Delivering Cost-Effective Demand Response Through Dynamic Pricing

The long view of dynamic pricing and demand response1

Ahmad Faruqui2

Sometimes there is simply no need to be either clever or original. Ivan Chermayeff

Dynamic electricity pricing, including critical-peak pricing and real-time pricing, has been shown to be a viable method of delivering consumer-based demand response, i.e., reducing electrical peak demands during critical times when the power system is stressed. Such stress can be caused by a number of factors:

 Unanticipated increases A sudden spike in demand brought on by hot weather  SuddenA drop in supply because of unit outages, transmission congestion, or local emergencies (fire, earthquake)  Or the reliability consequencesa general failure of supply to keep up with rising demand of aAging distribution infrastructure  Not investing in new generation, transmission and distribution capacity at a rate commensurate with demand growthand unexpected customer growth that require demand-side solutions.

Any of these conditions will could threaten the security of the power system. They could create by either creating reliability problems that in the extreme case would lead to powerbrownouts and blackouts outages. Or they or would increase the cost of service by inducing that include by creating sspikes in wholesale power costs and that ultimately raise would lead to higher customer bills, bringing with them the inevitable and attendant political pushback by legislators fearing a voter backlash.

The cost-effectiveness of dynamic pricing as a means of delivering demand response is dependent on a variety of factors:

 Specific characteristics of geographical territoriescustomers, their demand-side load characteristics, and their sensitivity to weather  The amount of energy and demandload customers consume during the critical peak periods  The willingness and ability of customers to reduce theirse critical peak electrical usageloads in response to higher prices  The incremental costs of supplying these critical-peak loads with peaking generation units or by procuring power on wholesale spot markets.

1 For presentation at the Smart Metering West Coast 2006 Conference, San Francisco, California, August 30th. 2 I have benefited from comments on a previous draft by Tom Bottorff, Steve Braithwait, Robert Earle, Ed Fong, Joel Gilbert, Bill Hieronymus, Lynne Kiesling, Chris King, Roger Levy, Mark Martinez, Bernie Neenan and Greg Wikler. It is well known that the lack of dynamic poor pricing of electricity encourages over- consumption of power during peak times and under-consumption during off-peak times. This reduces economic efficiency both in the short and also in the long term, by holding back technological innovation that can enable price responsiveness.

It was largely in response to poor pricing of electricity that policy makers created regulatory-driven demand-side management (DSM) subsidy programs in the 1980s. Unfortunately, these programs were largely driven by cash rebates and incentives and proved unsustainable.

They were cut back substantially in the 1990s because no one could afford to spend billions subsidizing DSM investments indefinitely. Without proper pricing of electricity to reflect the true costs of service, a similar fate awaits DR technologies, such as advanced meters, smart thermostats, gateway systems, thermal energy storage and back- up generation.

They won’t be developed or penetrate the market, since there is a limit to how long any one will continue subsidizing their research and development with public monies. This could become a self-fulfilling prophecy. Without a large market, their costs will remain high, being deprived of economies of scale, effectively and so they will effectively be shutting them out of the market.

The Art of the Long View

Other speakers at this conference have addressed the near term outlook for dynamic pricing in a variety of markets. In this presentation, I want to focus on the long term outlook for dynamic pricing. 3 By long term, I really mean the very long term such as the half way mark in the 21st century: the year 2050.

This may seem to be an impossible task. Does anyone even know what will happen to power demand before this summer ends? On July 18th, unusually hot weather led to high peak demands throughout the United States, severely straining power systems. Every ISO/RTO set a new record on that date and in the days to come.4 Initially, all areas, despite the new record, power supplies were adequate to meet customer needs. But ultimately parts of the country began to be hit by blackouts that in some cases, such as in New York City, lasted for days.

Update – On Monday, July 24, 2006, Southern California Edison (SCE) experienced very hot temperatures and increased customer demand as a result of an extended heat wave. To reduce customerdemand-side load, it activated its large interruptible rate program for the first time this year, shedding over 500MW of load from large commercial and

3 From a resource planning perspective, one has no choice but to take a long view, since capital investments have long lead times. 4 California set a new record of 46,561 MW on July 18th and this rose to 49,036 MW on July 21st and crossed the 50,000 MW mark during the subsequent week. New England, comprised of six states, set a record of 27,374 MW on July 18th. On the same date, TVA, serving 8.3 million customers in seven states, set a new record of 32,037 MW. industrialC/I customers. The last time these programs were activated was during the transmission emergency on August 25 th , 2005

Texas was not so lucky on April 17th. On that day, 100-degree weather coincided with several generating units being out for spring maintenance and experienced blackouts. Planners failed to foresee both the April 17th and the July 18th events. If it is difficult to know what will happen tomorrow, it is even more difficult to know what will happen next summer.

Paradoxically, it is easier to talk about the very long run, if one is willing to expand the mind and engage in a bit of creative visioning. In this paper, I will use a technique used by a variety of firms that make new products. It goes with various names such as The Sleeper Awakes and the Rip Van Winkle method. I think you get the point. We are required to go into a Big Sleep that extends through the year 2049. We wake up on New Year’s Day and turn on the TV (or whatever form that device has morphed into by then). The year is 2050.

Our task during the next 10 minutes is to conjure up images of what the world of demand response would like then.

Perhaps the methodology does not appeal to the scientifically minded among you. If it makes you feel a little better, think that you are engaging in a path-breaking gedanken (thought) experiment. This could be the kind of experiment that John F. Kennedy dreamed of when he talked about sending a man to the moon, or the experiment that vision of aeronautical engineers engaged in when they who wanted to wanted to break the sound barrier or the experimental attitude of that of scientists who wanted to map the human DNA. Sometimes this process is dubbed Imagineering, i.e., creating a vision of what is possible.

So let’s begin our experiment and go into . We have now gone into the Big Sleep.

First VisionUtopia (California Dreamin’)

Before we slipped into The Big Sleep, we had celebrated the land-mark decision of the California Public Utilities Commission (CPUC) approving PG&E’s $1.7 billion AMI filing dealing with 5 million electric and 4 million gas customers under 200 kW demand.5 Commission president Michael Peevey had said this decision would propel PG&E’s customers into the 21st century, empowering them to make informed, intelligent choices about their electricity usage.

In subsequent years, that decision taken in 2006 was recognized as a watershed in the history of regulatory decisions affecting the electricity industry, since the changes it induced transcendeding those e changes that PURPA had wrought in 1978.

5 http://www.cpuc.ca.gov/PUBLISHED/NEWS_RELEASE/58233.htm. The CPUC’s decision was cloned by numerous state commissions on the two coasts and even by several in the nation’s heartland and southern regions that had traditionally abhorred dynamic pricing being offered to small customers. Driving factors were the Energy Policy Act of 2005 and succeeding federal legislation that spurred investments on the demand-side, triggered by a national consensus about climate change, rising oil and gas prices and continued turbulence and instability in the Middle East.

What also helped swing regulatory opinion was a major power crisis in the Mid-West, along the lines of the crisis that hit the 11 western states in 2000-01. Extreme weather conditions and high fuel prices brought on a shortage of power capacity during critical- peak times, triggering blackouts in several communities. Regulators and utilities began to see the value of dynamic pricing and demand response. This position was best articulated by a regulator from Illinois who said that the duo of dynamic pricing and demand response these tools werewas akin to the shock absorbers in a car. You don’t need them all the time, because most roads are smooth. However, when you hit a bump in the road, they prove invaluable (especially to those who suffer from back problems) and pay for themselves.

By the year 2015, the improbable had taken place. The whole nation was afflicted with Ddynamic pricing fever. for small customers was approved throughout the nation and aAdvanced meters and associated billing systems began to be rolled out. By 2020, they had blanketed the nation. Customers were given the option of choosing dynamic pricing or staying with their default, non-time varying but higher priced rates. Utilities excelled in marketing the benefits of dynamic pricing rates to customers and three decades later, by the year 2050, a third of all small customers had voluntarily accepted such rates.

About a fifth of customers on dynamic pricing installed smart thermostats to further automate their price responsiveness. Such devices automatically raised the set-point in summer-peaking regions by a couple of degrees during critical peak periods and lowered it in winter-peaking regions by a couple of degrees during the same periodssame periods.

About a tenth invested in whole building “gateway” technologies that allow multiple devices, not just the heating and air conditioning systems, to be controlled to take advantage of lower off-peak prices. These systems were programmed to automatically reduce the building’s load without human intervention.

Whenever critical times occurred, utilities dispatched higher critical-peak prices to customers. Even without any enabling technologies, such as smart thermostats or gateway systems, small customers dropped peak demands by 13 percent. This number did not surprise those who had participated in California’s landmark experiment with dynamic pricing that was carried out through a multi-party working group at the turn of the century in 2003-2005. Small customers who invested in smart thermostats got quite a boost in demand response and dropped their critical-peak loads by twice as much as the average customer or by 26 percent. Finally, those customers who invested in gateway systems really got a turbo- charged boost and dropped their response by four times as the average customer or by 52 percent. Counting the impacts across all dynamic pricing customers, peak loads for the small customer class dropped by 19.5 percent.

In aggregate terms, peak loads in the US dropped by 5 percent. By 2050, US peak loads would have hit 1,000 GW. Small customers accounted for 40 percent of this load and a third of these customers were on dynamic pricing, representing 132 GW of load. With dynamic pricing, peak loads dropped by some 26 GW in the residential and small commercial and industrial customer class.

And, of course, a small but determined band of DR radicals kept their Energy Orbs, hoping that the glow from this fascinating and simple technology would light the way to a more demand responsive future. Sadly, the Orbs were outlawed in 2020 by the CAISO as an illegal energy forecasting tool, and can now only be found at the Smithsonium.

Of course, things had not stayed frozen for larger customers. A two-part real-time pricing design, modeled on Georgia Power’s successful design, proliferated across the country and large customers concluded that they had more to gain from lower off-peak prices that would prevail for most hours of the year than they had to lose by higher peak pricing that would prevail on a few hundred hours. Of course, not every customer saw things this way but enough did. The impact of large customers on RTP rates also came to some 26 GW. Thus, the combined impact of dynamic pricing across all customer classes amounted to 52 GW or roughly 5 percent of US peak demand.

DR was a big hit in 2050. It was featured in the New Yorker magazine’s section, “Talk of the Town,” and numerous talk shows that people heard on their , now available on cell phones and video IPods. Even presidential candidate Shilo Jolie-Pitt produced a Podcast about it, called “The Responsive Truth.” People talked about how DRit had shaved off an astonishingly large number of peaking generating units, saving billions in avoided capacity and fuel costs, reducing greenhouse gas emissions and reducing the odds of climate change that loomed as a distinct possibility halfway into the century. Demand reductions reduced price volatility in wholesale power markets, further lowering customer energy bills. DR was so successful that its advocates called for making dynamic pricing the standard pricing option for all customers. They succeeded in getting a good hearing in state and federal regulatory circles and even gained some converts. Some states, with the golden state in the lead, made dynamic pricing the default option for all customers. William Vickrey’s 1971 vision of “responsive pricing of public utility services” neared fulfillment.

Second VisionDystopia (Pricing Myopia) We wake up for the Big Sleep and find that DR has been stymied by the forces of reaction that resist every change, even the minutest change, in the status quo. And of course DR was a quantum change so it had to be resisted tooth and nail. Large commercial and industrial customers said they had done all they could do to modify their operations and schedulesload shapes, in response to the time-of-use (TOU) rates that were implemented on a mandatory basis in several states following the passage of PURPA in 1978. The same chorus had been heard in 2006, especially in California (yes, the same state where dynamic rates were being offered to residential customers). Customers overlooked the fact that the “financial transfers” from going to RTP from TOU rates were no worse than those that had occurred during the early PURPA days when they had shifted from non-TOU rates to TOU rates.6

Utility rate designers were reluctant to include a charge for capacity in their peak period rates, so customers never get a real incentive to reduce peak loads. Intervener groups for low income and small users successfully argued their case before state commissions that their customers would be made worse off by AMI investments. In many states, they got state legislatures roiled up to the point that they passed laws prohibiting dynamic prices, since they were portrayed them as a means of gouging customers. Voters in Ssome states prohibited utilities from suchoffering such pricing options by state referendum.

A few states passed legislation such as California’s AB 1X law that prohibits charging higher prices to customers, even during a few hours, and even if they are offset by lower prices during off-peak periods. The ostensible purpose of such laws is consumer protection which, of course, is obtained at even greater cost. However, because of the spin put on such events by glib but ignorant politicians, the myopia inherent in such legislation was lost upon the general public. And, in a move that evoked cries of “Et tu, Brutus,” some environmental groups that had generally supported demand-side initiatives, turned their guns on dynamic pricing, saying that by shifting load to off-peak periods, it raised emissions of greenhouse gases.

The dark visions cited by William Vickrey were fulfilled. In his 1971 article, he had opined that that “the main difficulty with responsive pricing is likely to be not just mechanical or economic, but political.” He felt that people shared the medieval notion of a just price as an ethical norm, and that prices that varied according to the circumstances of the moment were intrinsically evil. He spoke presciently:

The free market has often enough been condemned as a snare and a delusion, but if indeed prices have failed to perform their function in the context of modern industrial society, it may be not because the free market will not work, but because it has not been effectively tried.7

In a similar vein, writing 30 years after William Vickrey in the aftermath of the Great California Energy Crisis, Eric Hirst had noted, “The greatest barriers [to DR] are 6 Severin Borenstein, “, insert titlWealth transfers among large customers from implementing real-time retail electricity pricinge,” presented at the POWER conference, Berkeley, California, March 2006. 7 Vickrey, William, “Responsive pricing of public utility services,” Bell Journal of Economics and Management Science, 2, 1971, pp. 337–346. legislative and regulatory, deriving from state efforts to protect retail customers from the vagaries of competitive markets.”8

Participants in regulatory hearings failed to reach agreement on the value of generation capacity that would be avoided by DR, let alone on the value of the transmission and distribution capacity that would be avoided. Functional day-ahead and hour-ahead real- time markets for power did not materialize in many states. This was used to block any move toward dynamic pricing.

Even then, dynamic pricing was offered in a few states. But it only attracted those customers who benefited just by the act of switching rates, i.e., without reducing their peak loads. Even those customers who signed on hoping to save money by reducing peak loads during critical times dropped out when they were called “too frequently.” This was reminiscent of customer behavior on interruptible rates in the last century.

A small but determined band of DR radicals kept their Energy Orbs, hoping that the glow from this fascinating and simple technology would light the way to a more demand responsive future. Sadly, the Orbs were outlawed in 2020 by the CAISO as an illegal energy forecasting tool. A few now reside in the Smithsonian.

To make a long story short, dynamic pricing failed to make a dent into peak demands. Its champions became old and faded away. The new generation abandoned it as yesterday’s technology, a relic of the past that was discussed in footnotes to historical texts.

This outcome was a sobering reminder that ratemaking was more art than science, more politics than economics and when even after a century of practice in the United States, it remained a controversial and vexing field of endeavor. It was clear that the primary barriers to dynamic pricing were neither economic nor technological in 2050, nor had they been the primary barriers in 2006. In fact, they had not been the primary barriers in the prior century either.

In 1938, when the British tariff analyst D. J. Bolton penned his textbook on Electrical Engineering Economics, he wrote presciently:

“There is general agreement that appropriate tariffs are essential to any rapid development of electricity supply, and there is complete disagreement as to what constitutes an appropriate tariff.”

Quo Vadis?

I have shared with you two grand visions of the long term future, one very optimistic in its sweep and the other equally pessimistic. The optimistic vision has several of us

8 Eric Hirst, “Price-Responsive Demand in Wholesale Markets: Why Is So Little Happening?” The Electricity Journal, May 2001. excited, since it represents the fulfillment of our career goals. However, it is a Utopia. The pessimistic vision is the epitome of depression, a day when darkness falls at noon. without question a Dystopia, a day with darkness at noon, the epitome of depression.

One can reason that the future will be a bit less colorful more boring than either of these visionsextreme, mirroring the boredom of as it often is in the Real World.9 Maybe it will lie arithmetically between the Utopia and Dystopia sketched out above. However, even this will require strong leadership without which . Without it, the likely outcome will be the status quo as it exists in 2006, i.e., business as usual with minimal DR. DR will be confined to the status of remain a politically correct fad, bringing to mind a world where: .

The best lack all conviction, while the worst Are full of passionate intensity. 10

As this conference has shown, a cadre of new initiatives has been launched in California, the District of Columbia, Illinois, New Jersey and Texas in the United States and in Ontario, Canada and Victoria, Australia. Innovation is in the air and dynamic pricing threatens to become The Next Big Thing.

But, to use a gardening analogy, these new initiatives are like new shoots that sprout in spring. They can and will be easily and quickly trampled (or eaten by local wildlife) without some active gardening and protection.

Success forin keeping our nation secure, safe, and demand responsive will require will power and resolve over the long haul, since there will be many bumps in the road. One of the pre-requisites will be communicating successes to others, but also ensuring that the initial step – simply deploying meters and time-based pricing – is quickly followed up by effective action to promote customer understanding and education, to provide useful information from the metering to customers (on their monthly bills, not websites), to integrate with controls technologies such as smart thermostats, and so on. One DR pundit summed it up best by saying,

As one demand response pundit so eloquently stated, ‘“Demand response is not a flash in the pan – it is a long term customer relationship, one that will eventually provide the ability for energy providers to banish forever eliminate the rotating outage as a means of to maintaining electrical reliability” 11

9 I am indebted to Chris King of emeter for this insight. 10 Lines from Yeats. 11 I am forever indebted to mMark Martinez of SCeE for this commenthis insights and sartotial recommendations.