Money for Nothing? Why FERC Order 745 Should have Died.

• Author: Chen, Xu
• Position: Report

1. INTRODUCTION

   Increasing the responsiveness of consumers to price to create a more efficient and reliable system is an important issue in electricity energy supply markets. By exposing consumers to realtime prices, Demand Response (DR) can reduce peak demand and enhance system reliability. FERC Order 745 (FERC 2011b), which required RTOs to compensate DR with locational marginal prices (LMPs), was vacated by U.S. Court of Appeals for the District of Columbia (USCA Case #11-1486, 2014) on the grounds of both that FERC exceeding its jurisdiction and that the DR pricing formula was "arbitrary and capricious." The court order was widely regarded as the end of traditional DR in the wholesale market. After FERC's appeal, the Supreme Court in January 2016 overturned the lower court opinion and ruled that FERC has the authority to regulate DR. FERC, regional transmission organizations (RTOs) and state governments now have the opportunity to implement and to modify DR programs. In DR programs, demand reduction is measured by comparing a customer's actual load with an administratively determined customer baseline load (CBL). The CBL based DR system requires constant administrative interactions from FERC and RTOs. For example, a recent FERC Order directs PJM to increase the granularity of capacity DR performance monitoring (FERC 2014). Though with all the efforts from FERC and RTOs, DR participants may be able to inflate their CBLs and thus profit by creating artificial load reductions. Obtaining a precise CBL and eliminating CBL inflation incentives are therefore critical to effective DR implementation in the coming era.

   Researchers have determined that energy DR participants have theoretical opportunities to take advantage of the system by manipulating their CBLs (Chao 2011, Chao and DePillis 2013). Any "artificial" DR reduction may jeopardize system reliability, while creating transfers to DR providers from other rate payers. Here we empirically test for the existence of CBL-inflating behaviors.

   In section 2, we introduce the definition of DR in current electricity energy markets. We also discuss the contents of FERC's 2011 Order 745 and manipulation methods to which that Order is potentially vulnerable. Section 3 presents our theoretical approach and the concept of a "seemingly unattractive free-money opportunity" (SUFO). Section 4 describes our data, which comes from the pre-Order-745 era. Section 5 discusses the model specification, the econometric approach and empirical results modeling users' CBL. Section 6 shows our models and empirical results for DR reduction, which support the existence of inflated CBLs. We note that this result occurred even before FERC increased the incentives for such behavior through its enactment of Order 745. Section 7 offers conclusions.

2. BACKGROUND

   FERC (2011a) defines DR as "changes in electric use by demand-side resources from their normal consumption patterns in response to changes in the price of electricity, or to incentive payments designed to induce lower electricity use at times of high wholesale market prices or when system reliability is jeopardized." We focus here on DR in energy, as opposed to capacity, markets, the subject of FERC Order 745. Several recent articles discuss the peak load reduction effect of DR (for example, Faruqui and George (2005), and Faruqui, Hledik et al. (2007)) and the DR compensation method (Bushnell, Hobbs et al. 2009, Walawalkar, Fernands et al. 2010). Few papers, however, examine DR manipulation theories and CBL-inflating strategies (Chao 2011, Chao and DePillis 2013), while several documents describe DR manipulation cases (FERC 2012a, FERC 2012b). No previous research has examined whether inflated CBLs have occurred widely in RTOs.

   FERC Order 745 (FERC 2011b) requires all RTOs to compensate demand response resources with locational marginal price (referred to as the "full LMP payment"), regardless of CBL measurement methods or participants' retail contracts. Over the last several years, the appropriate payment for DR resources has been a topic of much controversy (Hogan 2010, Kahn 2010, Walawalkar, Fernands et al. 2010, Chao 2011, Chao and DePillis 2013).

   In PJM's energy market, DR resources and generators submit supply offers (or bids, i.e., willingness to supply a certain amount of energy with a certain level of compensation), and PJM dispatches generators and DR resources in economic order (lowest cost first) to meet system demands. Before FERC Order 745's implementation in PJM in April 2012, DR resources in PJM were compensated by locational marginal price (LMP) minus the generation (G) and transmission(T) parts of the retail tariff (referred to as LMP-G-T payment) in energy-market economic dispatches (PJM 2011). After April 2012, PJM paid LMP, i.e., an increase of generation and transmission fee from the original LMP-G-T payment, for demand response resources in energy market. Following the FERC directive, PJM calculated a firm's CBL based on its historical usage. CBL for a weekday is determined as the average of the four highest usages of the five most-recent non-event (or non-dispatch) (1) weekdays (in the same hour interval) in the previous 45 calendar days (PJM 2011). Other RTOs also have similar historically determined CBLs.

   The historically-based CBL determination method may incentivize potential manipulation strategies, which would lead to a "free-money" problem. Chao (Chao 2011) described moral hazards (over-consumption to increase CBL), adverse selection (consumers anticipating long term declining electricity demand being more likely to enroll in DR program) and behind the meter switching (switching usage between two energy sources to generate fake reduction measured from one source) as three potential free-money problems. Chao discusses DR payments and CBL construction, while reaching the topic of eliminating CBL manipulation through proper market rules. The article does not, however, seek to provide empirical evidence for existence of manipulation and little such evidence is provided. Here we attempt to fill this gap.

   In addition to the manipulation strategies discussed above, we suggest an "idiosyncratic-demand bidding strategy" may also result in free money to DR providers. In idiosyncratic-demand bidding, a DR participant's bidding behavior depends on its normal usage schedule instead of the price signal, i.e., the participant uses high consumer-specific usage days as CBL determination days and supplies DR resources on low usage days. Idiosyncratic-demand bidding is thus a CBL-inflating strategy and a market manipulation behavior, since it does not match FERC and RTOs' definition of DR: "reduction from normal usage in respond to price signals."

   For example, assume a ship factory that produces steel every Monday and Tuesday, consuming 100 MWh per hour. The factory assembles a ship every Wednesday to Friday, consuming 60 MWh per hour. With idiosyncratic-demand bidding, the factory may submit bids for 40MW of DR resources at a low price every Wednesday to Friday, and leave Monday and Tuesday as CBL-determination days. The factory is thus dispatched by the RTO from Wednesday to Friday and has a CBL 40 MW higher than its expected usage. Thus, without reducing usage, the DR participant has a consumption level below the CBL and, as a result, gains DR revenue. The participant is thus paid for an artificial reduction--one that does not actually take place.

   In the above idiosyncratic-demand bidding example, the factory clearly violates PJM rules and FERC Orders by claiming a regular consumption pattern as a DR activity. However, if the consumption pattern in DR days changes in a smaller scale from the regular one (for example, a several percent of usage change due to the weather,) it may be difficult to determine whether the DR participant intends to manipulate the market by idiosyncratic-demand bidding. This "free money" that is taken by DR providers who are able to inflate their CBLs is paid by Load Serving Entities and eventually by other rate payers in the RTO.

   The New England ISO (ISO NE) has uncovered evidence of idiosyncratic-demand bidding (ISO-NE 2008) in response to its rules on calculating CBL. ISO NE calculated CBL as the average usage of the previous ten non-event days and did not have a limited historical window for CBL-determination days (for example, 45 calendar days as in PJM) in 2007. DR participants in ISO NE could submit bids with a low price on most days and leave several high-usage days in the summer as CBL-determination days. Participants thus created a high CBL that was the average usage of several high-usage summer days and remained almost constant across the year. Further, some DR participants, who had operated on-site generators on a regular basis before participating in DR programs, were found reducing output from their generators during CBL-determination days to achieve a high CBL. FERC has announced an investigation of the above CBL-manipulation events (see, for example, FERC (2012a) and FERC (2012b)), and issued penalties for the fraudulent, or manipulative behaviors (see for example, FERC (2013a) and FERC (2013b)).

   In EPSA v. FERC 753 F. 3d 216, 225 (2014), the Appeals Court for the District of Columbia struck down Order 745 for two reasons. First, the appeals court concluded that FERC did not have jurisdiction to impose the order. FERC jurisdiction is limited to wholesale markets, and the court viewed DR implement under the order as affecting retail markets. Second, the Court, following the criticism noted above, viewed the LMP payment requirement as "arbitrary and capricious". On appeal, the Supreme Court overturned the Appeals Court in a 6-2 decision (FERC v. EPSA, slip. op. 14-840, January 25, 2016). The Supreme Court decision leaves the door open to further rules by FERC, RTOs, and states. We seek to contribute to the debate on these new rules.

3. THEORETICAL APPROACH

   We consider...