October 17, 2014

Begging to Differ: Federal Courts Strike Down State Contract-for-Difference Schemes

The Third and Fourth Circuits recently struck down measures in New Jersey and Maryland, respectively, which aimed to promote in-state electricity generation by setting wholesale rates. This post examines the regulations, the courts reasoning, and implications for renewable energy.

The Third and Fourth Circuit Courts of Appeal recently struck down measures in New Jersey and Maryland, respectively, which had aimed to promote in-state electricity generation by essentially setting wholesale electricity rates. The Third Circuit recently decided PPL EnergyPlus v. Solomon in March, while the Fourth Circuit decided PPL Energy Plus v. Nazarian in June. These cases are important to renewable energy because they highlight the fact that federal law constrains state strategies for influencing the energy market. In short, these cases reinforce that states may not set or alter wholesale electricity rates, which in turn suggests that state energy procurement mandates are a better option. This blog post describes the policies New Jersey and Maryland attempted to implement, explains the reasoning the Third and Fourth Circuits used to strike those policies down, and briefly explores what these cases entail for state efforts to promote renewable energy.

The electrical transmission grids in Maryland and New Jersey operate under the management of a Regional Transmission Organization (RTO) called the PJM Interconnection, LLC (PJM). Although “PJM” stands for “Pennsylvania, Jersey, Maryland,” PJM actually manages electricity transmission for a very large area that includes parts of twelve states and the District of Columbia. PJM’s role is to manage what the Third Circuit eloquently described as “a delicate circuitry of interdependence between private entities and public utilities, and between [states] and federally-regulated wholesale energy markets.” Basically, PJM runs markets for electricity and for the capacity to generate electricity on demand. Auctions in these markets determine which generators actually sell energy in the PJM service area.

Like any Regional Transmission Organization or Independent System Operator (ISO), PJM operates its energy and capacity markets under the blessing of the Federal Energy Regulatory Commission (FERC). FERC’s approval for PJM markets is necessary because Congress, in the Federal Power Act, claimed exclusive federal jurisdiction over wholesale electricity sales in interstate commerce. Since the 1990s, FERC has presumed that freely negotiated contracts are “just and reasonable” and therefore legal. FERC has thus in some locations delegated its authority over wholesale ratemaking to RTOs and ISOs, approving rates resulting from the auctions the RTOs and ISOs administer. In sum, Congress claimed exclusive jurisdiction over wholesale power rates, giving FERC jurisdiction over those rates, and FERC in turn allowed independent markets to actually determine wholesale rates. Thus, PJM’s markets, although run by an independent organization, operate under the aegis of federal law.

Although PJM’s markets are designed to send price signals that will promote construction of new power plants where they are most economically efficient, both Maryland and New Jersey found their electricity rates rising and too few power plants being built within their borders. Maryland worried about a “looming capacity shortage,” while New Jersey found that it had “become more reliant on coal-fired power plants” in other states (in conflict with state policies about climate change and renewable energy).

Before 1999, Maryland and New Jersey could easily have corrected these problems by simply ordering local utilities to build new, clean, local power plants. But in 1999, both states restructured their energy markets, requiring utilities to buy energy on wholesale interstate markets. Restructuring thus basically turned bundled retail electricity service into separate enterprises: wholesale electricity sales (subject to exclusive FERC jurisdiction), wholesale transmission services (also subject to FERC jurisdiction), and retail electricity services (subject to state jurisdiction). Thus, restructured states clearly lost some regulatory authority over electricity prices; how much authority they lost was the key issue before the Third and Fourth Circuits.

Under the Federal Power Act, even after restructuring, states retain authority over retail prices and power procurement. For example, states can continue to regulate the need for new power facilities and retail electricity rates. However, FERC and federal courts have made it clear that states cannot directly set wholesale rates or use retail ratemaking powers to interfere with exclusive federal power over wholesale rates. In the Fourth Circuit’s words, “throw[ing] in its lot with the federal interstate markets … [entailed] a relinquishment of the regulatory autonomy the state[s] had formerly enjoyed with respect to traditional utility monopolies.” Despite these constraints, both Maryland and New Jersey sought to guarantee wholesale prices to desirable power plants. In doing so, they overstepped their jurisdictional reach.

Maryland and New Jersey attempted to work within the complex overlay of federal and state authority in order to promote local electricity generation by creating a “contract for differences” scheme. The basic goal was to help proposed power plants secure financing by guaranteeing a fixed revenue stream. Under these contracts-for-differences, new in-state power plants would still sell power into the PJM markets. If PJM’s auction yielded a price below the contract-for-differences rate, the buyer of the power would pay the power plant the difference. If the auction price was above the fixed contract price, the power plant would pay the difference to the buyers. The result would be that new power plants would always receive the same price for their power, no matter what price PJM’s auctions determined. 

The Third and Fourth Circuits concluded that federal law preempted these contract-for-differences schemes. Essentially, the courts reasoned that Congress had intentionally occupied the field of setting wholesale electricity rates and that the contracts-for-differences were basically state attempts to fix wholesale rates. In the Third Circuit’s words, New Jersey “incentivize[d] the construction of new power plants by regulating the rates new electric generators [would] receive” for their output. The Fourth Circuit, meanwhile, held that Maryland “effectively supplant[ed] the rate generated by the [federally regulated] auction with an alternative rate preferred by the state.” Because the states attempted to fix wholesale rates, which is an exclusively federal prerogative, federal law preempted these state efforts.

Both Maryland and New Jersey raised some unsuccessful counterarguments. For example, the courts found irrelevant the states’ argument that independent market operators, rather than federal agencies, were actually setting rates, because federal law created those markets and a federal agency regulates them (although in a laissez-faire style). Similarly, both courts rejected the argument that the contracts-for-differences did not fix wholesale rates because they used a separate transaction from the PJM market. The courts found that “the fact that [the scheme] does not formally upset the terms of a federal transaction is no defense, since the functional results are precisely the same.” Similarly, while finding that states still retain some power to promote local energy generation, the Third Circuit reasoned that what New Jersey had done was not really merely subsidizing local generation, but rather was tinkering with wholesale rates. Ultimately, the courts found the states’ arguments unconvincing, finding, in the Third Circuit’s words, that the states “intruded into an area reserved exclusively for the federal government.” Thus, both Maryland and New Jersey’s efforts to use contracts-for-differences to promote in-state electricity generation have failed.

These holdings from the Third and Fourth Circuits have considerable implications for state efforts to promote renewable energy. Providing a secure revenue stream for new renewable energy generators is one of the most obvious strategies for increasing deployment, but these holdings make clear that courts will strike down state laws that are functionally equivalent to wholesale ratemaking. In some sense, this is not a surprise. FERC clarified in 2010 that states must act within the confines of the federal Public Utilities Regulatory Policy Act (PURPA) when setting wholesale rates that utilities must pay for renewable energy. Generally, PURPA provides a limited exemption from otherwise exclusive federal jurisdiction over wholesale rates, allowing states to require utilities to buy power at rates no higher than their avoided costs (the rates they would otherwise have paid for that power absent a state requirement). However, FERC clarified that federal law does preempt state regulations that go beyond what PURPA authorizes. These cases reinforce that point; in formulating policies to combat climate change and promote renewable energy, states must be careful to work within the constraints that federal laws establish. 

A thorough analysis of what state policies would be permissible under federal law is beyond the scope of this blog post. A forthcoming paper by the Green Energy Institute’s Director, Professor Melissa Powers, and my colleague Amelia Schlusser will discuss the significant limits that PURPA imposes on state efforts to establish European-style Feed-In Tariffs and will explore several other regulatory options. This post merely notes that these cases suggest that federal courts will seriously scrutinize state policies that encroach on exclusively federal jurisdiction. In other words, state efforts to set wholesale electricity rates will likely fail.

However, these cases are not a cause for despair for renewable energy advocates or for states that may seek to promote renewable energy. Importantly, the Third and Fourth Circuits both described limits to their holdings, noting that federal law would not preempt a state policy merely because it had an effect on wholesale rates. Noting that basically any regulation of the energy market would likely effect wholesale energy prices, the Third Circuit stated that “the law of supply-and-demand is not the law of preemption.” If federal law preempted all regulations that impacted wholesale rates, “the states might be left with no authority whatsoever to regulate power plants.” The Third Circuit was quite clear: “That is not the law.” The Fourth Circuit, meanwhile, noted that “states plainly retain substantial latitude in directly regulating generation facilities.” Moreover, the court was careful to note that its holding was not about “other state efforts to encourage new generation, such as direct subsidies or tax rebates.” 

The moral of the story is that states do retain significant authority to regulate about such matters as the type, location, and environmental impacts of power plants. That being said, when working to promote renewable energy, state laws must be carefully tailored to work within the federal framework. Otherwise, those laws risk being struck down in court. Renewable energy advocates would be wise to pay close attention to federal constraints; failing to follow federal law closely risks wasting the valuable time and effort that goes into designing and advocating for new policies.