Technology
Order 745 Yields New Era for
Competitive Markets
I
t has been a long time coming.
In recently issued Order 745, the Federal Energy Regulatory Commission (FERC) establishes
the following:
[W]hen a demand response resource . . . has
the capability to balance supply and demand
as an alternative to a generation resource and
when dispatch of that demand response resource is cost-effective . . . that demand response resource must be compensated for the
service it provides to the energy market at the
market price for energy.
With this ruling, FERC breaks the barriers preventing
demand resources from competing equally with traditional fossil supply.
With this ruling, FERC breaks the barriers preventing demand resources from competing equally
with traditional fossil supply. Those of us in the
demand-side management community who have
been around awhile have looked forward to this
day for some time. Over the last couple of decades,
many have written about the need to better integrate demand resources into the overall system-balancing process. In the late 1980s, Amory Lovins,
for example, coined the term “negawatts” to de-
R. Kenneth Skinner (kenneth.skinner@
integralanalytics.com, phone [513] 762-7621) is vice
president and chief operating officer of Integral Analytics.
MAY 2011
Natural Gas & electricity
R. Kenneth Skinner
scribe demand as a resource.1 With technological
advances driving the Smart Grid, today more than
ever demand as a resource is poised to usher in a
new era of competitive energy markets.
Although the ruling recognizes demand response is a viable alternative to traditional fossil fuel
generation, the decision was not without diverging
opinions. Much of the debate focused on the question of what is an appropriate level of compensation for demand-response resources. According to
the ruling, three differing views emerged, with
some in favor of paying the LMP [locational
marginal price] for demand reductions in the
day-ahead and real-time energy markets in all
hours, others arguing that paying the LMP for
demand reductions under any conditions will
result in overcompensation or distortions in incentives to reduce consumption, and still others
arguing that paying the LMP for demand reductions is only appropriate when it is reasonably certain to be cost-effective.
In the end, the ruling pointed to the advantage of perfectly competitive price determination in anticipation
of lower energy costs.
In the end, the ruling pointed to the advantage
of perfectly competitive price determination in anticipation of lower energy costs: “This approach for
compensating demand response resources helps to
ensure the competitiveness of organized wholesale
energy markets and remove barriers to the participation of demand response resources, thus ensuring
just and reasonable wholesale rates.”
DOI 10.1002/gas / © 2011 Wiley Periodicals, Inc.
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Economics of Contestable Markets
In order for perfectly competitive prices to develop, fundamental assumptions of competitive
markets must be met.
One of these assumptions—the ease with which
firms are able to enter markets—plays an important
role in the development of competitive markets.
Market entry assures that (1) long-run profits are
eliminated by the new entrants as prices are driven
to be equal to marginal cost and (2) firms will produce at the low points of their long-run average cost
curves. Even in oligopolistic markets, excess profits
and prices exceeding marginal cost can be eliminated if barriers to entry are eliminated.
Taken to the extreme, the reason a monopoly exists
is that other firms find it unprofitable or impossible
to enter the market. Exhibit 1 demonstrates the effect
of barriers to entry in reducing output below optimal
levels and raising the market price to capture consumer
surplus. The consumer surplus in this case results in a
transfer of wealth from rate payers to the generators.
Barriers to entry can be caused by numerous reasons. In the short term, transmission constraints,
forced outages, or collusion among market participants can limit free entry of competitive resources.
In the case of traditional generation, site development, permitting delays, turbine availability, and
construction lead-time create barriers to entry. Once
the facility is built, transmission rights, fuel availability, scheduled maintenance, and physically operating
constraints can limit market participation.
Because of these and other limitations, physical generation by itself cannot provide the real-time
market entry and exit required to assure marginal cost
pricing in today’s competitive market environment.
The near-absence of demand response participating
in energy markets is powerful empirical proof that the
current compensation mechanisms are inadequate.
Demand Response as a Competitive
Resource
The solution to overcoming real-time barriers to
entry is found in the negawatt market of real-time
load curtailment. Unfortunately, effective programs
designed to encourage active negawatt markets have
been slow to develop. One of the comments to FERC
reported in the final ruling points out that the nearabsence of demand response participating in energy
markets is powerful empirical proof that the current
compensation mechanisms are inadequate. The intent
of FERC Order 745 is to remove these price barriers.
Theoretically, real-time load management is
analogous to physical generation. Rather than dispatching and curtailing generation, real-time load
Exhibit 1. Barriers to Competitive Pricing
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© 2011 Wiley Periodicals, Inc. / DOI 10.1002/gas
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MAY 2011
management curtails and dispatches load. Until
recently, practical real-time load management has
only been available to large industrial consumers
due to the high cost of monitoring and telemetry
equipment and limitations in market design.
With recent advances in “smart” technology,
these benefits are now able to reach residential customers as well. Residential customers can be encouraged to shift demand from peak to off-peak
hours with smart meters. With Internet-based information and control technologies, end-use appliances can be programmed to dispatch into the grid.
Customers who participated in the pilot on average
saw an 8 percent reduction in their bills (or approximately $9.00), and there were “virtually no complaints
about discomfort.”
An example of this type of project was recently
demonstrated by Duke Energy in their McAlpine
pilot project.2 Managing the interplay of solar power,
energy storage, and home energy management systems, the project has been referred to as Duke’s “virtual power plant.”3 In its public utility commission
(PUC) filing, Duke reported a 52 percent peak energy reduction. Normalized for weather, customers
who participated in the pilot on average saw an 8
percent reduction in their bills (or approximately
$9.00), and there were “virtually no complaints about
discomfort,” showing that peak reductions can be
achieved while minimizing customer disturbance.
An Example of Voluntary LoadCurtailment Pricing
The most successful programs avoid much of
the downside price risk through voluntary participation. Instead of threatening users with possibility of extreme energy costs, voluntary programs entice them with rewards for curtailing usage. These
programs pass the price signals—and therefore the
incentive to curtail—to the consumer. However,
if consumers choose not to respond and continue
current consumption, they pay the conventional
stable rate for electricity. Under voluntary load
curtailment, shown in Exhibit 2, the energy user
pays a standard rate that is designed to average out
the highs and lows, but during a price spike event,
the user can “sell back” the curtailed energy to the
independent system operator (ISO).
An effective real-time negawatt market will automate much of the demand-response activity. First, the
energy consumer would determine ahead of time the
strike price and level of curtailment consistent with
Exhibit 2. Voluntary Load Curtailment Pricing
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Natural Gas & electricity
DOI 10.1002/gas / © 2011 Wiley Periodicals, Inc.
29
Exhibit 3. Call-Option Curtailment Program
their opportunity costs. The strike price would then
be compared to the expected system LMP on a dayahead and hour-ahead basis. If the expected system
price exceeds the strike price, the customer is automatically notified. The negawatt market participant would
automatically transition off of system load. Ideally, the
ISO would be indifferent to either paying a generator
the spot market price for wholesale energy or paying
the negawatt participant for load curtailment.
In practice, demand-response participants receive
both capacity and energy payments. Entrepreneurial
energy service providers are currently using a realoptions theory to value these price components.
Participants are able to choose the level of risk that
curtailment will occur and the amount of energy
curtailed by specifying how many consecutive hours,
how many total events, and at what price they are
willing to participate. Choosing a lower strike price
increases the possibility of curtailment. Participants
receive a corresponding capacity payment and an energy payment for curtailed energy. A “call option” in
this case gives the ISO the right to purchase energy
from the end-use customer at the agreed-upon strike
price. Exhibit 3 represents how end-user load shape
responds to the call option.4
FERC Order 745 addresses many of the barriers impeding demand-side participation in energy
markets and specifically helps “get the price right.”
Together with innovative program design and ad30
© 2011 Wiley Periodicals, Inc. / DOI 10.1002/gas
vanced technologies characteristic of the Smart Grid,
customers will be better enabled to control energy
costs and receive the full benefit of market participation. While elaborating on the final ruling, FERC
Commissioner Cheryl LaFleur stated the following:
I know that demand response doesn’t just happen, but requires technology, including aggregation technology, and customer communication.
The Final Rule gets the market signals right, and
will encourage investment in the infrastructure
needed to allow customers to collectively participate in the wholesale markets, when they
would not be able to do so directly.
NOTES
1. See, for example, Lovins, A. B. (1990, September). The negawatt revolution. Across the Board, 27(9), 18–23.
2. Duke Energy Carolina, LLC, Residential Energy Management
Systems Pilot Measurement, Verification, and Evaluation Report, Docket E-7, Sub 906 filed before the N.C. Utilities Commission January 13, 2011.
3. St. John, J. (2009, June 18). Integral Analytics: Orchestrating Duke’s “virtual power plant.” Retrieved from http://www.
greentechmedia.com/articles/read/integral-analytics-orchestrating-dukes-virtual-power-plant/.
4. Skinner, R. K., & Ward, J. (2009). Applied valuation of demand
response under uncertainty: Combining supply-side methods to
value equivalent demand-side resources. Paper presented at the
32nd IAEE International Conference, San Francisco, June 21–24,
2009. Integral Analytics values these programs using DRPricer,
the firm’s proprietary software developed for this purpose.
Natural Gas & electricity
MAY 2011