‘Demand Response’ in Electricity: Economists Vs. FERC on (Over)Pricing

Michael Giberson

As noted here at KP in August, a group of electric power economists (including me) filed an amicus brief on FERC’s demand response pricing rule.

At the Master Resource blog, Travis Fisher examines the issue with some detail. Here is a bit:

In Order No. 745, FERC reasoned that, “when a demand response resource has the capability to balance supply and demand as an alternative to a generation resource,” the demand response resource should be paid the full LMP. Some commenters agreed – some not so much. As FERC stated:

In the face of these diverging opinions, the Commission observes that, as the courts have recognized, ‘issues of rate design are fairly technical and, insofar as they are not technical, involve policy judgments that lie at the core of the regulatory mission.’ We also observe that, in making such judgments, the Commission is not limited to textbook economic analysis of the markets subject to our jurisdiction, but also may account for the practical realities of how those markets operate. (Order No. 745 at P 46, emphasis added)

Then Order No. 745 wades beyond ignoring textbook economics into the murky waters of justifying full LMP with the infant industry argument (with market power thrown in for good measure). As FERC argues:

Removing barriers to demand response will lead to increased levels of investment  in and thereby participation of demand response resources (and help limit potential generator market power), moving prices closer to the levels that would result if all demand could respond to the marginal cost of energy. (Order No. 745, at 59)

I wonder out loud whether FERC commissioners actually had anyone (1) estimate price levels that would result if all demand could respond to the marginal cost of energy, then (2) estimate what will happen to the actual wholesale price of energy in a world in which officially-registered-demand-response resources are overpaid, and finally (3) determine whether result 2 is closer or further from result 1 than current wholesale energy prices.

My guess it that the majority simply assumed that it must be the case that subsidized demand response will behave like unsubsidized demand response would have behaved but for the restraints of state retail ratemaking practices.

Fisher’s conclusion quotes Bastiat to good effect:

The economists and the FERC minority make valid points – get incentives right, examine unseen or unintended consequences (regulatory rent-seeking, gaming, the stifling of new generation), and don’t provide any “free” lunches.

Sadly for the economists, the Administrative Procedure Act sets a low bar for “reasoned decision-making,” meaning the Court of Appeals would have to find FERC’s ruling “arbitrary and capricious,” etc., to order reconsideration. Further, the DC Circuit has a penchant for explicitly granting agencies like FERC Chevron deference, which means it substantially defers to agency interpretation, especially on nuanced or ambiguous issues.

It strikes me, though, that the FERC majority would do well to return to “textbook economic analysis” on this issue, and I would recommend Bastiat as one of the textbooks. As Bastiat said in 1848:

“[N]ot to know political economy is to allow oneself to be dazzled by the immediate effect of a phenomenon; to know political economy is to take into account the sum total of all effects, both immediate and future.”

Demand response is the next new thing. It may have very positive effects now and in the future, but in the case of the FERC Order Nos. 745 and 745-A, the agency let itself be dazzled by the immediate effects and pulled into a misguided policy.

I’ve left out quite a bit of Fisher’s analysis and cut out the useful links, so please do go read the whole thing.