“The Rate Is What It Is”: Supreme Court Upholds FERC’s Demand Response Rule

At oral argument in FERC v. Electric Power Supply Association, the Government argued that the retail rate or price of electricity “is what it is”—exactly the amount charged to the customer, without considering any foregone benefits. On Monday, the Supreme Court agreed with that characterization and upheld FERC’s Demand Response rule, rejecting arguments that the rule exceeded FERC’s authority by regulating retail electric rates that are exclusively the domain of state regulators. But before we get to the merits, some background is in order.

What is Demand Response?

Demand Response (DR) refers to the practice of incenting electricity consumers to reduce their demand for power during times of peak power usage. During these peak times, electricity becomes very expensive to generate as older and more inefficient generators are required to run to meet the high demand.

Grid operators throughout the country are tasked with precisely balancing electricity demand and supply at all times. Historically, these grid operators focused on the supply side of the equation—overseeing markets to ensure there is an adequate supply of generation to meet forecasted demand. Over the last 10-15 years, however, FERC and regional grid operators have learned that by lowering demand, they can reduce wholesale power costs and improve grid reliability.

FERC’s Rule 745

FERC’s Rule 745 requires grid operators throughout the country to accept DR bids. It also requires grid operators to compensate DR bidders the same as they compensate generators. If a generator is paid $50 per MWh generated, the DR bidder would receive that same amount for electricity not consumed. DR bids must also clear a test that ensures that they actually reduce wholesale power prices.

Who Opposed the Rule?

The Electric Power Supply Association (EPSA) is primarily a group of large generators. These generators fear that their profits in the wholesale electricity markets will decline as a result of increased reliance on DR. After all, the purpose of the rule is to reduce the need for expensive generation.

EPSA made two primary arguments: (1) FERC exceeded its authority under the Federal Power Act by setting the price of retail electricity rates, which is a role exclusively reserved to the states and (2) the method of compensation was arbitrary and capricious because it gives DR bidders a double recovery—not only do they receive the wholesale power payments under Rule 745 but they also do not incur the costs of actually purchasing electricity in the retail market.

The D.C. Circuit agreed with EPSA on both arguments and struck down the rule.

Hamburgers, Plane Tickets, and Rates: Supreme Court Economics

The Court, 6-2 with Justice Kagan writing for the majority, reversed the D.C. Circuit’s decision and upheld the rule. The Court had no problem concluding that the FERC rule “directly affects wholesale rates,” which is a threshold requirement for FERC jurisdiction under the Federal Power Act (FPA). The more interesting question was whether FERC’s rule violated the FPA because it effectively regulated retail electricity rates, which is an area reserved exclusively for state regulation under the act.

EPSA came up with a creative argument: by paying electricity consumers to reduce their demand, FERC is actually regulating the retail price of electricity. According to the argument, FERC effectively increases the retail price of electricity under Rule 745, because retail customers not only pay the normal retail rate but they also forego a DR payment when they consume electricity. This foregone cost, according to EPSA, increases the effective retail price of electricity.

At oral argument, Chief Justice Roberts explained the EPSA’s argument, in typical Supreme Court fashion, by way of a food analogy. Suppose someone (FERC) was standing outside of a fast food joint, offering potential customers (electric consumers) $5 if they did not buy a hamburger from inside the restaurant (DR payment). Suppose that the restaurant charges $3 for hamburgers (retail rate). Now, according to economic theory, the cost of a hamburger is really $8. The $3 it normally costs plus the $5 in foregone revenue from the person standing outside.

The Court rejected this line of reasoning with its own non-food analogy. Suppose airline customers (electric consumers) paid $400 for a ticket (retail rate) on a flight that is overbooked. The airline (FERC) offers passengers $300 (DR payment) to switch to a later flight with open seats. According to EPSA’s logic, the offer by the airline increased the effective price of the flight to $700. But ask passengers on the original flight how much their ticket cost, and the common sense answer is $400.

The Court concluded that the price of a hamburger is still the price listed on the menu, the price of the airline ticket is what customers originally paid, and the retail price of electricity is still the rate set by state public utility commissions, regardless of any additional opportunity cost. In other words, the price “it is what it is.”

The Court further explained that adopting EPSA’s argument would seriously constrain FERC’s authority under the FPA. If the Court agreed with EPSA’s theory, it would call into question a variety of FERC rules that influence the retail market and would completely prevent FERC from regulating DR altogether.

Finally, the Court easily rejected the DC Circuit’s conclusion that FERC’s decision to compensate DR bids in the same manner as generation bids was arbitrary and capricious. The Court found that FERC’s decision to compensate DR like generation was reasonable because both provide the same value to a wholesale market.