TCS Daily

Green Market

By Lynne Kiesling - August 13, 2002 12:00 AM

The Federal Energy Regulatory Commission's price cap for the wholesale electricity market in the western U.S. has been renewed (it had been due to expire September 30). FERC is pursuing this strategy even though we have decades of experience in electricity and other energy markets showing that price caps don't work. Instead of creating a safe, affordable power supply, price caps create shortages and deter investment.

So where should we be focusing our attention instead? Dynamic pricing.

We should use the information benefits of price signals, making them work to the advantage of consumers instead of trying to short circuit them with price caps. Dynamic pricing of electricity does exactly that, putting more control in the hands of consumers and empowering them to make intelligent energy choices. Consumers could choose anything from a fixed price that incorporates an insurance premium to full real-time pricing, in which the customer bears the financial risk of price volatility, but could see electricity bills fall by shifting or reducing use. Dynamic pricing harnesses the dramatic improvements in information technology of the past decade to provide price signals that reflect variations in the actual costs of providing electricity at different times of the day. These same technological developments also give consumers a tool for managing their energy use. They can set electricity monitors to increase air conditioning temperatures if prices go above a certain amount, for example, or can shift manufacturing schedules to minimize electricity use during peak hours. Right now, with almost all consumers paying average prices (even industrial and commercial consumers), consumers have little incentive to manage their consumption and shift it away from peak hours during the day. That inelastic demand leads to more capital investment in power plants than would occur if consumers could make choices based on their preferences.

One of dynamic pricing's most enticing long-run benefits is that it induces conservation. If it's expensive to produce electricity in a peak hour and consumers face that price difference across a day, they have an extremely powerful incentive to shift their energy-intensive uses to non-peak hours. Price signals are the most effective way to encourage conservation and to get people to make informed choices about how and when they will use electricity. A strong economic incentive to conserve could limit or prevent blackouts. Dynamic pricing also helps us achieve our environmental goals, in two ways. First, seeing real price signals could decrease overall electricity use. Second, the higher prices in peak hours shift use away from peak hours, which decreases the need for backup generators and using older, dirtier power plants to meet the peak.

Another benefit of real-time pricing is that it gives consumers a direct way to hold generators accountable for their pricing decisions. Price signals discipline producers and decrease their ability to get higher prices in peak hours. If consumers can and will shift their demand to non-peak hours, then generators cannot charge the kinds of high prices that they could in California's dysfunctional "market" last year. And that's a benefit for all consumers, not just those who actually do shift their demand, because others will also see lower overall and peak prices. In addition, the direct accountability of generators to consumers would decrease their market power, some of which is due to the fact that consumers currently have no incentive to shift their demand away from peak hours, so generators can charge higher prices in those hours.

Experimental economists Vernon Smith, Bart Wilson, and Steve Rassenti have shown in repeated experiments that demand responsiveness makes electricity consumers better off, reduce price spikes and price volatility, and reduce the need to build more plants to serve peak demands. Customer demand response also disciplines the ability of wholesale suppliers to raise prices in peak hours, because customers have the alternative of shifting their use to other hours or cutting their use of electricity.

Dynamic pricing programs are in place in several areas of the country, including Georgia, New York, and Washington. Georgia has seen peak summer demand fall by 5 percent since Georgia Power implemented real-time pricing for only 1,650 large users. New York implemented a voluntary demand reduction program last summer, in which participants cut their peak demand by 39 percent and the state avoided blackouts on the hottest days of August. For more than a year, Washington's Puget Sound Energy has been running a "Personal Energy Management (PEM)" time of use program, where customers face different prices in four different time blocks over the day. Puget Sound Energy's customers are happy with the program, 90 percent of PEM customers have changed their energy use, and the program has been expanded as a more fixed feature of Puget Sound Energy's rate tariff. PEM customers have both shifted their use to different times of the day and reduced their overall use.

In fact, as early as November, 2000, officials at Puget Sound Energy suggested real-time pricing to the Federal Energy Regulatory Commission as a way to address California's electricity problems, which only escalated after then. In February, 2001, economists from the University of California Energy Institute proposed real-time pricing to California's Governor Davis. Their recommendation focused on large users who consume over 100 kilowatts a day; these large users account for half of California's peak-hour demand. Since then, though, the debate has centered on price caps as a way to manage the market power that generators have. Focusing more on real-time pricing and demand response programs, and less on political solutions that are proven to fail, would be a more constructive way to mitigate the market power of generators and keep the lights on in the west and the rest of the country.

Lynne Kiesling is Director of Economic Policy at Reason Public Policy Institute and Senior Lecturer of Economics at Northwestern University.

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