Danly Office White Paper: The Requirement that Competitive Markets be Protected from the Exercise of Market Power Applied to RTO Capacity Markets

A fundamental element of the Commission’s approval of market-based rates in the electric and natural gas industries is that “[i]n a competitive market, where neither buyer nor seller has significant market power, it is rational to assume that the terms of their voluntary exchange are reasonable, and specifically to infer that the price is close to marginal cost, such that the seller makes only a normal return on its investment.”[1]  

This white paper discusses the implications of this principle for RTO capacity market design and, in particular, for the support of resources based on state policy.  The discussion is divided into three parts.  Part 1 describes the evolution of the Commission’s regulation from requiring cost-based rates in almost all circumstances to a regulatory regime that relies extensively on market forces to establish just and reasonable rates.  Part 2 examines RTO capacity markets, how buyer-side market power is exercised in those markets and how, to date, those markets have included protections against the exercise of buyer-side market power through state subsidies.  Part 3 explains why RTO capacity markets cannot be just and reasonable under the law absent provisions designed to protect against the exercise of both seller-side and buyer-side market power, including buyer-side market power exercised by the states.

We are interested in hearing reactions to our analysis.  Please contact Matt Estes at matthew.estes@ferc.gov if you would like to discuss this further.

1. EVOLUTION OF THE COMMISSION’S RATE REGULATION UNDER THE STATUTORY JUST AND REASONABLE STANDARD

The same statutory standard applies to the Commission’s regulation of rates in the electric industry and the natural gas industry.  In each case, the Commission is required to ensure that rates are “just and reasonable.”[2]  Although the just and reasonable standard is typically thought of as being intended to protect consumers from unreasonably high rates, it also protects sellers from being required to provide service at unreasonably low rates.  As the Supreme Court put in in its seminal Hope decision, “[t]he rate-making process under the Act, i.e., the fixing of ‘just and reasonable’ rates, involves a balancing of the investor and the consumer interests.”[3]

The Supreme Court has held on numerous occasions that, under the just and reasonable standard, “the Commission is not bound to any one ratemaking formula.”[4]  Nevertheless, prior to the 1990s, the Commission generally applied a cost-of-service approach, based on the service provider’s costs plus a rate of return sufficient to attract necessary capital.[5]  Although there are numerous forms of cost-of-service regulation, they all boil down, in some fashion, to establishing a rate based on the cost of providing service plus an added rate of return.

In the early 1970s—at a time when the Commission was charged with the formidable task of regulating the prices of all natural gas sold in interstate commerce—the Commission attempted to apply a market-based approach to regulating sales by small producers.  This attempt was soundly rejected by the Supreme Court in 1974 in Federal Power Commission v. Texaco Inc.[6]  The Court’s reasoning was as follows:

For the purposes of the proceedings that may occur on remand, we should also stress that in our view the prevailing price in the marketplace cannot be the final measure of ‘just and reasonable’ rates mandated by the Act.  It is abundantly clear from the history of the Act and from the events that prompted its adoption that Congress considered that the natural gas industry was heavily concentrated and that monopolistic forces were distorting the market price for natural gas.  Hence, the necessity for regulation . . . .  In subjecting producers to regulation because of anticompetitive conditions in the industry, Congress could not have assumed that “just and reasonable” rates could conclusively be determined by reference to market price.[7]

This holding appeared to drive a stake into the heart of market-based pricing under the just and reasonable standard.  However, twenty years later, the Commission turned again to market forces to aid in setting rates, and this time it met with more success reconciling the employment of market-based rates and the reasonable standard. 

The first step came in a case—Tejas Power Corp.[8]—that did not actually involve a market-based rate.  There, the U.S. Court of Appeals for the District of Columbia Circuit (D.C. Circuit) reviewed a natural gas pipeline rate settlement that had been approved by the Commission on the grounds that all of the pipeline’s local distribution company (LDC) customers had agreed to it.  The court observed that:

In a competitive market, where neither buyer nor seller has significant market power, it is rational to assume that the terms of their voluntary exchange are reasonable, and specifically to infer that price is close to marginal cost, such that the seller makes only a normal return on its investment.[9]

The court then went on to reject the Commission’s approval of the settlement because it had not determined whether the pipeline had market power and there was thus no basis for the Commission to conclude that the LDCs’ voluntary agreement demonstrated that the settlement rates were just and reasonable.[10]  However, the court’s observation that market-based rates could be just and reasonable “where neither buyer nor seller has significant market power”[11] pointed a way past the Supreme Court’s holding in Texaco that “the prevailing price in the marketplace cannot be the final measure of ‘just and reasonable’ rates.”[12]  The Supreme Court’s holding had been grounded on the then-prevailing market conditions, where “the natural gas industry was heavily concentrated and . . . monopolistic forces were distorting the market price for natural gas.”[13]  However, if the Commission could show that neither buyers nor sellers had significant market power, thereby demonstrating that monopolistic forces were not distorting market prices, then the prevailing market price would not be the “final measure,” and the use of market-based rates could satisfy the just and reasonable standard.  This insight in Tejas Power has been cited in almost every subsequent court decision addressing the legitimacy of the Commission’s market-based rate regimes.[14]

In order to meet the requirements of Tejas Power, the Commission’s subsequent orders granting market-based rates have all relied on a finding that the participants in the market either do not have market power or that any market power they possess has been mitigated.  For example, in Elizabethtown Gas, the D.C. Circuit described in detail the market analysis conducted by the Commission before approving Transcontinental Gas Pipe Line Company’s (Transco) request that its merchant function be permitted to sell natural gas a market-based rates.  From this, the court concluded the Commission’s analysis “provides strong reason to believe that Transco will be able to charge only a price that is ‘just and reasonable’ within the meaning of § 4 of the NGA.”[15]

Order No. 697,[16] in which the Commission issued its regulations governing market-based rate sales in the electric industry, similarly focuses on ensuring that market prices are not distorted by market power.  Under Order No. 697, the Commission analyzes whether a seller has market power and, if so, whether that market power has been mitigated.[17]    The Commission recognized that monopsony power could also be an important issue, but at the time of issuance there was insufficient evidence to confirm what was then a theoretical problem, and the Commission reserved taking action until monopsony power issues were raised in a market-based rate proceeding or in a complaint.[18]  On appeal, the Ninth Circuit held: “By screening for market power before authorizing market-based rates, and by continually monitoring sellers for evidence of market power, FERC has adopted a permissible approach to fulfilling its statutory mandate to ensure that rates are just and reasonable.”[19] 

In sum, as the Supreme Court has made clear, “the prevailing price in the marketplace cannot be the final measure of ‘just and reasonable’ rates.”[20]  Instead, in order for sales at a market-based rate to be just and reasonable, the sales must be made in a market “where neither buyer nor seller has significant market power.”[21]  Where buyers or sellers do have market power and that market power is not mitigated, market-based rates cannot satisfy the just and reasonable standard.

2. THE EXERCISE OF BUYER-SIDE MARKET POWER IN RTO CAPACITY MARKETS THROUGH STATE SUBSIDIES

As the Supreme Court has explained, buyer-side market power, more commonly known as monopsony market power, “is market power on the buy side of the market.”[22]  The Court went on to observe that “monopsony is to the buy side of the market what a monopoly is to the sell side and is sometimes colloquially called a ‘buyer’s monopoly.’”[23]  Further, “[m]onopoly and monopsony are symmetrical distortions of competition from an economic standpoint.”[24]

In most markets, buyer-side market power is exercised through the prices offered by the buyer of a product.  For example, the claim examined by the Supreme Court in Weyerhaeuser was that a buyer with monopsony power artificially raised the price it paid for saw logs, thereby raising the market price for the logs and driving a competing lumber company out of business.[25]  Such a tactic is known as “predatory bidding.”[26]

Buyer-side market power in RTO capacity markets, while similarly distorting competition, is exercised in a completely different manner.  This is because of the relative lack of the ability of buyers to directly influence capacity prices through the submission of offers to purchase at a certain price.  Instead, the demand curves used by RTOs to set capacity prices are administratively derived by the RTOs.  This is necessary because there is very little price-elasticity of demand for capacity in the RTO markets, especially during the peak periods used to determine the level of demand in the capacity auctions.[27] 

Buyer-side market power can be exercised in RTO capacity markets not through altering the price offered for purchases by a buyer, but rather by subsidizing or otherwise paying owners of generation to submit below cost offers to sell capacity into the RTO capacity markets.  The submission of below cost offers into a capacity auction can artificially suppress the resulting price derived by the market for capacity in one of two ways: (1) if a subsidized resource would have submitted the marginal cost offer had it not been subsidized, offering that resource’s capacity below its marginal cost would cause the market clearing price to be lowered to the price offered by the next highest cost offer; and (2) if the cost of a subsidized resource is higher than the market clearing price, then offering the resource below its cost will lower the supply curve, thereby lowering the point of intersection of the supply curve and the demand curve and lowering the resulting capacity price.

The Commission and the RTOs recognized the potential for the exercise of buyer-side market power to reduce capacity prices almost from the first RTO capacity auctions.  For example, in its 2006 order first approving PJM Interconnection, L.L.C’s (PJM) Reliability Pricing Model (RPM) that, as subsequently modified, forms the basis for PJM’s capacity market today, the Commission approved PJM’s proposed Minimum Offer Price Rule (MOPR)—intended to mitigate buyer-side market power—on the following grounds:

The Commission finds the Minimum Offer Price Rule a reasonable method of assuring that net buyers do not exercise monopsony power by seeking to lower prices through self supply.[28]

The Commission also approved buyer-side market power mitigation provisions in early versions of the ISO New England, Inc. (ISO-New England) and New York Independent System Operator, Inc. (New York ISO) capacity markets.[29] 

The first iteration of PJM’s tariff governing the RPM capacity auction did not apply the MOPR to generation resources subsidized by states, as opposed to load serving entities.  The Commission approved this exclusion because it “enables states to meet their responsibilities to ensure local reliability.”[30]  However, in 2011, the Commission approved PJM’s proposal to eliminate the exclusion of state-supported resources from its MOPR.[31]  The Commission explained that:

The mounting evidence of risk from what was previously only a theoretical weakness in the MOPR rules that could allow uneconomic entry has caused us to reexamine our acceptance of the existing state exemption, which we approved as part of the 2006 RPM Settlement Order.  For these reasons, we accept as just and reasonable PJM’s proposal to eliminate the current state exemption.[32]

Based on this evidence, the Commission approved the elimination of the state exclusion because “we are statutorily mandated to protect the RPM against the effects of such entry.”[33] 

The Commission’s approval of the elimination of the state exclusion was upheld on appeal to the Third Circuit.[34]  First, the court found that the Commission had jurisdiction to apply the MOPR to state supported resources because “it is undisputed that New Jersey and Maryland’s plans to introduce thousands of megawatts of new capacity into the Base Residual Auction would have had an effect on the prices of wholesale electric capacity in interstate commerce.”[35]  The Court went on to find that the Commission’s decision to apply the MOPR was reasonable because:

[T]he actual prospect of thousands of megawatts of new generation, developed under arrangements that would explicitly subsidize the resources regardless of Auction price, potentially being offered into the Reliability Market at a zero bid brought into focus the distortive effect—no longer “theoretical”—that the state exemption could have on market prices for all capacity.[36]

The Commission made clear at about the same time that state-sponsored resources would also be subject to buyer-side market power mitigation in the ISO-New England and New York ISO capacity markets.[37]  The Commission subsequently permitted certain limited exemptions from the MOPR for state supported resources on the grounds that the limited exception would not lead to significant price suppression.[38]  However, the Commission has never found that it is appropriate to grant a blanket exemption to state supported resources from the buyer-side market power mitigation provisions applied to RTO capacity markets, and its refusal to do so has been upheld by the courts.[39]

Today, PJM, ISO-New England, and the New York ISO all have buyer-side market power mitigation provisions applicable to state-supported resources that protect the competitiveness of their capacity auctions.[40]  These provisions are controversial and subject to mounting criticism.  But they all reflect the Commission’s consistent determination to date that it is necessary to protect against the state exercise of buyer-side market power in order for RTO capacity market prices to be just and reasonable.

3. RTO CAPACITY MARKETS MUST BE PROTECTED AGAINST BOTH SELLER-SIDE AND BUYER-SIDE MARKET POWER IN ORDER FOR THE RESULTING CAPACITY PRICES TO BE JUST AND REASONABLE

The need for RTO capacity markets to be protected against the exercise of market power is not optional.  As I have explained, the Supreme Court has held that “the prevailing price in the marketplace cannot be the final measure of ‘just and reasonable’ rates.”[41]  Instead, the market-based prices derived from the RTO capacity markets are just and reasonable only when those prices are unaffected by the exercise of market power.  That means that markets must not only include provisions to mitigate seller-side market power, but RTO capacity markets must be markets “where neither buyer nor seller has significant market power.”[42]  Otherwise, it would not be “rational to assume that the terms of their voluntary exchange are reasonable,” or “to infer that [the] price is close to marginal cost.”[43]

And, because state subsidies to generation owners constitute the exercise of buyer-side market power, RTO capacity markets must have provisions to mitigate the effects of such subsidies, as the Commission has held on numerous occasions.  This is not a requirement the Commission has imposed only recently, based, as some have alleged, on political animosity toward renewable resources.  Rather, as described in Part II, the Commission has consistently held—and the courts have consistently affirmed—that RTO capacity markets must have provisions mitigating state buyer-side market power.  Without mitigation, the prices that result from those markets cannot be just and reasonable. 

There is, of course, more than one approach to the mitigation of the states’ exercise of buyer-side market power.  The merit of any particular approach is beyond the scope of this white paper.  The essential point is that RTO capacity markets must have provisions that adequately mitigate the states’ exercise of buyer-side market power or the RTO capacity markets cannot be just and reasonable.

Three major arguments have been raised against the application of buyer-side market power mitigation measures to state subsidies: (1) such application is beyond the Commission’s jurisdiction under the Federal Power Act (FPA); (2) such application unreasonably interferes with state policy choices; and (3) such application is unnecessary because RTO capacity markets are nothing more than administrative constructs that do not reflect competitive forces.  Each of these arguments is briefly addressed below.

1. The Commission Has Jurisdiction to Mitigate State Buyer-Side Market Power

The argument that the Commission has no jurisdiction to impose buyer-side mitigation to state-supported resources has been considered and rejected by the courts.  For example, the D.C. Circuit held as follows in addressing this argument made on appeal of the Commission’s approval of PJM’s elimination of the state exemption from the MOPR:

After reviewing the FERC Orders at issue here and the relevant case law, we conclude that FERC did not exceed its jurisdiction in eliminating the state-mandated provision.  Under the FPA, FERC has jurisdiction over rules affecting the rates of the transmission or sale of energy in interstate commerce.  See 16 U.S.C. § 824d.  Here, it is undisputed that New Jersey and Maryland’s plans to introduce thousands of megawatts of new capacity into the Base Residual Auction would have had an effect on the prices of wholesale electric capacity in interstate commerce.  See Mississippi Power & Light Co. v. Mississippi, 487 U.S. 354, 374, 108 S. Ct. 2428, 101 L.Ed.2d 322 (1988) (holding, among other things, that FERC had jurisdiction over power allocations that affect wholesale rates, and stating that “[s]tates may not regulate in areas where FERC has properly exercised its jurisdiction to determine just and reasonable wholesale rates or to insure that agreements affecting wholesale rates are reasonable.”) (emphasis added); Municipalities of Groton v. FERC, 587 F.2d 1296, 1302 (D.C. Cir. 1978) (rejecting jurisdictional challenge to FERC’s authority to levy deficiency charges on utilities that failed to procure generating capacity sufficient to meet its load requirements, and stating that, “[i]t is sufficient for jurisdictional purposes that the deficiency charge affects the fee that a participant pays for power and reserve service, irrespective of the objective underlying that charge.”).[44] 

The D.C. Circuit then reiterated its holding later that same year in the appeal of ISO-New England’s buyer-side mitigation provisions:

FERC’s rate-making authority confers broad power “to act in the public interest.” Miss. Indus. v. FERC, 808 F.2d 1525, 1549 (D.C. Cir. 1987) (internal quotations omitted), vacated and remanded in part on other grounds, 822 F.2d 1104 (D.C. Cir. 1987).  We hold that FERC has jurisdiction to regulate the parameters comprising the Forward Capacity Market, and that applying offer-floor mitigation fits within the Commission’s statutory rate-making power.[45]

2. Deference to State Policy Does Not Justify the Approval of a Rate that is Not Just and Reasonable

 The next argument asserts that, even if the Commission has the jurisdiction to require mitigation of state buyer-side market power, the Commission is not obligated to exercise that jurisdiction.  Instead, unless state support for a generation resource is preempted under the standards of Hughes v. Talen Energy Marketing, LLC,[46] the Commission should exercise its discretion to defer to the state policy and exempt it from RTO provisions protecting capacity markets against buyer-side market power.

It is of course appropriate for the Commission to take state policy choices into consideration in evaluating RTO capacity markets and it may be appropriate to accommodate those policies when doing so is consistent with the Commission’s statutory obligations.  But the Commission has the duty under the Federal Power Act to ensure that jurisdictional rates are just and reasonable.  As explained above, market-based rates are not just and reasonable unless reached in a market “where neither buyer nor seller has significant market power.”[47]  The Commission cannot defer to a state policy when doing so would lead to a rate that is not just and reasonable, and failing to mitigate a state policy that exercises buyer-side market power to suppress RTO capacity prices would result in rates that are not just and reasonable.[48] 

This holds true regardless of the whether the state articulates policy goals other than that of suppressing capacity prices.  The Commission’s evaluation of a seller’s market power focuses on identifying whether a seller has market power and, if so, if that market power has been mitigated.[49]  The Commission does not condition the requirement to mitigate a seller’s market power on any consideration of whether a seller with market power has indicated any intent to actually exercise its market power to raise prices.  Similarly, the question for buyer-side market power must be whether such market power exists and, if so, whether it has been mitigated.[50]  States clearly have the ability to affect RTO capacity market prices through subsidies, and therefore RTO markets must have provisions mitigating that market power in order for the prices resulting from RTO markets to be just and reasonable.

This does not mean that the Commission is powerless to accommodate state policies (other than a state policy of price suppression) favoring certain types of generation resources.  There are a number of RTO capacity market proposals that do just that.  It does mean, however, that such accommodation must be achieved without artificially suppressing the RTO capacity market prices, which would result in capacity prices that are not just and reasonable.

3. RTO Capacity Markets Employ Administrative Constructs to Achieve Competitive Prices

The third argument is based on a criticism frequently raised against RTO capacity markets.  It is based on the assertion that these markets are nothing more than an “administrative construct.”  The conclusion reached from this assertion is that prices determined in the RTO capacity markets are not the result of competitive forces. Therefore, so the logic goes, there is no reason to take action to protect those markets from distorted prices that do not reflect competitive outcomes. 

This view improperly conflates two distinct concepts: market design which, by its very nature, must be based on an administrative construct, and market outcomes, which are driven by competitive forces.  All central markets, by their nature, must be conducted pursuant to an administratively determined market design; whether that determination is made by a private market administrator or by a government regulator.  There must be a standard definition, for example, of the product that is being traded in the market, there must be rules governing who may participate in the market as buyers and sellers, how trades must be executed, and rules designed to prevent market manipulation and the exercise of market power.

Securities markets, for example, are subject to detailed rules administered by market operators and overseen by the U.S. Securities and Exchange Commission that define the characteristics of the security and how the securities markets are to be conducted.  Commodities markets likewise have detailed rules as to what constitutes, for example, the “lean hogs” or “soybean meal” that are traded in the commodities markets.  There also are detailed rules regarding the contracts used to trade commodities futures.  These rules all affect the prices that result from the market.  But, absent the exercise of market power or price manipulation, the prices that result from the administrative constructs governing these markets are established by competitive forces.

The same is true of RTO capacity markets.  These markets are circumscribed by complex rules that address issues such as the definition of the product being sold, the entities entitled to participate as sellers, and the obligations associated with receiving a capacity award.  There also are detailed rules designed to prevent the exercise of market power, both seller-side and buyer-side.  But these rules—administrative constructs—simply set the boundaries within which competitive forces establish capacity prices “where neither buyer nor seller has significant market power.”[51]  Far from divorcing RTO capacity markets from competitive forces, the administrative constructs governing RTO capacity markets are what ensure that the results of those markets are competitive.[52]  And the detailed rules protecting those results from the exercise of market power are necessary to ensure that those results continue to be competitive.

  Moreover, to the extent to which the Commission were to determine that RTO capacity markets are based on an administrative construct that does not provide for competitive capacity prices, the consequence would have to be that the prices from those markets could not be found to be just and reasonable.  The Commission would be required either to develop an alternative administrative construct that permits the establishment of competitive prices free from seller-side and buyer-side market power or else to return to a cost-based regime for determining capacity prices.  Continuing the use of the same administrative construct, modified only to eliminate mitigation of state buyer-side market power, would not lead to just and reasonable capacity prices being established in a market that did not produce competitive results in the first place.

4. CONCLUSION

The states have buyer-side market power, and that market power cannot be ignored any more than the seller-side market power possessed by a number of companies that have amassed significant quantities of generation capacity.  There are options for mitigating state buyer-side market power while at the same time accommodating state policies favoring certain types of generation resources.  But state buyer-side market power must be mitigated in the RTO capacity markets.  This is not a policy-driven position that can be changed by revising the Commission’s policy.  Rather it is a mandate dictated by the statutory requirement that the prices that result from RTO capacity markets must be just and reasonable.