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Pricing Negawatts

DR design flaws create perverse incentives.

Fortnightly Magazine - August 2010

A debate that started about 10 years ago turns around the question of how much a retail customer should be paid for not consuming electricity— i.e., how much are the customer’s negawatt-hours worth? Further adding to the debate, the Federal Energy Regulatory Commission (FERC) recently proposed a rule that would require all independent system operators (ISOs) and regional transmission operators (RTOs) sponsoring economic demand-response (DR) programs to pay the energy market price for demand reductions. 1 The FERC based its proposal on the assumption that a MWh of DR ( i.e., a negawatt-hour or NWh) has the same economic value as a megawatt-hour of energy. 2

The FERC’s assumption is wrong. Economic demand response isn’t a sale of energy; rather, it’s a sale of a call option on energy. Although the market price of energy contributes to the economic value of a negawatt-hour, it doesn’t completely determine that value.

Economic Rationale

Economic theory treats price-sensitive DR as a downward sloping demand curve (see Figure 1) . This economic principle is observed in action in everyday life—as the price of a good or service increases, consumers buy less of it. Unfortunately, this principle isn’t fully operative in wholesale power markets because most consumers buy their electricity through fixed-price retail tariffs, which effectively isolate them from wholesale market prices. Although sloped demand curves still represent how these consumers value electric energy, their consumption decisions are based on their fixed retail tariff prices.

The economic rationale for wholesale economic demand programs is to provide retail customers on fixed-price tariffs with incentives equivalent to those provided by dynamic retail prices that directly reflect the hourly wholesale market prices. Many large industrial and commercial customers are served through such dynamic tariffs, and thus don’t require any additional incentives to make economically efficient consumption decisions. If allowed to participate in economic DR programs, these customers will be grossly overcompensated for their demand reductions.

Ten years ago, DR generally was viewed as a retail activity outside the jurisdiction of the FERC. That changed during California’s electricity meltdown when FERC realized that a modest amount of DR could have eliminated the rolling blackouts and produced substantially lower wholesale market electricity prices. 3 In 2001, FERC asserted jurisdiction over wholesale market DR, stating:

These transactions are considered wholesale when they involve the sale for resale of energy that would ordinarily be consumed by the reseller. These transactions can occur in several ways. An aggregator can line up retail load to acquire enough negawatts to resell in a manner similar to what aggregators do when they sell power to retail load under retail choice programs. 4

Today, almost all ISOs and RTOs administer economic DR programs along with other programs through which DR provides capacity and ancillary services. The