PowerFacts
FERC Proposal to Pay Demand Response Full LMP Addressed by Noted Expert
In a policy paper issued today, noted economist Dr. William W. Hogan analyzes the economic impacts of the Federal Energy Regulatory Commissions (FERC) proposed rule to establish a generic compensation approach for all types of demand response (DR) resources participating in organized wholesale electricity markets. Specifically, FERC proposes that Independent System Operators (ISOs) and Regional Transmission Organizations (RTOs) with tariff provisions permitting DR providers to act as resources in the energy markets be required to pay these DR resources, in all hours, the full locational marginal price (LMP) for such reductions. Professor Hogan's paper, titled "Implications for Consumers of the NOPR's Proposal to Pay the LMP for All Demand Response," addresses the unintended consequences of compensating all DR resources at the full LMP in all hours. Such outcomes would be inconsistent with economic efficiency and require certain customers to subsidize other customers through higher rates. The paper was submitted to FERC as a companion to EPSA comments on the proposed rule.
- "[T]he 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." "Implications for Consumers of the NOPR's Proposal to Pay the LMP for All Demand Response," Dr. William W. Hogan, p. 2
- "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." p. 1
- "However, the most important case where the Commission 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." p. 1
Supporting Efficient Demand Response Is Appropriate
- "Not all consumers have the ability to respond to the marginal cost of electricity, and of those consumers with that ability, not all pay the LMP. Consequently, there is a role for programs that expand the ability for consumers to participate actively in the market by eliminating barriers to participation by demand response providers. There is also a role for programs that give consumers better incentives to submit bids that reflect the value they place upon electricity, and to consume when the price is less than that value, while not consuming when the price exceeds that value. But mandating that all RTOs and ISOs pay the LMP to all consumers all the time for all demand reduction will not bring about this outcome." p. 4
- "An alternative to using the implicit demand response price would be to create an effective purchase and sale of the imputed demand response amount... Briefly, each imputed demand response transaction would be unbundled into an electricity purchase and an electricity sale. The estimated amount of demand reduction that has been provided would still be equal to the difference between baseline and actual consumption. This quantity difference would be deemed to have been purchased by the consumer under whatever arrangements the consumer purchases from the system. It would be added to the metered electricity purchases of the consumer or its load-serving entity. Separately, the same quantity would be sold to the RTO or ISO by the consumer at the LMP, as with any other sport market electricity sale, and as envisioned under the proposed rule." p. 15
- "[I]f the Commission deems it necessary to mandate that RTOs and ISOs implement imputed demand response programs with certain standardized characteristics, any such programs should be limited to consumers who pay a fixed price for the electricity they consume that differs from the LMP, as it is only these consumers who may have inefficient incentives to consume electricity. Furthermore, the intent of any such programs should be to restore the incentives for economically efficient behavior that would exist if those consumers were paying LMP. This would, in almost all circumstances, entail a payment to these consumers that is less than the payment of full LMP that would be mandated by the proposed rule." p. 13-14
- "The NOPR is based on the premise that it is necessary to pay demand response providers the LMP for all demand reductions in order to place generation and demand response on a level playing field, but this premise is mistaken. Instead, to create a level playing field, it is only necessary to make demand response payments to consumers who do not pay the LMP for the electricity they consume, and who as a result may not have incentives to consume efficiently without such payments, and even those payments should, in almost all circumstances, be less than the LMP." p. 16
Inefficient Demand Response Policies Are Unsustainable
- "The imputed demand response provider receives a double payment because it never purchased the electricity that the proposed rule would permit it to sell back to the RTO or ISO. As a result, under the proposed rule, it would receive the LMP for selling the imputed demand response, without having to pay for the right to consume that electricity in the first place. If it had paid for the baseline electricity, then paying the demand response provider the LMP for reductions in the amount of electricity it purchased would be entirely consistent with economic efficiency. But the proposed rule contains no such provisions." p. 5
- "But actions that do not provide the correct incentives for well-defined demand response products may yield inefficient outcomes, contrary to the Commission's expectations, even if those actions happen to increase demand response participation in electricity markets. And the Commission's proposed rule would not provide incentives for demand response providers to submit bids that reflect the value they place upon the electricity they consume. It is therefore unlikely that the proposed rule would meet the Commission's stated objectives." p. 3
- "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 the RTO- and ISO-administered markets - exactly the opposite of the behavior that the proposed rule was intended to encourage." p. 2
Faulty Arguments on Price Reductions
- "An argument has been made that the inefficiencies and cost increases for remaining consumers would be justified or avoided by achieving price reductions in LMPs that would reduce the total payments by consumers. For example, in the [now-terminated] PJM proceeding, Allen Freifeld provided an affidavit for the Demand Response Providers asserting that the imputed demand response program would provide a "price mitigation service to all load in the region... The price reduction argument misses the impact it would have on other aspects of the electricity market, most visibly in the case of organized RTO/ISO markets with explicit capacity requirements or markets." p. 12
- "In effect, this price mitigation service is not a policy to move towards a more competitive and efficient market. Rather, it would be an application of regulatory authority to enforce a buyers' cartel. The price mitigation policy would not be improving efficiency. To the contrary, it would be employing government authority to transfer income from producers to consumers. Thus the pursuit of price mitigation of this type would run contrary to the Commission's policy of supporting and facilitating efficient, non-discriminatory electricity markets." p. 13
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EPSA is the national trade association representing competitive power suppliers, including generators and marketers. These suppliers, who account for nearly 40 percent of the installed generating capacity in the United States, provide reliable and competitively priced electricity from environmentally responsible facilities serving global power markets. EPSA seeks to bring the benefits of competition to all power customers.