affecting” jurisdiction, to review the capacity charges implemented by an ISO because the review was not a “direct regulation of an area subject to exclusive state control,” but rather a regulation of capacity that affects FERC jurisdictional rates.39  The majority claims that this case is not controlling because, with Order No. 745, FERC “directly incentivized action it cannot directly require.”40  However, Judge Edwards, in the dissent, argues that Order No. 745 does not, in fact, require anything of retail consumers and does not render Order No. 745 “direct regulation” of the retail market.41  Rather, the dissent points out that whether demand response is permissible is left to the states because there is a carve-out from the requirements of Order No. 745 where the laws or regulations of the applicable regulatory authority do not permit participation in the wholesale market.42  This distinction on the part of the majority, highlighted by the dissent, leaves the door open wide for appeal by FERC.

As noted above, FirstEnergy Service Company already has filed at FERC a “fast track” complaint against PJM requesting that: (1) “all portions of the PJM Tariff allowing or requiring PJM to include demand response as suppliers to PJM’s capacity markets” be removed from the PJM tariff; (2) a refund effective date be set; and (3) the results of PJM’s most recent capacity market auction results be stayed and considered void.43  Other similar complaints in other markets might follow.

Practical issues are raised if the majority opinion is applied broadly to invalidate, on jurisdictional grounds, requirements imposed by FERC on ISOs/RTOs regarding demand response participation in energy, capacity, and ancillary services markets.  For example, broad application of the opinion could result in: (1) the potential for a reworking of ISO/RTO program rules, tariffs, and economics to remove such requirements; (2) challenges to energy market settlements and capacity auction results that included demand response bids; and (3) efforts to seek refunds or return of penalties levied by FERC related to demand response programs.

The opinion does not mean, however, that states and utilities that currently have or are considering “retail” demand response programs will not continue to implement them, or that ISOs/RTOs will not find a voluntary way to maintain demand response capabilities.  However, the opinion does call into question various efforts by FERC to effectuate policy goals that may not be foursquare within its jurisdiction.