Pricing in Organized Wholesale Electricity Markets: Can We Make the Bright Line any Brighter? Introduction

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1 Pricing in Organized Wholesale Electricity Markets: Can We Make the Bright Line any Brighter? Scott Hempling * Originally published in Infrastructure, Volume 54, Number 3, by the American Bar Association Introduction Section 201(b)(1) of the Federal Power Act provides: "The provisions of this subchapter shall apply to... the sale of electric energy at wholesale in interstate commerce, but except as provided in paragraph (2) shall not apply to any other sale of electric energy..." With this language, "Congress meant to draw a bright line, easily ascertained, between state and federal jurisdiction." 1 Not so bright, not so easily ascertained. In vacating FERC's Order 745 (requiring compensation to providers of demand response), the D.C. Circuit held that FERC reached outside its wholesale domain into the states' exclusive retail territory. 2 In vacating a New Jersey statute 3 and a Maryland order 4 (each requiring retail utilities and their customers to guarantee state-specified supplements to the prices received by state-selected generators from selling capacity into PJM's wholesale markets), the Third and Fourth Circuits held that the states had reached outside their retail domain into FERC's exclusive wholesale territory. 5 FERC, Maryland and New Jersey all had the same goal: to protect retail consumers from wholesale prices that are not "just and reasonable." Yet 10 judges in five courts (the Third and Fourth Circuits each upheld a trial court decision), using nearly the same reasoning to interpret the same sentence, held that all three agencies got it wrong. And despite this nearunanimity, 6 there is no consensus in sight, as the multitude of certiorari petitioners and supporting amici attests. Legal uncertainty helps no one. This short article has a simple purpose: After summarizing the opinions, it seeks to derive some common, clear principles that will help federal and state regulators find the "bright line" that keeps them within their assigned lanes. Then market actors and regulators can lay down their litigation swords and get back to bringing efficiencies to consumers. 7 * shempling@scotthemplinglaw.com; B.A. cum laude in (1) Economics and Political Science and (2) Music from Yale University; J.D. magna cum laude from Georgetown University Law Center. Hempling is an adjunct professor at Georgetown University Law Center, where he teaches courses on public utility law and regulatory litigation. He has authored Regulating Public Utility Performance: The Law of Market Structure, Pricing and Jurisdiction, published by the American Bar Association in A companion volume, addressing the law of corporate structure, mergers and acquisitions, is forthcoming. He also has authored a book of essays, Preside or Lead? The Attributes and Actions of Effective Regulators.

2 Nazarian: States May Not Set Wholesale Prices Maryland is a retail competition state whose electric utilities, vertically integrated until the state enacted a retail competition statute in , have largely divested their generation. Each generation-less utility is now a poles-and-wires company, called an electric distribution company (EDC). Each has an obligation to provide physical distribution service to retail customers. The EDCs also must provide "standard offer service" to retail customers who do not shop with competitive suppliers. To provide this service the EDCs must buy capacity and energy at wholesale. Maryland is located within the footprint of PJM Interconnection, Inc., the "regional transmission organization" (RTO) responsible for providing transmission service and administering organized energy and capacity markets within its footprint. 9 Maryland's EDCs buy their wholesale capacity and energy from PJM's markets. Over time, Maryland became concerned that PJM's market design was attracting insufficient generation, resulting in reliability concerns and high wholesale prices for Maryland's EDCs and their retail customers. Although the Maryland Public Service Commission (MPSC) had no authority to compel independent companies to build generation, it could compel its EDCs to enter into wholesale purchase agreements. Using this authority, it issued in 2012 its Generation Order, soliciting competitive proposals to build wholesale generation in zones having reliability risk. In the Generation Order, the Commission promised to compel one or more of its EDCs to enter into a contract that would, as described by the Fourth Circuit, provide "the successful bidder [which turned out to be a company named CPV] a fixed, twenty-year revenue stream secured by contracts for differences (CfDs)." The contract would require the selected wholesale seller to build the specified generation, then bid to sell its energy and capacity in PJM's markets. As the Fourth Circuit explained: If CPV successfully cleared the market, it would be eligible for payments from the EDCs amounting to the difference between CPV's revenue requirements per unit of energy and capacity sold (set forth in its winning bid) and its actual [wholesale] sales receipts. These costs would in turn be passed on to the EDCs' retail ratepayers. If CPV's [wholesale] receipts exceeded its approved revenue requirements, it would be obligated to pay the difference to the EDCs. The CfDs did not require CPV to actually sell any energy or capacity to the EDCs. 10 In other words, this MPSC-ordered contract was not a bilateral contract by which a wholesale seller sold power directly to a wholesale buyer. The generating company was required to sell its output into the PJM market; the wholesale buyer (the Maryland EDC utility) would buy its power from the PJM market. Upholding the district court, the Fourth Circuit held the Generation Order fieldpreempted because it "functionally sets the rate that CPV receives for its sales in the PJM auction." Because the CfD payments (a) were conditioned on CPV clearing the PJM market, and (b) covered the difference between the compensation guaranteed by the state and the price 2

3 established by PJM, "[t]he scheme thus effectively supplant[ed] the rate generated by the [FERC-approved] auction with an alternative rate preferred by the state..." 11 It is true that the state-set compensation satisfied FERC's "minimum offer price rule" ("MOPR") a regulation established to prevent the abuse of monopsony power through lowball bidding by state-supported generators. 12 That fact might save the state's action from conflict preemption, but not from field preemption: Price-setting by the state, even if consistent with FERC's prices, enters FERC's exclusive domain. And the court found the conflict preemption anyway, for two reasons. First, the compensation CPV received under the CfD "directly conflict[s] with the auction rates approved by FERC." Second, compared to the threeyear period that FERC had approved for certain new generators to receive a fixed price, "the duration of the [CfD] subsidy twenty years is substantial." 13 EPSA: FERC May Not Set Compensation For Retail Consumers FERC's Order 745 required load-serving entities purchasing power in RTO energy markets to pay compensation to suppliers of cost-effective demand response resources whose bids cleared those markets. 14 The D.C. Circuit held FERC's action ultra vires because "demand response, while not necessarily a retail sale, is indeed part of the retail market, which, as the statute and case law confirm, is exclusively within the state's jurisdiction." 15 The court continued: "Instead of simply 'removing barriers,' [Order 745] draws demand response resources into the market and then dictates the compensation providers of such resources must receive." 16 The Bright Line: Curve-Shifting vs. Price-Fixing, Indirect vs. Direct Effects So where is the so-called "bright line"? Implicit in all five opinions is this answer: The bright line distinguishes (a) policies that shift supply and demand curves from (b) policies that fix compensation for particular sellers. Curve-shifting affects the market price but it does not set the market price. Consider these three examples: 1. State shifts supply curve. A state can lower the cost of inputs for in-state generation by, for example, reducing property, sales or income taxes; donating or subsidizing land and improvements; providing employee training; or reducing environmental requirements. Each such state action shifts the state s generation company supply curves rightward. At any a given market price, then, the state s companies will be willing to increase supply because their production costs will be lower (all else equal)). This rightward shift in one state's generator supply curves will lead to a rightward shift in the regional market s supply curve, causing the market price (all else equal) to be lower than would be the case absent the state s actions. The state's policies have affected, indirectly, the FERC-jurisdictional market price. But while the market price will be lower, each seller's compensation will still be determined, directly and entirely, by the FERC-jurisdictional market price. There is no "correcting" of any wholesale seller s compensation through a state-ordered payment, made by in-state load-serving entities and backed by their retail customers. These state actions fall on the state side of the bright line. 3

4 2. State shifts demand curve. The state can give away sweaters and compact fluorescent lightbulbs, tighten building codes, tax consumption, set high retail prices during peak periods, or pay consumers to reduce demand and consumption. These actions shift that state s demand curve leftward, causing it to intersect the wholesale market supply curve at a lower price. Again, that lower price a FERC-jurisdictional price is affected by the state, but it is not set by the state. The effect is indirect, not direct. But the Maryland Commission had to act alone. Lacking any power to reduce taxes, donate land, pay for labor training, give away sweaters or tighten building codes, and having already approved some retail demand response and energy efficiency programs, it crafted the Generator Order making its ratepayers cover the difference between the PJM market price and the revenue stream guaranteed to CPV. Doing so did not merely shift a demand or supply curve; doing so, the courts said, fixed the compensation received by the wholesale generator for making a FERC-jurisdictional sale the equivalent of setting a FERC-jurisdictional price. 3. FERC shifts supply and demand curves. Because FERC lacks the broad authority state legislatures and state commissions have (FERC cannot adjust taxes or building codes, subsidize employee training, or give away sweaters or lightbulbs), its opportunities to shift curves are limited. But opportunities do exist. FERC can use its authority specifically, its authority over regional transmission policy (pricing, siting, planning and market entry), gas pipeline siting and transportation, and wholesale gas sales to reduce these input costs for electricity generators, thereby shifting their supply curves to the right. While FERC cannot act directly to shift electricity demand curves, it can require RTOs to accommodate, and recognize, leftward shifts that result from the actions of others, such as LSEs, curtailment service providers (i.e., aggregators of those retail customers willing to supply demand response), and states. In doing so, FERC would not be shifting the customer demand curve directly, because FERC has no authority to regulate the behavior of customers. Rather, FERC would be requiring the RTO to recognize customer behavior that has been influenced by state policy and by other market actors. Just as the state would not be setting the compensation for the wholesale generator in the prior examples, FERC would not be setting the compensation for the retail customer in this example. This logic helps us understand the Fourth Circuit's distinction between effects that are "direct" and "indirect." Recognizing that "not every state statute that has some indirect effect is preempted," the court held that Generation Order's effect "on matters within FERC's jurisdiction is neither indirect nor incidental," because the Order "adopt[ed] terms and prices set by Maryland, not those sanctioned by FERC." 17 Fixing the wholesale seller s compensation sets the price directly; shifting a curve affects the price indirectly. Supplementing FERCauthorized compensation with state-specified compensation, the court said, is setting the market price directly. This reasoning may also explain why neither the Third nor Fourth Circuit bought FERC's argument, made in its brief to the Third Circuit in Solomon (the Third Circuit version of Nazarian), that the state actions were, as FERC's brief argued, a "preempted intrusion upon the Commission's exclusive jurisdiction [under FPA 205(c) and 206(a)] to 4

5 regulate practices 'affecting' rates." Plenty of state actions falling within the legitimate zone of curve-shifting "affect" rates. 18 Were the FPA's drafters thinking supply and demand curves and price points when they wrote 201(b)(1)? Unlikely. But they were thinking bright line, between FERC's exclusive wholesale jurisdiction and states' exclusive retail jurisdiction. The distinction between curveshifting and price-fixing is a way to discern the bright line, especially when a legitimate jurisdictional end (just and reasonable prices) can be achieved by both jurisdictional (curveshifting) and non-jurisdictional (price-fixing) means. And the technical analysis required to distinguish curve-shifting from price-fixing offers more precision than the "directly/indirectly" language offered by the courts. It is true that Maryland did not technically "set" a FERC-jurisdictional price. In the PJM-run market, prices were set by the intersection of market demand and market supply curves created from the bids of individual actors. And in the CPV-EDC wholesale relationship, CPV's compensation for wholesale energy sales was not "set," as a matter of contract law, when the Maryland Commission issued its Generation Order; CPV's compensation was set when CPV voluntarily accepted the contract terms that the Maryland Commission ordered its EDCs to offer. And since CPV was authorized by FERC's market-based pricing regime to charge what it wished, why didn't CPV's voluntary acceptance produce a rate necessarily acceptable to FERC? While the Fourth Circuit did not address this point explicitly, its reasoning does so implicitly: Maryland conditioned CPV's right to sell to a Maryland EDC on CPV's agreement to accept compensation different from the PJM-administered market price that FERC had authorized. This conditioning, because it substituted state-set compensation for FERCauthorized compensation, was, according to the court, the legal equivalent of setting a rate. Solutions: Legitimate Ends Require Legitimate Means In Nazarian and Solomon, four courts invalidated state orders setting compensation for wholesale sellers. In EPSA, the D.C. Circuit invalidated FERC's order setting compensation for retail customers. In all these situations, the state regulators and FERC sought the same legitimate end: just and reasonable wholesale rates. The problem was not the end but the means. And the problem with the means was not its technical design but its jurisdictional location. Compensation to wholesale sellers sufficient to attract generation investment in generation-scarce locations is a legitimate tool, but the FPA assigns that tool exclusively to FERC. Compensation to retail ratepayers for declining to consume is a legitimate tool, but the FPA assigns that tool exclusively to states. So if just and reasonable wholesale rates are the ends, what are the available means? In the context of demand response, FERC has at least three options. It can require RTOs, when determining each LSE's demand, to recognize cost-effective, verifiable demand response, thereby shifting the market demand curve leftwards. It can find, for specific sellers, that there are geographic markets and time periods in which, absent cost-effective demand response, the market supply and demand curves will intersect at levels exceeding just and reasonable prices, thereby justifying price caps (and thus, indirectly, give generation sellers an economic incentive 5

6 to advocate within states for policies that induce demand response). 19 And FERC can deem certain demand response products to be "ancillary services," which under FERC's Order No. 888 brings them within FERC's Commission's transmission jurisdiction. As for states, they can do their own curve-shifting: by opening their retail markets to curtailment service providers; and by defining prudent utility practice as bringing to the RTO markets wholesale demand curves that reflect all cost-effective demand response, with appropriate financial consequences for succeeding or failing to act prudently. * * * As industry actors sellers, buyers and regulators we have a choice: We can continue to involve federal judges in the intricacies of interconnected electricity networks, or we can view the FPA's bright line as distinguishing curve-shifting from price-fixing. The latter approach will get us to just and reasonable rates more surely, more quickly, and less expensively. 1 Nantahala Power & Light Co. v. Thornburg, 476 U.S. 953, 966 (1986) (quoting Southern Calif. Edison Co., 376 U.S. 205, (1964)) (internal quotation marks omitted). 2 Electric Power Supply Association v. FERC, 753 F.3d 216 (D.C. Cir. 2014) (EPSA), vacating Demand Response Compensation in Organized Wholesale Energy Markets, Order No. 745, 134 FERC 61,187 (2011). 3 4 The Long-Term Capacity Pilot Project Act, N.J. Stat. Ann. 48:3-51, 48: The Generation Order, PSC Order No PPL EnergyPlus LLC v. Nazarian, 753 F.3d 467 (4th Cir. 2014), aff'g PPL EnergyPlus, LLC v. Nazarian, 974 F. Supp.2d 790 (D.Md. 2013); and PPL EnergyPlus, LLC v. Solomon, 766 F.3d 241 (3d Cir. 2014), aff'g PPL EnergyPlus, LLC v. Hanna, 977 F. Supp.2d 372 (D.N.J. 2013). 6 Judge Edwards dissented from the D.C. Circuit opinion. 7 Because the 2000-word limit for Infrastructure articles limits details and digressions, this article assumes that all three court decisions will remain undislodged by the U.S. Supreme Court, an outcome sufficiently plausible as to justify creating a plan for living with them. Further, given the similarity in facts and reasoning between the Third and Fourth Circuit cases, to save space I will address only the Fourth Circuit's facts and reasoning. 8 The Electric Customer Choice and Competition Act. 9 For a description of RTOs, see 18 C.F.R. Part 35, Regional Transmission Organizations, Order No. 2000, 89 FERC 61,285 (1999). 10 Nazarian, 753 F.3d at (internal citations omitted). 6

7 11 Nazarian, 753 F.3d at The relevant MOPR version is described at PJM Interconnection, LLC, 137 FERC 61,145 at 96 (2011). As described by the Fourth Circuit, the MOPR requires that "new generators in certain circumstances bid at or above a specified price, fixed according to [FERC's] estimation of a generic energy project's cost. This rule was designed to prevent the manipulation of clearing prices through the exercise of buyer market power." 13 Nazarian, 753 F.3d at FERC has defined demand response to mean a "reduction in the consumption of electric energy by customers from their expected consumption in response to an increase in the price of electric energy or to incentive payments designed to induce lower consumption of electric energy." 18 C.F.R (b)(4). 15 EPSA, 753 F.3d at 222 n EPSA, 753 F.3d at F.3d at 478 (internal quotes omitted). 18 For FERC, the "practice... affecting rates" phrase has been a sore point. In requiring the California Independent System Operator to choose a new Board of Directors using a FERCprescribed method, the Commission had argued that "there is an infinitude of practices affecting rates and service," quoting City of Cleveland v. FERC, 773 F.2d 1368, 1376 (D.C. Cir. 1985). The D.C. Circuit responded pungently: "FERC apparently would have us hold that the existence of an 'infinitude' of practices supposes that there is also an infinitude of acceptable definitions for what constitutes a 'practice' to give it the authority to regulate anything done by or connected with a regulated utility, as any act or aspect of such an entity's corporate existence could affect, in some sense, the rates. We are not biting." California Independent System Operator Corp. v. FERC, 372 F.3d 395, 401 (D.C. Cir. 2004). 19 But see Judge Edwards dissent in EPSA, 753 F.3d at 234, stating that FERC could not issue a rule "requiring ISOs and RTOs to condition all wholesale sales of electricity on load-serving entities' agreeing to charge retail customers with real-time pricing that adjusted hourly for variations in the cost of producing electricity. Such a rule would unambiguously regulate each retail 'sale' because it would mandate a particular form of compensation for actual - not counterfactual - retail sales." 7