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.

Supplier Compensation: European Commission and US FERC See Eye to Eye

Energy suppliers are lobbying against a proposal from the European Commission to remove barriers to demand response schemes, writes Philip Baker. According to Baker, the Commission should stick with its proposal. Demand response, he argues, will bring great savings to energy consumers. What is more, the Federal Energy Regulatory Commission (FERC) in the United States has introduced similar measures, indirectly supporting the position of the European Commission.

Demand response is a vital source of flexibility in the cost-efficient transition to a decarbonised electricity system. A flexible demand side will ease the integration of intermittent wind and solar generation, while reducing or delaying the need for network investment to electrify the heat and transport sectors. Explicit demand response, where third-party “aggregators” pay domestic and smaller commercial customers to flex their demand, will play an important role in the development of a flexible demand side, providing a low risk and automated path to market participation that avoids exposure to variable energy prices.

Demand Response will Reduce Customers’ Electricity Bills

In addition to smoothing the transition to a low-carbon future, explicit demand response and demand flexibility can deliver an immediate and beneficial impact on customer’s electricity bills. Analysis commissioned by RAP demonstrates that even the modest application of demand response across the German/Austrian, Nordic, and French electricity markets will bring savings exceeding €1.6 billion annually, with proportionately greater savings seen across Europe as a whole. Suppliers will initially see these savings in the form of reduced energy costs, but, in a competitive market, they can pass the savings through to customers in the form of lower electricity bills.

Proposed Electricity Directive Eliminates Barriers to Demand Response

Despite the obvious need to encourage customer participation in the electricity market in the interests of decarbonisation and lower energy bills, significant barriers to the successful development of explicit demand response persist. In many Member States, aggregators must obtain permission from the customer’s supplier to operate on the customer’s load or compensate the supplier for lost income. These requirements threaten the development of a flexible demand side. The European Commission, in Article 17 of the proposed Electricity Directive, removes these barriers. We encourage widespread support for this proposal.

Energy is Not Transferred

Not unexpectedly, incumbent generators and suppliers strongly oppose these proposed changes. The savings in customer’s electricity bills come at the expense of wholesale market revenues seen by generators, and suppliers cannot bill for the energy not consumed by customers providing “downward” demand response. In making the case for compensation, suppliers contend that energy bought by them is transferred via aggregation to others for profit.

In reality, however, energy is not transferred. Downward demand response simply reduces the amount of energy that needs to be generated; the saved energy is neither generated nor consumed by anyone. These self-interested objections should therefore be resisted by the Commission, who should persist with their sensible objective of removing unjustified and damaging barriers to the growth in demand side flexibility.

US Compensates Demand Response at the Full Wholesale Market Price

A very similar debate in the United States supports the Commission’s position. It centered around the Federal Energy Regulatory Commission’s (FERC) Order 745, which requires market operators to pay the same wholesale price to providers of demand response as is paid to generators—essentially the same situation as exists in European markets today. The Order was adopted in preference to an alternative compensation scheme proposed by the Electricity Power Supply Association (EPSA) that would have subtracted from the wholesale price the savings made by customers in not consuming energy. The EPSA remedy was similar to, if not the same as, the incumbent’s supplier compensation proposal in Europe in that a third-party aggregator would retain the wholesale price minus the retail price of the unused energy. In Europe, suppliers are asking the Commission to require the aggregator to continue compensating the supplier for energy costs that cannot be recovered from customers who have chosen not to consume that energy.

The Supreme Court of the United States eventually reviewed Order 745 and concluded that deciding the terms on which demand response should be remunerated was a matter for FERC and not for them. As a result, the situation in the United States and Europe (based on the wording of Article 17 of the proposed Directive) is essentially the same—demand response will be rewarded at the wholesale market clearing price with no discount or compensation applied.

Although the Supreme Court did not express an opinion on the technical merits of the remuneration provided in Order 745, it is instructive to note the arguments deployed by FERC to justify its position. Firstly, FERC considered that, as the acceptance of a demand response and the equivalent generation offer have same impact on the wholesale market price, they should both receive the same value from the market. Secondly, although they did not inquire into the costs incurred by a market participant when making an offer to the market, FERC noted that the cost structure of different providers could be very different. While a generator needs to recover the cost of fuel, a demand response provider may need to recover significant up-front hardware costs.

The Commission can take comfort that an expert electricity regulator of FERC’s stature has reached a similar conclusion—the value of demand response is the full wholesale market price and no discount is warranted.

A version of this article originally appeared on Energy Post.

Proposed Electricity Directive a Step in the Right Direction for Customers, Demand Response

Explicit demand response, where aggregators enable small commercial and domestic consumers to directly participate in the wholesale power market by flexing their demand, is a vital resource in the transition to a sustainable electricity system. However, barriers to the successful development of this vital resource exist in many Member States, including the need for aggregators to obtain permission from the customer’s supplier and to compensate the supplier for lost income.

As the potential for demand response is significant and the savings likely exceed associated costs by a considerable amount, we should be doing everything we can to tear down barriers and open markets to this customer-centric resource. Article 17 of the European Commission’s proposed Electricity Directive is a positive step in this direction and should be widely supported. It ends the requirement for an aggregator to obtain permission to operate on a consumer’s demand or to compensate the consumer’s supplier (other than in some imbalance-related “exceptional circumstances”).

Unfortunately, incumbent suppliers are pushing back on the Commission’s proposal, maintaining that energy they purchase up front is transferred to aggregators free of charge, who then profit by selling it on, leaving suppliers unable to bill customers for unused energy. In reality, this is not the case and obfuscates the tangible benefits that aggregated demand response delivers. More details on the following discussion are available in the accompanying policy brief, Unleashing Demand Response with Effective Supplier Compensation.

Aggregators Help Customers Reduce Demand, Avoid Expensive Generation Costs

The services provided by demand response aggregators simply allow an energy supplier’s customers to reduce their demand. When the aggregator offers this product to the wholesale energy market, it removes the need to generate an equivalent amount of energy. As no more energy can be generated than is consumed, the aggregator’s product reduces the amount of energy generated and, hence, market costs. No energy is transferred; it is simply not used.

Figure 1 shows that even modest reductions in demand can avoid the need to run high-marginal-cost generation or other more costly measures, reducing market clearing prices. This allows suppliers to make significant savings when buying energy for their customers, and one would expect that most of these savings will make their way to customers through competitive or, where necessary, regulatory pressure. The point to note here is that all customers benefit from cost-competitive demand response, not just those customers who reduce their demand. It is a genuine societal benefit in the form of lower wholesale and retail energy prices and avoidance of uneconomic investment.

Figure 1. Explicit Demand Response Reduces Wholesale Electricity Prices

As suppliers cannot bill customers for energy not consumed, they are demanding additional compensation from aggregators to recover the lost revenue associated with explicit downward demand response. In the case where customers simply reduce consumption in response to price signals delivered through a time-of-use or dynamic tariff (price-based or implicit demand response), there is no suggestion that those customers should compensate the supplier for loss of revenue. However, requiring aggregators to compensate suppliers for lost revenue essentially amounts to the same thing.

Similar Debate in the US

Order 745 of the Federal Energy Regulatory Commission (FERC) in the U.S. requires wholesale market operators to pay the same wholesale price to providers of demand response as is paid to generators—essentially the same situation as exists in European markets today. No discount or supplier compensation is applied. Order 745 contains a “net-benefit” test to ensure that a demand response provider only receives the full market value if there is an overall benefit to consumers. This is a precaution the Commission may want to consider if it believes the “no-compensation” position set out in Article 17 of the proposed directive could lead to excessive demand response deployment.

Simple, Straight-Forward Alternative to Supplier Compensation

Last fall, I suggested an alternative to the complex and unfair practice of requiring demand response aggregators to pay energy suppliers for unused energy. Under this approach, suppliers retain a small portion of the wholesale market savings, which should always exceed, and often dwarf, any income lost by suppliers due to customers opting not to consume.

Relying on the retention of some of these wholesale market savings to ensure that suppliers remain financially whole rather than via negotiated or administered compensation is both a pragmatic and just solution. The alternative of direct compensation proposed by suppliers will significantly hinder the development of implicit demand response, resulting in fewer benefits to be enjoyed in the first place. Furthermore, as the reduction in wholesale energy prices brought about by demand response should be enjoyed by all customers via lower retail tariffs, it seems appropriate that all customers should share in the associated costs and not just the providers of that demand response. The proposal also has the virtue of simplicity, with no negotiation between aggregators and suppliers and no need to make the difficult assumptions necessary in establishing an administered alternative to negotiation, with the attendant risks of over– or under–compensation.

Article 17 of Proposed Electricity Directive Removes Barriers to Demand Response

In its current form, Article 17 removes a significant barrier to the development of explicit demand response and the enhanced customer market participation and flexibility so necessary to a cost-effective transition to a low-carbon electricity system. Any modification of the current wording to require aggregators to compensate suppliers for income associated with energy not consumed, would undermine these aims.

Photo Credit: Consumers Energy