A Pragmatic Proposal for Supplier Compensation
The European Commission has proposed that independent aggregators should not be required anymore to pay compensation to suppliers, as is the case in many EU member states today. According to Philip Baker this proposal should be supported, as it will improve the flexibility of the market and lead to lower prices for consumers. However, it may not be appropriate in the long term: once it has achieved its goals, the issue of compensation should be revisited.
Explicit demand response is a process in which third-party aggregators pay domestic and smaller commercial customers to flex their demand. It provides these consumers with a low-risk, automated path to market participation. It also helps to ease the integration of intermittent wind and solar generation, and reduce or delay the need for network investment associated with electrifying the heat and transport sectors.
In addition to smoothing the transition to a low-carbon future, explicit demand response can deliver an immediate and beneficial impact on customer’s electricity bills. By reducing demand during periods when capacity is scarce and wholesale prices are high, demand response reduces overall market costs thereby benefiting all consumers in the form of lower electricity bills, not just those who participate. Analysis suggests that even a modest application of demand response could generate savings of up to €1.6 billion annually across the German/Austrian, Nordic, and French electricity markets alone, with greater savings expected across Europe as a whole.
However, despite these benefits and the need to encourage customers to be more flexible, significant barriers to the successful development of aggregated demand response exist. In many Member States, aggregators are required to obtain permission from the customer’s supplier to operate on a customer’s load and to compensate the supplier for lost income. These requirements undermine the already fragile economics of explicit demand response, particularly in the domestic sector, and should be removed.
The Commission’s pragmatic proposals
The European Commission has proposed, in Article 17 of the Clean Energy Package Electricity Directive, which it presented on 30 November 2016, that aggregators should no longer be required seek permission from a customer’s supplier and that they should not be required to pay compensation to suppliers. This proposal is very much to be welcomed. While aggregators do not need to recover fuel costs, they do face significant capital costs in setting up explicit demand response programs, operating costs, and also need to pay participating customers. Given present market conditions, where highly restrictive price caps are often applied, forcing aggregators to compensate suppliers directly would undermine the economics of aggregation and significantly constrain its development.
The Commission’s proposal is a pragmatic response to this situation. It promotes the development of aggregation to ensure that all consumers have the opportunity to share in the associated benefits, while recognising that suppliers have the option of “self-compensating,” i.e., retaining some of reduction in wholesale prices before passing the remaining benefits on to consumers in the form of lower retail rates.
Anticipating the impact of wholesale market reform
The response to the Commission’s proposal has been mixed. The proposals are clearly helpful to the aggregator community, however suppliers are understandably concerned about not being able to recover the cost of energy that they may have bought up-front, but which they cannot bill to consumers who have opted not to consume that energy.
These concerns are not without justification. While the proposal that aggregators should not be required to compensate suppliers is appropriate in the prevailing circumstances, this may not be the case going forward. The Commission’s welcome proposals for wholesale market reform set out in the Clean package will, once implemented, substantially raise or remove price caps and ensure that wholesale energy prices more closely reflect the value that customers place on uninterrupted supply. Aggregated demand response will clearly benefit from periods of higher and more volatile energy prices, and market reform should significantly improve its profitability.
Therefore, once market reform has been introduced and aggregators, acting on behalf of customers, can access wholesale prices that reflect the true value of the demand response services they provide, it will become appropriate to revisit the issue of compensation. At that point, the question will become what level of compensation is appropriate?
Compensation set too low could over-stimulate demand response, at some point resulting in costs to non-participating consumers that exceed the benefits; compensation set too high could reward uneconomic behaviour by suppliers and suppress cost-effective demand-side resources. Given that the timing and extent of market reform will vary across jurisdictions, determining when to revisit the issue of compensation and what compensation should apply, are decisions best left to individual Member States.
A suggested amendment to the Commission’s proposal
Therefore, in order ensure that the Commission’s proposals for supplier compensation are consistent with the other market reforms called for by the Clean Energy Package, we suggest that a sunset clause should be applied to the current wording of Article 17 paragraph 3d of the Electricity Directive, which says that aggregators shall not be required to pay compensation to suppliers or generators. This would allow Member States to revisit the issue of compensation once market reform had been fully implemented or, alternatively, when it was considered that aggregated demand response was sufficiently developed or its economics sufficiently robust.
Once either of these two criteria has been satisfied, the goal of maximizing economic efficiency seems best achieved by linking compensation to the average year-ahead or seasonal wholesale energy price. This should both approximate the purchasing costs incurred by competent suppliers while rewarding aggregators and their customers roughly in line with the net benefits that price-responsive demand would realize. This approach has the added benefit of striking a fair balance between suppliers’ legitimate interest in being compensated and the intractable question of determining exactly what costs were incurred in any given case.
An additional safeguard to ensure the appropriate but not excessive deployment of aggregated demand response might be to include a net benefits test. This would compare the benefits of aggregated demand response seen by customers in the form of reduced wholesale energy prices with the market revenues seen by aggregators. If the latter exceeded the former, this would suggest that the introduction of direct aggregator to supplier compensation was justified. This would to some extent mirror the arrangements introduced by FERC (Federal Energy Regulatory Commission) in the United States, where explicit demand response is also subject to a cost benefit test.
In conclusion, we believe that Commission’s stance that aggregators should not be required to compensate suppliers directly is appropriate, given prevailing market conditions. But once the wholesale market has been reformed in line with the Commission’s proposals set out in the Clean Energy Package, demand response will become a far more profitable enterprise, so compensation should be allowed again.
A version of this blog was originally published by EnergyPost.