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DR Distortion

Are subsidies the best way to achieve smart grid goals?

Fortnightly Magazine - November 2010

public policy goals that DR subsidies possibly might support. Policy goals that DR contributes to, or that have been associated with, in FERC’s NOPR or elsewhere include: 1) reducing the amount of generation capacity needed for resource adequacy; 2) suppressing energy prices; 3) improving electricity market efficiency; 4) enhancing electricity market competitiveness; 5) reducing emissions; 6) facilitating wind integration; and 7) promoting the smart grid and its associated transformative capabilities for customers, distribution companies, and transmission operators.

Reducing the amount of generation capacity needed for resource adequacy : DR flattens the load shape by reducing demand in the highest-load periods, thereby decreasing the amount of generation capacity needed to meet resource-adequacy requirements. This is recognized in the RTOs’ resource-adequacy constructs, with DR generally being paid as capacity supply. DR’s opportunities to earn capacity payments have helped DR to emerge as a major source of low-cost capacity, 4 reaching 6 to 8 percent of peak load in PJM, NYISO, and ISO-NE. 5 This success seems to have surprised many market observers. It’s a good example of how markets can work well to attract and retain low-cost resources.

Is it possible that, in spite of this success, that DR is being paid too little, and subsidies might be needed in order to attract more DR and achieve a more efficient amount of DR capacity? RTOs and stakeholders have engaged in extensive discussions and tariff revisions to attempt to ensure that DR is receiving just the right price for capacity, with payments and performance obligations comparable to generation. These discussions generally recognize that to the extent DR isn’t being treated comparably to generation, the capacity market rules should be fixed, rather than introducing subsidies. To the extent that DR provides other sources of value besides capacity, it should be compensated for those, as discussed below.

Suppressing energy prices : Many regulators have expressed interest in promoting DR to suppress energy prices and lower customer costs. Indeed, energy price suppression can benefit customers in the short term, and it does so by transferring wealth from suppliers. However, price suppression can’t persist in a long-term competitive market equilibrium. 6 Suppliers eventually will respond to depressed prices by retiring more, or building less, generation capacity and/or by increasing their capacity market offers because of their reduced margins in the energy market. Until the suppliers fully respond, customers may enjoy temporary savings, a prospect that might be attractive to regulators considering supporting DR subsidies. However, those potential savings need to be weighed against the economic losses from behavioral distortions induced by subsidies, 7 the cost to customers of funding such subsidies, and the likely increase in risk premiums that suppliers will need to charge for operating in a market in which regulators provide subsidies to suppress prices. FERC appears to be soliciting comments on such tradeoffs in its supplemental NOPR issued on Aug. 2, 2010. 8

Improving market efficiency : without DR or dynamic pricing, customers pay fixed rates and are insensitive to changes in spot prices. This describes the status quo for most customers, and