Incentive effects of paying demand response in wholesale electricity markets

Recently issued U.S. Federal Energy Regulatory Commission regulations require comparable treatment of demand reduction and generation in the wholesale electric market so that they are compensated at the same market clearing price. The new regulations measure demand reduction as a reduction from a “customer baseline,” a historically based estimate of the expected consumption. In this paper, we study the incentive effects on the efficiency of the demand response regulation using a static equilibrium model and a dynamic extension of the model. Our analysis provides three main results. Firstly, our analysis shows that the demand reduction payment will induce consumers to (1) inflate the customer baseline by increasing consumption above the already excessive level during normal peak periods and (2) exaggerate demand reduction by decreasing consumption beyond the efficient level during a demand response event. This result persists when applied to alternative baseline designs in a dynamic model. Secondly, we study alternative policy remedies to restore the efficiency of demand response regulation and introduce a new approach to define the customer baseline as a fixed proportion of an aggregate baseline. In particular, the aggregate baseline approach can significantly weaken or eliminate the incentive to inflate the baseline. Finally, we illustrate that if the baseline inflation problem is solved and demand and supply functions are linear, the current policy can produce a net social welfare gain. However, the welfare improvement requires that demand reduction be paid only when the wholesale price is at least twice the fixed retail rate. This argues that the policy should include a sufficiently high threshold price below which demand response is not dispatched.