Social Welfare Implications of Demand Response Programs in Competitive Electricity Markets

The price volatility exhibited by wholesale electricity markets has stymied the movement to restructure the industry, and may derail it altogether. Market designers argue that prices are superior to regulation for directing long-term investments to the proper location and function, and that price volatility is a natural manifestation of a robustly competitive market. However, episodes of prices that soar to previously unimaginable heights try customers' patience and cause policy makers to reconsider if the prize is worth the consequences. As a result, there is growing enthusiasm for short-term demand response (DR) programs, including real time pricing (RTP) service, in regulated and competitive markets and load curtailment programs offered by utilities and ISOs. However, there is not universal agreement as to how such programs should be structured or what entity or entitles should offer them to retail customers. There has been only limited and somewhat abstract discussion in the literature to demonstrate exactly how DR programs can contribute to market efficiency, the management of market risk, and the overall social welfare in restructured electricity markets. This explains in part the current controversy over the role and value of DR in wholesale electricity markets, and who should be implementing them to end use customers. The debate can be summarized as follows: should load curtailments by retail customers be treated as resources that supplement generation reserves and compete against generation energy supply bids, as is currently accommodated to various degrees by the most of the existing ISOs? Or, does this practice amount to the ISO overstepping its charter, resulting in subsidies that disrupt long-term market efficiency more than they contribute in terms of short-term benefits (Ruff, 2002)? Setting the self- interests of the parties to the debate aside, the salient issue is whether the benefits, however distributed, justify incorporating DR directly into the design and structure of wholesale electricity markets. Or, should we stand resolutely on principle, waiting for DR to come about naturally as a result of initiatives by retailers or customers based on their expectations of private benefits (i.e., the value of DR only to their specific portfolio). We contend that at the heart of that issue is whether electricity is a private or public good, as that ES-II determination clarifies whether there is justification for accommodations in wholesale and retail market transactions to attract participation in DR programs, or alternatively to let customer load participation come about in the course of competition, at whatever rate private valuations dictate. This paper demonstrates that there is a gap between the private and public value of DR that justifies treating load as a resource and paying market prices or value for curtailments undertaken at the direction of the ISO. We focus primarily on two classes of ISO-administered DR programs: energy programs in which retail customers bid load curtailments into ISO-run energy markets and are paid at the market-clearing price if the curtailment is scheduled, and capacity programs in which customer load curtailments are dispatched by an ISO in order to preserve system reliability and are compensated accordingly. These activities are distinguished from demand response implemented by retailers specifically to lower their supply costs or undertaken by customers to reduce their utility bills, in either case with no explicit regard to the system or social consequences.