Most economists believe that they can solve any problem with the right mix of incentives. They dream them up and implement them, study their results, and then reshape them. Many economists believe the world has not yet invented a problem that cannot be fixed if given a free hand to design the proper incentive scheme. The solution may not always be pretty—often involving coercion—but the original problem can be fixed. If demand response is to play a large role in solving renewable portfolio standard's (RPS) reliability problems, finding the right mix needs to take place (review my first two articles in this series on RPS reliability problems Part I & Part II.

In Part III of this series, I outline the three broad categories of incentives that can be used to solve the demand response (DR) problem: Financial Incentives, Moral Incentives and Mandatory Incentives. Given the right mix of these three incentive types, I believe that the DR problem can also be solved. To help understand how the three interact, I am going to use an example from the international best selling book, Freakonomics, which is a summary of some of University of Chicago economist Steven Levitt's research on incentives. While the whole book provides a framework on how to frame questions and seek answers to solve this problem, I am going to use his example of an Israeli daycare center.

Parents picking up children late have always been a problem of daycare centers. A pair of Israeli economists who heard of this common dilemma offered a solution: charge an additional fee to the tardy parents. The economists decided to test their solution by conducting a study of ten daycare centers in Haifa, Israel. The study lasted twenty weeks, but the additional fee was not introduced immediately. For the first four weeks, the economists simply kept track of the number of parents who came late; there were, on average, eight late pickups per week per daycare center. In the fifth week, the fee was enacted. It was announced that any parent arriving more than ten minutes late would pay $3 per child for each incident. The fee would be added to the parents' monthly bill, which was roughly $380. After the new fee was enacted, the number of late pickups promptly went up. Before long there were twenty late pickups per week, more than double the original average. The incentive had plainly backfired. So, what was wrong with the incentive at the Israeli day-care centers? The $3 fee was simply too small. For that price, a parent with one child could afford to be late every day and only pay an extra $60 each month—just one-sixth of the base fee. The problem with the day-care center late fee was it substituted a Financial Incentive of $3 for a Moral Incentive (the guilt that parents were supposed to feel when they came late). For just a few dollars each day, parents could buy off their guilt. Furthermore, the small size of the fee sent a signal to the parents that late pickups weren't such a big problem. All of us know how the day care markets of the world solved this problem as we have experienced parents abruptly leaving meetings at the end of the day to avoid very high late fees. I have heard of some late fees that are so high and parents with few other options that they go from being a Financial Incentive to a de facto Mandatory Incentive.

Any incentive structure is a trade-off of these three types of incentives. If DR is to grow in the United States, it will require the right complement of Financial, Moral, and Mandatory Incentives. Financial Incentives have been the mainstay of the DR incentive structure to date and will continue to be. Every time a transmission operator or distribution utility calls for voluntary load curtailment during peak times and customers curtail load, a Moral Incentives is used. However, Mandatory Incentives have not been used extensively and if DR is to significantly expand in its utilization, understanding how to use it in compliment with the first two will need to take place.

Examples of Mandatory Incentives in the electric utility industry are numerous. At the Federal level in the last quarter of a century they can be viewed as major segments starting with the Public Utility Regulatory Policy Act (PURPA) of 1978 and the Energy Policy Acts of 1992 and 2005. These laws set in motion the unbundling of generation as a monopoly and opened the transmission system to bulk power sales. Most states have also implemented Mandatory Incentives for a number of competitive market measures and to solve environmental and social issues, such as recent renewable portfolio standards that have been implemented in twenty five states. At the federal level, DR has had no Mandatory Incentives implemented. This is probably the result of federal law delegating retail electric oversight to state authority and the FERC not regulating retail sales. At the State level, I can only identify a few DR Mandatory Incentives and most of them could be considered a secondary effect. The one I have written about most is the requiring of default service for large C&I customers based on the wholesale electric spot market.

So, what are the ranges of options for Mandatory DR Incentives? I group them into the following:

* Compulsatory Customer Reductions: Requires customers to reduce a certain amount of electric usage at the request of an entity with penalizing authority for non compliance.
* Obligatory End-Use Control: Requires certain end usages of electricity to be used during off peak times.
* Obligatory Facility Equipment: Requires retail customers to install equipment in their facilities that has the capability to support DR.
* Distribution Utility Requirements: Requires Retail Electric Distribution utilities to implement measures that promote the expansion of DR and will complement their Financial or Moral DR Incentives.

To implement Compulsatory Customer Reductions for retail electric users will entail the following:

1. Metering capable of measuring short-term energy consumption intervals;
2. Communication systems to notify customers of curtailment requirements; and,
3. A regulatory agency to establish customer specific curtailment amounts, set penalties and enforce non-compliance.

The metering infrastructure for measurement of a Compulsatory Customer Reduction incentive is already in place for a large segment of the US's commercial and industrial (C&I) customers. There are also many options for the DR communication technology. Both of these first two infrastructure needs are also needed to manage existing Financial DR Incentives type programs and would be easy to transfer to Compulsatory Customer Reductions. Enforcement of a mandatory requirement to curtail load would be very similar to enforcement of customers on present voluntary interruptible programs. The hurdle to a mandatory reduction requirement is that a central planning process will be needed to determine how much every customer will curtail and for what types of transmission reliability needs will trigger the curtailment. Because individual retail customers have a broad range of compliance cost and curtailment potential, Compulsatory Customer Reductions will require the central administration function to allocate different curtailment requirements towards different customers to ensure that there are economic efficiency gains. It is my opinion that Mandatory Incentives of this type have a high potential to decreased economic efficiency. They should be one of the last to be considered. Before it is implemented it should be studied under controlled conditions. Also other types of Mandatory Incentives that do not have a high potential to decrease economic efficiency should be implemented first.

Obligatory End-Use Control requires certain end usages of electricity to incorporate DR. It has the potential to increase DR, especially in areas which already have existing building inspectors that are already enforcing other codes. For example, a building code would only allow controlled water heating and the customer could put in dual fuel systems or a larger storage tank so that there would not be deterioration in service quality. Another example is the plug-in hybrid car and only allowing charging under a DR controlled electric charge.

An example of a DR Obligatory Facility Equipment requirement for customer facilities is an Energy Management Systems (EMS) to control heating, ventilating, air conditioning and refrigeration equipment for residential, commercial and industrial buildings. This building requirement could also accomplish another social goal of energy efficiency. These last two types of Mandatory DR Incentives should be evaluated in conjunction with Financial and Moral DR Incentives. In addition they can be incorporated into broader incentive structures to improve energy efficiency. In addition there are many types of controls for residential appliance controls that could be installed as part of standard features.

There are many examples of Distribution Utility Requirements. As part of an IRP process, State Regulatory Commissions can require rebates for an EMS or other DR enabling equipment. However, the one I believe would be most effective is to require all large C&I customers to take default service under rates that represent the wholesale electric spot energy and capacity prices. (See Part III of this series).

To help solve the reliability problems that RPS will create will require getting the "right mix" of these three incentive types. The "right mix" will always require fine tuning and will also be different by region and will change as the regional portfolio of supply side resources change as well as customer end-use technology evolves. The solution is definitely not static. My goal in this series is to start laying out the framework to identify the range of DR incentive options.

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