Last week, power generation companies asked the Supreme Court to review a pair of lower court decisions upholding states' Zero Emission Credit (ZEC) programs. Nearly identical ZEC programs enacted by New York and Illinois require utilities to compensate certain nuclear plants for their emission-free power by purchasing credits that represent the environmental benefits of zero-emission energy.

In its petition to the Court, the Electric Power Supply Association (EPSA) argues that these ZEC programs are preempted by the Federal Power Act (FPA) because they illegally infringe on FERC's exclusive authority to regulate rates for wholesale sales of electricity. EPSA's petitions are part of its concerted efforts in courts and at FERC to undermine state clean energy programs.

The heart of EPSA's petition is its claim that the Supreme Court's 2016 decision Hughes v. Talen provides states with too much authority to affect interstate power markets.

EPSA urges the Court to effectively overturn Hughes and instruct lower courts to invalidate state policies that pay generators in connection with their energy production. If the Supreme Court were to accept EPSA's view, it would set the stage for lawsuits against clean energy programs that reward renewable facilities for their emission-free energy generation, including renewable portfolio standards in nearly 30 states.

The Supreme Court should reject EPSA's petition. The Court's carefully crafted legal test in Hughes for preempting state energy policies reflects modern power markets and respects long-standing state authority over utilities, electric generators and environmental protection.

As this article explains, the Court's legal test correctly focuses on FERC's rate-setting mechanism. Hughes targets only state policies that "operate within" wholesale auctions and leaves intact state authority to enact policies that give generators out-of-market revenue.

Start with the statute

As with any debate about a federal law, it's instructive to start with the statute. The FPA grants FERC exclusive authority to determine whether rates for interstate wholesale sales — that is, sales of energy that will be resold to consumers — are "just and reasonable." The law explicitly preserves state jurisdiction over matters that they had been actively regulating when the statute was enacted in 1935, including generation facilities.

When Congress passed the FPA, most power was generated and sold by utilities directly to consumers within that utility's monopoly service territory. The FPA initially provided FERC with the relatively small task of regulating residual utility-to-utility sales, and left states with authority over all aspects of power plant development and operations.

But by the late 1990s, the volume of wholesale power transactions ballooned. Industry restructuring laws passed by about a dozen states catalyzed the development of non-utility power companies and fostered growing demand for wholesale electricity. Meanwhile, FERC reforms enabled generators to sell energy to wholesale auction market operators, such as PJM. These auction markets set just and reasonable rates by stacking generators' offers by price and selecting resources that can cost-effectively meet consumer demand.

FERC facilitated this industry transition by refocusing its duty to ensure just and reasonable rates. Historically, FERC evaluated individual utility tariffs or contracts to sell power by comparing the rate to the utility's costs and capping utility profits at a just and reasonable level. Today, for sales through wholesale auction markets, FERC has largely abandoned this cost-of-service methodology.

Rather than scrutinizing rates received by individual sellers, FERC regulates the auction's price-setting mechanisms. Rates generated by the FERC-approved auctions are generally deemed just and reasonable, regardless of the profits or losses of individual sellers.

To match these regulatory innovations at the wholesale level, states updated utility planning practices. Renewable portfolio standards, for example, require utilities to acquire credits that certify electricity was produced by specified types of generators. Sales of renewable energy credits (RECs) fund regional generators and ensure that the utility is drawing energy from a grid that includes renewable sources. RECs serve an accounting function, allowing utilities that buy energy from wholesale auctions to track their support of renewable energy development.

Hughes was significant

Returning to Hughes, the Maryland program at issue departed from this complementary energy credit policy design. Under state-mandated contracts, utilities paid a natural gas power plant the difference between PJM prices for energy and capacity and prices set by the state, as long as the plant bid into and cleared the PJM market. The Supreme Court held that the state's mandate was preempted by the FPA.

The "fatal defect" of the state's program, according to the Court, was that it "condition[ed] payment of funds on capacity clearing the [PJM] auction." The test struck a compromise between states and industry. The decision preempted the Maryland policy — as industry requested — but the "fatal defect" test gives states more flexibility to subsidize generation than the legal standard proposed by EPSA and its allies.

Hughes was a significant decision because it is the first (and only) Supreme Court case about FPA preemption in the context of wholesale auction markets. In treading into this new regulatory space, the Court was careful to root its decision in prior FPA preemption cases. Hughes explains that cases that predate restructuring hold that states may not "interfere with FERC's authority by disregarding interstate wholesale rates FERC has deemed just and reasonable."

The Court's "fatal defect" test specifies precisely how Maryland "disregarded" a wholesale rate. Crafted by the Court for restructured markets, the test preempts only those state policies that are "tethered to a generator's wholesale market participation." That Maryland's subsidy was contingent on the generator bidding into and clearing the wholesale auction ensured that the policy "operated within" the FERC-regulated auction.

The fatal defect test's focus on the bid-and-clear condition correctly interprets FERC's role in restructured power markets. As noted, FERC exercises its exclusive authority to ensure just and reasonable wholesale rates by regulating the rules of interstate auction markets.

By requiring a generator to bid into and clear the market, a state inserts itself into the market and meddles in FERC's rate-setting process. FERC's brief filed in Hughes emphasized this point, arguing that Maryland' bid-and-clear requirement "directly targeted the PJM market mechanism" and was therefore preempted. Cautious about upsetting the balance between state and FERC authority in restructured markets, the Court limited its holding to state interference with FERC's just and reasonable determination and did not prevent states from compensating an individual generator.

Broad preemption standard 

In its ZEC petitions, EPSA repeats the arguments that it filed in Hughes and again asks the Court for a broad preemption standard that focuses on an individual generator's revenue. In EPSA's words, any state policy that "guarantees favored generators a rate distinct from the auction price" is preempted by FERC's exclusive authority to set just and reasonable rates.

This legal standard would preempt state payments denominated in dollars per megawatt-hour under the theory that the state's payments change per megawatt-hour wholesale rates. State policies that are not paid out on a per megawatt-hour basis but that have identical economic effects would not cross EPSA's line. Applying EPSA's test, states would be free to provide tax credits or direct payments disconnected from energy production or funnel subsidies to utility-owned plants through retail rate cases.

The Court's "fatal defect" test avoids this inconsistent result. It preempts only state policies that explicitly connect the state's payments to the generator's participation in the FERC-regulated wholesale market. States may subsidize generation, as long as they don't directly interfere with FERC's determination of the just and reasonable rate by requiring a generator to clear an interstate auction.

Hughes correctly accounts for the FPA's preservation of state authority over generation facilities by recognizing that FERC has exclusive authority over the rate-setting mechanism but not over the costs and revenues of each generator selling into the market.

Should the Court endorse EPSA's reading of the FPA and eviscerate its carefully crafted "fatal defect" test, it might jeopardize renewable portfolio standards. If ZECs are an illegal per megawatt-hour payment, it seems plausible that RECs are too. Such a move by the Court would represent unprecedented judicial intervention in energy markets. It would not only threaten to overturn policies in nearly thirty states, it would also transfer much of the states' authority to regulate generation facilities to the federal government. 

Historically, FERC played almost no role in determining the mix of resources selling at wholesale. Since FERC approved the creation of interstate capacity auctions a decade ago, FERC has repeatedly approved market rules that diminish state authority.

The effect of EPSA's broad preemption test combined with its continued efforts at FERC to elevate wholesale capacity constructs over state preferences would be to invert the program of cooperative federalism created by the FPA. EPSA's two-pronged attack on state-authority — in courts and at FERC — seeks to block states from invoking historic authority while also increasing the costs of any remaining state generation policies.

The Court's narrow decision in Hughes strikes the right balance between state and FERC authority in restructured power markets. The Supreme Court should reject EPSA's requests for a do-over.