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Pricing Negawatts

DR design flaws create perverse incentives.

Fortnightly Magazine - August 2010

this is inefficient and someone would bear the $50 loss. Who bears that cost depends on how the ISO recovers its payments to the customer’s ARC.

To motivate a retail customer to offer prices reflecting the full economic value of its associated energy reductions, the ARC should pay the customer the energy market price less the customer’s MFRR. Knowing that its MFRR would be netted off the payments it receives, the customer would have a strong incentive to offer prices that fully and accurately reflect the productive values of the associated energy reductions.

Paying a retail customer the energy market price less its MFRR, produces the same net result as paying the customer the energy market price for the energy it “resells” to the wholesale market through its ARC and requiring the customer to purchase that energy from its LSE under its retail tariff. FERC initially adopted this sale-for-resale paradigm as the basis for declaring jurisdiction over retail customer DR, but no longer relies on it. 11

In reality, neither the retail customer nor its ARC injects energy into the transmission grid when the customer reduces its load in response to an incentive payment. Thus, DR isn’t the typical sale-for-resale in which energy is purchased by one entity and simultaneously resold to another entity. What the retail customer sells through its ARC isn’t physical energy, but rather a call option on energy.

Defining a Negawatt-hour

A retail tariff endows the customer with call options to purchase energy in any hour at a strike price equal to the marginal energy price in its tariff, i.e., at the customer’s MFRR. By reducing its energy usage in some hour in return for a payment from an ARC, the retail customer effectively sells to the ARC a call option that matures in that hour. The ARC then resells the option to the ISO which, in turn, resells it to one or more wholesale buyers. All of these purchases and sales trade financial products, not energy.

Because an ISO is revenue-neutral, the amount it pays the ARC for a call option must equal the amount it collects from wholesale buyers. One obvious beneficiary of such a call option is the load-serving entity (LSE) serving the retail customer that originated the call option. This is because the option, if retired unexercised, relieves the LSE of the obligation to purchase the option’s underlying energy at the market price in the hour of maturity and sell the energy at a loss to the retail customer. Thus, the LSE voluntarily will pay up to the market price minus MFRR for the option, at which price it will be indifferent to whether the demand reduction occurs.

Obviously, the LSE would prefer to free ride by enjoying the benefits derived from its customers’ demand reductions while letting someone else pay for those reductions. Such free riding can be avoided if the ISO recovers the DR payments from the LSE whose retail customers provided the DR. For example, assuming a given ARC’s customers all were served at retail by one LSE, the targeted