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Demand Response: Breaking Out of the Bubble

Using demand response to mitigate rate shocks.

Fortnightly Magazine - March 2007

the desire of regulators to “protect” consumers by not offering them choices. This is akin to “killing the market with kindness.”

Admittedly, the process of making choices in the marketplace is complex and burdensome. Nobel Laureate Dan McFadden has found in his new research on consumer behavior that because consumers are “suspicious of trading partners, and fearful of deception, exploitation, or unfair treatment … [they] … exhibit various degrees of agoraphobia, a term that means literally ‘fear of the marketplace.’” 11

However, in the case of electricity, especially for small commercial and residential customers, the issue is not so much about making a complex choice as making a simple choice. Do they want to pay higher average rates in return for price stability or do they want to pay lower rates in return for some price instability?

The time-honored Bonbright criteria suggest that prices for basic electricity service should be fair, simple, acceptable, effective, equitable, non-discriminatory, and efficient. 12 In today’s environment, this no longer translates into “flat” rates. Electricity prices vary, not only within a day, but throughout the entire year. This cost variation is especially pronounced in transmission-constrained locations. Yet, even in California, six years after the crisis, the only customers who see such time-variation in their basic rates are large commercial and industrial customers and even they are on static TOU rates, not dynamic rates that change based on demand-supply conditions.

It is economically inefficient to mask the time-variation in the cost of producing electricity. Typically, gas-fired combustion turbine plants are used as peaking plants because they are cheap to build but expensive to operate. Such peaking units have low capacity factors and are idle for most hours of the year. The issue is, in part, a cost-effectiveness one—when and whether to use price-responsive demand to replace the expensive power generated by a peaking plant. In other words, dynamic pricing (as well as other forms of DR) needs to be part of the resource-adequacy process.

Some argue that it is incorrect to introduce time-variation in default electric rates because customers prefer rate stability. But this preference for stability masks important cross-subsidies that often are ignored in the rate-setting process. Non-time varying rates subsidize customers with relatively peaky load shapes at the expense of customers with relatively flat load shapes.

Customers face time-varying rates for other products and services, such as cellular phone services, bridge tolls, airline tickets, and vacation packages, so why not for electricity? A likely reason is that a transition from non-time varying rates to dynamically time-varying rates, even though it will be cost-based, will create winners and losers. The losers will be those customers whose load shapes are peakier-than-average, since their average rates would rise, and the gainers will be those customers with flatter-than-average customers whose average rates would fall. Is it that the regulatory process has not been able to make well-informed tradeoffs between gainers and losers, especially when the losers are vocal and well-connected?

No, because there are other cases when such tradeoffs have been made. A case in point is inverted block rates