Demand Response - Electricity Pricing

Electricity Pricing

In most electric power systems, some or all consumers pay a fixed price per unit of electricity independent of the cost of production at the time of consumption. The consumer price may be established by the government or a regulator, and typically represents an average cost per unit of production over a given timeframe (for example, a year). Consumption therefore is not sensitive to the cost of production in the short term (e.g. on an hourly basis). In economic terms, consumers' usage of electricity is inelastic in short time frames since the consumers do not face the actual price of production; if consumers were to face the short run costs of production they would generally increase and decrease their use of electricity in reaction to those cost-based price signals. In effect, consumers served under these fixed rate tariffs are endowed with real "call options" on electricity.

In virtually all power systems electricity is produced by generators that are dispatched in merit order, i.e., generators with the lowest marginal cost (lowest variable cost of production) are used first, followed by the next cheapest, etc., until the instantaneous electricity demand is satisfied. In most power systems the wholesale price of electricity will be equal to the marginal cost of the highest cost generator that is injecting energy, which will vary with the level of demand. Thus the variation in pricing can be significant: for example, in Ontario between August and September 2006, wholesale prices (in Canadian Dollars) paid to producers ranged from a peak of $318 per MW·h to a minimum of - (negative) $3.10 per MW·h. It is not unusual for the price to vary by a factor of two to five due to the daily demand cycle. A negative price indicates that producers were being charged to provide electricity to the grid (and consumers paying real-time pricing may have actually received a rebate for consuming electricity during this period). This generally occurs at night when demand falls to a level where all generators are operating at their minimum output levels and some of them must be shut down. The negative price is the inducement to bring about these shutdowns in a least-cost manner.

Two Carnegie Mellon studies in 2006 looked at the importance of demand response for the electricity industry in general terms and with specific application of real-time pricing for consumers for the PJM Interconnection Regional Transmission authority. The latter study found that even small shifts in peak demand would have a large effect on savings to consumers and avoided costs for additional peak capacity: a 1% shift in peak demand would result in savings of 3.9%, billions of dollars at the system level. An approximately 10% reduction in peak demand (achievable depending on the elasticity of demand) would result in systems savings of between $8 to $28 billion.

In a discussion paper, Ahmad Faruqui, a principal with the Brattle Group, estimates that a 5 percent reduction in US peak electricity demand could produce approximately $35 billion in cost savings over a 20 year period, exclusive of the cost of the metering and communications needed to implement the dynamic pricing needed to achieve these reductions. While the net benefits would be significantly less than the claimed $35 billion, they would still be quite substantial. In Ontario, Canada, the Independent Electricity System Operator has noted that in 2006, peak demand exceeded 25,000 megawatts during only 32 system hours (less than 0.4% of the time), while maximum demand during the year was just over 27,000 megawatts. The ability to "shave" peak demand based on reliable commitments would therefore allow the province to reduce built capacity by approximately 2,000 megawatts.