In a landmark decision last month, the U.S. Court of Appeals for the D.C. Circuit fully vacated a major rule enacted by the Federal Energy Regulatory Commission (FERC). The rule—called FERC Order 745—mandated that electricity market operators overpay retail customers who participate in “demand response” programs. According to the court decision, FERC lacked the jurisdiction to write Order 745 and failed to address the legitimate arguments of dissenters before finalizing the rule. Politically, the decision is a blow to the administration’s energy agenda and a signal that the sleepy federal agency has become a more aggressive, more politicized agency since former Chairman Jon Wellinghoff took over.
What Is Demand Response?
A common definition of demand response is: “end-use customers reducing their use of electricity in response to power grid needs, economic signals from a competitive wholesale market or special retail rates.” But modern electricity markets are both technologically complex and highly regulated, so the common definition requires further explanation—how do the economic signals work, and what are these power grid needs?
Regarding economic signals, it’s important to note that organized wholesale electricity markets operate very differently from the retail markets with which most people are familiar. In retail markets, consumers typically pay a flat rate for electricity in a monthly bill, whereas wholesale markets are much more dynamic. Prices don’t only fluctuate widely throughout the day, but also occasionally spike to hundreds of times above normal levels.
Wholesale price spikes can be caused by sharp increases in demand (such as widespread use of air conditioners on very hot days) or abrupt interruptions in supply (such as unplanned outages of power plants or transmission lines). Retail customers do not see these price fluctuations and thus are unable to change their consumption in response to them. In the current structure of electricity markets, the economic signal to adjust consumption is lost in translation between wholesale and retail markets.
With regard to power grid needs, keeping the wholesale or “bulk” power grid in balance requires more time and attention than most people realize. Supply has to match demand on a second-by-second basis in order to avoid problems like equipment failure or blackouts, and there are system operators who monitor the supply/demand balance in real time, all the time.
Historically, grid operators have relied on supply resources like power plants to increase or decrease supply to follow demand. Demand response, on the other hand, gives grid operators a new way to manage stress on the grid before emergency procedures kick in—rather than only asking power plant operators to increase supply, they can also ask some consumers to reduce their demand. There is nothing objectionable about that, but FERC’s regulation went too far, as we explain below.
Who Participates in Demand Response Programs?
Any end-use electricity consumer who acts on real-time price information in organized wholesale markets is broadly participating in demand response. Practically, though, demand response providers tend to be large commercial and industrial consumers, as well as third-party providers who bundle smaller consumers together and offer cumulative load reductions into the wholesale markets.
For example, commercial consumers like Wal-Mart use demand response programs to save on power bills by altering their electricity demand based on wholesale prices and power grid conditions. In the PJM Interconnection, which is the wholesale market covering most of the Mid-Atlantic region, third party “curtailment service providers” (companies like EnerNOC) connect retail customers to the wholesale market.
FERC’s Role in Demand Response
Initially, FERC’s role in demand response was very limited. In the Energy Policy Act of 2005 (EPAct 2005), Congress instructed FERC to “prepare and publish an annual report…that assesses demand response resources.” In 2006, under former Chairman Joseph Kelliher, FERC published a fact sheet that outlined all of its new authorities and mandates stemming from EPAct 2005. Significantly, the fact sheet listed demand response only once, in the section labeled “studies and reports.”
FERC did not take a hands-on approach to demand response until Jon Wellinghoff became Chairman. As Commissioner from 2006 to 2009, Wellinghoff pushed for demand response provisions to be included as part of ongoing transmission tariff reform. However, when he became Chairman in March of 2009, he immediately raised the profile of demand response at FERC. In his inaugural remarks as Chairman, Wellinghoff ranked demand response above other key issues such as transmission planning and energy efficiency.
In fact, one of his first acts as Chairman was to establish the Office of Energy Policy and Innovation within FERC, an office focused on energy market reform which still lists demand response as its top focus area. Wellinghoff moved the issue of demand response at FERC from the fringes in 2006 to one of the agency’s top priorities.
Order 745: Demand Response Overcompensation
In early 2010, Wellinghoff announced the start of demand response rulemaking which proposed a generous rate structure that would apply to all organized wholesale markets under FERC’s jurisdiction. Wellinghoff’s proposed rule would pay demand response providers the full wholesale price for simply avoiding their usual electricity consumption. In FERC speak, the demand response rule ordered wholesale markets to compensate retail consumers at the Locational Marginal Price (or LMP)—which just means the wholesale price at a given time and place on the power grid.
The problem is that paying demand response providers the wholesale price for reducing electricity use results in overcompensation and distorts markets. Basically, Order 745 offers demand response providers a “free” lunch at the expense of actual (as opposed to conceptual) suppliers of electric power. As a group of energy economists argued in an amicus brief they submitted to the D.C. Circuit, Order 745 double-pays demand response providers and leads to perverse consequences.
“FERC’s Rule creates a counterproductive demand-response mechanism that produces economically undesirable behavior and wasteful outcomes that will injure consumers and society in the long run. Although FERC invokes economics to justify its course, the Final Rule is economically irrational. Retail customers that reduce their consumption should not be paid as if they generated the electricity they merely declined to buy.”
As FERC Commissioner Philip Moeller wrote in his dissent from Order 745:
[A]t the wholesale level, the corrosive effect of overcompensating demand resources over time will come at the expense of other resources, particularly generation resources that will have less to invest in maintaining existing facilities and financing new facilities.
Despite Commissioner Moeller’s dissent, FERC kept the “full LMP” compensation in the final version of Order 745, which it issued in March of 2011. With Wellinghoff pushing the FERC agenda, Order 745 shrugged off the concerns of Commissioner Moeller and others over demand response’s negative effects on power generators. FERC instead made the bold declaration that full LMP didn’t have to make “textbook economic” sense (paragraph 46):
In the face of these diverging opinions, the Commission observes that, as the courts have recognized, ‘issues of rate design are fairly technical and, insofar as they are not technical, involve policy judgments that lie at the core of the regulatory mission.’ We also observe that, in making such judgments, the Commission is not limited to textbook economic analysis of the markets subject to our jurisdiction, but also may account for the practical realities of how those markets operate.
The D.C Circuit’s Decision
After FERC denied rehearing of the rule, the Electric Power Supply Association and the California Independent System Operator Corporation petitioned the D.C. Circuit Court of Appeals. Petitioners argued that FERC lacked jurisdiction to issue the rule in the first place and seconded the arguments made by the energy economists. For an in-the-weeds explanation of the economic arguments, please see this article.
The Court heard oral arguments in September of 2013 and issued its opinion in May 2014. The Court not only held that FERC over-stepped its jurisdiction and vacated the rule in its entirety, but also found FERC’s demand response payments to be “arbitrary and capricious.” As the majority opinion noted, “if FERC thinks its jurisdictional struggles are its only concern with Order 745, it is mistaken.” In short, FERC does have to make textbook economic sense, especially when a standing Commissioner says FERC is out of bounds.
Acting FERC Chairman Cheryl LaFleur is seeking an en banc rehearing of the D.C. Circuit’s decision (before all of the D.C. Circuit judges, not just the panel of three judges that decided the case). Meanwhile, FERC’s authority over demand response is uncertain as its direct, statutory role may revert to its former “studies and reports” function.
Order 745 went beyond the limits of FERC’s authority and was ultimately rejected in the D.C. Circuit. The court’s decision is a surprisingly firm check on FERC’s authority, wiping out the entire demand response compensation program—the brainchild of previous Chairman Jon Wellinghoff and the subject of literally thousands of filings at FERC. The decision is also great news for U.S. energy policy, as it provides a level of accountability and scrutiny that the court rarely gives agencies like FERC. Here’s hoping that the court’s check on FERC’s expanded powers is the new normal.