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

“The [Federal Energy Regulatory] Commission’s recent progress in promoting competitive wholesale energy markets has the potential to be undone as a result of this well-meaning, but misguided Rule.”

- FERC Commissioner Philip Moeller, ”Demand Response Compensation in Organized Wholesale Energy Markets,“ Order No. 745 (2011).

Renewable energy subsidies are at the forefront of the public policy debate with constant talk of “green” jobs and the looming expiration of the production tax credit, a familiar subject at this blogsite. But qualifying renewables get other subsidies too, such as accelerated depreciation and state-level must-buy mandates.

The Federal Energy Regulatory Commission (FERC), regulating interstate electricity, is arguably subsidizing another favorite “green” resource – the practice of energy abstinence called “demand response.”

FERC Order Nos. 745 and 745-A established, for the first time, a uniform compensation scheme for demand response in organized electricity markets. Before Order No. 745, each regional transmission organization was free to develop its own compensation scheme, and demand response was already being implemented in organized markets such as PJM. Commenters disagreed with several aspects of the order, including the appropriate level of compensation. When FERC denied rehearing on that issue (and others), protesters sought review by the Court of Appeals (Electric Power Supply Ass’n, et al. v. FERC, No. 11-1486, et al.). The case is at the briefing stage, with oral arguments to be scheduled.

The MasterResource-worthy part of this case is the amicus brief filed by a group of academic energy economists. It takes a lot for economists to agree in the first place, let alone to jointly file a 30-page brief on a nuanced issue in the field of electricity markets. To raise the stakes a bit, I should also note that one of FERC Chairman Jon Wellinghoff’s main priorities, along with integrating renewables, is encouraging demand response. A reversal on this issue would be a big deal.

Background: ’Demand Response’

Retail electricity customers tend to pay a fixed rate for their electricity. However, in organized wholesale markets, the price of electricity at different points in the transmission grid can vary widely between seasons and even throughout the day depending not only on demand and supply, but also on transmission constraints. That wholesale market price is often referred to as the Locational Marginal Price (LMP).

That price structure means there is a disconnect between wholesale and retail electricity markets, and therefore retail customer usage is not responsive to wholesale price fluctuations. This can be troublesome as price-insulated electricity demand reaches the upper limits of the grid’s physical capacity to supply. Grid reliability is threatened, and despite sky-high prices at the wholesale level, retail customers carry on using electricity, blind to the wholesale price signal.

Enter demand response (or imputed demand response to be fair to the electricity nerds out there). The promise of demand response is to bridge the wholesale-retail gap by giving retail customers the incentive to withhold consumption when wholesale prices are high, easing the strains on the system at times of peak electricity usage. This “peak-shaving” effect can strengthen the reliability of the system and put off costly transmission investments. However, significant differences of opinion remain as to the best way to send wholesale price signals to retail customers. This is where the economists and the FERC majority are at odds.

The FERC Majority: Pay Demand Responders Full LMP

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)

That argument directly follows a large block quote of an EnerNOC comment that reads, in part:

Without sufficient investment in the development of demand response, demand response resources simply cannot be procured because they do not yet exist as resources. Such investment will not occur so long as compensation undervalues demand response resources.

Regulatory rent-seeking via infant industry arguments shouldn’t be too surprising to the MasterResource reader – nor should the undercurrent of conservationism (reducing energy use is inherently good, more conservation is always better, etc). However, those of us who are optimistic (realistic?) about energy abundance see the push for demand response and integration of renewables as part of an unfounded “less is more” philosophy. That is, only from the neo-Malthusian worldview would it make sense to give preference to a decrease in demand over an increase in supply, or to an intermittent renewable resource over a reliable one.

Economists and FERC Minority: Pay “LMP minus G”

The economists say FERC’s policy does not represent reasoned decision-making. Specifically, the brief finds that FERC’s decision to compensate demand response participants at full LMP “creates a counterproductive demand response mechanism that produces economically undesirable behavior and wasteful outcomes that will injure consumers and society in the long run.”

The differences start at the conceptual level – can a retail customer be paid not to buy electricity (FERC’s stance), or is he simply reselling his retail electricity on the wholesale market (economists’ stance)?

Economists fluent in both electricity and finance jargon see demand response as the sale of a call option. As the amicus brief states:

Like other call options, the amount the demand-response provider receives must be offset by the strike price (here, the retail rate). Failing to subtract the retail rate, by contrast, allows the consumer to sell its electricity at full rates without ever having bought it.

The economists’ answer is to pay “LMP minus G,” or the LMP minus the retail price. In call option terminology, G is the strike price and LMP is the spot price (and retail demand response providers would be in the money whenever LMP > G). They argue that full LMP compensation gives demand response providers both the LMP and the savings from not consuming, or LMP+G. To remedy the double-payment, economists call for subtracting G to achieve (LMP+G)-G, or just LMP.

According to the economists, demand responders receiving full LMP would enjoy a free lunch not available to generators:

[R]etail customers who curtail consumption both receive LMP and avoid the cost of purchasing electricity—a benefit electricity generators do not receive… [A] generator’s profit is not the LMP it receives. It is the LMP it receives minus the costs it incurred to deliver power.

A dissent written by the FERC minority, Commissioner Philip Moeller in this case, refreshingly grasps the central concept in Frederic Bastiat’s essay What is Seen and What is Not Seen and provides a long-run analysis of full-LMP compensation. As Commissioner Moeller notes:

Today’s determination, unencumbered by ‘textbook economic analysis of the markets subject to our jurisdiction’ will undoubtedly have effects, both in the short-term and the long-term….

[A]t the wholesale level, the corrosive effect of overcompensating demand resources over time will come at the expense of other resources, particularly generation resources that will have less to invest in maintaining existing facilities and financing new facilities. (Moeller dissent, pp. 9-10)

Conclusion

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.

13 comments

1 Ed Reid { 09.13.12 at 9:17 am }

I have one concern with this analysis: the apparent conflation of “demand response” and “conservation”. The basic intent of efforts to achieve demand response is to shift demand from peak periods, in which demand and cost are above average, to off-peak periods, in which demand and cost are below average. The basic intent of efforts to achieve conservation is to reduce total consumption over all periods.

I do not believe it is reasonable to base fundamental regulatory policy on the unproven assumption that energy not consumed on-peak will not be consumed at all. I believe it is far more reasonable to assume that demand response merely time-shifts demand from high cost periods to lower cost periods. For example, a business which requires power to produce its product will either consume that power or reduce the quantity of product it has available for sale. In the longer term, the business might be able to install more efficient equipment, which would reduce the power required to produce the required quantity of product. However, that more efficient equipment would reduce demand during all periods when the equipment was in use, not merely in response to some demand signal from the utility or marketer. Alternatively, a business could shift production entirely to off-peak periods, when demand and cost would be lower, assuming that the required quantity of product could be produced during those periods. However, such a shift would be demand response only in the broadest sense, rather than a response to a specific demand situation.

I agree that it important to “get incentives right”. I am unconvinced that either approach discussed above achieves that objective.

2 Jon Boone { 09.13.12 at 10:50 am }

“[Realists] see the push for demand response and integration of renewables as part of an unfounded “less is more” philosophy. That is, only from the neo-Malthusian worldview would it make sense to give preference to a decrease in demand over an increase in supply, or to an intermittent renewable resource over a reliable one.”

This distills the issue with parsimonious but elegant prose. Thanks for the clarity of this post, and its timeliness. It summoned forth a thought I had some time ago about some of the motives behind demand response management and the “integration” of renewables.”

In many ways, the integration of renewables in particular seems redolent of the desire for racial and class integration, and perhaps even mainstreaming of the disabled–part of the political impulse to inculcate social and economic equality.

Perhaps the FERC majority should better understand that there is a striking difference between people and the machinery and processes of electricity management. Wind and solar perform dysfunctionally, for example, not because of undeserved historic prejudice or lack of opportunity or even lack of training. Rather, they are completely inimical to the goals set forth for FERC from the get go: it’s their nature to be unpredictable, unreliable, imprecise, and uncompanionable. Requiring conventional generation to do most of the work so that wind and solar can appear to be a mainline player is a rather monstrous deceit, a failure of liberalism in large part because it’s so intellectually dim. Playing with renewables dolls as if they were human beings in order to create a more inclusive grid should be exposed for the perversion it represents.

And “rewarding” conservation as if electricity had to be a scarce resource nearly 70 years after the Manhattan Project demonstrates at some very basic level the failure of our education system generally and, more specifically, the obvious deficiencies in science education.

3 tfisher { 09.13.12 at 4:59 pm }

Ed: Good distinction. I tried to be careful to use words like “abstinence” and “conservationism” to denote the moral-laden nature of those ideas versus economic conservation. Economic conservation would come about if end-users received the wholesale price signal without omission or distortion, in times of both high and low prices. Correct me if I’m wrong, but Order No. 745 only deals with the case where the retail buyer responds to a high LMP by not consuming — in imputed demand response there is no matching mechanism in the case of very low LMP for the retail buyer to pay LMP rather than the retail rate and thus increase consumption through the same LMP signal. In other words, the full economic incentive (and more) exists to reduce consumption at times of high LMP, but the full economic incentive to increase consumption at times of low LMP does not. The omission of the analogous price signal at times of low LMP and the payment of full LMP (arguably a subsidy) at times of high LMP distinguish this case from true economic conservation. If my analysis is off, please set me straight. This is not an easy issue.

Jon: Thanks for the kind words and the interesting visual. I certainly see what you mean about the current “all of the above” or “all-inclusive” energy strategy — to me, it would make more sense to have an “all that are profitable” approach to electricity-generating resources (or conservation schemes). All that are profitable without subsidies or special privileges, that is. I’m sure some people would pedal a stationary bike to power the grid if they could get a big enough subsidy — doesn’t make it a good resource though.

4 Jon Boone { 09.13.12 at 5:40 pm }

You’re welcome, Travis. As far as windnomics is concerned, there is a disconnect between wind’s energy output, providing no modern power capacity and no real energy value, and its true function as an income producer via tax sheltering, which yields a lot of value. In the latter “marketplace,” it does indeed go beyond coal, since it doesn’t even have to do anything but spin a rotor to make money.

5 Ed Reid { 09.13.12 at 7:26 pm }

Travis,

“I think you’ve got it!” :-)

The consumer, at any level, is inconvenienced by the request to shift consumption to alternative time periods. The incentive to accept this inconvenience should be the combination of the high price of energy on-peak and the availability of lower priced energy during the time period to which the demand is shifted. The customer would respond if the perceived value of the incentives exceeded the perceived costs of the response. The utility should be able to offer incentives which offset the perceived costs of continuing to meet demand as it is presented. In such a situation, we would have both willing sellers and willing buyers; and, the market would clear, absent the influence of the “smartest people in the room”. First, however, we would have to get rid of the “smartest people in the room”.

6 Eddie Devere { 09.14.12 at 4:31 pm }

Demand response in the electricity market means one and one thing: customers pay according to the integral of the “price/kWh (at time t)” times the “power consumption in kW (at time t)” times dt. That’s it. It’s pretty straightforward.
When you go to the gasoline pump, you pay according to the price times the commodity. Paying for a product this way promotes economic growth because resources are used where they are needed the most.
Also, you can be for demand response and be against subsidizing renewable energy. There is no connection between the two.

I find it odd that so few people reading this blog understand the implications of ‘demand response.’
The point of demand response is to help grow the economy by matching demand and supply. If we implement demand response, we will increase our economic growth rates, which will increase the amount of electricity production, consumed and invested. This is a good thing.
Those people who think that demand response will reduce electricity consumption clearly are not aware of Jevon’s paradox.

7 tfisher { 09.15.12 at 8:45 am }

Eddie Devere,

I wish it were that straightforward. First, which price are you referring to? That’s the first catch — there is a rift between wholesale and retail prices in electricity. If you mean the wholesale LMP in an organized market, then no, the vast majority of retail customers do not pay the LMP. Instead, they pay a fixed or maybe two-tier time-of-use rate. Neither one looks anything like what you describe.

I’d encourage you to read Order No. 745 or the amicus brief in full, because what you’re describing is basic economics. What Order No. 745 and the amicus brief focus on is “imputed” demand response, which is essentially a second-best solution. Also, as discussed in comments above, it is one-sided (skewed towards load reduction), and full-LMP payment as mandated by Order No. 745 amounts to a subsidy (this ties back into your argument about being for/against subsidies for renewable resources).

The readers and writers on this blog are fully aware of demand response as it happens in the real world. We also understand Jevons’ paradox. I appreciate your background in physics but in this case I think the conversation stalled because the details of demand response as laid out in Order No. 745 are more nuanced than the equation you shared.

I’m all for real demand response. I’m an economist and I fully understand the growth implications of aligning incentives. But the animal I discussed in this post is not real demand response, and even the second-best solution that FERC came up with is misguided.

8 Carolyn Elefant { 09.24.12 at 2:23 pm }

As a FERC appellate practitioner, I disagree with your analysis of the likely outcome of this case on appeal. While it’s true that the DC Circuit, defers to FERC’s factual findings (indeed, it’s required by Section 313(b) of the Federal Power Act), and may defer to its reasoning, the court is far less likely to do so when there’s a dissenting Commissioner. Although generally, FERC is upheld in at least 75% of the cases that come before the DC Circuit, those numbers fall drastically when one or more Commissioners dissent – as I discussed here – http://us2.campaign-archive1.com/?u=c415dae576d3d706d0444773c&id=2576edec5f#mctoc4 Considering that FERC cases are highly complex and most practitioners do little to make them user friendly, the dissents are often the most understandable aspect of a case. Moreover, where the Commission fails to address concerns raised by a dissenting commissioner, the case will also be remanded (not sure how well the Commission addressed Comm. Moeller’s points here).

9 ‘Demand Response’ in Electricity: Economists vs. FERC on (Over)Pricing « Knowledge Problem { 09.24.12 at 2:59 pm }

[...] 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 [...]

10 tfisher { 09.25.12 at 9:39 am }

Carolyn, thanks for the link. After reading your blog I am happy to defer to your judgment. To be clear, I simply think the deck is stacked against remand. I agree that it helps the amici curiae that Moeller reaffirmed his dissent on rehearing, but on first glance it seemed to me that the orders addressed his arguments (not fully, and not well, but probably well enough to satisfy the court). We’ll find out soon enough.

Just out of curiosity, how big of an impact does a dissent have? (And what about a one-Commissioner dissent vs a two-Commissioner dissent?) You mentioned a 25% chance of winning without a dissent, on average, but what does that percentage become when you do have a dissent (or two)?

Someone remind me to update this post after it’s all said and done. Thanks again for the input, Carolyn.

11 FERC Nominee Ronald Binz: Another Anti-Energy Czar? | Institute for Energy Research { 07.15.13 at 8:30 am }

[...] of policy, Wellinghoff reached the high water mark on energy central planning, rehashing Carter-era demand-side management strategies and pushing through costly renewable-friendly rules. To this point, instead of advancing [...]

12 FERC and the Future of Energy Efficiency | Harvard Environmental Law Review { 08.21.13 at 4:10 pm }

[...] therefore retail customer usage is not responsive to fluctuations in wholesale electricity markets. Demand response promises to “bridge the wholesale-retail gap by giving retail customers the incentive to withhold [...]

13 FERC Is Already Anti-Coal and Ron Binz Would Tip the Scales | Institute for Energy Research { 09.18.13 at 2:33 pm }

[...] losers. FERC also recently sided with “demand response” at the expense of real generation by overpricing demand response in FERC [...]

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