Compensation of demand response in competitive wholesale markets vs. retail incentives

In 2011 the Federal Energy Regulatory Commission (FERC) issued a landmark ruling, FERC Order 745, standardizing the compensation of demand response (DR) in competitive wholesale markets. According to this order, demand response resources participating in competitive wholesale energy markets must, like generators, be paid full locational marginal price (LMP). Many economists opposed this ruling and argued that the most efficient method is to offer dynamic prices and naturally, demand reductions are rewarded with the avoided cost of the energy not used. One of the main arguments against the order is the fact that by paying LMP for demand reductions, the market collects less in revenue than it must pay out for resources, a phenomenon known as “the billing unit effect” and must therefore, allocate the shortfall. In this paper we compare wholesale DR compensation to retail level incentives. We define demand response as a short-term added cost for the load serving entity (LSE), voluntarily paid in order to save money over the long run. Based on this view of DR, we propose a benefit sharing incentive scheme at the retail level. This scheme involves the use of a publicly broadcast grid state index implemented by the California Independent System Operator (CAISO).