S TROOCK SPECIAL BULLETIN

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1 STROOCK & STROOCK & LAVAN LLP S TROOCK SPECIAL BULLETIN POSITIVE ENERGY Issue 3 November 2014 Power Up in the Air (Part I): EPA CSAPR and MATS Regulations It has been an eventful year for the U.S. Environmental Protection Agency ( EPA ) as it has continued to seek to regulate greenhouse gas ( GHG ) and other emissions, primarily to reduce the use of coal and oil for the generation of electricity in this country. Two major United States Supreme Court ( Supreme Court ) decisions and one from the United States Court of Appeals for the District of Columbia ( D.C. Circuit ) represent very important rulings under the Clean Air Act ( CAA ) 1 that have allowed the EPA to move forward to implement several significant regulations that directly affect power generation. 2 EPA also has proposed major regulations to restrict GHG emissions from both new and existing power plants. This article focuses on two EPA regulations one affirmed this past April by the Supreme Court and the other by the D.C. Circuit both of which are of great interest to the power industry. Cross-State Air Pollution Rule (CSAPR) Some states have faced difficulty meeting certain air quality standards developed under the CAA due to the long range transport of pollutants particularly sulfur dioxide ( SO 2 ), nitrous oxide ( NOx ) and fine particulate matter ( PM2.5 ) from upwind states to downwind states. 3 ALSO IN THIS ISSUE 1 2 Clean Air Act, 42 U.S.C At the very end of the Court s term this year, the Supreme Court held in favor of the EPA in Utility Air Regulatory Group v. EPA, 134 S. Ct (2014), allowing the agency to regulate greenhouse gases from all stationary sources through best available control technology. The regulations considered by the Court in that matter will not be the subject of this article. A Tale of Two Cases: Changing Views of Federal and State Jurisdiction Over Electricity SO 2 and NOx are precursors to PM2.5; NOx, a greenhouse gas itself, is also a precursor to ozone. STROOCK & STROOCK & LAVAN LLP NEW YORK LOS ANGELES MIAMI WASHINGTON, DC 180 MAIDEN LANE, NEW YORK, NY TEL FAX

2 EPA tried to solve this problem by promulgating the Clean Air Interstate Rule ( CAIR ) in For the past nine years, CAIR has been the subject of extensive litigation and multiple revisions. This article does not address the myriad ups and downs of that process which would take several articles, if not a book. The short version is that EPA has been trying to fashion a rule that will pass judicial muster and go further in solving the problem of long range transport. CSAPR was promulgated on August 8, 2011, to replace CAIR and set up a Federal program to further reduce SO 2 and NOx emissions from power plants that cross state lines and contribute to ground-level ozone and fine particle pollution in other states. 5 CSAPR applies to all states that contribute significantly to the pollution of other states. A significant contributor is defined in CSAPR as a state that (1) generates, in at least one downwind state, one percent or more of any pollutant that violates the EPA s air quality standards and (2) is able to reduce such pollutant emissions within the state in a cost-effective manner. For example, under CSAPR, if EPA has found State #1 to contribute at least one percent of the SO 2 emissions to State #2, which results in violation of SO 2 standards in State #2, and it will cost only $500 per ton of reduction to reduce SO 2 emissions in State #1, which is considered cost- 4 See Rule To Reduce Interstate Transport of Fine Particulate Matter and Ozone (Clean Air Interstate Rule), 70 Fed. Reg et seq. (May 12, 2005), promulgated pursuant to the CAA s provision on interstate pollution, 42 U.S. C. 7426, the so-called good neighbor rule. 5 See Federal Implementation Plans: Interstate Transport of Fine Particulate Matter and Ozone, 76 Fed. Reg et seq. (August 8, 2011). effective, then State #1 may be required to reduce emissions to alleviate long range transport to State #2, whereas if it were found to be too expensive for other states to reduce emissions, such other states might not be required to reduce their emissions. The new rule applies to 28 states, encompassing 1,074 coal, gas and oil plants producing 3,632 electric units, according to EPA. The rule has three different emission reductions platforms. First, the rule calls for NO x reductions in the ozone season (May through October). Twenty states are subject to this new limit, including Iowa, Michigan, Missouri, Oklahoma, and Wisconsin having to reduce NO x emissions in the summer. The rule removed Connecticut, Delaware and Washington D.C. from the ozone season program, and Houston-Galveston is specifically permitted to violate the program, due to an impossibility of compliance for the time being. Second, the rule sets SO 2 and NO x standards to meet annual PM 2.5 standards. Eighteen states must reduce emissions based on the 1997 annual standard. Texas, Iowa, Kansas, Michigan, Missouri, and Wisconsin must all comply with the PM 2.5 thresholds. Connecticut, Delaware, Florida, Louisiana, Massachusetts and Washington D.C. were conversely excluded from the program. Lastly, the rule establishes reductions of SO 2 and NO x to comply with PM hour standards. Twenty-one states must decrease emissions based on the 24-hour standard, excluding the Liberty- Clairton area in Pennsylvania which is certified to exceed the standard. Under CSAPR, the first phase of reductions for SO 2 and NO x emissions were to begin January 1, 2012, with ozone season NO x reductions 2

3 beginning May 1, Plants were not to be penalized for failure to comply with the first phase until The second phase of compliance was to begin on January 1, The rule permits four trading programs for trading SO 2 and NOx allowances or credits. 6 The trading is categorized based on the largest SO 2 reductions, lesser SO 2 reductions, annual NO x emissions, and NO x ozone season trading. Trading was very short-lived as the regulations were stayed by the D.C. Circuit in December 2011, as further discussed below. At the time, however, large SO 2 credits were trading at $20, lesser SO 2 credits at $50, and both the annual and ozone season NO x credits were priced at $55. 7 Trading in SO 2 allowances is only allowed within the SO 2 reduction groups, while NO x trading is permissible by all covered states. According to EPA, the rule was designed to reduce SO 2 emissions by 73 percent and NO x emissions by 54 percent from 2005 levels. EPA estimated health and environmental advantages to be between $120 and $280 billion, along with 13,000 to 34,000 lives saved due to increased air quality, in contrast to $2.4 billion in compliance costs. With the implementation of CSAPR, there also will be a concomitant reduction in greenhouse gases furthering EPA s goals with respect to climate change. Many states (and many in the power industry) have strongly disagreed with CSAPR s cost-benefit 6 7 One ton of emissions is equal to one credit or allowance. CSAPR SO2 targets for 2014 already met by 11 US states: Bentek analysis, WASH. (PLATTS) (May 15, 2014, 5:52 PM), news/coal/washington/csapr-so2-targets-for already-met-by analysis and believe the costs will be extraordinary because CSAPR will force power plant closures especially older coal plants and create significant reliability problems. The National Economic Research Associates (NERA) released a study showing the loss of 34,000 jobs from 2013 through 2037 because of CSAPR. 8 Texas is one state that has spearheaded much of the outrage, further claiming that CSAPR unfairly mandates certain states to bear more emission reductions than others. 9 Because of the intense controversy surrounding the new CSAPR rule, it is no surprise that promulgation of the rule resulted in extensive litigation. State and local governments, labor, and the power industry challenged CSAPR in the D.C. Circuit, alleging, inter alia, that it violated federal law by infringing on states rights to develop their own emission reduction plans. On December 30, 2011, the D.C. Circuit stayed the implementation of the regulation pending 8 9 U.S. Chamber of Commerce, Impacts of Regulations on Employment Examining EPA s Oft-Repeated Claims that Regulations Create Jobs (2013). Luminant, with a fleet of coal fired power plants in Texas, blamed CSAPR for recent layoffs and plant closures. Energy Future Holdings, owner of TXU Energy and Luminant, entered bankruptcy the very day of the Supreme Court decision, citing, inter alia, the harsh predicament CSAPR imposes on coal power plants. See U.S. HOUSE OF REPRESENTATIVES ENERGY & COMMERCE COMM., EPA RULE FORCES TEXAS COMPANY TO ANNOUNCE LAYOFFS; OVER 500 WORKERS COULD LOSE THEIR JOBS (2011); J.B. Smith, Power giant s bankruptcy raises questions of coal plants future, WACO TRIBUNE- HERALD (Apr. 30, 2014, 12:01 AM), c08026cfc0f0.html. 3

4 judicial review. 10 On August 21, 2012, the D.C. Circuit vacated CSAPR and left CAIR in place. 11 In EPA v. EME Homer City Generation, 134 S. Ct (2014), the Supreme Court overturned the D.C. Circuit decision and upheld the EPA s use of cost-benefit analysis when setting emission reduction requirements, as well as its authority to establish federal regulations to implement the reductions. The Supreme Court remanded some smaller issues to the D.C. Circuit. On October 23, 2014, upon the motion of EPA, the D.C. Circuit lifted the stay of CSAPR and scheduled oral argument for March 11, 2015, on the remand. Many states may already be complying with the rule by utilizing scrubbers and natural gas, and power plants have reduced SO 2 emissions by 32 percent and NO x emissions by 14 percent since Because compliance and implementation deadlines have passed, however, the EPA must now institute either a new compliance schedule or revise what might be outdated reduction requirements. It remains to be determined if the EPA s new implementation schedule will be a direct final rule or new rulemaking. Regardless, power plants likely will not be obligated to comply with the first phase until 2016 and the second phase until Mercury and Air Toxics Standards for Power Plants (MATS) The EPA controls coal and oil power plant contamination under Section 111 (New Source Performance Standards) and 112 (Hazardous Air 10 EME Homer City Generation v. EPA, No , slip op. at 2 (D.C. Cir. Dec. 30, 2011). 11 EME Homer City Generation v. EPA, 696 F.3d 7 (D.C. Cir. 2012). 12 Wash. (Platts), supra note 7. Pollutants) of the Clean Air Act. 13 The EPA s new MATS rule limits emissions for both new and existing coal and oil electric utility steam generating plants (EGUs), specifically those generating over 25 megawatts of electricity for sale or public distribution. The rule also contains a subcategory governing integrated gasification combined cycle (IGCC) plants. The MATS rule affects emissions of mercury, arsenic, chromium, nickel, hydrochloric acid, hydrofluoric acid, and consequently some SO 2 and fine particles. The rule s required reductions are based on the average reductions of the industry s top 12 percent best-operating facilities. In addition to the numerical limits MATS mandates, the new rule promulgates work practice guidelines for power plants generating organic air pollution such as dioxin/furan. These plants must conduct annual performance tests with inspection, adjustment and upkeep to ensure efficient operation. Similar work practices are in place for limited-use oil-fired EGUs. The EPA states that plants may use modern control methods such as wet and dry scrubbers, dry sorbent injection systems, activated carbon injection systems, and fabric filters to satisfy the new rule. Power plants will have four years to conform to MATS, or five years if the facility needs to install modern technology. If a plant is unable obey this schedule, the EPA will evaluate the situation based on individual circumstances. Efforts have been made to block or delay the MATS rule, relying on arguments that the rule will result in the shutdown of coal plants, oversteps EPA s authority, and costs too much to comply U.S.C

5 Members of Congress have attempted to pass bills to impede the EPA s new rules, yet none have proven successful. At the industry level, fears of the closure of coal plants have piqued concern that the electric grid will become unstable, with no fuel alternative to natural gas. 14 The Midwest is particularly vulnerable, with the highest percentage of electric generation from coal. 15 NERA s study, discussed above, reports that MATS will lead to a decrease in employee incomes equaling 180,000 to 215,000 lost jobs in EPA maintains that many coal plants currently satisfy the new rule through the use of control equipment or cleaner coal. Arguments over the MATS rule reached the D.C. Circuit in White Stallion Energy Ctr. v. EPA, No (D.C. Cir. Apr. 15, 2014), with the court issuing a 2-1 split decision to uphold the rule. The court ruled that the EPA may disregard costs when creating rules to protect public health, and the agency can instead rely on environmental and human health factors. The decision further upheld the EPA s plan for implementation of the standards. Because the D.C. Circuit upheld MATS and congressional action delaying implementation has been unsuccessful, the rule is in full effect. However, Judge Kavanaugh s forceful dissent in White Stallion Energy may provide some good encouragement for the Supreme Court to review the case on the issue of whether the EPA should consider costs in setting wide-reaching regulations. Conclusion Part I of this article focused on two important environmental regulations that may significantly affect the power industry. Part II of this article (which will be published in a future issue of Stroock s POSITIVE ENERGY) will review EPA s newly proposed greenhouse gas emissions regulations for new and existing power plants. Regulation of the latter has been tagged as EPA s Clean Power Plan. By E. Gail Suchman, a Special Counsel in the Energy and Project Finance and Environmental Law Practice Groups at Stroock & Stroock & Lavan LLP. Nicole Hanson, a law school graduate awaiting admission, assisted in the preparation of this article. * * * * * 14 EPA Rules for Coal-fired Power Threaten Midwest Reliability Grid Operator, COUNT ON COAL (Sept. 20, 2014), /09/20/epa-rules-for-coal-fired-power-threatenmidwest-reliability-grid-operator/. 15 Michael Bastasch, Federal Court Upholds EPA Rule Retiring Coal Plants, THE DAILY CALLER (Apr. 16, 2014, 11:37 AM), /16/federal-court-upholds-epa-rule-retiring-coalplants/. 16 U.S. Chamber of Commerce, supra note 8. 5

6 A Tale of Two Cases: Changing Views of Federal and State Jurisdiction Over Electricity Background: Federal Regulation of the Transmission of Electricity Across State Lines In 1927, the Supreme Court decided Attleboro Steam vs. Public Utility Commission 1 a case dealing with a dispute in which a corporation had generated electricity in Rhode Island for sale across the state line into Massachusetts. At that time, interstate commerce in electricity was in its infancy. Electricity was a local business. The transmission of energy generated in one state for use in another state was the exception, not the norm. The Supreme Court held that the generation and transmission of electricity across state lines was an interstate business and, consequently, not subject to regulation by either state, stating that if such regulation is required it can only be attained by the exercise of the power vested in Congress. Because at that time there was no federal agency that was authorized to regulate the interstate sale and transmission of electricity, the Supreme Court s decision in Attleboro Steam created a regulatory gap. It took eight more years for Congress to plug that regulatory gap the inability of state commissions to regulate interstate commerce in electricity affecting their own states by passing, in 1935, Part II of the Federal Power Act ( FPA ), which provided a limited remedy for federal regulation of only those electricity transactions affecting interstate commerce. Section 201 of the FPA grants a federal regulatory commission (now 1 Pub. Utilities Comm n of Rhode Island v. Attleboro Steam & Electric Co., 273 U.S. 83 (1927). known as the Federal Energy Regulatory Commission), jurisdiction only to those matters which are not subject to regulation by the States, thus preserving for state regulatory commissions their existing role in the regulation of generating facilities, local distribution and retail sales of electric energy. Under this rubric, Federal jurisdiction over wholesale electricity markets had come to be considered exclusive and plenary. In 1945, the Supreme Court observed that the statute conferring jurisdiction on the federal agency was couched largely in technical language following the flow of electric energy an engineering and scientific, rather than a legalistic or governmental test, because state lines and boundaries cut across and subdivide what scientifically or economically viewed may be a single enterprise. 2 In the ensuing years, the nascent wholesale electricity market evolved considerably. Regional transmission organizations now administer multistate trading platforms and interconnected grids for the economic dispatch of electric generation resources that did not exist in 1927 or However, on May 23, 2014, in Electric Power Supply Association v. FERC (EPSA 3 ) a decision that revisited the separate spheres of state and federal jurisdiction over electricity the U. S. Court of Appeals for the District of Columbia Circuit adopted a narrow statutory interpretation of federal authority that fails to take into account the broad view of the wholesale electricity market as a single enterprise cutting across state 2 3 Conn. Light & Power Co. V. Fed. Power Comm n, 324 U.S. 515 (1945). Electric Power Supply Assoc. v. FERC, No (D.C. Cir. May 23, 2014), rehearing en banc denied (Sept. 17, 2014). 6

7 boundaries. The court vacated FERC Order No. 745, thereby negating a federal effort to promulgate a uniform rule for demand response compensation in wholesale electricity markets. The court found that the federal regulatory commission lacked the authority to regulate demand response, a practice with clear effects on the wholesale electricity market, because the statutory text [of the FPA] forecloses the agency s assertion of authority over retail customers and their decision whether to purchase electricity at retail. Has the D.C. Circuit s latest decision correctly divined the line dividing federal and state jurisdiction? If correct, what effect will precluding a federal role in demand response have on the wholesale electricity markets and the prices consumers pay? Further, can the apparently shifting sands of Federal and State jurisdiction over electricity be reconciled, or has the D.C. Circuit identified yet another regulatory gap that may only be resolved by the intervention of Congress? Demand Response Demand response is the intentional reduction of electricity usage by end-use customers from their expected consumption in response to incentive payments designed to induce lower consumption. Order No. 745 proposed a relatively simple regime: equating a megawatt (MW) of energy supplied to a MW of energy saved on economic grounds. Demand response is important to the wholesale electricity markets because electric power systems have three important characteristics. First, because electricity cannot be stored economically, the supply of, and demand for, electricity must always be balanced in real time. Second, grid conditions change significantly in real time from day-to-day and hour-to-hour, and affect the supply-demand balance in interconnected systems virtually instantaneously. Demand levels can change rapidly and unexpectedly, with a disturbance in one area resulting in mismatches in supply and demand that can, within seconds, threaten the integrity of the grid over very large areas. Third, the electric system is highly capital-intensive. Generation and transmission system investments require long lead times and the physical assets provide service over long periods of time. The decision to build has economic effects over many decades. Demand for electricity and, consequently, the need for electric generating capacity varies throughout the year. Coincident peak demands can be sharply higher than average system demand and use. In Northeast power markets, as much as 15% of electric generating capacity is called upon less than 1% of the time to meet demand. This last fraction of generating capacity is expensive to build and to operate. If retail prices tracked wholesale market prices, customers would be expected to moderate or shift their consumption away from peak hours with a corresponding reduction in the need for installed generating capacity much like consumers moderate their driving behavior when prices at the gas pump peak. However, retail electric customers have no such direct incentive to shift consumption away from times of peak demand. Demand response is intended to correct this widely recognized flaw in wholesale electricity markets. Most electricity customers see stateregulated retail electricity rates, which are based on average electricity costs that bear little relation to the true production costs of electricity as they vary over time. Consequently, demand for electricity is 7

8 inelastic, because customers do not face accurate and timely price signals and therefore do not respond to the actual price of producing the electricity they consume. Demand response provides incentives to motivate end-use customers to change their behavior and consumption of electricity in response to real-time changes in the price of electricity. Demand response is not new. It originated in the 1970s as the spread of central air conditioning resulted in needle demand peaks during hot summer days. Originally developed by electric utilities (within their role as retail service providers) to temporarily shift or reduce peak energy demand and avoid costly energy production or capacity investments for a small number of hours of need, the focus has shifted to the wholesale market because of FERC s open-access policies fostering the growth in electric competition. Today more than 50% of electricity consumers are served in states where electricity procurement has shifted almost exclusively to a wholesale market activity. Independent System Operators (ISOs), subject to FERC s jurisdiction, operate wholesale markets that price electricity generation at the marginal cost of the next unit of generation. Yet, electricity consumers cannot directly respond to the higher or lower marginal costs of generating electricity because the retail prices they pay, largely still regulated by state regulatory commissions, are not closely correlated with the prices in the wholesale markets that FERC regulates. Consequently, the importance of demand response as a wholesale market tool cannot be understated. In December 2012, FERC Staff estimated that the potential demand response resource contribution from all U.S. demand response programs was nearly 72,000 megawatts (MW), or about 9.2 percent of U.S. peak demand. The EPSA Decision The DC Circuit s narrow construction in EPSA of the FPA ignores the significant evolution of the regulated electricity market since Whereas Attleboro Steam addressed whether a public service commission in one state could regulate a single sale of electricity in interstate commerce, the EPSA decision limits the extent to which FERC, a federal agency, can make broad rules regarding a far more integrated market for interstate commerce in electricity. EPSA takes the regulatory gap the inability of state commissions to regulate limited commerce in electricity affecting their own states and limits the available remedy federal regulation of commerce affecting interstate commerce. One can anticipate that FERC and other market participants may seek review of the EPSA decision by the Supreme Court because of the apparent conflict between that decision and other decisions of the D.C. Circuit that, reading the same statutory provisions more broadly, have found that FERC can regulate practices affecting the wholesale market provided the Commission is not directly regulating a matter subject to state control, such as the retail market. 4 The EPSA decision directly applies only to Order No. 745, which imposed specific requirements on the way demand response resources participate in the RTO-operated energy 4 See, e.g., Conn. Dep t of Pub. Util. Control v. FERC, 569 F.3d 477, 479 (D.C. Cir. 2009) (finding FERC could regulate the price for installed capacity in the wholesale market under its jurisdiction to regulate practices affecting wholesale rates and charges because FERC did not engage in direct regulation of an area subject to exclusive state control). 8

9 markets. However, demand response resources currently participate in the RTO markets for both energy and capacity. Read broadly, EPSA s holding, premised on demand response being a retail market activity subject to state regulation, may well prompt challenges to FERC s regulation of the capacity markets as well. Assuming it is upheld, the EPSA decision is likely to have a wide-ranging impact on the way demand response resources participate in RTO/ISO markets and the price consumers pay for electricity. FERC, the RTOs, and market participants are likely to spend considerable time and effort coming to grips with the repercussions of the court s decision. The reevaluation of FERC s process for regulating these markets already has begun. On May 23, 2014, a complaint was filed under Section 206 of the FPA, which was based on the court s conclusion that the FPA unambiguously restricts FERC from regulating the retail market. This complaint is likely to be the first of many actions by market participants, RTOs, and FERC itself to determine the permissible contours of policies governing demand response resources in the nation s wholesale electricity markets. Thus, one outcome of EPSA is continued uncertainty in the energy and capacity markets as RTOs will need to refine tools for economically resolving the effects of inelastic demand for electricity. By Jon R. Mostel, Partner in the Energy and Project Finance Practice Group at Stroock & Stroock & Lavan LLP. * * * * * For More Information Jeffrey W. Meyers Jon R. Mostel jmeyers@stroock.com jmostel@stroock.com Scott Le Bouef Andrea N. Satty slebouef@stroock.com asatty@stroock.com Armando X. Ramirez E. Gail Suchman aramirez@stroock.com gsuchman@stroock.com 9

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