‘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, may be 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.