On January 25, 2016, the Supreme Court of the United States ruled that FERC had not exceeded its legal authority under the Federal Power Act (“FPA”) in promulgating a rule—Order No. 745—that regulates the compensation paid to demand response resources in organized wholesale markets administered by Regional Transmission Organizations (“RTOs”) and Independent System Operators (“ISOs”).

In Order No. 745, FERC amended its regulations to require that demand response resources participating in organized wholesale markets administered by RTOs/ISOs be compensated by the RTO/ISO at the Locational Marginal Price (“LMP”)—the same price used to compensate generation resources participating in those markets—so long as the demand response resource can meet a “net benefits test” to ensure that the accepted bids from the demand response resource result in savings to consumers. On appeal, the United States Court of Appeals for the District of Columbia Circuit (“D.C. Circuit”) vacated Order No. 745 on the grounds that: (i) FERC lacked authority to issue the order because the order directly regulates retail electricity markets—an activity subject to the exclusive jurisdiction of the states under the FPA; and (ii) in the alternative, the order’s compensation scheme is arbitrary and capricious under the Administrative Procedure Act.

In upholding Order No. 745, the Court’s analysis was divided into three parts. First, the Court found that the practices at issue in Order No. 745—the payments made by RTOs/ISOs for demand response commitments—“directly affect” wholesale rates, and are thus under FERC’s exclusive jurisdiction under the FPA. The Court reached this conclusion by first noting that the FPA imposes a duty on FERC to ensure that rules or practices “affecting” wholesale rates are just and reasonable. Given the multitude of rules or practices that could in theory “affect” wholesale rates, the Court in its decision formally approved “a common-sense construction” that had previously been adopted by the D.C. Circuit in a prior decision. This “common-sense” construction limits FERC’s “affecting” jurisdiction to rules or practices that “directly affect” wholesale rates. Applying this test, the Court determined that Order No. 745 meets this standard “with room to spare” because it is focused on promoting competition and lowering wholesale rates—two practices that “directly affect” wholesale rates.

Second, the Court determined that FERC did not regulate retail sales of power—an activity subject to the exclusive jurisdiction of the states under the FPA—by promulgating Order No. 745. The Court found that Order No. 745 only addresses transactions occurring in RTO/ISO wholesale markets, and the fact that the order may have an impact on retail sales is “of no legal consequence.” Referring to the section of the FPA that prohibits FERC from regulating retail sales, 16 U.S.C. § 824(b), the Court stated that “[w]hen FERC regulates what takes place on the wholesale market, as part of carrying out its charge to improve how that market runs, then no matter the effect on retail rates, §824(b) imposes no bar.” The Court rejected arguments by the Electric Power Supply Association (“EPSA”) that FERC had usurped state power because the order “effectively” regulates retail rates by causing retail customers to consider both the cost of making such a purchase of power, and the cost of forgoing a possible demand response payment. Specifically, the Court stated that to set a retail electricity “rate” is to “establish the amount of money a consumer will hand over in exchange for power,” and nothing in the FPA, or in the Court’s precedent, indicated otherwise. Similarly, the Court also rejected EPSA’s argument that FERC intruded into the States’ sphere by “luring” retail customers into wholesale markets, and that FERC did so “only because it was dissatisfied with the States’ exercise of their undoubted authority” under §824(b). On this point, the Court stated that FERC did not invent demand response; rather, the impetus for Order No. 745 came from RTOs/ISOs that recognized demand response’s potential to lower wholesale electricity prices and improve the grid’s reliability, and subsequently sought and obtained Commission approval. The Court concluded that “[d]emand response, then, emerged not as a Commission power grab, but instead as a market-generated innovation for more optimally balancing wholesale electricity supply and demand.” Finally, the Court found that EPSA’s arguments were significantly undermined by the fact that Order No. 745 permits any state regulator to prohibit its consumers from making demand response bids in RTO/ISO wholesale markets. Referring to this fact, the Court stated that “[w]holesale demand response as implemented in the Rule is a program of cooperative federalism, in which the States retain the last word. That feature of the Rule removes any conceivable doubt as to its compliance with §824(b)’s allocation of federal and state authority.”

Third, the Court found that to rule in EPSA’s favor would prevent “all use of a tool that no party (not even EPSA) disputes will curb prices and enhance reliability in wholesale markets.” In particular, the Court noted that EPSA’s primary argument—that FERC cannot regulate wholesale demand response—was balanced by the fact that the States were themselves prohibited from regulating wholesale demand response under the FPA, and if neither FERC nor the states could regulate wholesale demand response, “then by definition no one can.” The Court found this potential jurisdictional “gap” to be inconsistent with the purpose of the FPA, which, according to the Court, was drafted “precisely to eliminate vacuums of authority over the electricity markets.” The Court determined that a consequence of accepting EPSA’s argument would be that a wholesale demand response program could not go forward, and that such an outcome would “flout the FPA’s core objectives,” which, according to the Court, are to: (i) protect against excessive prices; and (ii) ensure effective transmission of electric power.

Beyond its three-part analysis on the question of whether or not FERC had exceeded its authority under the FPA in promulgating Order No. 745, the Court also addressed a second, narrower question—“is FERC’s decision to compensate demand response providers at LMP—the same price paid to generators—arbitrary and capricious?” On this question, the Court deferred to FERC’s expertise on electric rate design, and found that FERC had provided a detailed explanation of its choice of LMP as an appropriate compensation mechanism, and had adequately explained its decision not to choose an alternative method of compensation.

In a dissenting opinion joined by Justice Thomas, Justice Scalia argued, among other things, that FERC’s demand response rule was contrary to the plain language of the statute, because demand response providers cannot reasonably be deemed to be engaging in sales for resale, which is the cornerstone of FERC’s FPA power sales jurisdiction.

A copy of the Court’s opinion, along with Justice Scalia’s dissent, can be found here.