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Pricing Negawatts

DR design flaws create perverse incentives.

Fortnightly Magazine - August 2010

recovery scheme fully would recover the ARC’s DR compensation from that LSE (see Figure 4) . Similarly, a second ARC DR payment would be recovered from a second LSE, etc. This analysis assumes a one-to-one correspondence between ARCs and LSEs only to simplify the explanation; actual ISO settlement systems can accommodate ARCs representing the customers of multiple LSEs.

Targeted recovery avoids the cross-subsidies and inefficient pricing distortions that accompany the socialized recovery of DR payments across multiple wholesale buyers. Socialized recovery also increases revenue uncertainty for the LSEs involved, and thus increases the risk premiums they need to charge their retail customers.

Another potential buyer of DR might be a coalition of retail customers on dynamic, wholesale market-based retail tariffs that want to use DR to lower wholesale market prices in order to reduce their electric bills. 12 During times when a significant surplus of generating capacity exists, over-stimulating DR in this manner would benefit these customers, but also would constitute the exercise of market power on the demand side. The immediate effect would be to deny generators a fair opportunity to recover fully their past investments and to discourage future investments in new supply resources, including renewables. In the longer term, capacity prices would have to increase, burdening future consumers who would also have to bear the inflated payments for DR. The primary result would be to transfer wealth from residential and small business customers to the large commercial and industrial customers selling the negawatt-hours. All these reasons argue for prohibiting the exercise of demand-side market power.

Implementing ARC Compensation

As discussed, a negawatt-hour of DR is a call option on energy, which economic value partly is determined by the wholesale market energy, i.e., the relevant LMP, and partly by the rates in the DR provider’s retail tariff, i.e., its MFRR. This suggests a natural decomposition of ARC payments into two transactions that ISO settlement systems easily can accommodate using information provided from external sources regarding the relevant MFRRs.

The information needed to determine MFRRs necessarily will be complex and detailed because retail tariffs are complex and detailed. For this reason, MFRRs are best quantified at the retail level, then applied at the wholesale level. It’s no coincidence that all FERC-jurisdictional ISOs and RTOs with economic DR programs have proposed settling their DR purchases using some variant of this two-transaction approach. 13

Ultimately, the adoption of smart meters combined with dynamic, cost-reflective retail tariffs will eliminate the disconnect between wholesale market rates and retail rates, obviating the need for economic DR programs. Meanwhile, the industry should avoid overpaying DR providers for their negawatt-hours.



1. Demand Response Compensation in Organized Wholesale Energy Markets , Docket No. RM10-17-000, Mar. 18, 2010 (FERC).

2. Id., at 15.

3. Massey, William L., “At the FERC, a Strong Commitment to Demand Response,” Remarks by FERC Commissioner Massey, Peak Load Management Alliance 2002 Spring Conference, Dallas, Texas, Apr. 25, 2002, at 2.

4. Order Removing Obstacles to Increased Electric Generation and Natural Gas Supply in the Western United States , Docket No.