In an opinion unanimous in judgment (albeit with two concurring opinions), the U.S. Supreme Court recently reiterated the reach of the Federal Energy Regulatory Commission’s (FERC) jurisdiction over interstate wholesale electricity sales in Hughes v. Talen Energy Marketing, LLC, 578 U.S. ___ (2016). In the midst of rapid transformation in the energy industry, the expansion of gas-fired electric generation capacity is prevalent. Natural gas capacity additions in 2016 as planned will be second only to solar and will exceed average natural gas capacity additions during the last five years. Although the gas-fired power plant incentive program put in place by the State of Maryland, as structured, was invalidated by the Court’s Hughes decision, the Court was clear in validating State efforts to encourage the development of new and clean power generation. The failure of the Maryland program lies in its encroachment on the wholesale electricity capacity auction that falls under the sole jurisdiction of FERC. We discuss key takeaways from the Court’s decision below.

FERC Regulated Wholesale Capacity Auction

Under the Federal Power Act (FPA), FERC has been granted exclusive jurisdiction over regulating the sale of electricity at wholesale in the interstate market. The States have the authority to regulate retail electricity sales and “control over in-state ‘facilities used for the generation of electric energy.’” The Hughes decision provides an excellent explanation of the operation of wholesale electricity auctions, including the capacity auction at issue which is managed by PJM Interconnection, the Regional Transmission Organization (RTO) authorized by FERC to manage the electric grid in several mid-Atlantic and Midwestern states and D.C. FERC regulates the PJM capacity auction to ensure that supply and demand are balanced efficiently, resulting in a just and reasonable rate. For purposes of understanding the Court’s reasoning in striking the Maryland incentive program, it will suffice to understand that PJM operates a capacity auction designed to ensure that the projected long-term demand for electricity will be met in the region. PJM projects electricity demand three years in advance, allocating a portion of that demand to each load serving entity (LSEs), which are the organizations responsible for purchasing electricity at wholesale from independent power generators and delivering the electricity to retail customers. Owners of capacity place bids to sell that capacity to PJM, which accepts bids from lowest to highest until enough capacity has been purchased to fulfill the projected demand. At the end of the capacity auction, all sellers receive the highest bid rate that PJM accepted to satisfy demand, i.e. the “clearing price.” LSEs purchase the amount of electricity necessary to meet their portion of overall projected demand from PJM, paying the clearing price.

State Incentive Program

The Maryland Public Service Commission issued an order to address what the State perceived as inadequate incentives in the PJM capacity auction to entice new power generators to enter the market. Under the Maryland order, a proposal by CPV Maryland, LLC to construct a new gas-fired power plant was accepted by the State. The order required LSEs to enter into long-term 20-year contracts to purchase capacity from CPV at a rate determined in the CPV proposal. These “contracts of differences” related to the PJM capacity auction as follows: CPV would bid its capacity into the PJM capacity auction and if its capacity cleared the auction at a clearing price that was lower than the contract price, the LSEs would be required to pay CPV the difference between the contract price and clearing price. Similarly, if CPV’s capacity cleared the auction at a clearance price higher than the contract price, CPV would pay the difference to the LSEs. LSEs would either recoup their additional costs through higher retail customer rates or would pass on any savings to retail customers through reduced rates. New Jersey also implemented a similar program.

Overstepping the Boundaries of the FPA

The District Court ruled that the Maryland program violates the Supremacy Clause of the U.S. Constitution because it sets the wholesale rate for electricity that CPV receives: “While Maryland may retain traditional state authority to regulate the development, location, and type of power plants within its borders, the scope of Maryland’s power is necessarily limited by FERC’s exclusive authority to set wholesale energy and capacity prices.” The Fourth Circuit Court of Appeals agreed, reasoning that “state laws are preempted when they ‘den[y] full effect to the rates set by FERC, even though [they do] not seek to tamper with the actual terms of an interstate transaction.’” The Fourth Circuit also invalidated the Maryland program on the grounds that it contradicts FERC’s New Entry Price Adjustment (NEPA) rule which guarantees new generators a stable capacity price for the first three years after they enter the market. By contrast, the Maryland program gives a 20-year price guarantee and FERC already “refused Maryland’s request to extend the duration of the NEPA past three years.”

The Supreme Court agreed with the Fourth Circuit’s judgment that the Maryland program encroaches upon FERC’s authority to set wholesale rates, but declined to determine whether the Maryland program also failed due to its conflict with the NEPA or because of interference with the PJM capacity auction’s price signals. The Supreme Court explained “FERC has approved the PJM capacity auction as the sole rate setting mechanism for sales of capacity to PJM, and has deemed the clearing price per se just and reasonable.” Because the contract for differences “operates within the auction” by “mandate[ing] that LSEs and CPV exchange money based on the cost of CPV’s capacity sales to PJM,” the Supreme Court found that the program impermissibly sets an interstate wholesale rate. The Court did note that its decision “does not call into question whether generators and LSEs may enter into long-term financial hedging contracts based on the auction clearing price,” as these contracts (also known as “contracts of differences”) do not implicate state action to the same extent as the Maryland program.

Limited Ruling: State Efforts to Incentivize New and Clean Energy Generation Encouraged

Despite the Court’s decision to invalidate the Maryland program, the Court explicitly stated that its holding is limited and is not intended to “foreclose Maryland and other States from encouraging production of new or clean generation through measures ‘untethered to a generator’s wholesale market participation.’” The Court listed several other avenues that States might pursue which should not be impacted by the Hughes decision such as tax incentives, land grants, direct subsidies, construction of state-owned generation facilities, or re-regulation of the energy sector. “So long as a State does not condition payment of funds on capacity clearing the auction, the State’s program would not suffer from the fatal defect that renders Maryland’s program unacceptable.”