February 8, An Economic Framework of Demand Response in Restructured Electricity Markets. Hung-po Chao 1 ABSTRACT

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1 February 8, 2009 An Economic Framework of Demand Response in Resrucured Elecriciy Markes Hung-po Chao 1 ABSTRACT This paper provides a unified economic framework for assessing he effeciveness of priceresponsive demand in promoing efficien elecriciy markes. The framework recognizes he ineracions beween a compeiive wholesale marke and regulaed uniform reail raes wihin a hybrid marke srucure. The framework feaures he basic principles of marginal cos pricing in he wholesale marke and average cos pricing in he reail marke while applying he advanced heory of prioriy service o shorage/scarciy pricing. The analysis addresses he insiuional and echnical barriers ha creae an asymmeric informaion srucure beween consumers and producers inhibiing efficien price responsive demand in elecriciy markes. The analysis indicaes ha while demand response incenives could poenially alleviae he inefficiencies before hese barriers are removed, he use of Cusomer Baseline is suscepible o gaming problems, and i could also creae an excessive incenive inadverenly causing inefficien price formaion. If no correced, his could resul in inefficiencies ha would ouweigh he benefis of demand reducion during he peak period and increase he average cos o he final consumers. 1. INTRODUCTION The imporance of demand response for a successful reform of elecriciy markes has long been recognized. (Joskow, 1983) During he pas wo decades, however an unbundled marke 1 Direcor, Marke Sraegy and Analysis, Marke Monioring Uni, ISO New England, One Sullivan Road, Holyoke, MA I am very graeful o he generous commens from and he producive exchanges wih many of my colleagues a ISO New England, NEPOOL Marke Paricipans, he saff of Public Uiliy Commissions and oher governmen offices in New England saes and individuals in academic insiuions, including he paricipans a a workshop held by MIT Cener for Energy and Environmenal Research (CEEPR) on November 21, The curren paper is informed by a sudy ha is sill in progress. I appreciae Kamen Madjarov and Gail Adams for heir capable assisance wih he modeling, while I am solely responsible for any remaining errors. The views expressed herein are hose of mine and do no necessarily represen he posiions of he ISO or he views of ohers. 1

2 srucure wih a hybrid of compeiive wholesale marke and regulaed reail markes has emerged in he U.S., presening new challenges for he developmen of demand response. In a recen paper, Chao, Oren and Wilson (2008) re-evaluaed verical inegraion and unbundling in resrucured elecriciy markes and concluded ha argumens can be musered for eiher srucure wihou any definiive conclusion ha one or he oher exreme is beer. Therefore, he curren hybrid srucure wih regulaed reail raes and compeiive wholesale prices is likely o persis as he indusry evolves. Wih a hybrid marke srucure, demand response akes on special imporance for i serves as a criical link beween he wholesale and reail markes. Given he sraegic imporance of demand paricipaion in elecriciy markes, Wellinghoff and Morenoff (2007) conend ha boh he federal and sae governmens have srong roles for assuming jurisdicion over faciliaing he developmen of demand response. This paper addresses some new challenges in ligh of he growing prospec of demand response in resrucured elecriciy markes. The U. S. Deparmen of Energy (DOE) defines demand response in is February 2006 Repor o Congress: Changes in elecric usage by end-use cusomers from heir normal consumpion paerns in response o changes in he price of elecriciy over ime, or o incenive paymens designed o induce lower elecriciy use a imes of high wholesale marke prices or when sysem reliabiliy is jeopardized. In general, here are a variey of mechanisms ha promoe price-responsive demand in boh wholesale and reail markes. The erms demand response and price-responsive demand have ofen been used inerchangeably, hough here are imporan disincions as well. Priceresponsive demand is a cusomer s abiliy o aler is elecriciy demand by reducing or shifing consumpion in response o marke prices or oher marke condiions. Programs promoing price-responsive demand in reail markes are predominanly ime-based pricing programs, including real-ime pricing and oher dynamic reail pricing programs, whereas demand response 2

3 programs in wholesale marke can be designed o promoe sysem reliabiliy and economic efficiency. 2 The economic heory of demand response is rooed in he peak load pricing lieraure. In he early lieraure, Seiner (1957) and Boieux (1960) inroduced he peak load pricing and invesmen issue in he presence of price-responsive demand. Subsequenly, Brown and Johnson (1969), Carlon, D. (1977) and Crew and Kleindorfer (1976, 1978) and Chao (1983) analyzed he pricing and invesmen issues in he presence of demand and supply uncerainies. Chao and Wilson (1987) and Wilson (1989) sudied prioriy pricing as an incenive mechanism for efficien coningen allocaion of elecric energy hrough aucion and forward conracing. More recenly, Borensein and Holland (2005) and Joskow and Tirole (2006, 2007) sudied reail compeiion in resrucured elecriciy markes. Borensein, Jaske and Rosenberg (2002) and Ruff (2002) reviewed he economic principles of demand response. This paper presens a unified economic framework on elecriciy pricing and invesmen wihin a hybrid marke srucure ha encompasses compeiion in he wholesale marke and regulaion in he reail marke. This paper presens an economic framework o advance undersanding of he effecs of price responsive demand on wholesale and reail markes, for he purpose of exploring conceps o improve program design and evaluaing alernaive designs. The analysis esablishes he socially opimal pricing and invesmen decisions wihin a hybrid marke srucure: The opimal uniform reail price equals o he marginal-demand-weighed expecaion of he compeiive wholesale prices. Efficien invesmen is described by he sandard free enry condiion. The opimal capaciy level srikes a balance beween he cos of shorage and he cos of excess capaciy. To foser efficien raioning during shorage periods, he analysis incorporaes he advanced heory of prioriy service o faciliae an incenive-based demand response mechanism for efficien scarciy pricing. The opimal allocaion wihin a 2 Demand-response programs ha focus on sysem reliabiliy generally provide he power sysem operaor he abiliy o call cusomers o ake heir elecrical load off of he bulk power sysem when he sysem is deficien in capaciy or operaing reserves. Since some cusomers are able o ake elecrical load off he grid very quickly and are ofen willing o do so a prices less han he cos of building new generaing capaciy, such demand response programs can be very cos-effecive sources of capaciy or reserves o wholesale markes. Demand response programs ha focus on price-responsive demand place a greaer emphasis on using wholesale energy marke price signals o improve he economic efficiency of energy consumpion. 3

4 hybrid marke srucure can be implemened hrough a compeiive wholesale marke wih a wopar reail ariff. The analysis recognizes he asymmeric informaion srucure beween consumers and producers wih respec o he real-ime prices. This reflecs he insiuional and echnical realiies associaed wih he defaul uniform reail rae and inadequae advanced meering infrasrucure ha enable demand managemen in response o real-ime prices. In oher words, a consumer s demand response abiliy is consrained. These consrains cause wo marke failures: Firs, since consumers canno respond o real-ime prices, he real-ime demand is inelasic. This creaes a moral hazard problem. As a consequence, he wholesale marke is suscepible o poenial marke power by producers when he sysem capaciy is igh. Second, since he local uiliy or load serving eniy canno bill reail cusomers for heir incremenal coss of services wih differen real-ime demand profiles, his creaes an adverse selecion problem. As a resul, during a peak-load period, cusomers over consume elecriciy wih values ha are ofen below he marginal cos, and during an off-peak period, cusomers under consume elecriciy wih values ha exceed he marginal cos. Given he realiy of an imperfec hybrid marke srucure, here is poenial for efficiency improvemen hrough demand response incenives. However, he analysis suggess ha o enhance efficiency, boh he exising and new approaches need o be evaluaed in recogniion of hese consrains. The remaining secions of his paper are organized as follows. Secion 2 presens he basic model of a hybrid marke srucure wih compeiive wholesale marke and opimal reail regulaion under uniform pricing. Secion 3 presens barriers o price responsive demand. Secion 4 addresses he demand response incenives issues associaed wih he use of cusomer baseline. Secion 5 concludes wih a summary of he main observaions. 2. The Basic Model This secion presens he basic model of a hybrid marke srucure consising of a compeiive wholesale real-ime energy marke and a regulaed uniform fixed reail rae wih 4

5 price insensiive demand. The basic model builds on he previous work of Chao (1983), Chao and Wilson (1987), Borensein and Holland (2005), and Joskow and Tirole (2006) among ohers. Ideally, he wholesale and reail markes are efficien when he marginal cos of energy equals he real-ime energy marke price in a compeiive wholesale energy marke, and reail consumers can see hese prices and may adjus heir real-ime consumpion in response o hese prices i.e., heir demand is price responsive. 3 However, we begin wih he more realisic assumpion ha elecric uiliies offer reail consumers a a uniform reail rae ha does no vary wih ime, while he wholesale marke produces compeiive energy prices ha varies from hour o hour. Uniform pricing was expedien when he meering echnology was primiive. The radiional elecric meer measures he oal kwh usage ha is only adequae for billing cusomers under a fla rae. Wih radiional meers, consumers can no be charged real-ime prices ha reflec he marginal coss of producion. Therefore, he demand is inelasic or insensiive o real-ime prices ha reflec marginal coss. The uniform reail rae represens an average cos per uni of elecriciy consumed, including componens for he recovery of invesmen coss. Therefore, reail elecriciy demand is responsive only o he fla rae ha reflecs he cos of service for all rae payers averaged over a rae period bu does no reflec he marginal cos of elecriciy producion in real ime. On he oher hand, he wholesale marke is grounded in he echnical realiy ha elecriciy is a ime-differeniaed produc ha canno be sored economically a he presen ime. Generaion unis are dispached in real-ime o mee consanly flucuaing demand. To minimize he cos of operaing an inerconneced power sysem, generaion unis are generally dispached in meri order, saring wih hose wih he lowes operaing coss, and progressively dispaching more expensive generaors as he demand increases in real ime. As a resul, he marginal cos of energy flucuaes from hour o hour in real ime. 3 The real-ime wholesale energy marke price is also known as he marke clearing price of energy, he spo price of energy, or he Locaional Marginal Price in he indusry 5

6 Model Assumpions In his paper, we focus on he energy marke and ignore he ransmission securiy issue. We assume ha he ransmission capaciy is abundan and reliable; raioning hrough load shedding is adequae o aver he possibiliy of cascading failures and sysem collapse. We consider he sochasic naure of demand and supply. Le Θ,, denoe a complee probabiliy space, is a σ-field on Θ, and a probabiliy measure on. The saes of naure are represened by a vecor. The ime-relaed variaion and he sochasic variaion of elecriciy demand can be reaed in he same manner. Le denoe expecaions wih respec o he probabiliy measure. A. Heerogeneous demand We assume ha reail consumers are heerogeneous wih differen ases and prefer differen demand profiles. The consumer populaion is denoed by L. The money-meric uiliy funcion of energy consumpion for a consumer of ype is denoed by. We assume ha is an increasing concave funcion wih 0 0. The consumer s behavior is described by he condiion ha marginal uiliy,, equals he price of elecriciy when he individual demand level is, or. The marke demand is he sum of individual demand funcions,. For any price P, he gross value funcion can be wrien as, or equivalenly,. Since consumer preferences can be differeniaed in many dimensions, here is no workable general heory for consumer preferences for differeniaed producs. In his paper, I focus on he ime differeniaion and consider a preference srucure ha capures some essenial ingrediens of price responsive demand. Specifically, I assume ha he individual consumer s uiliy funcion akes on he following srucure: /. (1) This implies ha /. Leing he marginal uiliy equal o he elecriciy price, p, we obain, where. Therefore, each consumer s 6

7 demand can be expressed as he produc of a sae-coningen componen and a pricesensiive componen,. The separable srucure of he uiliy funcion allows us o idenify consumers preferences based on he demand profile,. Theoreically, his preference srucure simplifies he presenaion of general resuls and sharpens he insighs. Pracically, i means ha a consumer s uiliy funcion can be esimaed from he observable daa. Shorage pricing The sochasic naure of demand and supply gives rise o he possibiliy of shorage evens and he necessiy for non-price raioning. Le 0,1 and 0,1 denoe, respecively, he fracions of marke demand and of consumer l s demand ha are served in sae θ. We assume ha is he acual demand for consumer l in sae afer raioning during a shorage even and ha he each individual consumer s gross surplus is proporional o he fracion of demand being raioned,, implying ha raioning generally resuls in non-opimal energy consumpion, or when 1. We assume ha he value of los load for consumer l equals he average uiliy of consumpion, 4. Every feasible raioning plan saisfies he condiion ha he acual marke demand equals he sum of he acual individual demands, or. The realized gross value funcion is wrien as,,. We define he value of los load (VOLL) as he marginal uiliy ha is reduced due o raioning,, / For illusraion, we consider wo special cases of raioning: 1) random raioning and 2) opimal raioning. 4 The linear formulaion is no resricive. I can be easily generalized so ha a consumer s uiliy funcion depends on raioning in a nonlinear fashion, say,,. There could be muliple demand blocks, wihin each of which he value of los load is defined linearly. 7

8 1) Random raioning For random raioning, we represen i hrough wo requiremens: 1) he each individual consumer s gross surplus akes he linear form of being proporional o he fracion of demand raioning,,, which implies ha consumers do no manage demand reducions efficienly during shorage evens, and 2) all consumer demands are raioned indiscriminaely wih an equal probabiliy,. For his case, we obain,. 2) Opimal raioning In his case, we assume ha he opimal raioning plan ( maximizes he gross surplus:,. The opimal raioning plan is o allocae he available supply during a shorage even o consumers wih he highes value of los load. The opimal raioning plan can be characerized as follows: he available resource supply is allocaed o demand in he decreasing order of consumer s value of los load, /, unil he supply is exhaused. Therefore, we have, 1, if 0,1, if. 0, if Wih opimal raioning, we obain, / 2 During a shorage even, he marginal raioning cos provides he basis for efficien shorage pricing, if informaion on he value of los load,, can be solicied from individual consumers. 8

9 Noe ha he value of los load funcion is independen of he sae of naure. Therefore, in principle, i is possible o obain is value in advance o form a sae-coningen forward conrac for raioning and pricing during shorage periods. We will reurn o his laer in he paper. B. Supply echnology On he supply side, we assume ha here is a coninuum of invesmen opporuniies wih differen amorized capial cos of uni capaciy invesmen, k, and operaing cos c. 5 The invesmen opporuniies are represened by he uni capaciy cos, k, including he cos of capial, as a funcion of he operaing cos, for,. We assume ha his funcion is decreasing in. If demand were cerain and consan, he lowes cos echnology, namely he base load uni, would be he only supply opion ha ges buil o mee he load. Bu when load varies sochasically, and oupu is no sorable, idled base-load capaciy is expensive. Some peaking unis may be off-line mos of he ime, running only for very low-probabiliy coningencies ha cover as few as 10 o 50 hours each year. The efficien resul is o inves in a balanced porfolio of echnologies wih varying capaciy and operaing coss ha minimize he overall producion cos. Le denoe he capaciy level of unis wih an operaing cos c. Le be he availabiliy facor of uni c in he sae θ. We suppose ha all available unis will be run in economic meri order from he lowes operaing cos o higher coss. The supply funcion can be obained as he cumulaive oupu from available unis wih operaing coss below he price, p, The oal capaciy invesmen cos is The oal operaing cos is. 5 Chao (1983) employed a discree model o represen invesmen opporuniies. Wih no loss of generaliy, we adop he more elegan coninuous model by Joskow and Tirole (2007). The wo differen models produce fundamenally he same resuls. 9

10 . C. Social welfare funcion In he basic model, we adop he economic surplus as he sandard measure of social welfare funcion. 6 Given he informaional consrain, a Ramsey planner chooses a uniform fixed reail price P, a se of wholesale prices, a capaciy plan and a raioning plan ha maximize he expeced oal economic surplus:, Assumpion: is decreasing in P. This echnical assumpion ensures he sufficiency of he second order opimaliy condiion. The firs-order opimaliy condiion for a hybrid marke srucure can be characerized as efficien pricing and efficien invesmen condiions. Firs, efficien pricing and allocaion dicaes a) he deerminaion of wholesale marke price in relaion o marginal coss and value of los load (VOLL) and b) he deerminaion of he uniform fixed reail rae in relaion o he wholesale marke prices under he condiion he marke clearing condiion of demand and supply. where,,1. 6 Economic surplus is he sum of consumers surplus and producers surplus, where he consumer surplus is he amoun ha consumers benefi by buying elecriciy a a price ha is less han hey would be willing o pay, and he producer surplus is he amoun ha producers benefi by selling a a marke price ha is higher han hey would be willing o sell. 10

11 The cleared marke demand,, is he poin on he demand funcion where he price equals he uniform reail rae,. The wholesale price,, is se a he level where he supply equals he cleared marke demand. Raioning is acivaed, 1, when he cleared marke demand exceeds he oal available capaciy. The efficien pricing resuls are summarized below: Resul 2.1: The compeiive wholesale marke price equals 1) he marginal cos of producion, during a normal period 1 when, or 2) he marginal value of los load, during a shorage period 1 when. Tha is,,, if 1 if 1 Resul 2.2: The opimal uniform reail price equals o he expeced marginal-demand-weighed average of compeiive wholesale marke prices, /. Second, efficien invesmen is characerized by he sandard zero-profi free enry condiion for new invesmen: Resul 2.3 The efficien invesmen plan is characerized by he zero-profi free-enry condiion., if 0. I is sraighforward o show ha k '( c) < 0, and his suggess ha efficien echnology fronier is downward sloping. Applying he efficien invesmen condiion o a peaker, a uni wih he highes operaing cos c and 0, we obain he condiion for he opimal capaciy requiremen, Pr 1 This is summarized in he following resul. where 1. Resul 2.4: The opimal capaciy level is aained when he los of load probabiliy equals /. 11

12 Example: Suppose ha for a peak load uni, $90/kW-year $250/MWh VOLL = $4000/MWh The opimal capaciy level is achieved when 90/ Resul 2.3 suggess ha in a compeiive wholesale marke, a generaor should be able o earn adequae reurns o recover he coss of capaciy invesmen. However, as we will show in he following, he revenue adequacy condiion does no always hold in he reail marke, because i is uncerain wheher he reail revenue under he opimal uniform reail price is higher or lower han he amoun of revenue needed o recover he procuremen coss. The only uniform reail price ha is revenue neural in he sense ha i will generae he righ amoun of revenue o recover he procuremen cos from he wholesale marke is he demand-weighed expecaion of compeiive wholesale prices. Resul 2.5: The demand-weighed expecaion of compeiive wholesale marke prices is he only uniform reail price ha will yield adequae ne revenue o recover he operaing and capaciy invesmen coss,. Since may be differen from,, he opimal reail rae does no assure adequae revenue o recover he invesmen coss. When marginal demand is independen of he sae of naure, he efficien uniform fixed price fla rae will run defici. Only in a special circumsance when consumers are homogenous wih he same demand profile,, he marginal demand is perfecly 12

13 correlaed wih he oal demand,. Borensein and Holland (2005) show ha under Berrand compeiion in he reail marke wih uniform fixed reail prices, he equilibrium reail price equals o he demand-weighed average wholesale price,. Since he resuling allocaion is less efficien han he second-bes opimal reail price,, Borensein and Holland conclude ha here is marke failure in reail compeiion. Joskow and Tirole (2007) refued he BH conclusion wih he suggesion ha he reailer could compee by offering cusomers wopar ariff. Economic heory recommends wo general approaches o collec fixed revenue from regulaed reail raes wih minimum inefficiency. One approach is Ramsey pricing or secondbes pricing, which suggess ha o minimize he overall inefficiencies in cusomers choices under a revenue consrain, he prices should deviae from incremenal coss in such a way ha cusomers wih more inelasic demands pay larger shares of he defici. The revenue neural price in BH can be inerpreed as Ramsey pricing, because he revenue neural price can be obained as a modified opimal price wih he marginal demand weighs scaled by he inverse of demand elasiciy. Tha is, / / / /, where /. The alernaive approach uses a wo-par ariff, which is generally considered o be more efficien han single-par linear ariff, like Ramsey pricing. (Brown and Sibley, 1986; Wilson, 1993; Joskow and Tirole, 2006) In a wo-par ariff, for example, each cusomer pays a demand charge ha depends on he peak load, and hen, for each kw wihin ha peak load, an energy charge based on he amoun of energy, measured in kwh, ha is used during he year. In effec, his scheme charges he cusomer for is load profile over a billing period. The above observaions are summarized in he following resul. Resul 2.6 The opimal allocaion and invesmen plan in a hybrid marke srucure is aained via a compeiive wholesale marke and an opimal wo-par reail ariff. 13

14 Scarciy pricing 7 In he remainder of his secion, we consider raioning during a shorage period as a form of reliabiliy-based demand response program. We consider prioriy service mechanism, a menu of forward coningen conracs which implemen shorage pricing for efficien raioning during a shorage period. Prioriy raioning is uniformly more efficien han random raioning, and here should be no losers by swiching from random raioning o prioriy raioning. 8 To implemen prioriy raioning, i is essenial ha he cusomers are willing o reveal heir value of los load per uni of demand, so ha demand reducion can be ranked in an efficien manner ha minimizes he oal value of los load. A prioriy service mechanism is buil on he diversiy among cusomers relaive preferences: some wan lower prices and are willing o be curailed more frequenly han ohers whereas ohers are willing o pay a premium for a more reliable service. Each consumer is asked o repor a value of los load,, in advance, for he purpose of esablishing a prioriy order in case of shorage. During a shorage even, he demand is curailed according o an increasing order of, wih a lower value demand cu off before a higher value demand, unil he demand is reduced o a level ha can be me wih he available capaciy. During a shorage period, he real-ime price equals he marginal value of los load for he demand no curailed,, where represens he ype of he marginal consumer. The curailed demand will be compensaed a a price ha equals o. The following resul shows ha his design is incenive compaible and efficien. Resul 2.7 The prioriy service mechanism implemens efficien raioning and scarciy pricing. Proof: Since he raioning plan based on he ranking order of value of los load is efficien, we only need o show ha he mechanism is incenive compaible. Suppose ha he real-ime price is during a shorage even. The consumer s surplus is given by 7 In general, he erms shorage pricing and scarciy pricing are used inerchangeably. The fine disincion made here is ha he in shorage pricing, he value of los load is based on an objecive esimae approved by he regulaor, whereas in scarciy pricing, he value could be obained hrough volunary demand bids, a process which is approved by he regulaor. 8 See Chao and Wilson (1987) and Wilson (1989). 14

15 ,, if if If consumer of ype l bids a value ha is higher han he rue value of los load, i.e.,, hen he only difference i makes is ha when, he consumer would no be curailed. However, he opporuniy cos o he consumer is o forego he scarciy ren,, which is higher han he consumer s surplus,, by he amoun, 0. On he oher hand, if he consumer under-repors he rue value of los load, i.e.,, hen he only difference i makes is ha when, he consumer will be curailed and be compensaed a a shorage price which is lower han he rue value of los load. Consequenly, he consumer s surplus will be reduced by he amoun, 0. Therefore, a consumer s bes sraegy is o repor ruhfully, and he mechanism is incenive compaible. Q.E.D. Revenue Inadequacy and Price-cap Price cap in he wholesale marke is generally considered as an inerim measure inroduced o miigae marke power and moderae price volailiy during a shorage period. Bu like any price inervenion mechanism, price cap causes inefficiencies. Firs, by limiing producers profis during peak periods, i diminishes he incenive for invesmen in new generaing capaciy. Second, by capping scarciy prices during shorage periods, i causes inefficien raioning and disors he price signals. In he following, we sudy he use of capaciy paymens as a compensaory marke mechanism o offse he undesirable effecs of price cap. Suppose ha consumers repor he values of los load ( ) ruhfully before he realime marke is conduced, he scarciy price can be calculaed during a shorage even as discussed earlier. We denoe by he price cap on real-ime prices. Wih a price cap,, he wholesale price during a shorage even is modified as follows: 15

16 ,, when 1. As a consequence, he price cap lowers a consumer s cos per uni of demand by he following amoun, The price cap lowers producers oal revenue per uni of available capaciy by an amoun ha reflecs he reduced scarciy ren, The oal amoun of capaciy paymen for producers equals he oal prioriy service charges for consumers: 1 1. The capaciy paymen recapures he scarciy ren reduced by he price cap and hus resores he financial incenives for efficien invesmen. The amoun is wha a risk-neural insurance underwrier would offer a cusomer in a supplemenal insurance conrac o compensae hem for he financial risks of shorage pricing during a shorage period wihou he price cap. Suppose ha a menu of prioriy service opions is offered o all consumers, and ha he raioning plan will be implemened according o a ranking order based on consumers selecions of prioriy paymen, a consumer whose value of los load is is prediced according o Resul 2.7 o selec he prioriy paymen,. Consequenly, consumers will reveal heir rue value of los load. In principle, price cap may affec no only he scarciy prices bu also real-ime prices in he wholesale marke during a normal period. Therefore, an efficien allocaion mus be predicaed upon a sufficienly high price cap. Therefore, we may summarize he resul generally as follows. 16

17 Resul 2.8 If he price cap is sufficienly high so ha i does no inerfere real-ime pricing, efficien allocaion can be aained hrough a supplemenal capaciy paymen and prioriy paymens. 3. Challenges o Price Responsive Demand Despie he echnical advances and poliical suppor over he pas wo decades, he progress of demand response has been modes. (FERC 2006) In his secion, we discuss he imporance of prices responsive demand in a hybrid marke srucure and enumerae barriers o is developmen. Price-responsive demand improves he economic efficiency by discouraging low value energy consumpion when real-ime wholesale energy prices are high during he peak period and encouraging high value energy consumpion when real-ime wholesale energy prices are low during he off-peak period. Price-responsive demand could reduce demand volailiy and he peak demand. This, in urn, reduces he need o insall addiional generaion and ransmission infrasrucure o serve he peak. Price responsive demand reduces he likelihood of calling on operaing reserves and he likelihood of involunary load shedding. I also reduces he abiliy of suppliers o exercise marke power improving compeiion in energy markes and lowering prices in consrained marke areas served by few generaion companies and igh supply siuaions. Facing an inelasic demand, producers can profiably increase prices wih lile or no loss of sales. When he demand for elecriciy is responsive o changes in he wholesale price, an aemp o wihhold or raise prices will cause reducion in sales, hus reducing he profiabiliy of such an acion and discouraging he exercise of marke power. When he reail price of elecriciy does no vary wih wholesale marke prices, however, consumers do no see changes in he (reail) price hey face, and hus he demand is inelasic despie he run-up in wholesale prices. 17

18 Various recen surveys provide empirical evidence ha cusomers respond o he higher prices by lowering demand. For insance, in a recen survey of seveneen pricing experimens, 9 Faruqui and Sergici (2008) conclude: Across he range of experimens sudied, ime-of-use pricing ariffs lead o a drop in peak demand ha range beween 3 and 6 percen and criical-peak pricing ariffs lead o a drop in peak demand of 13 o 20 percen. When accompanied wih enabling echnologies, he laer se of ariffs leads o a drop in peak demand in he 27 o 44 percen range. 10 Linking real-ime compeiive wholesale marke energy prices and reail raes would encourage price-responsiveness among reail cusomers. In realiy, however, he vas majoriy of consumers remain largely on uniform fixed reail raes, forming a barrier o price-responsive demand. The imporance o remove he insiuional barriers and o engage cusomers on he demand-side of he elecriciy marke is widely recognized as one of he mos imporan lessons from he California elecriciy crisis. As Joskow (2002) aply observed: The answer for California now is no o reurn o he old, cosly sysem of regulaed monopolies, bu o apply he harsh lessons i has learned from designing a flawed sysem. Compeiive elecriciy markes will no work if consumers are compleely insulaed from wholesale marke prices. In he following, we discuss he wo barriers ha preven he full poenials of price-responsive demand from being realized: he defaul uniform reail raes and he lack of advanced meering infrasrucure. 9 Faruqui and Sergici (2008), Household Response o Dynamic Pricing of Elecriciy: A Survey of Seveneen Pricing Experimens, The Brale Group, San Francisco, CA, and Cambridge, MA. See hp:// 10 The 2007 peak load in New England was 26,145 MW. A 20 percen of peak demand amouns o 5,229 MW. 18

19 Firs, a fixed-price uniform reail rae impedes price-responsive demand in wholesale and reail markes, and has adverse economic and insiuional ramificaions. The inefficiencies causes by fixed-price uniform raes can be enumeraed as follows: A fixed-price uniform reail rae causes a number of economic inefficiencies because i does no enable differen cusomers o express he individual value hey place on elecriciy, and does no reflec he rue cos of serving individual cusomer demand. Elecriciy cusomers have differen preferences for qualiy of service, load profiles and demand curves. For insance, a uniform rae creaes a ension beween hose cusomers who migh prefer lower raes wih higher risks of ouage and hose who prefer more reliable service a higher raes. A uniform rae causes volaile and inelasic levels of demand. Because a uniform rae does no reflec direcly he incremenal coss of services demanded by differen cusomers in response o ha rae, elecriciy may be produced and delivered a coss ha exceed he value of elecriciy o is cusomers or may be wihheld from cusomers wih values ha exceed he cos of producion. In pracical erms, he demand for elecriciy and wholesale marke energy prices become exremely volaile during ho summer weaher when elecriciy usage spikes. However, consumers are shielded from volailiy in wholesale energy prices hrough a fixed-price reail rae causing demand o be unresponsive o changes on wholesale energy prices. Hence, demand is inelasic in he wholesale energy marke resuling in higher overall energy coss. On he oher hand, increasing price elasiciy hrough price-responsive demand increases economic surplus relaive o uniform raes by avoiding over-consuming when wholesale prices exceed he uniform reail rae or under-consuming when wholesale prices are below he uniform reail rae. A uniform rae creaes cross subsidies and makes i difficul o recover infrasrucure coss wihou disoring incenives. A uniform rae charges cusomers ha consume mos of heir energy during low-cos, off-peak periods he same price as hose who consume mos of heir energy during high-cos, peak periods. By charging a fixed-price uniform rae across a broad range of cusomers each wih differen preferences and load profiles, some cusomers end up subsidizing he cos of serving oher cusomers (e.g., users who consume off-peak subsidize 19

20 on peak users). Finally, should infrasrucure coss (e.g., capaciy and ransmission) ha are driven by peak load also be charged hrough a fixed-price uniform rae (in /kwh), he incenive o avoid peak usage and encourage off-peak usage is miigaed by spreading such coss evenly across all hours. Uniform raes are a disincenive o Marke Paricipans in he supply/delivery chain o encourage demand response. There are also insiuional reasons why uniform raes are a barrier o price-responsive demand. Firs, since price-responsive demand is generally perceived o reduce reail revenue by reducing energy hroughpu, a uniform rae creaes disincenives for eniies ha are par of he supply/delivery chain o promoe demand response. 11 Decoupling reail revenue from consumpion levels has been inroduced as a soluion o his disincenive. Second, since he uniform rae is generally coupled wih a fullrequiremens supply conrac ha offers reail cusomers a hedge agains price volailiy, i removes he incenive for cusomers o sign forward conracs ha migh include paricipaion in wholesale markes hrough demand bidding. The issue of reail rae reform has been acively debaed wihin individual saes. California Public Uiliy Commission s landmark decision in 2008 o adop dynamic reail pricing as defaul rae for all cusomer classes is generally viewed as a posiive sep oward achieving price-responsive demand. Second, in he elecriciy secor, price-responsive demand depends on advanced meers and he infrasrucure ha enables demand response, including meering, communicaions, conrol, billing and demand managemen ools. If a load serving eniy wans o bill cusomers for imediffereniaed raes, inerval meers are needed a he very leas o record cusomer usage on an hourly basis. Price-response demand requires communicaions echnology ha sends hourly price and consumpion informaion in real ime o he consumer or heir energy-using devices (o deermine he level of response), and o billing eniies wih he capaciy o efficienly process hourly price and consumpion informaion from numerous cusomers. To manage air condiioning usage, conrol echnologies such as smar hermosas ha adjus room emperaures 11 Because many demand response programs have been oriened oward reducing peak demand, i is perceived ha overall sales would decrease as a resul of price response. However, price response ha improves sysem uilizaion by increasing off-peak usage may mainain overall sysem hroughpu and miigae such perceived revenue erosion. 20

21 auomaically in response o price signals would grealy faciliae price-response. During shorage evens, he sysem operaor needs a secure, dispach and communicaion nework o conrol cusomer loads in response o sysem emergencies or price signals. Over he pas wo decades, advances in digial echnology have reduced he coss and increased he funcionaliy of smar meering echnologies and lowered he enry barrier for price-responsive demand. The echnical barrier caused by he lack of advanced meering infrasrucure is largely due o he economies of scale and scope for he invesmen in he echnological infrasrucure needed o faciliae price-responsiveness. Moreover, price-responsive demand ends o reduce energy prices during peak load period yielding exernal benefis o oher cusomers. As a resul, reliance on pure privae invesmen o finance he developmen of advanced meering infrasrucure seems insufficien. Evidenly, only large indusrial and commercial cusomers can jusify he expense of meering, communicaions, and enabling echnologies a his ime. As a resul, priceresponsive demand has been limied o dae. Given he insiuional and echnical barriers defaul uniform reail rae and lack of advanced meering infrasrucure consumers are likely o say on fixed-price uniform rae service. This creaes wo fundamenal marke deficiencies ha preven he marke from realizing he benefis of price-responsive demand described above. Firs, since consumers canno respond o real-ime prices, real-ime demand is inelasic and is suscepible o he poenial exercise of marke power by producers especially during peak hours when available capaciy is scarce. Second, when a uiliy or load serving eniy canno charge is cusomers for heir incremenal coss of services in real-ime, and cusomers are billed for heir aggregae energy consumpion raher han heir hourly energy consumpion, inefficiencies resul over-consumpion during peak-load periods requiring exra invesmen in generaion and ransmission capaciy, underuilizaion of idle capaciy during off-peak periods, and ulimaely, higher reail elecriciy prices and bills. Uniform Reail Rae in he Shadow of Obsolescence 21

22 When all consumers are able o respond o real-ime prices, we conend ha he average-cos based uniform reail rae is likely o become obsolee. For example, as will be shown below, when consumers are given he opporuniy o choose freely beween wo pricing approaches, uniform pricing and demand-profile pricing, no consumer will say wih uniform pricing in equilibrium. The basic model can be exended o explicily include demand-profile pricing and real-ime pricing approaches. The model exension, which is fairly sraighforward, is included in he Appendix for compleeness. Under demand-profile pricing, each consumer pays for he service a a fixed price based on he real-ime prices weighed by he demand profile for he individual consumer. For demand-profile pricing o be viable, consumers needs o have advanced meers; oherwise reail service provider will suffer adverse selecion and moral hazard problems due o he asymmeric informaion from no being able o rack down he acual usage. (Joskow and Tirole, 2006) While demand-profile pricing can be revenue neural by passing hrough he real-ime prices direcly o cusomers, i can be implemened in such a way ha a reailer may include a risk premium and offer a price hedge for some risk-averse consumers. Therefore, when we compare demand profile pricing wih uniform pricing, we may absrac from he risk managemen consideraions. Demand-profile pricing sraegically dominaes uniform pricing in he sense ha in equilibrium, all raional consumers should swich from uniform pricing o demand-profile pricing. This can be esablished by simulaing consumer choice over ime. Iniially, consumers wih he lowes-cos demand-profile are subsidizing he higher-cos consumers under uniform pricing. These consumers should be he firs ones who will swich o demand-profile pricing. Afer he lower-cos consumers have swiched o demand-profile pricing, he cos of service for he remaining consumers will increase, and he uniform rae needs o be adjused upward accordingly. This process feeds iself, including more consumers o swich. This process will coninue unil he inheren cross-subsidizaion in he uniform rae is eliminaed. Ulimaely, no consumer will say wih uniform pricing. This process can be expedied by regulaory reform 22

23 making dynamic pricing he defaul service raher han he uniform fla rae. The above observaions are demonsraed in he following resul. Resul 3.1 When consumers can choose free beween demand profile pricing and uniform pricing, all consumers will ulimaely swich o demand profile pricing. Proof: Under demand profile pricing, consumer l pays a fla rae,. Under uniform pricing, each consumer is charged he price,. The consumer prefers demand profile pricing, if, given ha he raioning plan is no affeced by his choice: This implies ha consumers will choose o say wih uniform pricing only if. Bu we show below ha his leads o a conradicion in equilibrium.. Therefore, no consumer can be found o say wih uniform pricing in equilibrium. Q.E.D Suppose ha a reail service provider (RSP) purchases energy from he wholesale marke based on consumers demand profiles. Le denoe he fla reail rae ha he RSP charges consumer l. The reail profi is given by. The free enry condiion implies ha 23

24 he compeiive reail price equals he opimal demand-profile price:. By conras, Borensein and Holland (2002) showed ha he free enry condiion was violaed under uniform pricing and concluded ha reail compeiion is inefficien. We summarize he above observaions as follows. Resul 3.2: Under demand-profile pricing, reail compeiion is efficien. The following resul shows ha real-ime pricing is superior because real-ime pricing offers an informaional advanage over demand-profile pricing derived from he opion value associaed wih dynamic decision-making. Resul 3.3 For risk-neural consumers, real-ime pricing is superior o demand-profile pricing. Proof: Firs, recall ha solves he following maximizaion problem for consumer l under demand profile pricing:. Since, we have, Therefore, for, we obain,. 24

25 Q.E.D. 4. Demand Response Incenive and he Use of Cusomer Baseline In his secion, we address he incenive programs for demand reducion. Policy makers have recognized many of he benefis and barriers o price-responsive demand. Regulaors have approved demand-response programs ha involve paying cusomers o reduce or eliminae heir demand during high price periods. These programs emphasize demand reducion during peak periods or igh sysem condiions when he benefi is expeced o be he greaes. Demand reducion is concepualized as a resource ha can be reaed like a supply resource. This resource perspecive is expedien in resrucured markes, because i provides reail cusomers incenives o reduce consumpion when he wholesale price is high or he sysem condiion is igh bu oherwise reain he access o he reail ariff. However, in he long run afer he barriers o price responsive demand discussed above are removed, hese incenive programs should no longer be needed. Demand and supply should naurally adjus o marke prices efficienly wihou he need o pay someone exra incenive no o buy he produc. As prices for a produc ha consumers pay begin o increase, consumers will naurally conserve usage of ha produc. Consumers could use long-erm conracs o hedge he price risks. Economic efficiency is advanced when he reail raes reflec wholesale prices. Since many of hese programs pay cusomers based on how much demand hey reduced, i is necessary o esimae wha heir demand would have been had i no been reduced. This esimaed amoun is called he Cusomer Baseline. As we describe below, here are heoreical and pracical problems wih calculaing a Cusomer Baseline ha make i possible for cusomers o ge paid for load ha was no acually reduced. These problems call ino quesion he viabiliy of approaches o promoe price-responsive demand ha rely upon an esimaed Cusomer Baseline. Moreover, if demand is paid o reduce consumpion, i may arificially lower prices 25

26 and resul in prices ha are no high enough o reain exising supply, or o arac new supply needed o mee fuure demand. Concepually, he Cusomer Baseline is he esimaed level of normal or counerfacual consumpion during he ime period agains which demand reducions are measured and paymens are deermined. For he purpose of selemen and billing, a mehodology mus be implemen ha esimaes he Cusomer Baseline from which a paymen for reduced consumpion can be deermined. However, he Cusomer Baseline is conjecural and is no direcly observable and is generally esimaed from daa ha represen he pas cusomer behavior using saisical esimaion mehods. A cusomer does no ypically pay for energy associaed wih he Cusomer Baseline nor have a financial obligaion o purchase he Cusomer Baseline amoun. The abiliy of cusomers o consume any quaniy of elecriciy wihou making a financial commimen before-hand o purchase ha quaniy enables he cusomer o sell a quaniy of energy ha i does no own. The lack of a financial commimen o purchase energy a he Cusomer Baseline level means ha he cusomer has an abiliy o increase is revenues from he demand response program by alering is baseline so ha i appears o be as high as possible. The incenives o increase he baseline fall ino wo caegories well sudied by economiss: adverse selecion and moral hazard. The adverse selecion problem arises from asymmerical informaion on Cusomer Baseline. Since he baseline is no direcly observable, cusomers usually have beer informaion on heir baseline consumpion levels han he ISO and can use his informaion o heir advanage in is decision o join a price-response program. Therefore, he program is likely o arac disproporionae paricipaion from cusomers who anicipae lower consumpion for reasons having nohing o do wih he incenives paid by he program o reduce load. For insance, if las year s or las season s consumpion is used as he basis for he Cusomer 26

27 Baseline, firms whose producion have shrunk since ha ime are likely o sign up. 12 The ISO, herefore, could end up paying for load reducion ha would have occurred anyway, which has nohing o do wih he demand-response program incenives. A he same ime, firms ha are enering heir high demand season, or have grown rapidly since las year simply will no sign up. The moral hazard problem arises from aciviies ha may be underaken by cusomers o affec he Cusomer Baseline, bu are difficul o deec. Since he baseline is based on a cusomer s pas consumpion, a cusomer can arificially increase i consumpion iniially o creae a higher baseline. As indicaed in an ISO filing wih he Commission in February 2008 concerning he Day-Ahead Load Response Program ( DALRP ), some DALRP paricipans appeared o have arificially inflaed heir Cusomer Baselines in order o collec energy and capaciy paymens wihou acually reducing load. For example, cusomers wih base-load, onsie generaion may urn off heir generaors emporarily o esablish an arificially high baseline level of consumpion and hen urn he on-sie generaors back on o collec exra paymens for wha is oherwise normal consumpion behavior. 13 Given ha cusomers alone know heir rue demand, i is impossible o foresee all possible gaming sraegies and he coss hey could evenually impose on oher cusomers. More sophisicaed measuremen and verificaion mehods for esimaing he Cusomer Baseline may help, bu will no solve he problem because he problem is he resul of he incenive srucure creaed by reliance on an esimaed Cusomer Baseline and no in he Cusomer Baseline esimaion mehodology. Finally, paying cusomers no o consume energy can cause inefficien price formaion in he wholesale energy markes because i can resul in cusomers no consuming power when he value of consumpion exceeds he cos of producing he energy. This can happen when he sum 12 For example, in he fall of 2007, he ISO New England deeced an unusual surge in paricipaion in is Day- Ahead Load Response Program. I was found ha some of he Cusomer Baselines were frozen in a higher summer levels, so when demand sared naurally decreasing during he off-peak fall season, paymens were being made for load reducions ha would have occurred in any case. See ISO New England, Docke No. ER (February 5, 2008). 13 Id. 27

28 of he cusomer s of bill savings and he program s incenive paymens, exceed he cos of producion. A simple example can be used o illusrae an inefficien marke resul caused by paying for demand reducions: Suppose ha a consumer is willing o pay he reailer up o $250/MWh for energy (imagining ha his could be he opporuniy cos o run an on-sie backup generaor including ime, maerials and inconvenience). 14 When he reail rae is $120 per MWh, he consumer would be willing o offer load reducion a $130/MWh (= $250 - $120). If he real-ime LMP of $140 per MWh, and he load reducion offer clears, i would displace a marginal generaing uni offered a $140 per MWh. This resuls in a ne socieal cos increase of $110 (= ) per MWh. In oher words, he double paymen from he demand response program caused a higher cos resource o be dispached i.e., he on-sie generaor a $250/MWh while a less expensive resource he sysem generaor a $140/MWh was no uilized. I is possible ha he dispach of he on-sie generaor caused a reducion in he marke clearing price say from $150 o $140/MWh. Even in ha siuaion, sociey ends up paying a resource cos of $250/MWh while a subsanially less expensive alernaive (a sysem generaor a $150/MWh) wen unused. To furher illusrae, suppose ha demand reducion receives an incenive paymen,, which equals he produc of he real-ime price (RTP), P, and amoun of demand reducion from he Cusomer Baseline level (CBL= Q 0 ) o he acual demand, Q. To see he effecs of he incenive paymen on consumer behavior, we wrie he consumer s surplus as follows: max The consumer s surplus is maximized by seing he marginal willing-o-pay o he sum of reail and wholesale prices:, where P 0 is he fixed reail rae (RR). Therefore, he incenive paymen causes excessive demand reducion ha affecs boh peak and 14 The use of an on-sie generaion was used in his example for illusraive purposes only. This example is generally applicable even in siuaions where he cusomer does no have an on-sie generaor. In ha case, a consumer s willingness o pay could be driven by he value derived from consumpion. For example, he consumer may be a manufacuring business in which i is no longer profiable o operae if he cos of elecriciy exceeds $250/MWh hence, he consumer will cease elecriciy consumpion a prices exceeding $250/MWh, 28