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DR Distortion

Are subsidies the best way to achieve smart grid goals?

Fortnightly Magazine - November 2010

it isn’t economically efficient. For example, when spot prices are high, customers have no incentive to cut back on relatively low-value uses of energy. Dynamic retail pricing is the most direct and natural way to address this problem by charging more when marginal costs to serve are high and charging less when marginal costs are low. Dynamic retail pricing is economically more efficient than fixed retail pricing.

However, wholesale DR is an alternative mechanism to expose retail customers to the right price signal at the margin, even if they are on fixed rates. Even if they pay a fixed amount for energy they actually consume, customers can sell load reductions at wholesale energy spot prices. Their participation as DR can increase short-term economic efficiency, so long as their wholesale payment is LMP minus the avoided retail rate (not full LMP). Adding a subsidy to the wholesale payment is less efficient than with no subsidy and possibly less efficient than pure fixed rates with no DR at all ( i.e., because the subsidy is distortionary). 9

DR’s relationship to market efficiency becomes more interesting in the long-run. Imagine if a large fraction of customers became responsive to wholesale market prices. The peak load might be reduced by 10-20 percent, 10 and if that resulted in less generation capacity being built, energy price volatility and the frequency of shortage conditions could increase. 11 In shortage conditions, energy and operating reserves prices would have to rise until sufficient customers responded for supply to equal demand. Prices in scarcity conditions would be set according to the customers’ marginal willingness to pay for energy. 12

In effect, by responding to high prices during scarcity conditions, the customers would sort themselves into various levels of non-firmness instead of everyone having to pay for the same level of reliability. There would be less need for administratively determined scarcity prices. There still might be administratively determined planning-reserve margins to ensure a certain level of reliability for the fraction of load that prefers to be firm, but the market price of capacity to meet such a requirement might be very low or zero due to the higher energy prices. Compare such an ideal, market-based outcome to today’s: Billions of dollars are paid for capacity in order to meet administratively-determined reliability levels uniformly across almost all customers.

Attaining a more efficient, customer preference-based market depends primarily on achieving deep penetration of DR or dynamic pricing, e.g., 60 to 75 percent in the FERC potential study. 13 The limiting factors primarily are the development of advanced metering infrastructure (AMI) and the introduction of dynamic retail rates. Arguably, the direct funding of AMI infrastructure ( i.e., roughly $200 per meter before counting operational savings and other benefits, discussed below) should be viewed as competing with DR subsidies for scarce ratepayer dollars. Funding AMI is a more direct way to expand the number of customers that are price responsive. Full LMP subsidies for load reductions certainly stimulate more frequent activity by existing DR resources, but it’s unclear how many new DR resources they