Demand Response: New Offers and Customer Acceptance Prepared for the: Peak Load Management Alliance (PLMA) Annapolis, MD By: Daniel M. Violette, Ph.D. Summit Blue Consulting Boulder, Colorado Phone: 720-564-1130 dviolette@summitblue.com October 7, 2002

Background Recent Experience draws from two white papers co-authored for the Peak Load Management Alliance (www.peaklma.com). “Demand Response: Principles for Regulatory Guidance,” February. 2002 “Demand Response: Design Principles for Creating Customer and Market Value,” October, 2002 Recent work for utilities on demand bidding, DR valuation in wholesale markets, benefit-cost tests for DR, program design for ISOs.

Demand Response Defined Three Components: 1. Load response called for by others -- includes direct load control, partial or curtailable load reductions, load interruptions. 2. Price response -- includes real time pricing, dynamic pricing, fixed time-differentiated rates (e.g., time-of-use rates), and demand bidding at different prices. 3. Distributed generation -- includes backup generation and “net” on-site generation. All three represent some form of “price response”.

What’s Up in Retail Markets Regulators who are working on existing market design and planning post-transition market design are keenly aware of demand response. Several states are initiating pilots to address time-differentiated pricing (New York, Massachusetts, California, Pennsylvania) Others are following (e.g., New England Demand Response Initiative). NARUC meeting agendas show high regulator interest. FERC designated ISO NE as a test bed for DR offers. Customers are actively being brought into the discussions Increases awareness and helps put energy on customers’ agenda Develops better understanding of what they can bring to the table with demand response and pricing options.

Key Trends The value of demand response offers (pricing and load) is becoming more widely recognized As a risk management tool (past planning tools understated value) As a supplier of reliability and operational services to grid operators. Projections of modest wholesale electric prices for the next few years has interesting effects: Creates more headroom for retailers in markets open to retail choice. Returns the willingness of regulators to experiment with pricing and demand response offers. Still, risk remains from unexpected events such as forced outages, and transmission bottlenecks.

Benefits of Demand Response Creates opportunities for risk management Enhances Market Efficiency Price reduction at the margin Enhances system reliability Potential environmental improvements Customer service and choice Market power mitigation

Key Factors So, what are markets about? Demand response is important to the continued development of wholesale and retail markets. Competitive markets are based on the interaction of supply and demand in response to price signals. However, the history is one of cost-based administered pricing in retail markets with average rates that ignore the fact that costs vary across hours, months and seasons. So, what are markets about? 1. Markets should be designed to to allocate resources efficiently. 2. This is done through price signals. 3. A promise of innovation and improved productivity -- this was a promise made by regulators as part of restructuring activities.

Bottom Line for Markets If we don’t “price what’s scarce” (e.g., peak-period commodity), how do we incent innovation and enhance productivity. If we don’t price what’s scarce, how do we improve load factors in one of the country’s most capital-intensive industries. Issues: Uncertainties from restructuring and bifurcation of incentives have discouraged investment in infrastructure to support demand response. While wholesale competition has been encouraged, it can be argued that price elasticity and demand response capabilities have actually decreased in recent years. This creates a disconnect between wholesale and retail markets.

Key Factors Opportunities for generators have increased with open access and market based rates -- this needs to be balanced with market incentives and access for demand response resources. Market designs need to provide support for this balance between supply-side and demand-response resources. This is a long term proposition -- markets that incorporate economic demand response capability will promote efficient resource investments over time. The appropriate transition path to markets with economic demand response may be uncertain and open to debate; but markets are going to change. Where are the points of leverage and how will the retail business be affected?

RTO and ISO Issues A liquidity point is needed for DR, i.e., customers able to respond to price need to benefit from taking these actions. RTOs and ISOs can provide price signals and settlements ONE VIEW: Any market in which generation competes should be open to DR resources including: Energy resource markets (day-ahead, hour-ahead, and real time) Ancillary services markets (as appropriate) Replacement reserves Emergency demand response Capacity markets In these markets, demand response resources should be treated on an equal footing with generation.

What is the Impact on Your Business? Do you believe that the retail industry is facing change? Think about the regulatory initiatives going on across the country. Think about the FERC SMD NOPR and White Paper: “Demand response is essential in competitive markets to assure the efficient interaction of supply and demand.” “Demand response options should be available so that end users can respond to price signals.” What are the implications of this attention to demand response? Are customers willing to discuss innovative pricing for electricity?

Distribution Company Distribution companies are likely to continue to have a major supply responsibility. Regulatory rules on rates (pricing) and cost recovery will be critical. Factors that impact the financials of LSEs may also impact the distribution company, specifically the role of risk management. In states with retail choice, what happens after the transition period? Up till now, demand response has not been on the regulator’s agenda -- Does that matter for the future?

Key Regulatory Issues Who benefits from and pays for demand response: If a customer is served by an unregulated energy services provider? If a distribution company acts as a standard offer provider or provider of last resort? If DR is provided by a specialist curtailment services provider (CSP)? Regulators need to develop rules that keep distribution companies from taking on additional risks without equal opportunity for reward.

Market Challenges How should DISCOs be expected to manage the large fixed-price MWh obligations as markets continue to transition? How to align retail offerings with products from wholesale markets? What types of regulatory and market rules will allow for, and even encourage, the development of tools to address these issues?

Key Trends Three trends can be expected as retail markets expand: 1. Increased recognition of the value of flexibility across both price and quantity dimensions (regulators and retailers). 2. A drive to develop innovative price and related demand response offerings that meet strategic and financial objectives. 3. There will be a re-integration of retail and wholesale activities. Physical hedges will complement financial hedges A portfolio play that manages risk will be needed to maintain margins

Pricing Options Innovation in pricing is already occurring: quantity limits two-tiered fixed/spot contracts variable TOU rates where the peak and off-peak periods are tailored to or defined by the customer hour-ahead and day-ahead quantity adjustments in contracts and demands bidding contracted quantities back into supply by customers standby and buy-through contracts retailer serving as a broker for portions of customer load on peak days Customer load control through on-site or proximate generation options

Success Factors Don’t follow. Instead, seek to create new markets with appropriately priced product offerings: Develop sales tools and techniques that engage customers in the process of procuring energy. Sales discipline -- negotiating specific pricing schemes requires setting limits and creating enabling sales tools. Analytics are developed to value the negotiated offer: A contract confers future rights to buyers which can be represented by a strip of options. Setting prices that appropriately reflect the value of these options to the seller and buyer is a challenge. Can this be done by DISCOs in a tariff environment?

Appropriate Regulatory and Market Rules Many distribution companies will continue to be in the supply business. Regulators need to set incentives that encourage economic demand response. DISCOs may already have sizeable incentives to seek out demand response that are not fully recognized. DISCO benefits depend on nature of the contracts for default, standard-offer or basic service obligations. Is there a regulatory hedge against price volatility, i.e., fuel-clause pass through? Are there inadvertent penalties for load reductions? What happens after the transition period? Outsourcing standard-offer/default service may alleviate some concerns.

Conclusion Customer differentiation matters. Different product and pricing options can be marketed. Attain what ever flexibility is available. Identify opportunities by engaging customers in the sales process. Risk management is a necessary and a critical success factor. Demand response can be one of the most cost-effective methods of managing risk, and providing operational reserves. Customers will become increasingly sophisticated. Time-differentiated pricing will increase the market for energy services by rewarding technology that manages energy use. A period of modest wholesale electric prices may promote experimentation by regulators.