Finding the Right Price for Demand Response in Energy Markets

Last week, the Federal Energy Regulatory Commission issued Order No. 745 (PDF), which declares that demand response — turning down power use — can demand the same market prices as real megawatts of generated electricity. It’s a big present for demand response, but they won’t get to open it right away — the grid operators that create and manage energy markets, known as ISOs and RTOs, have until September 2012 to get their market plans in order.

That may be enough time to deal with a key complication. FERC expects demand response to make the grid more efficient, reduce the need for expensive peaker power plants and, eventually, drive down electricity prices for everyone. But might these new markets drive energy prices too low?

Constellation Energy, which is both a power generator and a demand response provider, pointed out this potential problem in an Oct. 2010 filing with FERC. Constellation doesn’t mind setting the price of demand response at that of the energy market. It does, however think the retail price of that power should be subtracted from the overall price, since the customer is, after all, getting that savings out of the electricity it doesn’t consume at that time. (The formula for that, by the way, is LMP-minus-G, where LMP is the “locational margin price” set by the markets, and G is the retail cost.)

But FERC’s order requires energy markets to offer the same LMP, or market price, as generators get. That’s a big deal — demand response providers such as EnerNOC and Viridity Energy say FERC’s new order could lead to a doubling to a nearly five-fold increase in the share of the 4,000 or so hours per year where they can compete against power plants. Increasing the margins for demand response, in turn, should drive down costs and lead to bigger markets — and that, in turn, should drive down market prices for everyone, since more market participants should yield lower prices.

But according to some studies by power generation industry groups, FERC’s decision isn’t a leveling of the playing field, it’s a market-distorting subsidy. Peak power plants have very few hours during the year to earn the money to pay back the cost of building them. Artificially low demand response bids from competitors could put them out of business, worsening the peak load problem, the studies argue.

For example, say you have an on-site generator that costs twice as much to run as a nearby power plant. You won’t run that generator to replace cheaper retail power, but if you can play its power into energy markets and save on their power bill, you might run it far more often. That concern, while genuine, appears limited to me. Businesses face legal limits on how often they can crank up noisy and polluting backup generators, after all.

Power plant operators also argue that turning down power use itself could distort the market. They say customers may forego revenues associated with whatever they normally do with their electricity in favor of becoming miniature energy market players. Again, I’m skeptical. Any factory that can make more money by turning itself off than by conducting its daily business probably isn’t going to survive long anyhow.

Still, to answer these concerns, FERC requires each ISO and RTO in the country to devise a “net benefits test” to set price points for measuring when demand response is cost-effective. That subject is far too complicated to get into, but read the section of FERC’s order (PDF) that deals with it for details.

Question of the week

What’s the proper balance between pricing demand response “negawatts” and power plant megawatts in energy markets?