Trying to fix FERC’s demand response pricing mistake

Michael Giberson

Last year the Federal Energy Regulatory Commission ruled that RTO and ISO markets should pay retail consumers an amount equal to the market’s real-time marginal price when consumers reduce consumption at peak periods. Economically speaking, it is the wrong price.

Parties opposed to FERC’s action have taken the issue to court. A group of “leading economists and educators” have filed an amicus brief in the case (and somehow I got invited to be part of this group). Here is the introduction:

Amici curiae (listed in Addendum A) are leading economists and educators who have designed, studied, taught, and written about the electricity markets affected by the Federal Energy Regulatory Commission Final Rule under review here, Demand Response Compensation in Organized Wholesale Energy Markets, Order No. 745, 76 Fed. Reg. 16,658 (Mar. 24, 2011), FERC Stats. & Regs. ¶31,322 (2011), reh’g denied, Order No. 745-A, 137 FERC ¶61,215 (Dec. 15, 2011). That Rule establishes the rate wholesale market participants must pay retail customers for reducing purchases of electric energy during peak-demand periods. In particular, FERC now requires market participants to pay the full “locational marginal price” (“LMP”) for electricity that is not consumed, treating non-consumption of energy as the equivalent of costlessly producing energy. See Pet. Br. 45-61.

Although the views of amici may diverge on market-design issues in other contexts, they all agree that FERC’s Rule creates a counterproductive demand response mechanism that produces economically undesirable behavior and wasteful outcomes that will injure consumers and society in the long run. Although FERC invokes economics to justify its course, the Final Rule is economically irrational. Retail customers that reduce their consumption should not be paid as if they generated the electricity they merely declined to buy. Instead, retail customers should be compensated as if they had entered into a long-term contract to purchase electricity at their retail rate but instead, during a peak demand period, resold the electricity to others at the market rate (LMP). In other words, they should be paid “LMP-minus-G,” where G is the rate at which the retail customer would have purchased the electricity. Simply put, the customer must be treated as if it had first purchased the power it wishes to resell to the market.

FERC never adequately explains its decision to adopt its contrary approach. Nor could it. By overcompensating reductions in retail purchases, the Final Rule encourages retail customers to reduce demand even when society would be better off if they continued purchasing electricity needed to engage in productive activity. It encourages inefficient self-supply of electricity. And it leaves market participants paying for the delivered electricity more than once—first to the generator that created it and then to the user who provided the demand reduction. That overpayment harms both suppliers and non-demand-response consumers, to whom the cost of the subsidy ultimately will be passed on.

So far as I can tell, the case Electric Power Supply Association v. Federal Energy Regulatory Commission hasn’t been heard yet at the U.S. District Court of Appeals. The full name of the brief is: “Brief of Robert L. Borlick, Joseph Bowring, James Bushnell, and 18 other leading economists as Amici Curiae in support of petitioners.”

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4 thoughts on “Trying to fix FERC’s demand response pricing mistake

  1. Until we have innovative market mechanisms like FERC Order 745, we will never solve our energy and environmental challenges. Why do you feel that a customer does not deserve the full wholesale market price (LMP)? At present, the customer has no market incentive to reduce. Paying the customer the wholesale (not the retail) price does not distort markets but provides an incentive for behavior that should be rewarded and encouraged.

  2. I don’t think it is as clear-cut as you’re making it seem. Some big-shot economists, including Alfred Kahn (“the Father of Airline Deregulation”), disagree, since “a negawatt is as good as a megawatt”.

    Sources to their papers and coverage of the issue below:
    http://www.sciencedirect.com/science/article/pii/S1040619010002575
    http://www.sciencedirect.com/science/article/pii/S104061901100265X
    http://www.fortnightly.com/fortnightly/2010/10/one-if-wholesale-two-if-retail

  3. Pro DR:

    I’m all in favor of an engaged retail consumer sector in markets, but we ought not to require RTOs to overpay for demand response in order to encourage additional consumer engagement. The problem with overpaying is that is leads to inefficient underconsumption, as the excerpt above mentions and the brief explains in more detail. Let’s try to get RTO policies that produce efficient prices. Then, separately, if we think with need to subsidize consumer engagement to achieve some other policy objectives, then let’s have legislators vote to subsidize consumer engagement. Maybe there are good reasons for such subsidies, but what we ought to avoid doing is re-jiggering RTO market rules to embed non-transparent cross-subsidies among consumer classes.

    Libert:

    Alfred Kahn is a good name to drop on the opposing side to my view. (Are there any others?) I think my response is still the same as my response to ‘Pro DR’ above, more or less, but I’ll find some time to look at the cites and give it some more thought.

  4. My sense is the group opposing double payment for DR doesn’t really have such strong feelings as they let on about compensating consumers that way for what we would consider genuine demand reduction at times of high prices. They surely are (and should be) concerned about behind-the-meter generation getting mixed in with demand management to meet market participation commitments.

    Leave it to a group of bulk generators to decide what is and what isn’t “inefficient self-supply of electricity.” I find that stance confounding since double paying for demand side capacity during high price periods will only serve as competition for the least efficient and sometimes very dirty peaking power plants these companies are clearly interested in keeping around because they somehow know that “society would be better off if they continued purchasing electricity needed to engage in productive activity.”

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