Elsevier

Economic Analysis and Policy

Volume 48, December 2015, Pages 128-138
Economic Analysis and Policy

Full length article
Which electricity market design to encourage the development of demand response?

https://doi.org/10.1016/j.eap.2015.11.006Get rights and content

Abstract

Demand response is a cornerstone problem in electricity markets under climate change constraints. Most liberalized electricity markets have a poor track record at encouraging the deployment of smart meters and the development of demand response. In Europe, different models are considered for demand response, from a development under a regulated regime to a development under competitive perspectives. In this paper focusing on demand response and smart metering for mid-size and small consumers, we investigate which types of market signals should be sent to demand managers to see demand response emerge as a competitive activity. Using data from the French power system over nine years, we compare the possible market design options which would enable the development of demand response. Our simulations demonstrate that under the current market rules demand response is not a profitable activity in the French electricity industry. Introducing a capacity market could bring additional revenues to demand response providers and improve incentives to put in place demand response programs in a market environment.

Introduction

Physical equilibrium between generation and load in real-time has always been a key issue for the power system operator because this energy cannot be stored economically on a large scale. Without storage, equilibrium in real-time has been traditionally managed thanks to a flexible portfolio of different generation units. Meanwhile, demand response has been used by incumbents to balance their power system for quite a long time. For instance, there were 6 GW of demand response in France at the end of the 1990s while there were only 3.5 GW in 2007 (CRE, 2013). Demand response is becoming now more interesting with the development of smart grid technologies. With these new technologies, the potential capacity of demand response in France could reach 10–15 GW (E-cube, 2013). The market rules are hence evolving in different countries to ease the integration of demand response in the power market (e.g. in France–RTE, 2013–in Belgium–CREG et al., 2014–or in the USA—Hurley et al., 2013).

The main interest of demand response is that it participates in balancing the power system for some hundreds of hours a year in the same way peak generation does (Faruqui and Earle, 2006, Faruqui and Sergici, 2010, Faruqui et al., 2010). Demand response has been capturing attention because most liberalized power systems with an ‘energy only’ market are characterized by a deficit of investment in peaking units, caused by a lack of revenue. This so-called “missing money” problem has now been widely studied (see Joskow, 2007, Joskow, 2008, Cramton and Stoft (2006) and Finon and Pignon, 2008a, Finon and Pignon, 2008b for an in-depth survey). The solutions to address the peaking unit missing money issue include a range of market arrangements, such as the introduction of a strategic reserve of power plants owned (e.g. in Finland) or contracted by the system operator (e.g. in Belgium), capacity payments (in Italy or Argentina) or capacity markets (in different markets in the USA, in PJM, ISO-NE or NY-ISO). Different countries have tried different arrangements (see Finon and Pignon, 2008a, Finon and Pignon, 2008b; see also Stamtsis and Lynchnaras, 2015 for a description of the national capacity remuneration mechanisms in the European Union) and Khalfallah (2011) proposed a model for generation capacity adequacy that allows comparison between investment incentive mechanisms in electricity markets.

But assuming that demand response can be a substitute for peak generation invites us to analyze the potential impact of the missing money problem on demand response solutions. To test the existence of this “missing money for demand response” hypothesis, we will try to evaluate this gap using empirical data from the French power market over nine years. By doing so we contribute to the debate on the challenges the smart grids and demand response investment programs will undergo in the future (Allcott, 2011, Joskow, 2012).

Our simulations show that the ‘missing money’ issue in current power markets is very likely to affect demand response aggregators and to make the recovery of the upfront investment in smart metering infrastructures difficult to recoup through market revenues without additional capacity remuneration. We will then wonder which market design could foster the development of demand response toward small (domestic and tertiary) consumers, that is to say which types of market signals should be send to demand managers to see demand response emerge as a competitive activity solving the missing money issue. In Europe, demand response is considered as a new vector to foster competition and liquidity. To the contrary, because of the subsidiarity of Member States with regard to their energy policy, the diversity of policies supporting Renewable Energy Sources for Electricity (Finon and Perez, 2007, Henriot, 2015, Saguan and Douguet, 2013) as well as the diversity of capacity remuneration mechanisms (ACER,22013; Glachant and Henriot, 2013; Veyrenc, 2014) and the integration of interconnection capacity in those mechanisms are seen as obstacles to the integration of the European electricity market and the development of competition (European Commission, 2015a, European Commission, 2015b).

The paper is structured as follows: we first specify the economics and technical characteristics that distinguish demand response from peak generation. Then, we highlight the problem of compensation that a demand response program would experience on a power market. At last, we study the matching between the incentive mechanisms implemented to ensure sufficient peak generation investment and the specificities of demand response. We conclude about the ability of pure liberalized market solution to provide sufficient incentives for the development of demand response.

Section snippets

The parallel between a demand response program and a peak generator

A demand response program and a peak generator face a number of similar issues, including the “missing money” problem observed in most liberalized power markets. But there are also several significant differences to be highlighted. In this section, we demonstrate that both similarities and differences in issues met should be taken into account when evaluating the impact of the missing money issue on the profitability of a demand response program.

The need to pay a demand response program for availability

The implementation costs of demand response for the big industrial consumers11 and the big tertiary consumers12 are quite low and adapted to load management (5000–10,000 €/MW for investment,13

Which solution to solve the missing money problem for a demand response program?

Electricity markets currently implement different tools to solve the missing money problem for peak generation. Some markets have implemented regulation-oriented mechanisms to remunerate peak generation while other regions have implemented market-oriented mechanisms instead. Finon and Pignon, 2008a, Finon and Pignon, 2008b distinguish four main types of solutions to compensate for the missing money problem: namely Strategic Reserves (detained by the system operator), Long Term Contract,

Conclusion

In this paper we wondered which market design (if any) could permit the merchant development of demand response and smart metering. We answered this question considering the similarities (as for investment, use and economic function) between peak generation and demand response and the difficulties experienced at the international level by peak generation for its revenue in a pure market configuration and the solutions proposed by the electricity markets.

Studying the matching between the

Acknowledgments

The views expressed are those of the authors only. We thank Sébastien Douguet and the anonymous referees for their careful reading and valuable comments.

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