Demand Response in California’s Electricity Future

1. Demand Response in California’s Electricity Future by Severin Borenstein, Professor, Haas School of Business Director, UC Energy Institute (www.ucei.org)

2. A Brief History of Electricity Pricing • In the beginning, there was no metering • Then <someone> begat aggregate consumption meters • Businesspeople and economists said it was better • But utilities still had to plan for highest plausible demand • Unlike nearly most other industries, price didn’t adjust to reflect demand changes • Technology to do so didn’t exist or was too expensive • “buyers wouldn’t respond to prices anyway”

3. “System Operator’s 1st, 2nd, and 3rd, priority is reliability” • Avoiding blackouts was/is job #1 • But, maybe in a pinch demand could help out • Thus begat “interruptible service” • Lower rate, but first to black out if system is short • Promise not to black out very often • Actually, mainly an industrial customer discount • “Interruptions” were actually just high prices • Interruptible service minimizes phone calls, but is the most costly way to ration demand • Not all power usage has the same value • Not all power usage is “critical to our lives”

4. Time-Varying Prices for Electricity • Time-of-Use Pricing • Peak/Off-peak, but highest costs are in few hours • TOU with Demand Charges • Old technology attempt to capture highest peaks • Critical Peak Pricing • New technology attempt to capture highest peaks • Paying for Demand Reduction • The “nice guy” approach, but with many headaches • Realtime Pricing • The gold standard

5. The Value of Time-Varying Retail Prices • Efficient pricing in the short-run gives efficient incentives to consume • and efficient load shifting among periods • Efficient pricing gives optimal long-run incentives to invest in capacity • More immediate demand response reduces generator incentive to exercise market power in wholesale market • Reduces need for reserve capacity • Bottom Line: Lower Long-Run Costs, Higher Consumer Benefits, CSEM WP#116

6. Methods for Implementing Time-Varying Retail Pricing • Key differences among plans • Granularity of retail prices • Timeliness of retail price setting - “dynamic” • Adaptability to varying revenue target • Bill Volatility – protection against price spikes • Granularity and Timeliness are different, but interact in important ways • Adaptability need not conflict with protection against volatile bills

7. Flat-Rate Service Revisited • poor granularity, no time variation • prices are not timely, change annually (?) • very adaptable -- change rate to hit revenue target, but prices are very inefficient • protection against volatile bills • Wholesale price spikes smoothed over long periods

8. Real-Time Retail Pricing (RTP) • Excellent Granularity • Prices usually change hourly • Very Good to Excellent Timeliness • Using “day-ahead” or “real-time” price • Arguments against RTP • bills will be volatile • not adaptable to meet revenue requirements • BUT straightforward alterations to RTP overcome these objections

9. Issues in Implementing RTP • Customer Price/Bill Risk on RTP • Meeting Retailer/Utility Revenue Requirements • Mandatory versus Voluntary RTP • RTP and Reserve Requirements

10. Mitigating Customer Risk Under RTP • Customer risk comes from the possibility of unexpected high wholesale prices • Hedge through long-term contracts • Active Hedging by Customers or Hedging by Retailer on Behalf of Customer • How to pass along gain/loss from hedge while minimizing distortion of retail price?

11. Mitigating Customer Risk Under RTP • Retailer Hedges for Customers • Still charges RTP on the margin • Passes through gains/losses from hedge with minimum distortion of retail price • Customer Baseline Load (CBL) approach • Constant adder/subtractor to retail RTP • Active Hedging by Customers • “BYO Baseline” offered by retailer • Hedging instruments from energy sector

12. Meeting Retailer/Utility RevenueRequirements Under RTP • RTP revenues won’t match retailer’s costs • if some power bought under long-term contract • if some power generated by retailer • if retailer has fixed costs unrelated to energy • e.g., distribution costs • if retailer has sunk/stranded costs

13. Meeting Retailer/Utility RevenueRequirements Under RTP • Collect differential as lump-sum, so marginal price is still RTP • CBL approach does this • Politics of setting lump-sum levels/baselines • Collect differential as constant per kilowatt-hour adder or subtractor • still have variability in RTP • small inefficiency of consumption

14. Example: Passthrough of Fixed Hedging Gains with Constant “Subtractor”

15. Mandatory versus Voluntary RTP • If RTP is so great, why do we have to make it mandatory? We don’t. • But don’t cross-subsidize flat rate customers • The vicious cycle of equalizing average price between RTP and non-RTP customers • some RTP customers will always be paying more than they would on flat rate so will switch to flat • eventually RTP collapses

16. Voluntary RTP Without Cross-Subsidy • The virtuous cycle of allowing each group to stand on its own -- no cross-subsidy • lowest-cost customers on flat-rate better off switching to RTP • mimics a competitive market outcome • lower prices for those who are cheaper to serve • if that’s “cherry picking,” I’m for it • all customers still pay for fixed/sunk costs, • not a method for dodging sunk cost liability

17. The Role of Demand Response in Resource Adequacy and Reserves • RTP will not eliminate the need for reserves • so long as price-responsive demand is slower than callable supply • But RTP offers more than peak demand reduction • demand “tilts” as well as shifts • RTP will gradually reduce use of reserves • as system operators recognize its reliability • Eventually, RTP will reduce the standard for percentage reserves

18. Demand Response and Renewables • Demand response flattens load, reducing peaks and raising off-peaks • Reduces use of peaker gas power • Helps wind and solar power • Can make baseload coal more attractive • Demand response is not Energy Efficiency • Both will play a critical role in CA energy future

19. How Price-Responsive is Demand? • Evidence from California 2001 and other conservation programs • Evidence from RTP programs and pilots • Evidence from dynamic pricing programs and pilots • These estimates almost certainly understate price responsiveness as technology improves • The next programmable thermostat

20. Where is Demand Response in now? • Nowhere in California (worse than pre-2000), but working groups and pilot projects to restart it – CPUC/CEC joint initiative • Still great resistance to RTP. Most initiatives are Critical Peak or paying for demand reduction • Open question of resource adequacy for a “non-core” group and role of demand response

21. Conclusions • Static pricing of electricity is based on old metering technology, has large inefficiency • RTP is the gold standard of electricity pricing • Resistance to RTP is understandable, but not difficult to address • Real barrier to RTP is metering cost, but only for small customers (and maybe not even them) • starting with large customers probably gets biggest bang for buck • Demand response will play significant role in resource adequacy and future CA electricity industry