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Implications for Consumers

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Implications for Consumers of the NOPR’s Proposal to Pay the LMP for All Demand Response WILLIAM W. HOGAN Mossavar-Rahmani Center for Business and Government John F. Kennedy School of Government Harvard University Cambridge, Massachusetts 02138 Prepared for Electric Power Supply Association Comments on Demand Response Compensation in Organized Wholesale Energy Markets Notice of Proposed Rulemaking Federal Energy Regulatory Commission Docket No. RM10-17-000 May 12, 2010Implications for Consumers of the NOPR’s Proposal to Pay the LMP for All Demand Response William W. Hogan May 12, 2010 Summary The Federal Energy Regulatory Commission has proposed a rule for compensation of demand response acting as a resource in the electricity energy market. The rule would pay the full Locational Marginal Price (LMP) for all types of demand response. This pricing rule would be appropriate in some cases and not in others. The analysis distinguishes among three general types of demand response. - Real-time Pricing Demand Response. Consumers are paying the applicable LMP for their marginal consumption. - Explicit Contract Demand Response. Consumers purchase a fixed quantity of electricity but consume less than the purchased amount and sell back the difference. - Imputed Demand Response. Consumers have an estimated consumption baseline and the difference between actual consumption and the baseline is the imputed demand response. The first two types of demand response have a straightforward framework for using the applicable LMP. However, the important case where the Commission’s policy would be problematic is the likely ubiquitous circumstance of imputed demand response against an estimated consumption baseline. For this important case, full payment of the applicable LMP for the difference between actual consumption and the baseline would not be appropriate. The proposed rule would create an incentive for consumers to avoid real-time pricing and explicit contract demand response in preference for the higher net payments under imputed demand response. There would be further incentives to move generation behind the meter in the organized markets. The higher costs created would be born by other consumers less able to participate in the imputed demand response program, and would likely be unsustainable. The Commission has available a number of alternatives that would better serve to support efficient demand response without creating perverse incentives or unintended consequences. The details would depend on many factors of electricity tariffs, but the essence would be to put the net payments for imputed demand response on an equal footing by emulating the payments under an explicit contract.1Implications for Consumers of the NOPR’s Proposal to Pay the LMP for All Demand Response William W. Hogani May 12, 2010 Introduction While many advances have been made in the development of competitive electricity markets in the decade since they were originally implemented, there remain aspects of those markets that are ripe for improvement. One such area is the treatment of demand response. There is little question that current market rules may give demand response providers incorrect incentives to consume electricity, and that as a result, the amount of demand response that is provided is inefficient. In its March 18, 2010 Notice of Proposed Rulemaking,1 the Federal Energy Regulatory Commission (“FERC” or the “Commission”) addresses this concern, by proposing standard rules for the compensation of demand response resources that would apply to all energy markets administered by Regional Transmission Organizations (“RTOs”) and Independent System Operators (“ISOs”). The Commission’s proposed rule would pay the full LMP for all types of demand response in the energy market. The present paper addresses further the impacts of the Commission’s proposed policy and demonstrates that the pricing rule would be appropriate in some cases and not in others. The analysis distinguishes among three general types of demand response. - Real-time Pricing Demand Response. Consumers are paying the applicable LMP for their marginal consumption. - Explicit Contract Demand Response. Consumers purchase a fixed quantity of electricity but consume less than the purchased amount and sell back the difference. - Imputed Demand Response. Consumers have an estimated consumption baseline and the difference between actual consumption and the baseline is the imputed demand response. The first two types of demand response have a straightforward framework for using the applicable LMP. However, the most important case where the Commission’s policy would be problematic is the likely ubiquitous circumstance of imputed demand response against an estimated consumption baseline. For this important case, full payment of the applicable LMP would not be appropriate, but the Commission has available a number of alternatives that would better serve to support efficient demand response without creating perverse incentives or unintended consequences. 1 130 FERC ¶61,213 (2010) (“NOPR”).2The PJM proceeding subsumed by this NOPR included a paper submitted to the Commission as part of the filing by the Electric Power Supply Association.2 The analysis in that paper continues to apply and is addressed to issues that appear again in the NOPR. As discussed further here, the Commission’s proposal is grounded in a misunderstanding of the outcomes that one would expect to observe in markets in which all demand response resources were able to participate on an equal footing with generation. As a result, adoption and implementation of the proposed rule could produce outcomes that are inconsistent with economic efficiency. Certain consumers would be paid subsidies for reducing their consumption that exceed the payments that are necessary to induce them to consume electricity in an efficient manner. The cost of these subsidies would, in all likelihood, be shouldered by other consumers, who would thereby be charged amounts that are unrelated to the cost of the electricity they consume or any other service that is rendered to them. The proposed rule may be unsustainable in the long run and thus not achieve the NOPR’s demand response objectives. The increase in costs resulting from the need to pay for these subsidies will encourage consumers to purchase their electricity outside of


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