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DR Distortion

Are subsidies the best way to achieve smart grid goals?

Fortnightly Magazine - November 2010

than by subsidizing DR on a volumetric, full LMP basis. Emissions reductions are best achieved through programs and incentives to promote energy efficiency and clean generation. Energy price suppression might be achieved through DR subsidies, but it should be understood that the resulting customer energy savings come at the expense of supplier profits and only be can temporary ( i.e., although capacity savings are likely to be permanent). Market efficiency and competitiveness are best achieved without distortionary subsidies; a preferable approach would be funding AMI directly and introducing dynamic retail rates to make the market more efficient and competitive by enabling more customers to be price-responsive. Finally, full LMP subsidies alone are unlikely to stimulate the development of the smart grid and shouldn’t be confused with the smart grid or the far-reaching effects it might achieve.

In short, whether full LMP constitutes a subsidy isn’t a serious economic question. How best to enable customers to respond to spot prices and how to promote the broader policy goals that DR supports are serious questions. Full LMP subsidies don’t appear to be the best answer.



1. For the purposes of this article, DR refers to load reductions that are treated as supply resources and subject to payments by the RTOs, not dynamic retail pricing.

2. Comments of Samuel Newell, Kathleen Spees, and Philip Hanser, Docket RM10-17-000 (filed May 13, 2010 in response to FERC’s NOPR on DR compensation). See also Hung-po Chao, “An Economic Framework of Demand Response in Restructured Electricity Markets,” Feb. 8, 2009, Retrieved from:

3. See Supplemental comments of Samuel Newell, Kathleen Spees, and Philip Hanser, Docket RM10-17-000, filed October 5, 2010 in response to FERC’s Supplemental NOPR on DR compensation.

4. In some ISO programs, DR capacity providers also receive payments for the energy value of load reductions they actually provide during emergency events, although these payments tend to be much smaller than the capacity payments.

5. The higher numbers sometimes reported by ISO-NE include passive DR, which refers primarily to energy efficiency.

6. Frank A. Felder and Samuel A. Newell, “Quantifying Demand Response Benefits in PJM,” report prepared for PJM and the Mid-Atlantic Distributed Resources Initiative, Jan. 29, 2007.

7. Hung-po Chao, “An Economic Framework of Demand Response in Restructured Electricity Markets,” Feb. 8, 2009, Retrieved from

8. Supplemental NOPR and Notice of Technical Conference, Re: Appropriate Compensation for Demand Resources (RM10-17-000).

9. Ibid.

10. FERC staff found that expanded participation in the current mix of DR programs could lead to a 9-percent reduction in peak demand by 2019, relative to a baseline forecast with no demand response. With full participation in mostly price-based demand response programs, this impact could be as much as 20 percent. (FERC Staff, “A National Assessment of Demand Response Potential,” prepared by The Brattle Group, Freeman, Sullivan & Co., and Global Energy Partners, June 2009.)

11. Adding DR that provides capacity and energy should make prices more volatile in the long run, since it’s like adding a super-peaker to the exclusion of other, lower variable cost