What is LMP – G? Compensation to Demand Response in Wholesale Electricity Markets

The Supreme Court of the United States is set to hear arguments on two questions concerning demand response. This blog entry discusses the second question before the court, concerning the level of compensation to demand response. This blog entry assumes federal jurisdiction to determine compensation for demand response, the subject of the first question before the court.

Demand Response, for purposes relevant here, is a reduction in the consumption of electricity by customers from their expected consumption in response to incentive payments. For a primer, see this report from the Department of Energy.

The level of compensation to demand response drew the overwhelming share of attention during the rulemaking process leading to FERC Order No. 745. FERC initially proposed, and ultimately adopted, a requirement of compensation at the market-clearing price, or LMP. In support of this requirement, FERC argued that compensation at LMP will help to overcome remaining barriers to participation of demand response in wholesale electricity markets. FERC also argued that demand response helps to balance the market for electricity in a manner that is comparable to generation, so demand response should be compensated at the same price as generation. Opponents of the FERC requirement, including FERC Commissioner Moeller, argued that payment of LMP is over-compensation. These opponents support either a requirement of compensation at LMP – G, where G is the avoided retail rate, or a measure of flexibility for regions to differ in compensation. In a May 2014 decision, the D.C. Circuit vacated the FERC compensation requirement in Order No. 745, finding that FERC had not engaged the arguments before it.

The concept of opportunity cost can explain LMP – G and its proponents’ position. The opportunity cost of demand response is the value of the expected consumption but for demand response (e.g., the value produced by using electricity to power a widget factory).

In the simple case, an end-use customer will only use electricity if the value (V) to the customer of the expected usage of electricity is greater than the value of the cost in dollars of retail electricity. In an equation, an end-use customer will only use electricity if

V_{expected usage of electricity –}V_{retail rate}  >0.

Opponents to the FERC requirement argue that demand response should be compensated at LMP – G, thereby incenting demand response if

V_{expected usage of electricity} – V_{retail rate} < V_{LMP – Vretail rate,}

which can be reduced to

V_{expected usage of electricity}  <  V_LMP.

Here, the end-use customer is trading off the value of demand response payments for the value of the expected usage of electricity. With a compensation of LMP – G, an end-use customer will not provide demand response if the value of the expected usage of electricity is greater than the value of the LMP payment.

That tradeoff is in contrast to the FERC requirement of compensation at LMP. Compensation at LMP incents demand response if

V_{expected usage of electricity –}V_{retail rate}  < V_LMP,

or transposed to

V_{expected usage of electricity} < V_LMP + V_{retail rate.}

 Here, the end-use customer is not trading off the value of demand response payments for the value of the expected usage of electricity. As such, an end-use customer may be willing to provide demand response even if the value of the expected usage of electricity is greater than the value of payment of LMP. This is the basis for arguments that the FERC requirement entails compensation of LMP + G. Actual compensation is not LMP + G, but the incentive to provide demand response is at that level.

Opponents to the FERC requirement argue that the upshot of this distortion is that end use customers could be perversely incented to shut down or use self-generation to a larger extent than is socially optimal. Moreover, because overcompensation to demand response resources leads to artificially low prices, other end-use customers might (wrongly) perceive power as cheaper and use more of it. Further, this over-participation of demand response resources will drive down generators’ revenues and potentially lead to market exit of generators. The long-run mix of market resources would thus be distorted as well.

On the other hand, there are a number of factors not taken into account by wholesale electricity markets, like generator tax credits. As Judge Edwards recognized in his dissent to the two-judge majority opinion of the D.C. Circuit, a generator’s incentive to provide electric power is affected by the presence of tax credits, but a recipient of tax credits does not receive less revenues in the wholesale market as a result. Judge Edwards found FERC’s comparability argument to be reasonable. Another factor not taken into account in the pricing of wholesale electricity markets, as noted in rulemaking comments from Wal-Mart Stores, Inc. and others, is the environmental benefits of demand response.

Arguments to the court are due this summer and the oral argument is scheduled for this fall. As the case progresses, this blog will be updated with additional entries.