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DR Distortion

Are subsidies the best way to achieve smart grid goals?

Fortnightly Magazine - November 2010

In a notice of proposed rulemaking (NOPR), the Federal Energy Regulatory Commission (FERC) proposes to require all regional transmission organizations (RTOs) to pay demand response (DR) providers the full locational marginal price (LMP) for load reductions. 1 It shouldn’t be a matter of economic debate that this would allow DR providers to earn more than the value they directly provide to the market. Because customers pay their retail providers only for the energy actually consumed, their ability to sell load reductions as DR into the wholesale market is like reselling energy they never bought in the first place. Thus, full LMP compensation would allow them to earn the wholesale energy market price plus the avoided retail rate for every kWh reduced.

The embedded subsidy would inefficiently distort behavior and would provide compensation that isn’t comparable to the compensation generation receives.

Paying DR the LMP minus the avoided retail generation rate (LMP – G) would be more efficient, so that the customer’s total savings, including avoided retail payments, would be the full LMP. For example, a customer with a $100 per MWh retail generation rate would be willing to run a $250 per MWh backup generator or load reduction when LMPs are $250 or higher because that customer would earn $100 in avoided retail payments plus $150 (=$250 - $100) LMP-G compensation from the wholesale market; by contrast, wholesale compensation of full LMP will induce the customer to use its $250 resource when the LMP is only $150, thus displacing $150 production with $250 production. 2

This isn’t to say that DR is worth less than generation, which it isn’t. The full LMP should be paid out, but with only LMP-G going to the customer and G going to the LSE. This creates the same efficient incentives and the same financial outcome as if the customer had bought the energy from the LSE before reselling it. 3

Notably, even LMP-G can provide excessive compensation in some cases, for example, if the customer’s apparent load reduction merely is shifted to another high-LMP hour in which the customer pays only the retail rate for incremental consumption—and thus earns a net payment of LMP minus the retail rate for having accomplished nothing. Customers would have to be exposed to market prices in every hour in order to avoid this problem.

The question we should be debating isn’t whether paying DR the full LMP constitutes a subsidy, which it clearly is. The questions should be whether FERC should require regional transmission organizations (RTOs) to subsidize DR, and whether other policy interventions could expand the number of price-responsive customers and achieve the larger policy goals more efficiently.

Policy Goals

The answer to these questions begins by articulating the