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Pricing Negawatts

DR design flaws create perverse incentives.

Fortnightly Magazine - August 2010

difficulty of measurement and verification and potentially create additional gaming opportunities. In contrast, dynamically indexed retail tariffs provide customers with just the right incentives for adjusting their consumption in all hours of the day or night.

Recognizing the shortcomings, PJM envisages and actively supports the replacement of its economic DR programs with price-responsive demand achieved through dynamic retail rates. 9 Notwithstanding their shortcomings, properly designed wholesale DR programs can provide a valuable service until cost-reflective, dynamic retail tariffs become widespread. On the other hand, programs that aren’t properly designed in accordance with sound economic principles might do more harm than good.

DR as a Resource

Classic economic theory treats DR purely as a demand-side effect. In contrast, economic DR programs treat DR as an equivalent supply-side resource. This latter treatment has given rise to much confusion.

Because retail customers see only the fixed tariff price, they consume electricity regardless of wholesale market prices in peak and off-peak hours (see Figure 2) . If the same customers were exposed to real-time wholesale market prices, their consumption patterns would change, producing economically efficient wholesale market clearing prices. These efficient market solutions would equate each retail customer’s marginal value of electric energy with the marginal cost of producing and delivering the energy to that customer. However, when served through fixed-price retail tariffs, the customers will over-consume electricity in a peak hour and under-consume in an off-peak hour.

A properly designed economic DR program can provide an ISO with a useful tool for approximating economically efficient market outcomes in the peak hours by treating DR as a resource equivalent to generation. In such a market, the optimal least-cost dispatch solution occurs at the intersection of the generation-offer and DR-offer curves, because that solution minimizes the ISO’s total payments for the resources needed to meet the nominal fixed demand in a given hour, and reduces wholesale prices (see Figure 3) .

In practice, however, the dispatch software employed by an ISO doesn’t clear the energy market as described above; instead, it comingles the generation supply offers with the DR offers to produce a composite supply curve, which the ISO treats in the same manner as a supply curve consisting solely of generator offers. The composite supply curve produces the same market outcome as that described in Figure 3 .

Unfortunately, such a composite supply curve creates the illusion that generation and DR are equivalent energy resources, rather than equivalent balancing resources. From there it’s easy (and incorrect) to conclude that both types of resources deserve to be paid the same energy market price. The fallacy occurs in assuming that DR and energy trade in the same market. In fact, these fundamentally different resources trade in separate and distinct markets that are linked by the requirement that the sum of the resources clearing in their respective markets must equal the power system’s nominal demand (Dh in Figure 3) .

The energy market is a commodity market where generators and power marketers sell energy to wholesale buyers ( e.g., LSEs and other power marketers). In contrast, the DR