In this post, Outsmartingthegrid gladly opens its pages to air a guest editorial submitted by Dr. Alfred E. Kahn in direct reply to the recent post — “The Nutty Professors: Bill, Fred and the Strange Case of Demand Response” (September 10, 2010). That  post aired the debate betwen Professor Kahn (“Fred”), and Professor William W. Hogan (“Bill”), over a proposal by the U.S. Federal Energy Regulatory Commission to pay the going market price for bulk power to demand response resources, putting curtailment offers on par with actual electric generation supply.Background info, plus links to documents, will appear at the end.

 But for now, Outsmartingthegrid turns the podium over to Professor Kahn who writes as follows:

As the second of the two “nutty professors” whose conflicting testimonies — respectively opposing and initially successfully proposing (and subsequently defending) the provisional decision by the Federal Energy Regulatory Commission to require regional electric transmission operators (RTOs) to conduct daily and hourly auctions of proposed curtailments in the purchase of electric power — Bruce W. Radford summarizes with an apparently fine impartiality, it will take me little more than to rearrange his exposition to demonstrate that, as a matter of the most elementary economic principles — to which all of us subscribe — FERC and I are right and “Bill,” along with other opposing interveners, wrong.

The easiest way to demonstrate this is to begin — as “Bruce” does, following a fine journalistic instinct — by looking a little more deeply at Bill’s superficially relevant proffered reductio ad absurdum of the FERC plan to reward successful bidders offering to curtail (or help others to curtail) their use of electric power, particularly at times of peak demand — according to the schedules set forth in their winning bids — by having the pool pay them the marginal costs (LMP) of the power they refrain (or help others to refrain) from consuming. Where Bill has noted there is no need for consumers to be paid for shoes they don’t purchase, Bruce poses a (deceptively) simple analogy of some character in an automobile showroom approaching a salesman and demanding payment of the retail price of a car that he says he has decided not to purchase. Would that absurd demand be any different from the FERC proposal? Why wouldn’t his sufficient reward be the dollars that he automatically retains — without government assistance — saving (both himself and society) by his refraining from making the purchase? What logic is there in the FERC (and my) proposal to reward people who refrain from using electric power (with or without intermediary assemblers of “negawatt” bids) explicitly and additionally with the market-equilibrating marginal costs that their restraint saves the system?

The answer is to be found where I put it, deliberately, at the very beginning of my testimony, in describing the critical characteristics of electric power supply — a description that Bruce presents only near the end of his article, without confronting its critical difference from the irrelevant, though hilarious, shoe, bananas, and now automobiles caricatures.

All of these observations of mine, Mr. Radford — excuse me, “Bruce” — reproduces with an apparent fine impartiality but without pointing out the critical way in which those characteristics of electricity supply and demand render Bill’s and his own, proffered analogies irrelevant.

In short, as I pointed out, electric power generation is subject to steeply increasing marginal supply costs with increasing demand — including, in the extreme, the increasing risk of system-wide breakdown.*

*As Robert Borlick points out in his rebuttal, such breakdowns are characteristically avoided by prearranged curtailments of purchasers by large industrial customers. But such curtailments are of course not costless.

This would not in itself create problems requiring regulatory intervention: it is the essential virtue of the market that prices reflect the consequent widely varying and changing marginal costs of supply, moment-to-moment, day-to-day, season-to-season: economic efficiency requires that prices fluctuate correspondingly.

But, second, as I also pointed out in my original testimony, the critical ingredient missing from the case of electric power (in stark contrast with automobiles and shoes, the marginal costs of which do not fluctuate so widely), is that the costs of the metering necessary to confront consumers of electricity with those widely varying and constantly changing marginal costs are prohibitive for the great majority of individual purchasers, as (once again) I emphasized in my original testimony. I also acknowledged the regulatory barriers at the state level to exposing retail customers to those costs — which Bill and other witnesses emphasize, going on to demand that FERC overcome by adopting solutions they propose instead of the ones at issue in this proceeding. And yet there is also a universal interest of all consumers collectively that each of them confront those ever-changing marginal costs and, especially, be sparing in their usage as collective demand and marginal costs approach their peak: the price I pay depends upon the responsiveness to price of each and every other user.

That is why the FERC order makes provision for middlemen or institutions bidding for the opportunity to encourage the rational reaction of individual consumers to the changing marginal costs, from moment to moment, day to day and so on. That is the justification for vesting in ISOs responsibility for establishing markets for “negawatts” — promised reductions in purchases: the price that each of us pays for electricity depends — inversely — on the extent to which all others of us customers react rationally to the prices we confront.

I pass over the responsibility of the ISOs for validating the performance of successful bidders, providing rewards and penalties to ensure that they do in fact fulfill the promises in their successful bids — not because I believe those problems are unimportant, but because I have no particular competence to advise them.

As to Bruce’s postulated stranger in the automobile showroom, I have a direct interest in his being sparing in his use of electric power, particularly at times of peak consumption, but as to whether he does or does not buy that postulated car — frankly, my dear Bruce, I don’t give a damn.

–Professor Alfred E. Kahn

Editor’s Notes and Background:

Dr. Alfred E. Kahn is the Robert Julius Thorne Professor of Political Economy, Emeritus, Cornell University, and special consultant to NERC Economic Consulting.

Professor Kahn first testified on FERC’s idea in an affidavit filed in September 2009 as Attachment “A” to comments filed by Demand Response Supporters (DRS), in the  FERC proceeding, Docket ER09-68. Professor Hogan responded in October 2009 in a paper attached to comments in that Docket filed by EPSA, the Electric Power Supply Association (EPSA). I covered this exchange in Public Utilities Fortnightly in December 2009, in a column I wrote  entitled “Negawatt Pricing.”   

Professor Hogan then supplied a second paper in May 2010, attached to EPSA comments filed in FERC Docket RM10-17. Kahn then answered in August 2010 in testimony attached to DRS comments in RM10-17. Hogan then replied in testimony he gave in person at a technical conference held at FERC on September 13.

That technical conference in turn revealed a philosophical split within the FERC itself, as was reported here in September, and in my column published in October in Public Utilities Fortnightly, “One if by Wholesale, Two if by Retail.”

–Bruce W. Radford, Public Utilities Fortnightly magazine