Last week, the Supreme Court ruled that the federal government is empowered to regulate wholesale demand response, or targeted reductions in electricity use by consumers in response to peak demand.

The ruling in Federal Energy Regulatory Commission (FERC) v. Electric Power Supply Association (EPSA) has been hailed by a broad coalition comprising environmental activists, regulators and companies, because demand response can reduce rates and ease strain on the grid.

Insofar as it places demand response on firm legal footing, the decision is eminently sensible. But the broader implications of this decision for the line between federal and state jurisdiction in the electricity sector could be problematic for a more decentralized future power system intended to be cheaper, cleaner and more reliable.

My take is that this decision can guide the development of demand response, but we still need congressional action (and perhaps a broader Supreme Court decision) to update a U.S. electricity market framework that is over 80 years old.

Think back to Econ 101

The full Supreme Court decision is actually riveting reading. In particular, Justice Kagan, writing for the majority, takes pains to explain a fairly complex power market issue, urging readers to “think back to Econ 101” and quipping that artificially stable electricity retail rates “short-circuit the normal rules of economic behavior.” (By the way, Justice Scalia’s dissent promptly ridicules the majority for misconstruing elementary economics, “notwithstanding its own exhortation.” Entertaining stuff.)

The case arose because of a 2011 FERC regulation (“Order 745”) that compensates providers of demand response identically to traditional electricity generators in wholesale markets (most commonly interstate markets for generated electricity that is then transmitted and sold to customers). That means that a consumer -- or, more commonly, a group of consumers pooled through a third-party aggregator -- can bid into wholesale energy markets and get paid per unit of energy they save at the same rate that generators are paid per unit of energy they produce. 

At issue was whether Order 745 overstepped the jurisdiction granted in the 1935 Federal Power Act (FPA) to FERC to regulate wholesale power sales, but devolved to states' authority over retail prices, which are final prices consumers pay for electricity that include wholesale energy costs, as well as other costs to deliver the energy to the consumer. A lower court had ruled that Order 745 had overstepped, leaving demand response in regulatory limbo and chilling the investment climate for such services.

The court’s majority opinion lays out a three-part argument upholding the legality of FERC Order 745. First, FERC has jurisdiction over demand response, because it directly affects wholesale power rates. If bids to reduce energy consumption displace bids to produce power, then the marginal price of electricity -- which sets the wholesale market rate -- falls.

Second, FERC is not straying into regulation of retail rates because it does not tell states how to set final consumer rates (and in fact, Order 745 allows states to prohibit their consumers from participating in demand response). Although wholesale demand response may increase or decrease (more likely decrease) the retail cost of power by changing an input cost -- the wholesale power cost -- the court found that such knock-on effects are inevitable in any lawful regulation of the wholesale market.

And third, FERC pursued a reasonable decision-making process to stipulate identical compensation for demand response providers as for traditional generators. The court acknowledges FERC’s sound justification that demand-response providers are providing the exact same service as traditional generators, thereby meriting equal compensation, and that demand response can help the power grid when it is overburdened. Still, the court defers to FERC’s technical expertise and statutory mandate as the reasons why Order 745 is legal, rather than the correctness of its compensation decision.

All of this makes sense, both legally and as good policy. But taking a step back, this case was important not just because of the narrow demand-response issue at stake, but also because of the broader question of what the federal government gets to regulate and what states can regulate.

By clearly coming down on FERC’s side in this decision, the court makes it easier for the federal government to claim jurisdiction over other aspects of the power system that 1) directly affect wholesale rates and 2) only indirectly affect retail rates. Is this a good or bad thing?

The hazy 'bright line'

That is probably the wrong question to ask. The existing U.S. framework for regulating the power sector, dating back to 1935, draws a “bright line” (a phrase used by the Supreme Court in 1964) “between state and federal jurisdiction.” Within that framework, the Supreme Court’s decision in FERC seeks to define where exactly that bright line is, in the process probably expanding the federal government’s jurisdiction.

But as energy lawyer Robert Nordhaus points out, “the hazy ‘bright line’" is a poor construct for regulating the modern power sector. So this decision does not change the underlying imperative to update the regulatory framework to enable the evolution of the power system.

The only aspect of the court’s majority opinion in FERC that bothered me was this passage in footnote 7 (emphasis mine):

The dissent’s framing of the issue is wrong if and to the extent it posits some undefined category of other electricity sales falling within neither FERC’s nor the States’ regulatory authority. Sales of electric energy come in two varieties: wholesale and retail.

That was true in the last century, and that is tautologically true under the “bright line” regulatory framework. But the power market has become considerably more complex, and more issues after demand response will continue to pop up as regulatory ambiguities. As Nordhaus points out:

Trying to apply the Bright Line to tomorrow’s grid may be even more problematic than applying it to today’s. New technologies and new commercial practices, including: microgrids -- where retail customers in an area take power from, and deliver the output of distributed generation into, a local network which in turn may purchase or sell at wholesale to a distribution utility; energy storage -- where end users may charge storage at retail and discharge and sell at wholesale; automated demand response -- where an RTO [“regional transmission operator,” a nonprofit entity that operates the transmission grid] can signal retail customers to reduce demand or charge or discharge batteries or other storage; and real-time pricing -- which permits customers to increase or decrease energy use based on wholesale prices; all challenge the assumption that we can easily distinguish between wholesale and retail service. They may require new forms of regulation that probably cannot be accommodated by the existing wholesale/retail division of labor.

What’s more, initiatives like Reforming the Energy Vision in New York or Distribution Resource Plans in California aim to create localized, distribution-level markets for energy services -- including energy, capacity, ancillary services and more. These markets would enable an efficient, decentralized power system that could partially replace today’s centralized grid.

Such a system could avoid massive infrastructure build-outs to provide power more cheaply, improve reliability by spreading out the network, and reduce greenhouse gas emissions by integrating cleaner sources of electricity. But these distribution-level markets may very well meet the court’s two-part test in FERC of directly affecting wholesale rates and indirectly affecting retail rates, triggering federal jurisdiction over state initiatives.

The right response is for Congress to update the statutory framework for power-sector regulation. A new framework should recognize that rather than a federal vs. state framework, the two most relevant levels of modern electricity systems are the regional level (i.e., the interstate level at which wholesale markets now operate) and the local level (i.e., the sub-state level at which decentralized distribution markets may operate in the future). 

The court’s decision in FERC was the right one in relation to the narrow issue of enabling demand response. But even though this decision relied on an outdated framework, I hope it does not calcify that framework, leaving the country stuck with yesterday’s policy tools to deploy tomorrow’s technology.

Instead, assuming that this decision is the first step toward broader reform, I’m going to join the celebrations.


Varun Sivaram is a fellow at the Council on Foreign Relations. He holds a doctorate in physics from Oxford University. This piece was originally published at the Council on Foreign Relations website and was reprinted with permission.

Full disclosure: Sivaram is an advisor to New York’s REV. This piece reflects his personal views only.