Why are DER Compensation Mechanisms Important? | Clean Power Hub

Why are DER Compensation Mechanisms Important?

Compensation mechanisms are important for incentivizing consumer adoption of DERs and for encouraging DER operation to support electricity system needs. However, these priorities must be balanced with the impact DERs may have on other system stakeholders. Also, some compensation mechanisms may be better suited for certain policy objectives than others, and the mechanisms may need to change as the power system evolves and policy objectives change.

These factors make it essential for policymakers and regulators to understand compensation mechanism design decisions and to know when to adapt compensation programs to address new circumstances.

What You Need To Know

  • Compensation mechanisms are critical for aligning customer behavior with power system needs. They have a profound influence on which DERs customers adopt, which customer classes adopt them, and ultimately how DERs are operated.
  • Well-designed compensation mechanisms can reduce the risk of cost-shifting between customers and ensure revenue sufficiency for distribution utilities. There are tools regulators can use to gauge the potential level of financial impact on utilities and non-adopting customers.
  • Some compensation mechanisms may be mutually exclusive with particular power sector objectives; they may also need to be customized for different DER technologies and/or customer classes.
  • Compensation mechanisms should be regularly reviewed and revised to address new circumstances.

First, Read This

Installing distributed generation (DG) systems affects all power system stakeholder groups. Carefully designed compensation mechanisms can ensure that the benefits and any negative impacts are shared equitably among stakeholders while still achieving policy goals.

Why Do Compensation Mechanisms Matter?

A well-designed compensation mechanism can help minimize the negative impacts and maximize the value of DG to all stakeholder groups, including distribution utilities, the DG system owner, and other ratepayers (non-DG-system owners). Different compensation mechanisms have been tested in different country contexts, revealing useful lessons for utilities, regulators, and policymakers.

Who Is Affected When a Customer Installs DG?

Installing a DG system can have financial implications for utilities and ratepayers in addition to system owners. Utilities often experience lost electricity sales under metering & billing arrangements that allow DG system owners to self-consume electricity prior to export (i.e., NEM [net energy metering] and net billing). Self-consumption allows DG system owners to reduce or eliminate the variable charge portion of their electricity bills. This may lead to an underrecovery of the utility’s fixed costs because utilities often recover some of the costs incurred for maintaining the network from the volumetric energy charge component of their electricity tariff.

DG systems may also lead to an increase or decrease in required utility grid infrastructure investments. If additional investments are warranted, utilities may pass these costs on to customers through rate increases. If investments can be deferred or avoided, rates may decrease.

The net effect of DG adoption on nonadopting customers therefore depends on the entire set of costs and benefits caused by DG adoption. If the net effect of DG adoption is determined to be a net cost, then nonadopting customers may experience an increase in their bills. This outcome is sometimes called cross-subsidization or cost shifting because DG adoption sometimes shifts costs onto nonadopting customers.

A well-designed compensation mechanism mitigates negative effects, reinforces positive effects, and supports the full and fair value of DG to distribution utilities, DG system owners, and non-DG-owning ratepayers.

Text excerpts from pages 1 - 2 of NREL: Grid-connected Distributed Generation: Compensation Mechanism Basics

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Determining DG Value

At the heart of designing a compensation mechanism lies two questions: What is the value proposition of DG to the utility and ratepayers, and how does it change over time? Is the average level of DG compensation greater than, equal to, or less than the value of DG to the utility? These questions can be quite challenging to answer. On the one hand, the metering & billing arrangements, the sell rate, the retail rate of electricity, and the DG system costs are known, and hence an average compensation level for DG can be estimated based on generation from the DG system and customer load profiles. However, from the utility perspective, the avoided costs less the incurred costs of a DG system are more difficult to quantify and may be realized over different time frames.

When assessing utility impacts and cost shifting, it is essential to do so from both short-term and long-term perspectives because the benefits of DG are not always realized immediately. In many circumstances, short-term rate increases resulting from reduced electricity sales can be followed by longer-term decreases resulting from deferred or avoided investments and other DG benefits. The true long-term system value of DG systems may outweigh immediate-term cost shifting impacts.

The sell rate for DG electricity exported to the grid can be higher or lower than the value of that electricity to the utility. The value of exported DG electricity to the utility is frequently not well understood, and utilities may overcompensate or undercompensate DG system owners. Overcompensation can exacerbate cost shifting to non-DG-system owners and can, in some cases, accelerate deployment; conversely, undercompensation can shift additional costs to DG system owners and potentially stymie DG deployment.

Given this complexity, it is critical that DG analyses that examine DG programs distinguish between short- and long-term impacts, and also consider different stakeholder perspectives to achieve a balanced and holistic understanding of DG impacts at large. There are numerous methodologies for quantifying DG costs and benefits. As these methodologies evolve and technologies (e.g., communications, smart grid) advance, policymakers and regulators will glean more insight into DG’s value to customers, utilities, and society.

Text excerpts from pages 8 and 11 of NREL: Grid-connected Distributed Generation: Compensation Mechanism Basics

Suggested Actions & Next Steps

  • Review these Best Practices and Takeaways and Other Practical Considerations for DPV analysis from Greening the Grid. These best practices and considerations can apply to analysis of any DER technology.
  • Continue with the other sections of this topic on DER compensation measures before taking further steps.


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