Last week, the U.S. Supreme Court heard arguments addressing whether the Federal Energy Regulatory Commission (FERC) has the authority to establish rules for consumer engagement in electricity markets.

At issue is FERC Order 745, which the agency established in 2011 to set consistent rules for an emerging electricity market mechanism called “demand response,” in which an electricity customer temporarily reduces their energy use (e.g. by turning off their air conditioning) during peak hours in exchange for compensation. A group of electricity producers and grid operators challenged the rule, arguing that’s FERC’s authority does not extend into retail electric markets, through which demand response programs are facilitated. FERC contends that its jurisdiction does include demand response, because it impacts wholesale electricity markets.

The case is important because it addresses a fundamental shortcoming that electricity markets have had since their inception: the inflexibility of customer demand.

In an ideal market, the amount of demand should reduce as supply becomes constrained. Take the example of rental apartments illustrated in the figure below. The red supply curve represents the number of apartments (on the x-axis) available for a price less than or equal to the corresponding price on the y-axis. Likewise, the green demand curve represents the number of potential tenants that are willing to pay at least a given monthly price. Where these two curves intersect represents the market equilibrium price—the point at which there are no more tenants willing to pay for the next available apartment, because its monthly rent is higher than their willingness to pay.

This classic microeconomics example illustrates how the number of apartments available below a certain price (the supply curve) and the number of potential tenants willing to pay up to a certain price (demand curve) intersect to establish a market equilibrium price—the point at which there are no more tenants willing to pay for the next available apartment, because it is too expensive.

The supply-demand picture for today’s electricity markets looks far different from the example of an ideal market. The demand curve is not a curve it all but a vertical line—indicating that electricity customers behave as though they have an unlimited willingness to pay for electric power. In other words, demand for electricity is completely inflexible. This behavior occurs because we are typically charged a fixed retail price for electricity, so we tend to use as much electricity as we want to whenever we want to, regardless of how high the wholesale price of electricity climbs on the supply side of the grid.

In today’s electricity markets, retail customers typically pay a fixed price for electricity that is decoupled from the real-time cost of supplying power. Thus, customers have no incentive to reduce their demand, even when the cost of supplying electricity greatly exceeds the retail price.

While the retail price of electricity is typically fixed, the wholesale price can vary wildly based on the variable cost of producing electricity, as illustrated by the red supply curve in the figure above. Over the entirety of 2014 in Texas’s wholesale electricity market, the real-time price of electricity varied from a minimum of -$47 per megawatt-hour (yes that is a negative sign, representing oversupply) on November 25th at 8:15 a.m. to a maximum of $5,259 per megawatt-hour (about 50 times the average retail price) on January 6th at 7 a.m. While these prices are uncommon and extreme (the January 6th price spike coincided with an emergency shortfall in generation), they illustrate the extent to which the real-time price of electricity can vary.

These historic prices from the Electric Reliability Council of Texas (ERCOT) electricity market illustrate the extent to which the wholesale electricity price can vary over the day and over the year.

FERC established Order 745 to alleviate the inflexible nature of demand that persists in electricity markets today. The order establishes uniform rules to govern the amount that customers are paid in exchange for reducing their energy use when the real-time market price of electricity peaks, like it did on the morning of January 6, 2014 in Texas. It stipulates that customers should be paid the corresponding market price of electricity for every unit of energy they don’t use if and only if their action causes the overall cost of electricity to be less than if they had not acted. This “net benefits” test imposed by FERC ensures that customers are not paid to reduce their demand when it would not be valuable to the rest of the grid system. In other words, customers would only really be paid for curtailing their electricity use when the wholesale price of electricity vastly exceeds the retail price.

Regardless of whether or not FERC Order 745 adequately addresses customer engagement in electricity markets, challengers to the rule argue that FERC’s authority does not extend into retail markets, so the agency can’t establish rules for demand response. They argue that the responsibility to implement demand response lies with the 50 different Public Utility Commissions that govern retail electricity markets in each state.

The dispute between FERC and its challengers is a classic example of differing interpretations of the Article 1, Section 8, Clause 3 of the U.S. Constitution, or the “commerce clause,” which gives the federal government authority to “to regulate commerce with foreign nations, and among the several states, and with the Indian tribes.” FERC argues that demand response falls under its authority to regulate wholesale interstate markets under the commerce clause, while challengers argue that the commerce clause does not apply to retail electricity in any form, regardless of the impacts that demand response is meant to have on the wholesale markets.

In my opinion, FERC did not overstep its boundaries in establishing federal demand response rules, because reducing demand for electricity can have an immediate impact on the market price. Unlike markets for other commodities, electricity markets operate 24 hours a day, 365 days a year, and carry out continuous settlement and adjustment operations to establish a price in real time. Thus, any immediate change in demand could have an immediate impact on the price, and help to reduce the overall cost that is seen by all participants in an interstate electricity market.

Depending on how the court battle shakes out, FERC might have to drop its efforts to implement rules for demand response. That would still leave the states with authority to create demand response programs, but I suspect this would make it more difficult for emerging customer energy management companies to implement demand response products, and slow the progress of demand response nationwide.