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Demand Response: What it Really Means, and What it Implies

(Simplifying Unnecessarily Complicated Proposals for the Efficient Pricing of Electricity)

John KellyDirector, Economics and ResearchAmerican Public Power Association

Washington, DC

Presented at theCalifornia Municipal Rates Group Fall Conference

La Quinta HotelLa Quinta, California

October 25, 2007

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Novelist Sybil Bedford wrote …

“Only so much can be written about a

subject before it becomes a racket.”

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Point One:

Many Discussion of Demand Response are

vague or unnecessarily complex and

sometimes strays from basic economic

principles.

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Point Two:

DR Discussions often stray or ignore the

most basic economic principles.

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Aims Here:

A. Clarify, focus, and refine discussion

B. Propose simplified yet effective alternatives

DR pricing proposals (e.g., RTP, Critical

Peak Pricing, etc.)

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Overview:

I. Current discussion

II. Brief look back

III. Compare & Contrast

IV. Bridge – Marginal Cost Pricing Experiment at Lincoln (NE) Electric Service

V. DEED Research Project on MCP Methodology

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Current Demand Response Reports/Activities

General Accountability Office Report (2004)

Energy Policy Act of 2005

Demand Response Research Center

Peak Load Management Association

Critical Peak Pricing (Calif. Statewide Pricing Pilot)

The Long-Run Efficiency of Real-Time Electricity Pricing, UC Energy Institute, et al

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Demand Response: Definition

“Changes in electricity usage by end-use customers from their

normal consumption patterns in response to changes in:

(1) the price of electricity over time, or to

(2) incentive payments to induce lower electricity use at times of high wholesale market prices or when

system reliability is jeopardized.”

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Demand Response: Definition

Simply says – Demand Curve for Electricity is Downward Sloping.

Side-steps problem – most prices for “normal consumption” do not reflect the economic costs of electricity;

Consequently, the so-called normal consumption is actually abnormal;

And when costs during peak hours may be 5, 6 or more times non-peak hours, not surprising that the aggregate demand for electricity will vary significantly.

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Correctly Defines Problem -- Initially

Disconnect between short-term marginal electricity production costs and retail rates paid by consumers leads to an inefficient use of resources;

Customers don’t see the underlying short-term cost of supplying electricity … and have little or no incentive to adjust their demand or supply-side conditions;

Flat electricity prices encourage customers to over-consume relative to an optimally efficient system in hours when electricity prices are higher than average rates, and under-consum in hours when the cost of producing electricity is lower than average rates.

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As a Consequence …

“Electricity costs may be higher than they would otherwise be because high-cost generators must sometimes run to meet the non-price responsive demands of consumer.”

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Improved capacity factors and lower costs all but ignored

Little ever said about the “wasteful idleness” identified by Clark …

or about the efficient use of available resources discussed by Watkins, Hotelling, or Vickrey (i.e. Capacity Factors

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Early Engineers:

Alfred Gibbings came close to holding that prices should equal marginal costs.

(1894)

Criticized rates based on demand charges on grounds that are essentially the same as those modern economists use to criticize demand charges.

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W.S. Barstow argued that a utility should charge “customers a low rate during the light load” periods.

“(1st.) The broadening of the maximum peak, and

(2nd.) an equally important result, the increasing of minimum peaks; that is it encourages the forming of peaks during the minimum period of the load curve.”

(1895)

Noted “that time-of day meters had progressed to the point that they were available from both General Electric and Westinghouse” in test cases by the use of a double meter with clock working controlling devices.”

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Early and Modern Economists:

“If consumers can make extra demands on the utility without paying as much as the extra expense they are causing, they are likely to make wastefully large demands on it .... But any consumers who can not make extra use of the utility without paying many times more than the extra expense they would be causing, will skimp on their use, and the tendency will be to keep the plant in wasteful idleness.” [emphasis added]

John Maurice Clark

(1911)

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The main reason customers should be charged more during peak periods than non-peak periods is not to recover costs. Rather, it was to encourage consumption during non-peak hours, thereby making better use of utility plant and lower the average cost of electricity.

George Watkins (1921)

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Electric rate structures should “be developed by careful weighing of the relevant factors with a view of guiding consumers to make efficient use of facilities that are available.”

Short-run marginal cost “must play a major and even dominant role in the elaboration of any scheme of rates or prices that seriously pretends to have a major motive of the efficient utilization of available resources and facilities

William Vickrey (1955, 1992)

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Costs As Such

Opportunity costs:

“The simple, though far-reaching, observation that the true cost of any action can be measured by the value of the best alternative that must be foregone when the action is taken.”

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For firms making business decisions.

Not all costs are relevant for every pricing decision.

Relevant costs are “costs that are incremental (not average), avoidable (not sunk).

Relevant costs are “those that actually determine the profit impact of the pricing decision.

Thomas Nagle and Ronald Holden

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For Electricity … “Short-run marginal social cost” should reflect:

Replacement costs of fuel;

Using up of capital;

Harm to the environment;

Likelihood of impaired quality of service to other customers.

William Vickrey (1992)

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DOE Recommendations: Restrained and fail to follow the logical consequences of

its assertion about the “disconnect between electricity production costs and retail prices.”

States should consider adopting” real-time-pricing as a customer option or as default service means that customers should continue to be “given the option” of whether they want to pay the real economic cost of electricity.

More Studies?

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“Cost” – as such – Given Short Shrift in Current Discussions

Assumption is that time-of-use prices customers should reflect market prices and that market prices reflect competitive prices.

Important connection between economic costs and market prices given short shrift .

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States with retail competition “should consider adopting [real-time-pricing] as an option or default service for large customers;”

States that do not allow retail competition should consider offering RTP to these customers on an optional basis for large customers;

For small businesses more studies to determine if “homogeneous sub-sectors” may be “better candidates for price-based demand response” programs.

Similarly, for residential customers, more studies to investigate the cost-effectiveness of time-or-use pricing and critical peak pricing programs in particular.

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However, elsewhere …

Price-based demand response programs are recommended because they:

-- “reflect the value” of electricity in different periods as well as its cost;

-- “The most important benefit of demand response is improved resource efficiency of electric production due to closer alignment between customers’ electricity prices and the value they place on electricity.”

TOU pricing is discussed in the context of “time-varying value of electricity” and the notion of time-varying costs all but falls out of the picture.

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Bridge: MCP Study at Lincoln (NE) Electric System

Purpose: Measure the impacts of MCP on revenue recovery:

(1) Overall; and

(2) Between Customer Classes

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Estimated Average Hourly Revenues with Average Costs and Marginal Cost Pricing, Year 2004

0

5

10

15

20

25

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 0

Hour

Do

llar

s (t

ho

usa

nd

s)

Marginal Cost Pricing

Average Cost Pricing

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Estimated Average Hourly Revenues by Season (June, July, August), with Average Costs and Marginal Cost Pricing

0

5

10

15

20

25

30

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 0

Hour

Do

llar

s (t

ho

usa

nd

s)

Marginal Cost Pricing

Average Cost Pricing

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A Modest Yet Effective Approach to TOU Pricing

Oftentimes …

“The Best is the Enemy of the Good.”

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Benefits of TOU Pricing:

Capacity Utilization;

Reduced peak capacity;

Eliminate Cross Subsidies;

Investment and Use Ramifications for Businesses and Households

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Proposal: Expand and Refine Current TOU Pricing Programs

Expand to most all customers:

Refine: (1) Number of Periods (12-20);

(2) Variation in Prices (1to 30 times or so depending on

short-run marginal social cost)

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Modest administrative adjustments to existing TOU pricing programs would pay large economic dividends.

Use Existing TOU Pricing Programs as Model

Magnetic Matrix for Fridge Sent in Jan.