FERC Should Get DR Pricing Right in Organized Wholesale Markets it Regulates

by Dan Watkiss, Bracewell & Giuliani

A hot controversy embroils–at least by the standards of the academy–the Federal Energy Regulatory Commission’s (FERC’s) proposal to “improve the competitiveness of organized wholesale energy markets” by determining the just and reasonable rate at which to compensate providers of demand response to those markets.

FERC’s proposal is to compensate in all hours those who lower demand in response to price or operator instructions exactly as it has compensated those who sell energy to organized wholesale markets: that is, by paying the locational marginal price (LMP).

Because at stake are transfer payments–potentially large ones–from supply resources to demand resources, much of this controversy is smoke without fire. When the smoke clears, FERC’s proposal seems to be the correct policy choice.

On the virtues of implementing robust demand response in organized wholesale markets, voices on both sides of this controversy sing in apparent harmony. No commentator appears to contest FERC’s rulemaking findings that even modest reductions in demand can lower wholesale energy prices by even a greater percentage, particularly during high demand when the price curve steepens.

That wholesale market demand response stabilizes grid operations by shaving peaks, thereby averting or at least deferring the need for some generation and transmission additions, is not challenged.

Neither does there appear to be serious doubt about the environmental and resource management benefits of demand response, particularly when that response supplants demand for generation or defers longer-term infrastructure requirements. Rather, what elevates temperatures is price.

Central to the pro-LMP camp is the proposition that delivered wholesale demand response is equivalent to delivered wholesale supply response.

As explained by the venerable champion of marginal-cost pricing, professor Alfred Kahn, both provide the same economic benefits to wholesale consumers, with one supplying energy at the system marginal cost and the other preventing through conservation the incurrence of the identical margin cost.

Accordingly, the LMP proponents contend that competition is maximized when each service provider is paid the same just and reasonable rate, which FERC–the wholesale rate regulator–has long equated with LMP, at least for energy sellers.

The additional environmental and resource management virtues of less demand militate against any price lower than LMP, argue the supporters of FERC’s proposal.

The opposition to LMP, in contrast, is grounded in a belief that the two responses–demand and supply–are not the same. As explained by a principal interlocutor for opponents, professor William Hogan, they are not the same because of the “difference between reselling something that you have purchased and selling something you would have purchased without actually purchasing it.”

Payment of LMP in the latter case would “subsidize” the demand response seller and may induce inefficient sales of demand response in instances where the seller places a value greater than LMP on consuming rather than forgoing consumption.

To fix this efficiency loss, Hogan and other LMP opponents advocate paying demand response providers no more than LMP minus G where G is the retail price of a kilowatt-hour not consumed.

Because Hogan for more than a decade has been a tireless advocate of LMP as the right price for energy, it is initially surprising to find him as a leading spokesman for the LMP-G advocates.

This alliance is less surprising, however, when it is recognized that his clients in this fray are generators in the business to supply wholesale energy and whose revenues decline as demand response reduces the demand for their energy.

Kahn’s case in support of FERC’s proposal to maximize wholesale market competition should carry the day. Much of the opposition to FERC’s proposal assails a straw man of the opponent’s, but not FERC’s creation.

The opponents argue that the payment of LMP to demand responders must be rejected as inefficient because the wholesale LMP in most cases would not be passed through in retail prices to end-use consumers.

But so what? Regardless whether an LMP is paid to an energy or demand response seller, FERC has no authority to control its treatment in retail rates.

FERC’s stated objective in its proposed rule is to increase competition in wholesale markets, which paying marginal-cost prices to all potential competitors achieves.

FERC never undertook to impose marginal-cost pricing on the retail rates that state regulators formulate. It would have been a fool’s errand if FERC had had the temerity to trespass in what has always been the state’s bailiwick. Moreover, by making wholesale markets more competitive and economically rational, FERC may induce state regulators to follow its lead.

The contrary approach of paying some price at wholesale other than the economically efficient marginal cost to “unwind” (Hogan’s locution) the economic distortions of retail rates risks making all rates–wholesale and retail–economically inefficient and arguably would transgress FERC’s statutory obligation to ensure that market-based wholesale rates are the product of robust competition.

Remember that the PJM Interconnection’s use of a variant of LMP-G was found to suppress competition from demand response providers.

Also a straw man is the contention that demand response providers are selling energy they never bought and therefore cannot really sell.

No one (save the LMP opponents) contends that demand response providers are selling energy. They are not. They are selling conservation. The demand response providers–particularly those that aggregate smaller loads lacking access to interval meters–are selling to the organized wholesale market load that has been aggregated (at a cost) and that is willing in certain hours to forgo consuming at historical levels.

Hogan is correct that payment of LMP for this service sometimes may result in a customer’s forgoing demand in instances where that customer attaches a value to consumption that is greater than LMP. But I suspect that would occur far less often than the converse in which kilowatt-hours are generated and compensated at LMPs that exceed the value consumers attach to those kilowatt-hours and exceed the rates paid at retail for them.

Rather than unwinding inefficiencies in retail rates through departures from marginal-cost pricing, FERC should persist in maximizing supply and demand resource competition in the organized wholesale markets that it regulates, while encouraging state and local regulators to set retail prices at levels that, to the extent politically tenable, prevent distortions requiring unwinding.


Dan Watkiss is a partner with Bracewell & Giuliani in Washington, D.C., representing power companies, exploration and production and midmarket companies, natural gas pipelines, power and liquefied natural gas project developers and lenders, as well as government agencies and regulators. Reach him at dan.watkiss@bgllp.com

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