The time has come to start the transition from the current economic demand-response programs to demand response that arises naturally through market-based retail pricing.
Over the past few decades, utility sponsored conservation and load-management programs have helped thousands of customers better manage their energy costs. While these programs have helped lower overall electricity use, they generally have not provided an economic incentive for customers to reduce their consumption at specific times in response to wholesale electricity prices.
Customers who can reduce their electricity consumption in response to changing wholesale electricity prices often are referred to as “price-responsive demand.” As many are aware, by lowering overall demand at times of high wholesale electricity prices, these customers proactively can reduce their own electricity costs and help to lower electricity costs for all customers in their region. For this reason, many state regulators, electric utilities, competitive suppliers, customer groups, and independent system operators (ISOs), such as ISO New England, are advocating more innovative retail rate designs that encourage price-responsive demand.
With most products, retail prices directly reflect the balance of supply and demand in the wholesale markets. All customers, at one time or another, have experienced the price impacts resulting from shortages of various consumer products. Following hurricanes Katrina and Rita, customers experienced gasoline prices changing daily (and sometimes hourly) in response to rapidly changing wholesale prices. Many customers became “price responsive” by changing their driving habits and reducing their consumption.
However, the electricity markets are atypical in this respect. For the most part, retail electricity prices do not reflect the daily and hourly changes in wholesale prices. Instead, they change slowly over time. Retail electricity prices generally are set either by a state commission order or through a long-term contract with an energy supplier. Under these fixed rates, unit prices remain stable for months or even years. For most customers, the retail price (per kilowatt-hour) they pay remains the same, sending a message that the cost of providing electricity service is the same regardless of the time of day or season. The fact is that customers who consume during times of peak demand or supply shortages collectively contribute to driving up the wholesale price for everyone. It has been well documented that while a customer’s fixed-price rate or contract may protect them from an immediate price increase, their consumption behavior contributes to higher wholesale price volatility, which ultimately will result in higher wholesale prices and retail rates for everyone. Inevitably, all customers will end up paying for the choices made by them and their neighbors.
Why is encouraging price-responsive demand important to retail customers? Reducing electricity demand by even a modest amount at times of high wholesale prices can help lower prices for all customers. In certain hours, particularly during supply shortages or peak demand, the steeply sloping wholesale supply curve creates tremendous leverage for a small reduction in demand to significantly reduce wholesale prices. As illustrated in Figure 1, the minor shift of demand from D1 to D2 results in a considerable reduction in price from P1 to P2. Further, price-responsive demand contributes to a more efficient allocation of society’s resources and improves the overall reliability of the wholesale electricity system. Since many wholesale price spikes coincide with periods of high demand, if customers reduce their use when demand is highest, it ultimately “shaves the peak” and lessens the need to build new capacity.
So, how can we modify the markets to encourage and empower customers to change their consumption based on changes in wholesale electricity prices?
One way is through the implementation of dynamic retail pricing. Unlike traditional fixed retail rates, dynamic retail pricing varies the retail price of electricity as wholesale prices fluctuate over the course of a day. Customers across the region can “see” the true price of electricity and can choose to shift their electricity use according to their sensitivity to price. This type of price-responsive demand is a powerful but virtually untapped tool to manage electricity use and costs. Such a tool may be particularly valuable in New England given customers’ recent exposure to rising energy prices (gasoline, home heating oil, natural gas, and electricity) and growing peak demand.
While demand-response programs and dynamic pricing rates are in many ways related to traditional energy efficiency programs, they are fundamentally different. Traditional utility-sponsored, energy-efficiency programs attempt to offer products and services to virtually all customer classes—residential, commercial, industrial, and municipal. From the smallest to the largest, across all income ranges, most utility programs offer something for everyone. But while customers from each customer class can benefit from dynamic pricing, such pricing may not be suitable for all customers.
Dynamic pricing works best for customers where electricity represents a significant portion of their operating expenses and they have the ability to reduce or shift consumption in response to high prices. Yet, not all customers have the ability or the desire to do this. Many customers may look at dynamic pricing and say, “No thank you; give me a fixed price just like I had before.” Because dynamic pricing is not for everyone, alternative rates and supply options need to be available for those customers who want the short-term price certainty that comes from fixed pricing.
The good news is that not all customers need to be price responsive for the region to experience significant benefits. The preliminary results of a dynamic-pricing study currently underway shows that retail customers in New England can potentially save approximately $340 million over the next five years if retail customers with 1 MW loads or greater are exposed to dynamic pricing. Less than 600 price-responsive customers in New England, each with loads greater than 1 MW, are needed to produce these benefits. The cost of achieving these savings (driven by additional meter reading and billing costs) would be only about $12 million over the same five-year period. Like energy efficiency, the actions of a few customers can result in significant benefits for all customers. Given the impact that rising energy costs are having on the nation’s economy, the benefits from dynamic pricing no longer can be ignored.
To advance the concept of dynamic pricing, we need to create stronger links between wholesale and retail electricity markets, so that customers can respond to changes in wholesale prices in real time. The greatest barrier to achieving more price-responsive demand is the lack of a retail price signal for customers to respond.
The implementation of more dynamic retail pricing will require changes in state regulatory policy; investment in metering, communications, and software technology; and education of customers to enable them to respond appropriately. Although it may seem as though customers responding in real-time to wholesale price indicators is a hazy and distant vision, the advancements made to date with demand-response programs give us hope.
ISO New England has pioneered efforts to build infrastructure and markets for demand response at the wholesale level. We offer two types of demand-response programs that allow customers to be compensated for not using electricity during capacity shortages or high-price periods. Since these programs operate at the wholesale level, customers must be enrolled through a wholesale market participant or eligible demand-response provider (ISO New England does not have jurisdiction over the retail markets).
Under our reliability programs, customers respond to ISO New England requests to curtail based on system conditions, and receive both capacity and energy payments. Under our price programs, customers voluntarily can respond to real-time or day-ahead wholesale prices and receive energy payments based on the wholesale prices. The new day-ahead program gives customers the flexibility to specify the price at which they will interrupt and schedule their reduction a day in advance. ISO New England currently is working on a project to demonstrate demand response’s ability to provide reserves.
In the past three years, participation in our demand-response programs has grown six-fold, to more than 600 MW, and these resources have proven highly valuable. Research done by ISO New England and others has shown that even when a few customers reduce their consumption during times of high wholesale prices, this action can help lower costs for all customers. In 2005, these programs resulted in more than 13,000 MWh of decreased electricity use, helping us manage the system under extreme conditions and lowering both short-term and long-term wholesale electricity prices.
But ISO New England’s price-based demand-response programs, as with any centrally administered programs, have inherent design problems. For one, the financial incentives given to participating demand-response customers are collected from other market participants, resulting in out-of-market transfer payments. Because such out-of-market transfer payments are vulnerable to changes in public policy and market stakeholder sentiment, the long-term sustainability of such demand-response programs is questionable. To address this vulnerability, price-responsive demand should be directly integrated into the retail electricity market—that is, the savings in electricity costs produced by price-responsive behavior should be the incentive for such changes in behavior.
CRA International studied the impacts of California’s Statewide Pricing Pilot in 2004 and found that residential customers reduced, on average, peak period energy usage on “critical price” days by between 13 and 16 percent.1 Customers using smart thermostats were able to reduce peak consumption by roughly 27 percent. These results are more than double the average 6 percent peak reduction from customers on traditional fixed time-of-use rates.
Lawrence Berkley National Laboratory conducted a survey of 43 voluntary real-time pricing (RTP) programs offered throughout the United States in 20032 and found that RTP programs have reported peak load reductions in the range of 12 to 33 percent.
Even the best designed programs will have little impact on reliability or price if the retail customer cannot see the true price for the electricity being used, or lacks the ability to control it. ISO New England’s vision is to fully integrate demand resources into the electricity markets so that retail customers can participate, and demand-response providers can feel comfortable investing in demand-response projects and technologies, knowing it will be a permanent part of the portfolio of resources in the wholesale market.
To truly advance this concept, we need stronger links between wholesale and retail electricity markets. Mechanisms for creating closer linkages between wholesale and retail market pricing include:
• Implementation of dynamic retail pricing, which varies directly with changes in wholesale spot-market energy prices;
• More sophisticated metering, communications technology, and billing systems to send more accurate price signals directly to customers in real time;
• Control technology, which adjusts customer consumption levels automatically as prices vary over the course of the day; and
• Customer education to help retail customers better understand how the markets work and their choices for managing changing price levels.
The Energy Policy Act of 2005 requires that each state regulatory commission conduct an investigation and issue an order regarding the adoption of dynamic pricing and advanced metering standards. The act further requires the Federal Energy Regulatory Commission and the Department of Energy to estimate the regional potential and national benefits of demand response.
Given that the wholesale electricity system serving the New England region is a tightly integrated network and that much of the value will accrue to the members of that network, the New England states can benefit by coordinating their investigation and implementation of dynamic pricing. This could increase overall regional participation and benefits, and reduce the costs of investigating and implementing the needed metering and billing infrastructure. The same holds true of possible inter-regional efforts between and among contiguous regions in the Northeast.
To begin this effort, ISO New England and the New England Conference of Public Utility Commissioners (NECPUC) have formed a collaborative partnership to analyze, design, and implement solutions that would capture greater price-responsive demand throughout the region. ISO New England’s immediate focus will be on conducting research that investigates the feasibility and benefits of widespread implementation of dynamic pricing on the wholesale market.
State regulators have a far more important role to play to establish the retail policies and rate structures that would support the implementation of dynamic retail pricing. They have the instruments that can forge the links in the chain.
We highly recommend that the states should:
• Establish a region-wide process to coordinate the investigation of dynamic pricing and advanced metering;
• Develop policy objectives and determine the common policy questions and issues to be raised and resolved in individual state proceedings;
• Respond to issues raised by industry stakeholders, with the goal of maximizing benefits and standardizing approaches to improve economies of scale;
• Seek technical assistance from the U.S. Department of Energy through the NECPUC to support regional coordination efforts; and
• Report on the findings of the individual state proceedings.
Notwithstanding the benefits of current price-based demand-response programs being implemented by ISO New England, they were never intended to be a permanent part of the wholesale market. Rather, the programs were intended to be a catalyst to jumpstart the demand-response industry in New England and encourage the development of price-responsive demand. The time has come to start the transition from the current economic demand-response programs to demand response that arises naturally through market-based retail pricing.
Endnotes:1. CRA International, “ Impact Evaluation of the California Statewide Pricing Pilot,” California, 2005.
2. Demand Response Research Center, “Real Time Pricing as a Default or Optional Service for the C&I Customers: A Comparative Analysis of Eight Case Studies,” Lawrence Berkeley National Laboratory, California, 2005.