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The recent FERC Notice of Public Rulemaking regarding the payment to demand-side resources in wholesale markets has engendered a great deal of comments including FERC's obligation to ensure just and reasonable rates in the wholesale market and criteria for what FERC should do (on grounds of economic efficiency) without any real focus on what that commitment would really mean if FERC actually pursued it.

The issue before the Federal Energy Regulatory Commission was to decide how much an independent system operator or regional transmission operator (ISO/RTO) should pay for demand response energy delivered to the wholesale market. One view is that a demand response resource (DRR) delivering the energy should be paid the locational marginal price (LMP) because that is what generators receive for delivering energy. The alternative view is that the DRR should be paid a lesser amount that accounts for the bill savings of the retail customers that produced the demand response that the DRR delivered. These savings occur because the retail customers’ demand reductions cause their meters to record smaller amounts of energy consumed so they avoid paying for the energy they sell through the DRR. Paying full LMP for demand response energy collectively produces compensation that exceeds LMP for the DRR and the retail customers it represents. This is because the DRR is paid LMP while its customers additionally enjoy bill savings by avoiding payment of the marginal energy rates in their respective retail tariffs (hereafter referred to as “G”).3 If these bill savings are not subtracted from the LMP payment the total compensation received for the demand response energy will be LMP + G, thereby providing an excessive incentive to reduce consumption. When that happens the productive value of retail customers’ foregone consumption is likely to exceed the cost that would have been incurred by wholesale market generators to produce and deliver that energy to the customers. Clearly, such an outcome is prima facie inefficient.Proponents favoring payment of full LMP argue that we cannot be sure that reducing the payment by G will produce an economically efficient result, primarily because of the many market imperfections that exist in energy markets, and ultimately because the “theory of second best” informs us so.4 At the same time, these naysayers fail to show how paying full LMP for demand response will produce a more desirable outcome. This article examines Order No. 745 from the following perspectives: •economic efficiency, •the nature of economic demand response, • FERC's legal obligation, •Implementation difficulty, •The Net Benefits Test, and • The last section summarizes my conclusions.

It is clear that Order No. 745 prescribes subsidy payments for demand response energy. Those subsidies are very likely to produce economically inefficient market outcomes and will unfairly burden residential and small business electricity consumers by forcing them to pay for the subsidies that will almost entirely go to large industrial and commercial customers. In addition, the ill-conceived net benefits test further confounds demand response compensation and explicitly sanctions the exercise of monopsony power. Understandably the Commission faced a challenging jurisdictional issue. Had it simply mandated that ISOs/RTOs pay demand response providers the same market price as they pay generators while avoiding the double payment problem by directing the ISOs/RTOs to reconstitute LSEs’ loads, the Commission's decision would have been justifiable on jurisdictional grounds even though it would have potentially produced inefficient market outcomes, depending on the responses of retail regulators. Instead, the Commission explicitly rejected load reconstitution, effectively blocking the capability of retail regulators to eliminate the over-compensation at the retail level while also effectuating an interstate cross-subsidy mess. This cross-subsidy issue has caused many retail regulators to ban ARC participation in their respective jurisdictions, thereby slowing further development of all forms of wholesale demand response. In their fervor to stack the deck the four FERC commissioners that supported Order No. 745 may have mortally wounded economic demand response. They thought they were choosing the first alternative in Jonathan Falk's false dichotomy but instead were dealt the second one. This would be laughable if the consequences weren’t so costly to the industry and the U.S. economy. The Commission had a pivotal opportunity to improve the efficient functioning of wholesale electricity markets and to facilitate development of the Smart Grid. It squandered that opportunity – along with the substantial public and private sector resources that were consumed in responding to the two related dockets.33 Of course, Order No. 745 may be reversed, either by the courts or by a future Commission, but that will take years. Meanwhile the nation will have to bear the wasteful costs that Order No. 745 will impose on the economy at a time of record unemployment and skyrocketing deficits. Could the Commission have produced a more dysfunctional order? Probably so – but it is difficult to imagine how. 1 Demand Response Compensation in Organized Wholesale Energy Markets, Order No. 745, 134 FERC ¶ 61,187, (2011). 2 Order No. 745 was not unanimously supported. Commissioner Phillip D. Moeller strongly disagreed with his four colleagues on a myriad of grounds, which he articulated in a brilliantly crafted dissenting opinion. In particular, he questioned the legal justification for the order, stating: “The use of a net benefits test also is troubling in that the Commission's decision can be viewed as somehow equating the concept of a just and reasonable rate with a lower price.” See: Order No. 745, Commissioner Moeller, dissenting, at 7. 3 The term, “G,” was originally introduced by PJM, which assumed that the appropriate price to subtract from LMP was the marginal cost of generation. As Prof. Hogan (and others) pointed out, the correct price to subtract is the marginal energy rate in the load-curtailing customer's retail tariff. See: William W. Hogan, Providing Incentives for Efficient Demand Response, at 18, statement submitted on behalf of the Electric Power Supply Association, filed in FERC Docket No. EL09-68-000, Oct. 29, 2009. 4 Richard Lipsey and Kelvin Lancaster, The General Theory of Second Best, Rev. Econ. Studies, 24(1) 1956, at 11–32. 5 Jonathan Falk, Paying for Demand-Side Response at the Wholesale Level, Elec. J., Nov. 2010, at 14. 6 Id. 7 Alfred Kahn, Affidavit of Alfred E. Kahn, at 4, statement submitted on behalf of the Demand Response Supporters, filed in FERC Docket No. EL09-68-000, Sept. 16, 2009. 8 134 FERC, supra note 1, ¶ 50. 9 Falk, supra note 5, at 15. 10 Order No. 745 is ambiguous regarding compensation for apparent demand reductions produced by behind-the-meter-generation, rather than by actual load reductions. The regulatory text in the order states that compensation only applies to demand response resources that “…participate as a resource in the energy market by reducing consumption of electric energy from their expected levels in response to price signals….” [Boldface added for emphasis]. 18 C.F.R. § 35.28 (2011). In the order the Commission cites EPSA's objection to treating behind-the-meter-generation as demand response but did not respond to it. 134 FERC, supra note 1, ¶ 34. 11 Power system reliability (as opposed to system security) loses meaning in an energy-only market because all load reductions that occur to match demand with supply are voluntary and based on customers’ comparisons between market prices and their respective willingness to pay. The following reports further describe this concept: William W. Hogan, On an ‘Energy Only’ Electricity Market Design for Resource Adequacy, Harvard University, Sept. 23, 2005; Midwest Independent System Operator, An Energy-Only Market For Resource Adequacy in the Midwest ISO Region, Nov. 23, 2005. 12 See: Federal Energy Regulatory Commission, Docket No. ER04-1188-000, Letter Order to New York Independent System Operator, Oct. 29, 2004; ISO New England Inc., Filing of Changes to Day-Ahead Load Response Program, Expedited Comment Period and Consideration Requested, FERC Docket No. ER08-538-000, Feb. 5, 2008; PJM Interconnection, LLC, Revisions to the PJM Open Access Transmission Tariff and the PJM Operating Agreement, FERC Docket No. ER08-824-000, April 14, 2008. 13 Midwest Independent System Operator, supra note 11, at 15–17. 14 Henry Y. Yoshimura, Testimony of Henry Y. Yoshimura, at 48–49, Order No. 745 Compliance Filing, ISO New England Inc., Docket No. ER11-4336, Aug. 19, 2011. 15 Removing Obstacles to Increased Electric Generation and Natural Gas Supply in the Western United States, 94 FERC ¶ 61,272, at 61,972, order on rehearing, 95 FERC ¶ 61,225, order on rehearing, 96 FERC ¶ 61,155 (2001). 16 Federal Energy Regulatory Commission, Order Conditionally Granting Market-Based Rate Authority and Providing Guidance, at 7–8, EnergyConnect, Inc., Docket No. ER09-1307-000, 001, Jan. 19, 2010. 17 Robert Borlick, Robert L. Borlick's Response to the Demand Response Supporters’ Witnesses, at 7–8, statement filed in FERC Docket No. EL09-68-000, Sept. 28, 2009; Robert L. Borlick, Pricing Negawatts: DR Design Flaws Create Perverse Incentives, Pub. Util. Fortnightly, Aug. 2010. 18 Fischer Black and Myron Scholes, The Pricing of Options and Corporate Liabilities, Journal of Political Economy, 81:637–654 (May–June 1973). Note, however, that the Black-Scholes model does not strictly apply to call options on energy products because the model assumes that future prices of the underlying stock or commodity are log-normally distributed. In contrast, energy prices exhibit a mean-reversion tendency. Even so, the Black-Scholes model is often use to obtain approximate valuations of options on energy products. 19 16 USC §§ 824d, (Federal Power Act). 20 Demand Response Compensation in Organized Wholesale Energy Markets, Notice of Proposed Rulemaking, 130 FERC ¶ 61,213 (2010), ¶ 2. 21 id., ¶ 18. 22 William Hogan, Implications for Consumers of the NOPR's Proposal to Pay the LMP for All Demand Response, at 16, statement submitted on behalf of the Electric Power Supply Association in FERC Docket No. RM10-17-000, May 12, 2010. 23 Edison Electric Institute, Request for Rehearing of the Edison Electric Institute, at 8, FERC Docket No. RM10-17-000, April 14, 2011. 24 For a incisive analysis of the Commission's “balancing” argument, see: Steven Stoft, Concurring opinion on Economic Issues Raised by FERC Order 745, Demand Response Compensation in Organized Wholesale Energy Markets, Market Surveillance Committee of the California ISO, June 7, 2011. 25 Alfred Kahn's, affidavits are consistent with conventional markets that do not involve ARCs. 26 California Independent System Operator, Tariff Amendment to Implement Proxy Demand Response Product, FERC Docket No. ER10-765-000, February 16, 2010; Midwest Independent Transmission System Operator Inc., Filing re Aggregators of Retail Customers, FERC Docket No. ER09-049-002, Oct. 2, 2009. 27 ARCs typically retain about 20 percent of the revenues and pay the retail customer the remainder. If the demand response is sold into both the energy and capacity markets, the ARC may cover its costs and profit contribution from the capacity payments alone and may pay the retail customer the full energy price for curtailed load. 28 134 FERC, supra note 1, ¶ 101. 29 Organization of MISO States, Request for Rehearing of the Organization of MISO States, Demand Response Compensation in Organized Wholesale Energy Markets, Docket No. RM10-17-000, at 8-9, April 14, 2011. 30 California Public Utilities Commission, Request For Clarification or, in the Alternative, Request for Rehearing of the Public Utilities Commission of the State of California, at 9, Demand Response Compensation in Organized Wholesale Energy Markets, Docket No. RM10-17-000, April 14, 2011; California ISO, Demand Response Compensation in Organized Wholesale Energy Markets, ISO Compliance Filing, at 13, Docket No. ER11-4100-000, July 22, 2011. 31 Economists will recognize this prescription as the mirror image of a profit-maximizing monopolist's behavior. However, the Commission is confused in thinking that lower LMPs will directly benefit electricity consumers because most retail customers, including virtually all residential and small business customers, are served under tariffs that substantially lag behind changes in LMPs. Thus, the primary beneficiaries to the short-term benefits produced by the NBT may be LSEs – not their retail customers. 32 Hogan, supra note 22, at 13. 33 FERC Docket Nos. ER09-68-000 and RM10-17-000.