The Essential Environmental & Energy Blog

“Demand response ... emerged ... as a market-generated innovation for more optimally balancing wholesale electricity supply and demand.”

– Federal Energy Regulatory Commission v Electric Power Supply Association (Justice Elena Kagan)

The United States Supreme Court recently ruled that energy users could be paid to not use energy at peak times. An industry group representing utilities argued that doing so was not permitted by statute. The ruling was roundly praised by consumer and environmental groups.

What if consumers of energy obtained a benefit for not using energy during peak periods? That’s exactly what the Federal Energy Regulatory Commission (FERC) did when it issued a rule to promote “demand response,” or DR. DR provides incentives on the wholesale level to those who use less electricity during times of high demand when compared to their expected consumption. Instead of paying utilities top dollar to increase production at times of high demand (which increases the costs of electricity across the board), FERC decided it would be more economical and improve system reliability to pay users to dial down their usage.

Electric utilities make more money when the demand is the greatest. Auctions set the wholesale price of energy in which utilities and “load-serving entities,” or LSEs, purchase from generators of energy and resell to the users. The greater the demand, the costlier the energy. If an incentive exists to forgo using that power, the utility cannot make money from the electricity it does not sell. But, it may save money on capacity it does not have to operate.

Under DR, large users bid prices to lower usage by a specific amount during a specific time. Utilities and LSEs compare the cost of production with the cost of avoiding energy use and then select the most economical option. In order to avoid DR bids that are not economical, the DR bidder must show that it can actually provide the reductions promised and that the reductions will provide a net benefit by actually providing savings and reliability on the wholesale level.

The Electric Power Supply Association (EPSA), a power suppliers’ trade association, challenged the rule on the basis that under the Federal Power Act, FERC could only regulate interstate sales of energy at the wholesale level. EPSA argued that the practical effect of DR was to affect prices at the retail level to the extent that it was equal to “regulating” the retail market, which was the province of the states. Further, EPSA argued that FERC’s rule was arbitrary and capricious because FERC could not justify “overcompensating” users by allowing them to earn money by being paid not to use energy AND receive the benefit of not having to pay for the energy they did not use. At the federal district court level, EPSA’s challenge prevailed.

The Supreme Court reversed the lower court on all counts. The focus of the ruling was not whether DR would keep prices down and improve grid reliability – Justice Elena Kagan (writing for the majority) noted that no one, not even EPSA, disputed DR’s benefits. Instead, the focus was solely on whether DR impermissibly regulated retail sales and whether FERC was arbitrary and capricious in issuing the rule.

In looking to see if the rule impermissibly regulated retail rates, Justice Kagan noted that wholesale and retail rates are intertwined and policies affecting wholesale rates would necessarily affect retail rates. As the rule’s intent was to control wholesale rates and guarantee the efficacy of the grid, incidental effects to retail rates, while expected, did not amount to regulating retail rates. Also, the rule provides that states could prohibit consumers within that state from taking advantage of DR in the wholesale market.

In justifying the rate at which DR compensates users (i.e., Locational Marginal Price (LMP)), FERC concluded that DR bids should receive the same weight as generation bids because the value both provided to the grid was equal. The net benefits test would ensure that in the event DR failed to provide the same benefit, it would not apply. The Supreme Court determined that FERC adequately explained its rationale and, as a result, FERC did not abuse the discretion afforded to it in rule-making.

Nothing requires users to forgo purchasing energy at peak levels. The FERC rule seeks instead to provide market incentives to reduce usage. The benefits to the grid are that peak use is reduced by the amount of energy not used as a result of the incentives, thereby easing strain on the grid. At the same time, power plants normally used to provide extra power to the grid during these times remain idle, resulting in fewer air emissions, and energy prices are reduced, saving consumers money.