United States: The Court Has Spoken: State Programs To Incentivize The Construction Or Continued Operation Of Electric Generators Must Be Crafted To Avoid Preemption By Federal Law Or May Be Rejected

Energy regulators throughout the United States are looking for ways to encourage production of clean electricity, including from renewable sources. States, public utility commissions, power producers, power distributors and other stakeholders must be cautious not to run afoul of federal law or risk having their efforts derailed under the Supremacy Clause of the US Constitution.

The case of Hughes v. Talen Energy Marketing, LLC, 136 S. Ct. 1288 (2016), decided by the US Supreme Court on April 19, 2016, is a cautionary tale with helpful insights.

Hughes involved the State of Maryland's effort to encourage new in-state power generation. In Maryland, wholesale sales of electricity are conducted via auction administered by PJM Interconnection, a Regional Transmission Organization (RTO). RTOs, together with Independent System Operators (ISOs), manage the wholesale bulk power grid for two-thirds of electricity consumers in the United States under oversight from the Federal Energy Regulatory Commission (FERC). The Federal Power Act (FPA) grants exclusive jurisdiction to FERC over wholesale sales and transmission of electricity in interstate commerce. The FPA preserves for the states regulation of retail electricity sales, local distribution of electricity and generation, including siting of generation. 

The Maryland Public Service Commission (MPSC) became concerned that PJM's electric generating capacity auction failed to provide sufficient economic incentives to encourage new in-state electricity generation where and when needed. As a result, the MPSC took matters into its own hands.

In Maryland, as in most states where generation has been unbundled from transmission and distribution service, Load Serving Entities (LSEs) typically purchase electricity at wholesale (for resale) through the regional markets administered by the ISO or RTO. Wholesale rates are determined by auction under ISO/RTO market rules approved by FERC. The LSEs, in turn, resell the electricity to retail consumers. Some RTOs (ISO-New England, NYISO, PJM and MISO) hold capacity auctions to meet the projected power demand. Each LSE must procure sufficient electric capacity to meet its customers' peak demand plus a reliability reserve margin. Power suppliers sell the electric capacity in the interstate market through RTO/ISO-administered auctions. All the electric capacity that clears the auction is purchased by LSEs at the locational "clearing price" for the capacity zone in which it is sold. In the case of PJM, all the capacity that bids in below a demand curve developed by PJM (and approved by FERC) receives the locational clearing price.

In some markets, in addition to purchasing power through the RTO auction, LSEs enter into bilateral contracts with electricity suppliers. The bilateral contract transfers ownership of the electric capacity and/or energy from the supplier to the LSE. LSEs may use bilateral contracts in such a way that the LSE purchases electricity below the auction rate. The FERC has long made accommodations for the use of bilateral contracts.

In 2012, MPSC issued an order aimed at encouraging construction of new in-state electric power generation by soliciting proposals for construction of a new power plant and requiring LSEs in Maryland to enter into long-term contracts with the new power plant at a specified rate determined through a competitive solicitation process. The MPSC ordered electric distribution companies (EDC) to enter "contracts for differences" (CFD), which required the seller to clear capacity from the new power plant in the PJM auction, but the EDC would pay the owner of the power plant the difference between the auction clearing price and the CFD price if the clearing price were lower. The owner would pay the EDC the difference between the auction clearing price and the CFD price if the auction price were higher. The CFD in effect locked in the capacity price the generator would receive. The MPSC scheme did not transfer the capacity from the new power plant to the EDC. Rather, the contract for differences constituted a financial arrangement to assure the owner of the power plant that, regardless of the auction price, it would receive the state-approved CFD price for the wholesale sale of its capacity.

Incumbent generators in PJM challenged the Maryland scheme in federal court, claiming that the State imposed a wholesale price for capacity outside the FERC-approved PJM auction. They asserted that such a state-supported price must yield to FERC's exclusive jurisdiction over wholesale sales of power in interstate commerce.

The district court ruled in favor of the generators and the US Court of Appeals for the Fourth Circuit affirmed, finding that the Maryland program and CFDs were both field preempted and conflict preempted. PPL EnergyPlus, LLC v. Nazarian, 753 F.3d 467, 476, 479 (4th Cir. 2014). Under field preemption, when a state law or regulatory action targets regulation of the same subject matter that federal legislation has reserved for FERC in a field which the federal regulator fully occupies, there is no room for state regulation. Oneok, Inc. v. Learjet, Inc., 135 S. Ct. 1591, 1595 (2015). Under conflict preemption, both one or more states and a federal regulator may regulate the same subject matter so long as the state regulation does not conflict with the federal regulation. Id.

In Hughes, the Supreme Court found that the MPSC order was preempted by the FPA because it "set[] an interstate wholesale rate." The Court noted that states improperly "interfere with FERC's authority by disregarding interstate wholesale rates."

The Supreme Court took issue with the MPSC initiative in three significant ways. First, the MPSC compelled LSEs to enter into "contracts for differences" with the new power plant at a price approved by the MPSC. Second, the "contracts for differences" required by the MPSC differed from bilateral contracts because the MPSC "contracts for differences" did not transfer ownership of electricity to the LSEs outside the auction. Third, traditional long-term hedging contracts between generators and LSEs, also known as contracts for differences, need not require a party to enter and clear the capacity auction. The MPSC order, on the other hand, tied the payment at the state-approved rate under the "contracts for differences" to power that cleared the PJM capacity auction (under exclusive jurisdiction of FERC), thereby setting a non-FERC approved wholesale rate.

By carefully pointing out these differences, the Supreme Court indicated that had the MPSC order been more precisely crafted, it may have survived judicial challenge. The Supreme Court stated that its holding is "limited" and that the MPSC order was rejected "only because it disregards an interstate wholesale rate required by FERC."

A long line of Court decisions make it clear that a state is not permitted to modify wholesale rates approved by FERC, even if a state believes the rates are unreasonable. The Court noted, however, that its opinion does not address the permissibility of using tax incentives, land grants, direct subsidies, or other means to encourage development of new or clean energy. The Supreme Court appears to be inviting states to experiment with other programs "untethered to a generator's wholesale market participation." The fight for years to come will likely be to determine the outer limits of state incentive programs where the programs only indirectly affect the interstate wholesale rate. A key question going forward for state incentive programs is: To what extent does this program stand as an obstacle to Congress's objective to have FERC establish interstate wholesale rates?

A major takeaway from Hughes is that regulators and market participants that wish to participate in state programs would be wise to craft state programs that achieve new, clean and renewable generation objectives without interfering with or establishing wholesale rates.

Market participants interested in addressing state regulatory policy issues, including new, clean and renewable energy development, are encouraged to contact Dentons' Energy Markets & Regulatory practice lawyers.

Readers who would like to hear a more in-depth analysis are encouraged to attend the Energy Bar Association Annual Meeting in Washington, DC, on June 7, 2016, where Stuart Caplan, a partner at Dentons US LLP, will moderate a distinguished panel discussing the impact of Hughes, together with Oneok, Inc. v. Learjet, Inc., 135 S. Ct. 1591 (2015) and FERC v. Electric Power Supply Ass'n, 136 S. Ct. 760 (2016), a rare trilogy of Supreme Court cases all focused on the dividing lines between FERC and state authority to regulate the electricity and natural gas markets.

Dentons is the world's first polycentric global law firm. A top 20 firm on the Acritas 2015 Global Elite Brand Index, the Firm is committed to challenging the status quo in delivering consistent and uncompromising quality and value in new and inventive ways. Driven to provide clients a competitive edge, and connected to the communities where its clients want to do business, Dentons knows that understanding local cultures is crucial to successfully completing a deal, resolving a dispute or solving a business challenge. Now the world's largest law firm, Dentons' global team builds agile, tailored solutions to meet the local, national and global needs of private and public clients of any size in more than 125 locations serving 50-plus countries. www.dentons.com.

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