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Areas of Congruence, Yes, But ‘Pseudo-Agreement’ on LMP
Areas of Congruence, Yes, But ‘Pseudo-Agreement’ on LMP
T
he correspondence between Robert Borlick1 and Jonathan Falk and Michael Rosenzweig2 on demand response compensation has not only been entertaining, but has been surprising in that Messrs. Falk and Rosenzweig ultimately conclude they and Mr. Borlick agree on almost every issue, except for taking the last step to concede that LMP (rather than LMP: the retail rate, G) should be paid to demand responders (DRs) – regardless of cost allocation. I assess the surprising degree of consensus and the subtle differences between these economists in Table 1. I amplify on only some of the points. Their apparent agreement that DRs should be paid LMP is only a pseudo-agreement because Mr. Borlick qualifies that the loadserving entity (LSE) should be billed LMP for each MWh of demand response in its territory. This breaks down the apparent consensus completely since the LSEs will allocate these costs. The logical step for them, according to Mr. Borlick, is to bill the DR the retail rate G, thus the DR’s net
10
(LMP G), so they no longer get a free ride of not paying for energy they don’t use but effectively resell to the ISO at LMP. As Mr. Borlick states, ‘‘That’s all there is to it!’’ Both agree that a call option is the appropriate framework for analyzing the value of demand response. First, neglecting any difference in LMP between when the demand responder exercises in the day-ahead market and the final settling value of LMP, Mr. Borlick believes the strike price equals G while Messrs. Falk and Rosenzweig believe it is too complicated to assess, and really depends on each individual demand responder’s opportunity cost. All energy marketers know that when they price retail deals, the financial option value of power struck at a fixed price (such as G) is simply the intrinsic value (LMP G) at the time the customer actually consumes the power. However, customers have various operational constraints, load factors, and preferences so a marketer can give a better price to a customer with a better load
1040-6190/$–see front matter # 2012 Elsevier Inc. All rights reserved.
factor – because the customer is not exercising the real option optimally. But this is not the problem here. What is, is assessing the financial value of the option when they do exercise it regardless of a customer’s individual preferences. The price paid for demand response is going to be the same for a steel mill as for a discount tire chain. And at option exercise time in the day-ahead market, there is no time value left. Thus the option strike price is G and the net value of the option is (LMP G). There is some question since when the demand responder exercises, additional hours may elapse further during which LMP continues to fluctuate before settling at the close price. Both believe this creates more option time value: Mr. Borlick a little, and Messrs. Falk and Rosenzweig, a lot. But because the demand responder cannot further opt out of his option election when LMP closes, he is stuck with whatever he gets. LMP may fluctuate in his favor. Or it may go against him. Because the expectation value either way is the same, these cancel so there is no additional premium value at the exercise time in the day-ahead market. Put in commodities market terms, at option exercise the demand responder exchanges the option for a short-term futures contract. Then, the forward price of, say, a commodity like corn might be LMP with respect to the option to buy corn at G; a day later the price might settle at LMP0 .
The Electricity Journal
Jan./Feb. 2012, Vol. 25, Issue 1
Table 1: Where the Debaters Stand on Key Issues, from Who Pays Cost of Demand Response to Falk’s Hilarity Issue ISO should pay DR’s LMP
ISO should charge LSEs for cost of demand response
Falk Position Yes
States should rectify any unproven
Borlick Position
Comment
Yes, if and only if ISOs bill LSEs the
If the LSEs are charged LMP they will probably bill demand resources
LMP for perceived demand reduction due to DR; otherwise,
G since to do otherwise is to explicitly burden their residential and small commercial users with cost of demand response (‘‘missing
ISOs should pay DRs (LMP G)
money’’). The LSE loses (LMP G), which it would have anyway if the DR resource had not responded
Yes
financial imbalance. . . if any (probably not)
Falk’s qualified ‘yes’ appears to be a way to blur differences rather than overt disagreement. . . since he implies there is no financial imbalance. Besides, it’s unlikely the states will either be given this responsibility or take it, so it becomes a moot point. In any case, FERC order 745 precluded cost allocation to DRs
Environmental benefits should be
Yes
Yes
accounted for 1040-6190/$–see front matter # 2012 Elsevier Inc. All rights reserved.
Call option is appropriate way to
Falk believes there are substantial (but unquantifiable) benefits to reducing apparent load while Borlick is agnostic although apparent load reduction due to BTM generation results in
Yes
value DR The option strike price is G
No, the strike price is the
Option value is substantial at exercise and should be
Yes – not exactly sure what that premium value should be but it’s
Yes
environmental externalities, not benefits Everyone (Kahn, Hogan et al.) is agreed on this; however, there is
Yes
disagreement on what this option is worth The strike price is G
No – option value is small over intrinsic value of (LMP G)
Call option premium over intrinsic value (LMP G) is actually zero at time of exercise. Even though there may be a delay between when
customer’s opportunity cost
compensated
Behind the meter (BTM) generation should operate whenever its marginal cost < LMP, and should receive LMP, the same as wholesale generation
got to be substantial and LMP is close enough without further
a DR elects to curtail and when LMP is determined, during which LMP may change substantially from its value at the time of the DR
analysis as a premium over
election, because it’s just as likely to vary in favor of the DR as
(LMP G)
against it, there is no premium value. Essentially, at the time the DR elects to participate, he is exercising his option and receiving a
Yes
Yes
swap for LMP instead of cash right away Motherhood and apple pie
11
12 Table 1 (Continued )
1040-6190/$–see front matter # 2012 Elsevier Inc. All rights reserved.
Issue
Borlick Position
Comment
No; this provides free energy to BTM generators for running their
Unclear why Falk believes debiting BTM customers G for the value of load they continue to operate; he equates this with depriving wind
apparent consumption even though load is still active (fed by
loads. Thus BTM customer should be debited G for load they
generators of the production tax credit for their generation. That is to say, equating the outcome of a subsidized example with an
BTM generation)
continue to operate even though
unsubsidized case that could be based on economic efficiency
BTM customers should avoid paying G for reduction in
Operation of BTM generation is
Falk Position Yes
Yes
powered by the BTM unit. Yes
indistinguishable from DR caused by reduced consumption
Falk concludes that therefore all DRs should be paid LMP; Borlick concludes that because the retail value of the load the customer continues to operate must be accounted for, with a net payment to the BTM generator of (LMP G), all DR should receive the same,
DR compensation should replicate incentives for a real-time-pricing customer
No; demand response is a supply
Yes
resource, should be treated equivalently to a supply
economic activity with the same result (curtailment by load in nonshortage/emergency conditions) can have different values at the
resource, and has nothing to do
same time.
with demand bidding Yes
Yes
FERC has an obligation to avoid
No – as long as rates are ‘‘just and
Yes
introducing market inefficiencies ISO’s do more than balance supply
reasonable’’ Yes
Yes
and demand DR payments should reflect value of
Yes
No
Economists are sometimes ignored
not LMP (unless the LSE reallocates costs further, as above) Borlick is correct; to argue otherwise is to argue that the same
by markets, which are often inefficient
lost load
FERC NOPR at p. 2: ‘‘This. . . provision will not apply to demand response under programs that ISOs and RTOs administer for reliability or emergency conditions;’’ however, DRs activated
The Electricity Journal
under these circumstances should receive other compensation, such as ancillary services or capacity payments for the willingness to curtail on demand by the ISO to avoid load shedding Falk is hilarious
Yes
Yes
No comment
There is no extra premium value as there is no longer any option contract. Another philosophical difference between the two sides is whether demand response energy payments should consider the very high value of lost load (VOLL). The Federal Energy Regulatory Commission was explicit that its order 745 did not apply to emergency supply conditions, only to ‘‘economical’’ demand response. Thus, for the purposes of the FERC order, premiums relating to VOLL are not relevant. However, demand response has critical value for aiding system reliability providing that the system operator is able to order load curtailments and count on compliance. Demand responders have argued that what they provide is a service by finding customers the ISO can dispatch, distinct from load response via real-time pricing or other
voluntary programs. This is inseparable from the value demand response provides during system critical events and is best seen as an ancillary service such as a reliability reserve. Or it can be compensated by capacity payments, as in many market regions. FERC appropriately suggested either solution. Thus full compensation for this service may be provided these ways without interfering with price formation in energy markets. A typical capacity value for demand response might be $5/kW-mo ($60,000/MW-year) while the energy value realized might be at most 200$/MWh called, for 40 hours/year equaling $8,000. Thus even for conservative assumptions, the capacity value of demand response dwarfs the energy value. This should bring perspective to the debate so we can focus our attention on a critical issue,
Falk, Rosenzweig to Borlick: We Agree on Price, but Who Pays, And in What Form?
N
ow that we agree that whoever offers to bring supply and demand closer in
Jan./Feb. 2012, Vol. 25, Issue 1
balance should be paid LMP, which was the question that the FERC asked and is the answer
incentives for demand response in capacity and ancillary service markets, while avoiding energy market distortions.& Endnotes: 1. Robert Borlick, Electricity Journal (Nov. 2011) at 9 and 25. 2. Jonathan Falk, Electricity Journal (Nov. 2010), at 13; and Jonathan Falk and Michael Rosenzweig, Electricity Journal (Nov. 2011), at 19 and 30.
Constantine Gonatas, of CPG Advisors, consults extensively in energy markets, with both public and private sector work covering renewables, project development, economic, technology and regulatory assessments. Earlier in his career he led business development teams at Enron in utility acquisitions and restructuring, and new technology development at ExxonMobil. He holds a B.A. in Physics from Princeton, a Ph.D. in Physics from the University of Chicago, and an M.B.A. from Babson College. doi:/10.1016/j.tej.2012.01.005
that we and Fred Kahn have always given, we can now turn to the tricky, succeeding question of how that price should be collected. Who should pay it and in what form? The ISO is just a pass-through nonprofit entity, who will end up collecting everything they send out in some way, whether by charges to LSEs who take power or through uplift of some sort. We have no opinion on this at all, other than to say that if the current institutional arrangements leave a revenue collection
1040-6190/$–see front matter # 2012 Elsevier Inc. All rights reserved.
13
T
he correspondence between Robert Borlick1 and Jonathan Falk and Michael Rosenzweig2 on demand response compensation has not only been entertaining, but has been surprising in that Messrs. Falk and Rosenzweig ultimately conclude they and Mr. Borlick agree on almost every issue, except for taking the last step to concede that LMP (rather than LMP: the retail rate, G) should be paid to demand responders (DRs) – regardless of cost allocation. I assess the surprising degree of consensus and the subtle differences between these economists in Table 1. I amplify on only some of the points. Their apparent agreement that DRs should be paid LMP is only a pseudo-agreement because Mr. Borlick qualifies that the loadserving entity (LSE) should be billed LMP for each MWh of demand response in its territory. This breaks down the apparent consensus completely since the LSEs will allocate these costs. The logical step for them, according to Mr. Borlick, is to bill the DR the retail rate G, thus the DR’s net
10
(LMP G), so they no longer get a free ride of not paying for energy they don’t use but effectively resell to the ISO at LMP. As Mr. Borlick states, ‘‘That’s all there is to it!’’ Both agree that a call option is the appropriate framework for analyzing the value of demand response. First, neglecting any difference in LMP between when the demand responder exercises in the day-ahead market and the final settling value of LMP, Mr. Borlick believes the strike price equals G while Messrs. Falk and Rosenzweig believe it is too complicated to assess, and really depends on each individual demand responder’s opportunity cost. All energy marketers know that when they price retail deals, the financial option value of power struck at a fixed price (such as G) is simply the intrinsic value (LMP G) at the time the customer actually consumes the power. However, customers have various operational constraints, load factors, and preferences so a marketer can give a better price to a customer with a better load
1040-6190/$–see front matter # 2012 Elsevier Inc. All rights reserved.
factor – because the customer is not exercising the real option optimally. But this is not the problem here. What is, is assessing the financial value of the option when they do exercise it regardless of a customer’s individual preferences. The price paid for demand response is going to be the same for a steel mill as for a discount tire chain. And at option exercise time in the day-ahead market, there is no time value left. Thus the option strike price is G and the net value of the option is (LMP G). There is some question since when the demand responder exercises, additional hours may elapse further during which LMP continues to fluctuate before settling at the close price. Both believe this creates more option time value: Mr. Borlick a little, and Messrs. Falk and Rosenzweig, a lot. But because the demand responder cannot further opt out of his option election when LMP closes, he is stuck with whatever he gets. LMP may fluctuate in his favor. Or it may go against him. Because the expectation value either way is the same, these cancel so there is no additional premium value at the exercise time in the day-ahead market. Put in commodities market terms, at option exercise the demand responder exchanges the option for a short-term futures contract. Then, the forward price of, say, a commodity like corn might be LMP with respect to the option to buy corn at G; a day later the price might settle at LMP0 .
The Electricity Journal
Jan./Feb. 2012, Vol. 25, Issue 1
Table 1: Where the Debaters Stand on Key Issues, from Who Pays Cost of Demand Response to Falk’s Hilarity Issue ISO should pay DR’s LMP
ISO should charge LSEs for cost of demand response
Falk Position Yes
States should rectify any unproven
Borlick Position
Comment
Yes, if and only if ISOs bill LSEs the
If the LSEs are charged LMP they will probably bill demand resources
LMP for perceived demand reduction due to DR; otherwise,
G since to do otherwise is to explicitly burden their residential and small commercial users with cost of demand response (‘‘missing
ISOs should pay DRs (LMP G)
money’’). The LSE loses (LMP G), which it would have anyway if the DR resource had not responded
Yes
financial imbalance. . . if any (probably not)
Falk’s qualified ‘yes’ appears to be a way to blur differences rather than overt disagreement. . . since he implies there is no financial imbalance. Besides, it’s unlikely the states will either be given this responsibility or take it, so it becomes a moot point. In any case, FERC order 745 precluded cost allocation to DRs
Environmental benefits should be
Yes
Yes
accounted for 1040-6190/$–see front matter # 2012 Elsevier Inc. All rights reserved.
Call option is appropriate way to
Falk believes there are substantial (but unquantifiable) benefits to reducing apparent load while Borlick is agnostic although apparent load reduction due to BTM generation results in
Yes
value DR The option strike price is G
No, the strike price is the
Option value is substantial at exercise and should be
Yes – not exactly sure what that premium value should be but it’s
Yes
environmental externalities, not benefits Everyone (Kahn, Hogan et al.) is agreed on this; however, there is
Yes
disagreement on what this option is worth The strike price is G
No – option value is small over intrinsic value of (LMP G)
Call option premium over intrinsic value (LMP G) is actually zero at time of exercise. Even though there may be a delay between when
customer’s opportunity cost
compensated
Behind the meter (BTM) generation should operate whenever its marginal cost < LMP, and should receive LMP, the same as wholesale generation
got to be substantial and LMP is close enough without further
a DR elects to curtail and when LMP is determined, during which LMP may change substantially from its value at the time of the DR
analysis as a premium over
election, because it’s just as likely to vary in favor of the DR as
(LMP G)
against it, there is no premium value. Essentially, at the time the DR elects to participate, he is exercising his option and receiving a
Yes
Yes
swap for LMP instead of cash right away Motherhood and apple pie
11
12 Table 1 (Continued )
1040-6190/$–see front matter # 2012 Elsevier Inc. All rights reserved.
Issue
Borlick Position
Comment
No; this provides free energy to BTM generators for running their
Unclear why Falk believes debiting BTM customers G for the value of load they continue to operate; he equates this with depriving wind
apparent consumption even though load is still active (fed by
loads. Thus BTM customer should be debited G for load they
generators of the production tax credit for their generation. That is to say, equating the outcome of a subsidized example with an
BTM generation)
continue to operate even though
unsubsidized case that could be based on economic efficiency
BTM customers should avoid paying G for reduction in
Operation of BTM generation is
Falk Position Yes
Yes
powered by the BTM unit. Yes
indistinguishable from DR caused by reduced consumption
Falk concludes that therefore all DRs should be paid LMP; Borlick concludes that because the retail value of the load the customer continues to operate must be accounted for, with a net payment to the BTM generator of (LMP G), all DR should receive the same,
DR compensation should replicate incentives for a real-time-pricing customer
No; demand response is a supply
Yes
resource, should be treated equivalently to a supply
economic activity with the same result (curtailment by load in nonshortage/emergency conditions) can have different values at the
resource, and has nothing to do
same time.
with demand bidding Yes
Yes
FERC has an obligation to avoid
No – as long as rates are ‘‘just and
Yes
introducing market inefficiencies ISO’s do more than balance supply
reasonable’’ Yes
Yes
and demand DR payments should reflect value of
Yes
No
Economists are sometimes ignored
not LMP (unless the LSE reallocates costs further, as above) Borlick is correct; to argue otherwise is to argue that the same
by markets, which are often inefficient
lost load
FERC NOPR at p. 2: ‘‘This. . . provision will not apply to demand response under programs that ISOs and RTOs administer for reliability or emergency conditions;’’ however, DRs activated
The Electricity Journal
under these circumstances should receive other compensation, such as ancillary services or capacity payments for the willingness to curtail on demand by the ISO to avoid load shedding Falk is hilarious
Yes
Yes
No comment
There is no extra premium value as there is no longer any option contract. Another philosophical difference between the two sides is whether demand response energy payments should consider the very high value of lost load (VOLL). The Federal Energy Regulatory Commission was explicit that its order 745 did not apply to emergency supply conditions, only to ‘‘economical’’ demand response. Thus, for the purposes of the FERC order, premiums relating to VOLL are not relevant. However, demand response has critical value for aiding system reliability providing that the system operator is able to order load curtailments and count on compliance. Demand responders have argued that what they provide is a service by finding customers the ISO can dispatch, distinct from load response via real-time pricing or other
voluntary programs. This is inseparable from the value demand response provides during system critical events and is best seen as an ancillary service such as a reliability reserve. Or it can be compensated by capacity payments, as in many market regions. FERC appropriately suggested either solution. Thus full compensation for this service may be provided these ways without interfering with price formation in energy markets. A typical capacity value for demand response might be $5/kW-mo ($60,000/MW-year) while the energy value realized might be at most 200$/MWh called, for 40 hours/year equaling $8,000. Thus even for conservative assumptions, the capacity value of demand response dwarfs the energy value. This should bring perspective to the debate so we can focus our attention on a critical issue,
Falk, Rosenzweig to Borlick: We Agree on Price, but Who Pays, And in What Form?
N
ow that we agree that whoever offers to bring supply and demand closer in
Jan./Feb. 2012, Vol. 25, Issue 1
balance should be paid LMP, which was the question that the FERC asked and is the answer
incentives for demand response in capacity and ancillary service markets, while avoiding energy market distortions.& Endnotes: 1. Robert Borlick, Electricity Journal (Nov. 2011) at 9 and 25. 2. Jonathan Falk, Electricity Journal (Nov. 2010), at 13; and Jonathan Falk and Michael Rosenzweig, Electricity Journal (Nov. 2011), at 19 and 30.
Constantine Gonatas, of CPG Advisors, consults extensively in energy markets, with both public and private sector work covering renewables, project development, economic, technology and regulatory assessments. Earlier in his career he led business development teams at Enron in utility acquisitions and restructuring, and new technology development at ExxonMobil. He holds a B.A. in Physics from Princeton, a Ph.D. in Physics from the University of Chicago, and an M.B.A. from Babson College. doi:/10.1016/j.tej.2012.01.005
that we and Fred Kahn have always given, we can now turn to the tricky, succeeding question of how that price should be collected. Who should pay it and in what form? The ISO is just a pass-through nonprofit entity, who will end up collecting everything they send out in some way, whether by charges to LSEs who take power or through uplift of some sort. We have no opinion on this at all, other than to say that if the current institutional arrangements leave a revenue collection
1040-6190/$–see front matter # 2012 Elsevier Inc. All rights reserved.
13