Imagine walking into a new Honda showroom and telling the salesman that you won’t be buying that new model this year, as you often do.

And by the way, before you kick the tires one last time and stroll out the door, you ask if the dealer would be so kind as to write you a check for the full sticker price of a brand-new Accord, fully loaded, since, by resisting the urge to buy, and making do with your tired old vehicle for one more year, you have made sure that the dealership now will have one more car in its inventory than it otherwise would — a benefit for the dealer every bit as tangible as if the factory had shipped one extra car for free to the showroom floor.

Sound nutty? Well, on Monday, September 13, the FERC Staff will hold a conference to debate this very idea – applied not to new model cars, but to wholesale electricity. (Notice of Technical Conference, FERC Docket RM10-17.)

Back on March 18, the Federal Energy Regulatory Commission (FERC) issued a notice of proposed rulemaking (NOPR) that seemingly would do just as our imaginary Honda buyer might want. (Press Release, “FERC Seeks Comment on Demand Response Compensation.) FERC would mandate that in regional wholesale power markets, the RTO, ISO or applicable market operator would compensate so-called “demand response resources” that offer to cut back their power purchases in the wholesale market to reduce demand on costly electric generating capacity. You promise not to buy power and presto, the market owes you for that new megawatt you won’t be buying. And as a non-consumer of electricity, you get paid just as if you were a generating plant owner selling your output into the market.

According to FERC’s proposal, customers and aggregators offering to sell demand response into wholesale power markets would receive compensation set equal to the full market-clearing price – otherwise known as LMP (Locational Marginal Price). As for how much this would cost, well, the RTO market operator would fund this mandate presumably by adding some sort of surcharge to the price-setting formula and allocating a share of this “uplift” to all traders participating in the market.

As you might expect, this idea has got the entire power industry bent out of joint. It has put power industry upstarts, such as EnerNoc, Comverge, Viridity, and even Wal-Mart at loggerheads with traditional industry players, such as the EEI (Edison Electric Institute), representing retail utilities, and even EPSA (Electric Power Supply Association), representing generating plant owners. It has even set against each other two of the industry’s most celebrated economists and thinkers – Harvard Professor William Hogan (Bill), the father of RTO wholesale power markets, who argues against FERC’s proposal as a double-payment windfall for demand response, and Cornell Professor-Emeritus Alfred Kahn (Fred), the godfather of utility deregulation, who claims that anything less will do a disservice to market economics.

FERC’s idea requires a leap of faith. In short, the commission is saying that a megawatt not bought (a “negawatt”) is just as good as a megawatt generated. Thus, demand response should sell at wholesale at the same price as generated power.

Bill Hogan says no – that paying full LMP for demand response is an inefficient subsidy. Armed with charts and graphs, he argues that a customer who promises not to consume already reaps benefit because he is avoiding having to pay the purchase price. Thus, paying the full market price amounts to a double payment. Hogan and these other experts add that since the consumer never bought any power in the first place, and so cannot claim to be any selling power now, through his DR offer.

In fact, even the Federal Trade Commission, weighing in with comments on FERC’s proposal, has taken Hogan’s side. “We question the soundness of a policy that would pay companies the proceeds from the sale of power that they never bought in the first place.”

Instead, the FTC argues that FERC should determine the compensation level “by subtracting the retail price from the LMP.”

In line with the FTC’s take, as experts such as consultant Robert Borlick have argued, the consumer who offers to sell demand response into the wholesale market is not really selling a supply of power.

As Borlick explained in an article he published in August issue of Public Utilities Fortnightly, the DR bidder is selling back to the utility his right to obtain retail electric service at just and reasonable rates, as guaranteed by the electric utility “regulatory compact.” In essence, the consumer is offering to release the utility from its “duty to serve.” Thus, what the consumer is really selling is a call option – a contract right that should carry a very different value than the LMP market-clearing price.

Borlick explained this idea further in comments he filed at FERC back in May:

“[A] negawatt-hour of demand response delivered by a retail customer is essentially a physical call option on energy whose economic value is partly determined by the wholesale market price of energy and partly determined by the energy prices in that customer’s retail tariff.”

Hogan and many others agree. Instead of paying full LMP, they argue, the RTO should pay LMP-G, with “G” being the generation component of the retail electric rate. Anything more, says Hogan, would represent a subsidy.

Fred Kahn responds, “Subsidy, schmubsidy.” Kahn counters that demand response marks the mirror image of generation, and should be compensated the same. He emphasizes that the electric utility industry is plagued by rising marginal costs: the more power that is produced, the more it costs to generate that next increment. Thus, Kahn argues that paying full market price for demand response is justified because it produces net positive effects for society at large, in the form of lower overall electric rates.

In fact, just as Fred Kahn claims, demand response can save millions for consumers at a very low cost, owing to the increasing-cost nature of power generation, as I explained last year in the Fortnightly in my “Commission Watch” column, “Negawatt Pricing: Economists take sides in the battle for DR’s soul.”

That column reported the Hogan-Kahn rift and showed how PJM in the summer of 2006 had saved $650 million for consumers in lower electric prices, simply at a cost of just $5 million in demand response payments, by lowering the quantity of generated power, and thus avoiding those higher-priced megawatts at the high end of the marginal cost curve that Kahn feels are so important.

And this question of societal benefits is crucial to FERC’s Technical conference set for September 13. It seems some parties have suggested a middle ground – pay the full LMP price for DR only if it can be proven that the particular negawatts in question will confer measurable “net benefits” to the market or the operational grid system.

But does FERC have any business doling out societal benefits, when it’s statutory charter appears to limit its role to transmission regulation?

Another noted academic and former utility commissioner, Charles Cicchetti, has his doubts. Note first that Cicchetti counts himself as a friend and colleague of both Hogan and Kahn, and in fact gives them credit for contributing ideas for Cicchetti’s recent book, “Going Green and Getting Regulation Right: A Primer for Energy Efficiency” (Public Utilities Reports, Inc., 2009).  But in comments he filed on the DR compensation issue, Cicchetti questions whether FERC should get involved in the spreading around of societal benefits stemming from energy efficiency and conservation:

“Call me old fashioned,” writes Cicchetti, “but this seems more like legislation than regulation.

“I do not want to speculate, but if the Commission takes this approach, I suspect the energy generated will be in legal wrangling, not energy efficiency.”

But that has not stopped our beloved professors Hogan and Kahn from trading barbs in the latest round of debate.

Bill Hogan got in a subtle dig back in a policy paper he prepared as part of EPSA’s formal comments to FERC, in which he questioned why consumers should be rewarded for the simple act of not buying. Take shoes, for instance:

 “In the market for shoes,” Hogan wrote, “there is no need to pay consumers for reducing the number of shoes they purchase.”

Then Fred Kahn then fired back, in testimony he provided for Comverge, EnergyConnect, EnerNOC, Viridity, and Wal-Mart (the “Demand Response Supporters,”), who included Kahn’s testimony in comments they filed at FERC just two weeks ago.

 In his testimony, Kahn noted what he felt was the even greater folly of comparing electricity to shoes, and accused both Borlick and Bill Hogan of “overlooking” the phenomenon of diminishing returns (rising marginal costs) in the electric power industry:

“I begin with the rebuttal testimony of Mr. Robert Borlick … he and Professor Hogan have both overlooked … the phenomenon of diminishing returns or increasing unit costs … which also, incidentally, demonstrates the irrelevance of Professor Hogan’s example of the retail purchase of shoes.”

So, how can these professors be so “nutty.”  How can they differ so completely on such a simple question?

In a sense, it all boils down to different agendas. Hogan, Borlick and others see demand response not as an end in itself. Rather, they believe that DR should function as a bridge to the long-hoped-for world of the smart grid. That’s where, with the aid of improved electric meters, fancy digital software, and revamped electric rates, consumers will be able to track dynamic changes in the cost of electricity, minute-by-minute, and make their buying decisions accordingly. Under this idea, sometimes expressed as “price-responsive demand,” electricity customers should behave just like any other consumers. When the electricity price rockets up, if you don’t want to pay the going price, you just do without. Just like shoes. Or a new Honda Accord.

Under this view, demand response is seen as a second-best substitute for a true and effective competitive retail electricity market. To Hogan, Borlick and the like, the idea that DR compensation equals LMP-G is a mathematical construct that can be easily proved with charts and graphs. That’s because, in their view, DR programs should be structured accordingly on purely market principles, in an effort to approximate the smart grid world of price-responsive demand – what Borlick calls the “gold standard.”

In fact, in a column I wrote in Fortnightly in April (“Two Hands Clapping: Has demand response reached an evolutionary dead end?), I explored the idea that FERC’s views on demand response may eventually run afoul of the smart grid concept, with digital entitlement, total consumer sovereignty, and purely market-based dynamic retail pricing. I also noted how at least some academics agree, to the tune that FERC may just be its own worst enemy when it comes to demand response.

To Fred Kahn, however, such ideas ignore the political and legal reality.

First Kahn points out that a purely market-based dynamic pricing could spark a customer backlash leading to the well-documented “reluctance of state regulatory commissions, reflecting a populist distaste, to charge customers for their usage.”

Kahn then adds that any effort to convince FERC to jigger wholesale power markets simply to fix shortcomings at the retail level will lead to chaos:

 “The concerns [of Hogan and Borlick] are uniformly based – consciously or unconsciously – on the conception that [FERC] should be guided in setting wholesale rate by – actual or potential – inefficiencies in retail markets.”

That, says Kahn, would lead FERC away from its limited mandate to keep wholesale rates just and reasonable.

Intead, what Kahn wants, essentially, is for FERC to conduct a sort of federally directed integrated resource planning; to use its power to regulate wholesale power markets not to achieve consumer sovereignty in a smart grid world, but to keep overall costs as low as possible:

“In a situation in which an increment in consumption has the external effect of increasing the cost of service to other customers, and there is a social interest in encouraging energy conservation, it is perfectly reasonable for society … to reimburse such efforts.”

Kahn’s conclusion?

“If the commission tends to its own knitting, the approach it has set out [paying full LMP for demand resonse] … is clearly the correct one.”

And he warns FERC against leading any crusade to the smart grid or a perfect retail market:

[T]o interpret its mandate as equivalent to political correctness … would be, I suggest, madness.”

Yet elsewhere in his comments, Fred Kahn admits that demand response pushes the boundaries of regulatory imagination:

“Of course, there is an element of strangeness in a supplier being required to reimburse a customer for refraining from purchasing.”

Madness indeed.