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DR design flaws create perverse incentives.
market trades in retail customers’ commitments to not consume electricity (see Figure 4) . These commitments are financial derivatives indexed to market energy prices.
Incenting Value-Based Offers
The least-cost solution illustrated in Figure 3 will yield an economically efficient market outcome only if the DR offer curve (DRR) accurately reflects the economic values ( i.e., opportunity costs) that participating retail customers respectively would forego by reducing their electric energy consumption. If that condition is fulfilled, the marginal value of consumption will equal the marginal cost of producing and delivering the electricity consumed, resulting in the efficient market outcome (P*, Q*, illustrated in Figure 2) . A properly designed economic DR program will include economic incentives to achieve this outcome.
The DRR offer curve aggregates the individual price offers of the retail customers represented by ARCs; consequently, the way ARCs compensate their customers affects the prices at which those customers will offer their load reductions. One way to influence how an ARC compensates its customers is to pay it the same prices it should pay its customers for their load reductions.
Ideally, an ARC will pass through to each customer the full price it receives for the customer’s load reduction and will recover its costs and profits through fixed monthly subscription fees that minimally distort the customer’s consumption decisions. If the customer also is selling capacity into the wholesale market, the ARC can deduct the subscription fee from the customer’s capacity payments. While this too may be distortive by discouraging investment in the needed metering and communications infrastructure, it likely will be less so than a recurring disincentive to fully respond to energy market price signals.
The economically efficient price a retail customer should be paid is its offer price minus the price in its retail tariff at which it would have purchased the curtailed energy, i.e., its marginal foregone retail rate (MFRR). 10 In contrast, if the customer is paid its full offer price, it will submit offers that net off the MFRR from the marginal productivity values, resulting in offer prices that are too low, thereby causing the ISO to dispatch excessive and inefficient amounts of DR.
Consider an example in which a retail customer, whose MFRR is $50 per MWh, decides to offer one MWh of load reduction in hour h. Assume the customer places a value of $300 on the product that MWh would produce. By consuming that MWh, the customer would gain an economic benefit of $300 but would pay its LSE $50 for the energy, for a net gain of $250. Thus, the customer would want to be paid at least $250 for its load reduction. If the customer knows it would be paid the market energy price for its curtailed energy, it rationally would offer $250, which obviously is less than the productive value of the energy. If that offer clears the market, a generator somewhere in the system would be backed down even if it could have delivered the energy at a cost lower than the productive value of the curtailed energy. Clearly,