Zero Emissions Credits: A Strong Legal Case Just Got Stronger
Eric Selmon Hugh Wynne
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July 10, 2017
Zero Emissions Credits: A Strong Legal Case Just Got Stronger
On June 28, the U.S. Second Circuit Court of Appeals issued its decision in a case regarding Connecticut’s renewable energy programs, Allco Financial v. Klee, which appears to support the legality of the Zero Emissions Credits (ZEC) programs in New York and Illinois. The decision rejected both federal pre-emption and dormant commerce clause claims that are similar to those made by generators against the NY ZEC program. As the Second Circuit is the court of appeals for Federal courts in New York, this decision will be binding on the court hearing the complaint against the NY ZECs. We believe the logic laid out in the Allco decision, combined with last year’s U.S. Supreme Court decision in Talen v. Hughes, will support a decision in favor of the NY ZEC program. If, as we expect, the lower court follows the logic of the Second Circuit’s decision, it will remove an overhang of uncertainty over Exelon (EXC), the sole beneficiary of the New York and Illinois ZEC programs. If other states implement ZEC programs, other owners of nuclear plants, such as Public Service Enterprise Group (PEG) in New Jersey and FirstEnergy (FE) in Ohio, could also benefit. For fossil generators in New York and Illinois, such as NRG Energy (NRG) and Dynegy (DYN), a lower court decision supporting the ZEC program would ensure that a large source of low priced generation remains in the market and continues to suppress power prices.
Portfolio Manager’s Summary
- On August 1, 2016, the New York Public Service Commission (NYPSC) adopted a Clean Energy Standard (CES) designed to promote the growth of renewable energy resources and support existing renewable and nuclear power plants in the state. Introduced by the CES, Zero Emission Credits (ZECs) are tradeable certificates representing the environmental benefits created by each MWh generated by nuclear plants in the state.
- From April 1, 2017, each load serving entity in New York must purchase ZECs from the New York State Energy Research and Development Authority (NYSERDA) in proportion to its share of the state’s electric load. In turn, NYSERDA will purchase ZECs from qualifying nuclear plants under a contract expiring on March 21, 2029.
- The pricing of the ZECs starts at $17.48, a price based on the social value of carbon emissions avoided. After the first two years, the price will be (i) adjusted based upon changes in the price of CO2 emissions allowances in the Regional Greenhouse Gas Initiative (RGGI) market and (ii) reduced by the excess of the sum of (a) the combined price of energy in NY Zone A and (b) the capacity price in the Rest of State zone over $39/MWh.
- Illinois passed a law creating a similar ZECs program in December 2016. Because that program has not yet been implemented, we are not addressing it in this note. However, the close similarity to the underlying principles of the NY program mean that the analysis herein should apply to legal challenges to the Illinois ZEC program as well.
- In October 2016, a group of generators, including Dynegy (DYN) and NRG Energy (NRG), challenged the NY ZEC program in a Federal court in New York, arguing that the program was invalid on two grounds:
- Pre-emption: State law is pre-empted by federal law if Congress “has legislated comprehensively to occupy an entire field of regulation.” Northwest Central Pipeline Corp. v. State Corporation Commission of Kansas, 489 U. S. 493, 509.
- The generators claim that the NY ZEC program intrudes upon FERC’s exclusive jurisdiction over wholesale power markets and prices, granted to FERC under the Federal Power Act of 1935, by making out-of-market payments to uneconomic generators.
- Furthermore, by keeping uneconomic generators in the market, the NY ZEC program suppresses power prices and impermissibly interferes with wholesale power pricing.
- Dormant Commerce Clause: “…the negative or dormant implication of the Commerce Clause [of the U.S. Constitution] prohibits state taxation or regulation that discriminates against or unduly burdens interstate commerce…” Selevan v. N.Y. Thruway Authority, 584 F.3d 82, 95 (2d Cir. 2009).
- The generators claim that the NY ZEC program solely benefits in-state nuclear generators to the detriment of out-of-state wholesale generators and therefore is an unlawful interference with interstate commerce.
- In assessing the pre-emption argument, it is important to recognize that there are many areas of traditional state jurisdiction where states can act as long as the impact on areas of exclusive federal jurisdiction is incidental.
- States’ power to regulate health and safety permits state environmental regulation, while regulation of utilities is recognized as part of the police power of states.
- Included under regulation of utilities is the power to direct the planning and resource decisions of local utilities, including ordering utilities to build generating resources.
- We find the generators’ arguments based on pre-emption and interference with interstate commerce to be undermined by recent court precedents, including the U.S. Supreme Court’s decision in Talen v. Hughes and the decision of the Second Circuit Court in Allco Financial v. Klee.
- In Talen, the Supreme Court struck down a state subsidy designed to supplement the PJM capacity market revenues of gas-fired generators in Maryland, finding that Maryland’s program was pre-empted by FERC’s authority to regulate wholesale power markets.
- Critically, however, the Supreme Court’s opinion in Talen states, “Nothing in this opinion should be read to foreclose Maryland and other States from encouraging production of new or clean generation through measures untethered to a generator’s wholesale market participation. So long as a State does not condition payment of funds on capacity clearing the auction, the State’s program would not suffer from the fatal defect that renders Maryland’s program unacceptable.”
- A key question regarding the legality of the NY ZEC program, therefore, is whether the ZECs are “untethered to a generator’s wholesale market participation.” We believe they are.
- First, the NY Public Service Commission cited several reasons for creating ZECs, including avoiding emissions of carbon dioxide, sulfur dioxide, nitrogen oxide and other pollutants, as well as maintaining fuel diversity. These are areas of traditional state jurisdiction where states can act as long as the impact on areas of exclusive federal jurisdiction, such as wholesale power markets, is incidental.
- Second, generators’ eligibility for ZECs is in no way contingent upon their participation in the power markets. That the ZEC generators sell nuclear generation into the power market should not be deemed to be an impermissible connection to the wholesale market; the generation of clean energy, which was explicitly mentioned by the Supreme Court in Talen, is only of environmental value if it displaces less clean energy sources in the power market.
- Third, the pricing mechanism of ZECs, while partly dependent on power prices, does not directly tie the ZEC revenues of the generator to its power market revenues. Power prices are only one part of the pricing mechanism, which is based in large part upon the price of CO2 allowances, and they are only a reference point, similar to the use of NYMEX pricing in commodities contracts. Thus ZEC prices and revenues do not replace or override the wholesale prices and revenues that generators receive in the power markets.
- The pre-emption argument advanced by generators against the NY ZEC program is further undermined by the June 28th decision of the Second Circuit Court of Appeals in Allco Financial v. Klee. The court in Allco addressed the impact of state mandated renewable, or, in this case, clean, generation on power prices, finding that the “incidental effect on wholesale prices does not…amount to a regulation of the interstate wholesale electricity market that infringes on FERC’s jurisdiction.”
Dormant Commerce Clause
- Also contradicted by Allco is the generators’ second argument against the NY ZEC program, that it solely benefits in-state nuclear generators to the detriment of out-of-state wholesale generators and therefore is an unlawful interference with interstate commerce.
- The Allco decision on Connecticut’s renewable energy programs is the first circuit court case to directly address a challenge to renewable portfolio standards (RPS) and renewable energy certificates (RECs) based on such a dormant Commerce Clause claim. We believe that the decision is strongly supportive of New York’s ZEC program.
- The court in Allco found that RECs are property rights created under state law; that in-state RECs are different products, as defined by the state law, than out-of-state RECs; and, therefore, that the different treatment of the two products is non-discriminatory.
- There are valid reasons why in-state RECs, and, by logical extension, NY ZECs, would be a different product than out-of-state RECs and ZECs and of greater value to the state.
- First, the localized benefit of reduced pollution, including from particulate matter and nitrogen oxides, a precursor of ozone, argue strongly in favor of distinguishing between in-state and out-of-state RECs and ZECs.
- Second, in Allco, the Court recognized Connecticut’s use of ISO New England to geographically limit the source of RECs to comply with its RPS. Importantly for the New York ZEC program, the New York ISO power grid that serves New York is coterminous with the state, so the definition of in-state generation only follows the boundaries of the local electrical grid as determined by FERC.
- Given its decision in Allco, we believe the Second Circuit will find the NY ZEC program to be non-discriminatory and would then assess the rule on whether the burden it imposes on interstate commerce is not clearly excessive in relation to the in-state benefits.
- The burden claimed by the generators in the NY ZEC lawsuit is suppression of power prices for and displacement of generation by out-of-state generators.
- The finding in Allco that the burden imposed by the Connecticut RPS rules on interstate commerce were clearly not excessive relative to the local benefits should also hold for ZECs as the burdens and benefits of each are similar.
- Exelon (EXC), as the sole owner of nuclear plants currently generating ZECs, would benefit from the certainty that a positive court decision would give to an important component of its earnings for the next ten years.
- Generators in New York and Illinois, such as Dynegy (DYN) and NRG Energy (NRG) would suffer as ZECs provide support to a large source of low priced generation in the market, suppressing power prices and contributing to reduced output from existing CCGT and coal-fired generators. (See our note of June 7, Creative Destruction and Your IPP Portfolio: Flat Demand & Capacity Additions Likely to Erode Gas & Coal Capacity Factors Through 2019.)
Exhibit 1: Heat Map: Preferences Among Utilities, IPP and Clean Technology
Source: SSR analysis
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Illinois has not set up the rules yet for implementing its ZEC program, but the law does appear to allow for bids by nuclear generators in MISO and PJM, not just Illinois. We still expect that only Illinois nuclear generation would win contracts because the Illinois Power Agency is supposed to also explicitly consider various public interest factors, including the impact on local pollution. ↑