We characterize the optimal regulatory policy to promote efficient demand response (DR) in the electricity sector. DR arises when consumers reduce their purchases of electricity below historic levels at times when the utility’s marginal cost of supplying electricity is relatively high. The US Federal Energy Regulatory Commission (FERC) advocates compensation for DR that reflects the utility’s marginal cost. We show that the optimal policy often provides less generous compensation, and demonstrate that implementation of the FERC’s policy can reduce welfare well below the level secured by the optimal DR policy.