Old statutes, new problems.

• Author: Freeman, Jody
• Position: II. Policymaking in the Absence of Congress B. Managing Changing Electricity Markets Under the Federal Power Act 2. Adapting the "Just and Reasonable" Standard to Market Rates through Conclusion, with appendices and footnotes, p. 47-93

2. Adapting the "Just and Reasonable" Standard to Market Rates

   After Order No. 888, FERC accelerated the process of authorizing wholesale sellers to sell power at market rates, rather than setting the rates itself in a traditional ratemaking proceeding. To accomplish this, FERC interpreted its traditional duty to set "just and reasonable rates" as encompassing the authority to approve market-based rates. There was some precedent for the notion that market-based rates could be "just and reasonable" under the FPA. Under the long-standing Mobile-Sierra doctrine, FERC routinely authorized rates negotiated in long-term bilateral agreements between sophisticated parties, concluding that such rates satisfied the just and reasonable standard; (199) Mobile-Sierra, however, had never been applied to sales in the new, fast-moving spot markets for electricity. Thus, authorizing the broad use of market rates represented a rather momentous shift away from historical understandings of cost of service regulation, which the agency undertook without the benefit of congressional amendment to the FPA. (200)

   FERC executed this strategy as part of a difficult transition from regulated, localized electricity markets to geographically broader, more robust markets. The California electricity crisis of 2000 and 2001 illustrates the challenges FERC has faced trying to ensure that prices for power and transmission services remain "just and reasonable," while seeking to promote efficiency in organized markets. During the crisis, wholesale energy prices in California skyrocketed to more than fifty times historical norms, driving one utility into bankruptcy. (201) As a result, wholesale buyers flooded FERC with claims that prices charged by sellers violated the FPA's just and reasonable standard, entitling them to refunds. (202) In sorting out these claims, FERC learned that in the dysfunctional California market, sellers were able to charge exorbitant prices not only because their product was scarce, but also because sellers took steps to increase its scarcity, such as withholding generation from the market on high demand days (203) or colluding with affiliate companies. (204)

   FERC struggled with how to apply the statutory "just and reasonable" standard to these transactions. One cannot capture the efficiency of markets without letting prices fluctuate to signal the relative scarcity of the good, and high prices in the California market ought to have invited increases in supply and decreases in demand--at least in the long run. The California market, however, did not react in these ways because it was broken, a victim of manipulation made particularly easy by the market's poor design. (205) The FPA is silent on the question of what "just and reasonable" means in this context, and Congress has not spoken on the matter. Thus, it was left to the courts to decide whether broadly applied market-based rates are "just and reasonable" under the FPA.

   In California ex rel. Lockyer v. FERC, (206) the Ninth Circuit determined that market-based rates are consistent with the just and reasonable standard, reasoning that FERC's regulation of electricity rates under the FPA had long contemplated (and authorized, in the context of bilateral negotiations) market-based rates. (207) The Supreme Court denied certiorari in the Lockyer case (208) but took up another challenge arising out of the California crisis in the case of Morgan Stanley Capital Group Inc. v. Public Utility District No. 1 of Snohomish County. (209) Morgan Stanley involved a challenge not to rates charged in the California spot market, but rather to rates paid by buyers who entered into long-term wholesale power purchase contracts at the tail end of the California crisis. (210) The buyers argued that (i) manipulation in the California market artificially increased the negotiated contract rates, rendering them unjust and unreasonable, and (ii) the Mobile-Sierra doctrine's presumption that such rates are just and reasonable is inapplicable to these contracts because FERC did not have an opportunity to approve the contract rates, and the contract rates were so high as to violate the public interest. (211) The Supreme Court rejected these contentions, but remanded the case to FERC on procedural grounds. (212) Justice Scalia's majority opinion went out of its way to stress that the Court was not resolving "the lawfulness of the market-based-tariff system" under the FPA. (213)

   Thus, the courts have left FERC's broad authorization of market-based rates intact. As for the question of how to control abuse of market power in electricity markets, eventually, the agency determined that sellers ought to be able to charge scarcity rents, but not to create scarcity where none exists. (214)

   The process by which FERC came to this conclusion reflects the same kind of strategic behavior EPA used when adapting the CAA to address the problem of GHG emissions--proposals of bold action followed by more measured action in the final analysis. FERC tried several approaches, only to withdraw them in response to public reaction. The agency initially suggested aggressive "market behavior rules" limiting the ability of sellers to engage in economic withholding (215) and a "standard market design" for all transmission and wholesale power sales markets, (216) but abandoned those proposals after they met widespread opposition. (217) In the end, while Congress did not address the question of whether broad use of market pricing is consistent with the FPA, it did eventually address the question of how FERC ought to manage abuses of market power in wholesale electricity markets. In the only case in our sample in which Congress intervened to resolve a regulatory dilemma facing the agency, the Energy Policy Act of 2005 directed FERC to adopt an approach to market manipulation borrowed from the securities laws--one that focuses on the use of fraud or deceit in electricity markets. (218)

3. Adapting the Transmission Grid to New Market Realities

   The rapid growth of competitive wholesale electricity markets has presented FERC with another problem that is ill-suited to an FPA regulatory regime from another, bygone era: namely, the problem of helping geographically broader, more active and robust wholesale markets grow and thrive on an aging, balkanized transmission grid. Increasingly, long-distance transmission of power is both economically desirable and technically efficient. Wholesale buyers now have the (at least theoretical) option of purchasing power from a larger universe (both numerically and geographically) of potential sellers; (219) at the same time, engineers have improved the efficiency of transmitting power over greater distances. (220) Consequently, more generating plants are being built farther and farther from loads. The last two decades have seen new wind and solar farms, (221) almost all of which are located far from cities and often far from existing transmission lines. (222) This has been spurred by a combination of technological advances, (223) public policy incentives like tax credits, (224) and state renewable portfolio standards. (225) Finally, the advent of the "smart grid" makes it possible to integrate information technology into the electricity transmission system, (226) enabling grid operators to identify and avoid congestion problems, price power transfers more efficiently, and allow demand-side resources to participate in energy markets, (227) all of which can enhance the value of long-distance power transmission.

   The United States cannot capture this value if it cannot resolve to build interstate transmission lines, but finding that resolve has been difficult. Most experts estimate that modernizing the grid to meet new electricity-market needs will require investment in tens of thousands of miles of new transmission lines at costs in the tens of billions of dollars. (228) Because the 1935 Congress never conceived of national or regional power markets, the FPA of 1935 did not grant FERC the power to site interstate transmission lines in the way that its companion statute, the Natural Gas Act, granted the agency the power to site interstate natural gas pipelines. (229) For these historical reasons, siting approval for transmission lines has traditionally rested with the states, and even sometimes with local governments. This is an artifact of the original configuration of the grid, built by vertically integrated, state-chartered IOUs to provide monopoly service within their individual service areas. Consequently, FERC has used its power to set wholesale power and transmission rates and to authorize the charging of market-based rates, as leverage to promote the development of an efficient, reliable transmission grid that serves larger and more robust wholesale markets. FERC has used that leverage strategically, alternating between bold action and caution.

   As a first step, in 1996, FERC's Order No. 888 encouraged owners of transmission lines (mostly IOUs) to create and join regional nonprofit entities known as Independent System Operators (ISOs) (230) (later, Regional Transmission Organizations or RTOs231) to manage the grid, ensure system reliability, and guard against discrimination and the exercise of market power in the provision of transmission services. (232) The new grid managers would be independent of any individual utility and would have operational control of multi-utility transmission networks; they would answer to FERC. (233) Because FERC lacked the explicit authority under the FPA to mandate participation in such bodies, however, it used the levers it had to encourage their formation. FERC issued orders establishing "principles" for ISOs and RTOs and made clear it would strongly prefer all utilities to join them. (234) FERC also conditioned other benefits, such as merger approval and approval of market-based rates, on utilities' willingness to participate in ISOs/RTOs. (235) In...