Renewable Subsidies in the Age of Deregulation

Fortnightly Magazine - December 1997


energy in a restructured electricity market?

Renewable resource funding marks a major point of contention in utility deregulation. Environmental groups fear that without some form of compulsion or subsidy, or both, renewable resources will not survive in an energy economy based on least direct consumer cost. However, utilities do not want to be saddled alone with the chore of carrying all renewables to market.

To satisfy the various constituencies, state regulators are mandating the collective maintenance of the so-called "stranded benefits" of renewable energy and demand-side management. The techniques the states are using vary widely - from encouragement to compulsion. But there are legally right, wrong, and highly suspect ways of fulfilling these policy directives.

Many states are plunging ahead to implement the quickest or most controllable option, without analyzing the legality of their initiatives in advance.

California, for example, has earmarked $540 million by legislative action for renewable energy projects. fn1 Legislation in Massachusetts would fund renewable energy development for tens of millions of dollars annually. The Wisconsin Public Service Commission has allocated $210 million annually for energy conservation, development of renewable resources, and support of low-income customer assistance. All of these initiatives would impose a systems benefit charge, a levy on each kilowatt-hour of retail electricity sales, to fund in-state renewable energy development, as an avowed purpose of the programs.

This raises two potential problems. First, the Supreme Court prohibits the imposition of a levy on sales in interstate commerce to subsidize in-state industries (see sidebar, "Tax-Funded Subsidies"). The Supreme Court allows distinctions in the imposition of a tax on fundamentally different regulated and unregulated commodities. However, in a deregulated market, an in-state subsidy funded by levies on interstate electricity sales (especially where the state does not own the generating equipment) is legally suspect (see sidebar, "Home-Grown Favoritism").

A second problem is created when a state relinquishes control to deregulated competition but does not relinquish its preference for how the resultant market treats certain technologies. State regulators may attempt to regulate out of their customary retail waters.

Power Shifts to Federal Level

With deregulation, increased competition and brokers, aggregators and intermediaries, a greater percentage of total power sales will occur at the wholesale level. Retail load should remain relatively constant, but deregulation will "pancake" additional layers of wholesale transactions within the chain of title transfers prior to retail sale. These additional transactions will fall under federal regulation, boosting FERC's power and diminishing the state role.fn2

So if the FERC gains the whip hand, what awaits renewable preferences subject to FERC regulation?

First, states legally are not permitted to regulate the wholesale power market. Renewable technologies will operate in a deregulated wholesale market, selling power to aggregators and marketers. Subsidizing wholesale renewable energy markets injects the state indirectly into tilting prices in the wholesale market. Absent congressional allowance, when a state imposes a retail levy to influence power prices in wholesale markets, it risks transgressing the regulatory divide: States are not allowed to do indirectly what the Federal Power Act prohibits them from doing directly (see sidebar, "Wholesale-Retail Conflicts").

Second, the so-called "filed-rate doctrine" holds that state utility commissions may not second-guess or overrule a wholesale rate determination under federal jurisdiction.fn3 The Supreme Court has upheld the filed-rate doctrine,[fn.4] which extends to nonrate matters as well.fn5

Here is an interesting conundrum: At least in the short term, the "market" is perceived to work against higher-cost renewable technologies whose environmental benefits are not internalized into the price calculation of all technologies. Nevertheless, the new regulatory scheme at the Federal Energy Regulatory Commission promotes competitive least-cost transactions.

Under Section 205 of the Federal Power Act, the FERC cannot allow rates that are unjust, unreasonable or discriminatory. Further, FERC policy for permitting market-based rates [fn6] will not justify wholesale prices for renewable power that diverge from all other resources, absent extenuating circumstances. Any particular higher costs of renewable energy production will not be a factor.

In fact, recent FERC decisions governing wholesale transactions conducted under the Public Utility Regulatory Policies Act have barred the states from either regulating or configuring markets to ensure a higher sales price for renewables in wholesale power transactions than for non-renewable resources.fn7 The price set through a bidding mechanism, must reflect all feasible options for the procurement of power.fn8 While the state can control the portfolio mix of generation and DSM assets, the FERC controls the pricing of any of these wholesale transactions.

All this is not to say that the federal government has shown indifference to renewable power from a policy perspective - as distinct from a regulatory perspective.

Both PURPA (enacted in 1978) and the Energy Policy Act (1992) promote renewable energy projects. At its very core, PURPA was to promote renewable energy to reduce reliance on traditional fossil fuels, as articulated by Congress.fn9 In enacting PURPA, Congress explicitly sought to lessen dependence on foreign oil and other fossil fuels.fn10

Market Sculpting: Problematic or Permissible?

What techniques to promote renewables fall within state authority in a deregulated market?

As of 1993, 32 states had integrated resource planning programs in place, and at least seven more were considering them.fn11 Although not required by the Energy Policy Act of 1992,[fn12] many state public utility commissions have required utilities to recognize environmental externalities when planning to fulfill future resource needs. Some states require utilities to quantify these externalities,[fn13] others require utilities to consider externalities only qualitatively.fn14

The good news is that there are more techniques within the clear authority of state commissions, than outside its authority. The countervailing news is that most states to date have elected the systems benefit charge, which must be deployed with great care.

Some renewable energy promotion techniques, employed at the state level, could be legally suspect in a deregulated market, including controlling the price of wholesale power and pricing the acquisition of wholesale resources through environmental externalities.

Some techniques fall in a legal gray zone - where specific program design could pass or run afoul of legal limitations depending on how they are implemented, such as environmental performance-based rates, net metering[fn15] of renewable resources and system benefit charges.

Other techniques should be permissible, such as:

Voluntary "green power" marketing;[fn16]

Portfolio standards for retailers of power;[fn17]

Renewable energy priced to reflect savings in distribution services;[fn18]

Dispatch requirements reflecting renewable resources;[fn19]

A nonprofit quasi-public funding source using independent funding unrelated to retail rates;

Expedited state approval or removal of financial, siting or other barriers for renewable or DSM projects;

Voluntary partnering with federal programs to leverage funds or opportunity;

Efficiency standards for appliances or buildings;

State tax incentives for renewable power generation or DSM provided from general state revenues;[fn20] and

Segmentation of the market into renewable retail requirements. fn21

Renewable Portfolios: A Matter of Degree

Let's focus on this last popular option, requiring renewable energy to satisfy certain segments of the retail market.

Clearly, states may regulate the mix of generating/efficiency resources that regulated utilities must procure, as explained by the FERC in 1995.fn22 However, the FERC has not definitively declared the degree to which the market can be segmented for purposes of resource procurement or supply-side planning.fn23 Nothing in the case law suggests that segmentation of the market into various fuel types is impermissible. In addition, there is nothing to suggest division of the wholesale or retail electricity market into demand-side and supply-side resource portfolios is impermissible. FERC regulations provide that "[s]tate authorities may also favor particular technologies or fuel types through direct subsidies or favorable regulatory or tax treatment."fn24

While a state, then, can segment the market to require renewable energy in the supply mix, it cannot establish separate prices for more-expensive-to-produce, or renewable, resources deemed more desirable.fn25 The FERC has stated, in dicta, that wholesale power transactions may reflect real non-price factors that represent "real costs that would be incurred by utilities."fn26 In other words, externalities may reflect real costs. They cannot be manipulated as an artificial means to rig the market.fn27 By market segmentation, states could require that certain renewable resources be procured and also can value incurred environmental externalities of different technologies in the determination of the total marginal costs of generation and price-setting.

A Political Solution?

Federal legislation could mandate collective preservation of renewable energy and DSM programs. Bills proposed by Rep. Dan Schaefer (R-Colo.), as well as by Sen. Dale Bumpers (D-Ark.), loom on the horizon.

Legislation proposed by Sen. James M. Jeffords (R-Vt.) would require an annual renewable portfolio standard for the generation mix climbing from 2.5 to 20 percent over 20 years. It also proposes a 2 mills/kWh, $6-billion/year stranded benefits subsidy to match state grants to fund these benefits. Absent new federal mandates, some of the current vanguard of state renewables initiatives could be deemed ultra vires to state authority.

The legal question comes down to where and how the state promotes renewable resources. A state could regulate the composition of what types of energy are sold, but not discriminate regarding the situs of renewable resources.

Conversely, it will be politically unappealing for most states to tax their residents' power purchases, only to devote much of those funds for out-of-state renewable energy businesses. There lies the choice between policy goals and constitutional limitations. F

Steven Ferrey is professor of law at Suffolk University Law School in Boston. He is the author of The Law of Independent Power (10th Ed., 1997), a three-volume text on electric power deregulation. He consults widely as both legal counsel and an expert witness on electric power deregulation for companies including LeBoeuf, Lamb.

Home-Grown Favoritism

A preference for renewable resources produced locally must not run afoul of Constitutional law.

Proprietary Action. Acting as an owner, state bias appears OK. The Constitution's Commerce Clause allows the state in a proprietary mode to marshal state-owned energy resources, even if that might discriminate in favor of in-state interests, or against out-of-state interests or interstate commerce.fn28

Regulatory Action. Regulatory bias raises problems. A state cannot act in a regulatory manner to unduly favor in-state private interests. When states promote private renewable energy, they are acting in a regulatory rather then proprietary role to subsidize or favor these resources. Courts will strictly scrutinize regulatory efforts and will probably invalidate such actions if state regulations or programs appear to unduly favor in-state interests at the expense of interstate commerce.fn29

Site Preferences. Restricting the in-state location of promoted renewable resources likely would run afoul of the Commerce Clause under a "strict scrutiny" test.fn30

Health and Environment. In the alternative, if a state is exercising a traditionally recognized area of state jurisdiction in a manner that does not discriminate against interstate commerce on the face of the rule, yet discriminates nonetheless, the court will balance the burden on interstate commerce against the public interest served by such regulation.fn31

These traditional areas might include protection of health, safety, the environment and natural resources in the diversification of renewable resources in the state energy mix. A balancing test is more deferential to the state policy than the "strict scrutiny" test.

Tax-Funded Subsidies

CAN states use taxes to fund a preference for renewables?

When Levies Are Permissible. The Supreme Court allows a state to tax in-state and out-of-state energy transactions differently if such treatment reflects a rational distinction between differentiated regulated and unregulated entities and commodities.fn32

When Subsidies Are Impermissible. However, the court does not allow a state to tax all transactions in the state for the purpose of using the proceeds to subsidize in-state participants in that market.

Example. An in-state preference will fail to pass judicial review where it appears designed to protect local interests from interstate competition, even if the cost of the subsidy falls entirely on state residents.

In West Lynn Creamery v. Healy,[fn33] the court overturned a tax imposed on all wholesale milk sales in Massachusetts, where proceeds were used to aid troubled in-state dairy farmers. The state claimed it should enjoy discretion to design its own tax policy, so long as the levy fell entirely on in-state consumers, but the court found no legitimate purpose in protecting the local market: "Preservation of local industry by protecting it from the rigors of interstate competition is the hallmark of the economic protectionism that the Commerce Clause prohibits."

The court noted that the tax had allowed in-state wholesalers a competitive advantage in the wholesale market. In essence, the state had subsidized the future wholesale activities of the in-state competitors. Tying the subsidy directly to the tax made the illegality worse, not abated.

Wholesale-Retail Conflicts

WHEN can states impose a system benefit charge to promote renewable energy?

Retail. State system benefit charges must be imposed only on retail distribution services - not on wholesale transmission services that are federally regulated. Demand-side management and consumer rate subsidies generally apply on the retail side of the transaction and thus fall within state authority.fn34 Here, the state is regulating retail rates and retail portfolios, without incursion into wholesale transactions.

Wholesale. States cannot impose system benefit charges on wholesale transmission services, but it may prove difficult to judge when this will occur.

Distinction. Where a state adopts a power exchange or pool concept, wherein the actual power supplied to a given customer varies hour-to-hour, the transmission and distribution path and services used hour-to-hour to serve a particular customer would vary correspondingly. Sorting out the retail distribution T&D services which legally may be surcharged becomes legally and factually complex.

Funds collected at the retail rate level but deployed to subsidize prices in the wholesale market[fn35] illustrate precisely the kind of retail charge, redirected to promote in-state suppliers, that the U.S. Supreme Court ruled unconstitutional in West Lynn Creamery v. Healy. (See sidebar, "Tax-Funded Subsidies.")

1California Assembly Bill 1890. This fund will be created by a surcharge on all electric bills, beginning in January 1998, and continuing for four years.

2The FERC does not regulate local distribution, intrastate commerce or the self-generation power. See, e.g., CL&P v. FERC, 324 U.S. 515 (1945). States have regulated what can be sited, where it can be sited, controlling environmental standards of plant operation and the mix of demand-side and supply-side resources. PG&E v. California Energy Resources & Develop. Comm'n, 461 U.S. 190, 204 (1983).

3The Supreme Court has determined that Congress, in enacting the Federal Power Act, intended to vest exclusive jurisdiction in the FERC to regulate interstate wholesale utility rates. FPC v. Southern California Edison Co., 376 U.S. 205, 216, 84 S.Ct. 644, 651, 11 L. Ed.2d. 638, 646 (1964).

4Nantahala Power & Light Co. v. Thornburg, 476 U.S. 953, 963 (1986); Mississippi Power & Light Co. ex rel. Moore v. Mississippi, 487 U.S. 354 (1988).

5Northern Natural Gas Co. v. Kansas Corporation Comm., 372 U.S. 84, 90-91 (1963); Nantahala, 476 U.S. at 966-67.

6See, for example, Kansas City Power & Light Co., 67 FERC ¶ 61,183 (1994).

7So. Calif. Edison and SDG&E Co., 70 FERC ¶ 61,125 (1995), requests for reconsideration denied, 71 FERC ¶ 61,269 (1995). Holding costs of renewable energy to level of cost of all other sources of energy makes ratepayers indifferent as to the procurement of wholesale power.

8This is not to say the price established through a bidding process must select the lowest-priced bid. Some states price winning bidders at the price bid by the least expensive losing bidder. These "second price" auctions are used in California. The marginal clearing bid may also be employed for pricing pool-dispatched power in deregulated systems, such as that which displaces NEPEX in New England.

9S. Rep. No. 95-361, 95th Cong. 1st Sess. 32 (1977), reprinted in 1978 U.S. Code Cong. & Ad. News 8173, 8178.

10See FERC v. Mississippi, 456 U.S. 742, 745-46 (1982).

11Eugene M. Trisko, "Environmental Externalities: Thinking Globally, Taxing Locally," Public Utilities Fortnightly, March 1, 1993 p. 52.

12Energy Policy Act of 1992, 102 Pub. L. No. 486, 1992 H.R. Rep. No. 776, 106 Stat. 2776 (Oct. 12, 1992).

13California, Massachusetts, Nevada, New York, Vermont and Wisconsin require quantitative consideration of environmental externalities in utility planning. These range from the Massachusetts system - since stricken by the state Supreme Judicial Court - for explicit monetary quantified externality values, to that of Vermont, where a proxy percentage adder distinguishes supply-side and demand-side resource externalities.

14Hawaii, Virginia and Colorado have required only qualitative consideration of externalities. William Kenworthy, "Regulatory Review," Electric Light & Power, March 1993.

15Net metering effectively sells renewable power to the utility at the retail rate, now typically significantly above utility avoided cost. While sanctioned for small qualifying facility projects by PURPA, it may be at odds with recent FERC precedent on wholesale pricing for renewable power.

16Voluntary actions of power marketers or retailers to offer so-called "green power," which result without regulatory compulsion, are legally acceptable. There is contention in New England as to whether only new renewable should count as "green" power, so as to tilt the total portfolio evolution, or existing diverse portfolios can be segmented to sell the "green" slice, but deliver intermixed generation.

17States must be careful on how far their regulations reach back "upstream" into wholesale markets. These requirements can affect market entry and participation. Without directly regulating the wholesale transaction, states could indirectly influence the wholesale transaction by regulation of retail sellers, who are wholesale buyers. States must create a proper record, based on fuel diversity, reliability, conservation, intergenerational equity issues and other factors. A New York decision held that a state cannot compel a utility to purchase power from a particular wholesale source. Consol. Edison Co. v. NY PSC, 63 N.Y.2d 424, 438, 472 N.E.2d 981, 987 (1984).

18The state can promote certain renewable generation technologies through transmission and distribution charges. For example, where renewable energy is intermittent, the demand component of T&D charges, based on capacity equivalence rather than on maximum rated capacity, would lower the effective cost of transmitting intermittent resources, without discriminating. This lower cost of transmission would offset the often higher cost of generation of renewable energy resources. States could evaluate the total delivered cost of various energy resources, rather than just the cost of generation and delivery to the utility bus.

19New protocols must be devised for system operation, including dispatch and curtailment which might involve individual utilities, a power pool or an independent system operator. Dispatch could occur based on lowest marginal cost of operation or include environmental externalities in the dispatch protocol. FERC holds substantial authority over these transmission issues.

20The FERC has sanctioned the use of tax credits to promote certain supply-side QF technologies. C.G.E. Fulton, L.L.C., 70 FERC ¶ 61,290. What the state cannot do, is to attempt to set the price of a wholesale transaction, which is exclusively within FERC jurisdiction, so that sales by QFs at wholesale to utilities exceed PURPA's avoided cost cap.

21States may not directly regulate or control the price for such transactions, except under federal PURPA for QF transactions, and then with no price discrimination of renewable or DSM power. So. Calif. Edison, supra.

22"Under state authority, a state may choose to require a utility to construct generation capacity of a preferred technology or to purchase power from the supplier of a particular type of resource." So. Calif. Edison, supra. The FERC adds that "In setting an avoided cost rate, a state may account for environmental costs of all fuel sources included in an all-source determination of avoided cost." The FERC noted that this could include a tax on fossil generators or a subsidy to alternative generation, but that costs thus imposed must reflect only actual costs incurred by the utility buyer. Environmental "adders" or "subtractors" must be based on real environmental externality costs, substantiated on a record before the PUC.

23So. Calif. Edison, supra. When segmentation occurs, non-QFs cannot be excluded in determining the avoided price of wholesale power for purposes of PURPA avoided cost determinations.

24FERC Stats. & Regs., ¶ 32,455, at 32,044 (1988).

25So. Calif. Edison, supra (order on reconsideration).

26So. Calif. Edison, supra.

27Massachusetts courts struck down an externality process as beyond state commission authority. Mass. Elec. Co. v. Mass. DPU, 419 Mass. 239, 643 N.E.2d 1029 (1994).

28See Hughes v. Oklahoma, 441 U.S. 322 (1979) (subsidies to in-state auto hulk removers).

29See e.g., Philadelphia v. New Jersey, 437 U.S. 617 (1978) (impermissible ban on interstate waste disposal).

30See e.g., Wyoming v. Oklahoma, 112 S.Ct. 789 (1992) (requiring indigenous fuel resources); New Energy Co. of Indiana v. Limbach, 486 U.S. 269 (1988) (tax credit only for in-state ethanol); Alliance for Clean Coal v. Miller, 44 F.3d 591 (7th Cir. 1995) (preference for Illinois coal).

31Philadelphia v. New Jersey, 437 U.S. 617 (1978); Dean Milk Co. v. City of Madison, 340 U.S. 349 (1951) (regulating milk quality).

32General Motors v. Tracy Corp., 11 S.Ct. 811 (1997)

(distinguishes bundled gas distribution from unbundled gas commodity).

33512 U.S. 186 (1994).

34The Massachusetts Supreme Judicial Court upheld a reduced rate for low-income elderly persons subsidized by ratepayers. American Hoechest Corp. et al v. D.P.U., 379 Mass. 408, 399 N.E.2d 1 (Mass. 1980).

35In Massachusetts, the substantial funds collected would pass to a state-sanctioned entity that would function as a venture capital fund to subsidize wholesale market entry for renewables through grants, loans, and equity investments.


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