Now Is the Time to Implement Real-time Pricing of Electricity

Editor’s Note: This is the second of two posts. Yesterday’s examined the need for a carbon tax as a way to reduce carbon emissions.

Real-time pricing of electricity is a logical complement to a carbon tax. Economists are fond of saying:  “First, get the price right.” What they mean is, if we can take the actions needed to price a good or service at its full social cost, including externalities, we will have much less need to use crude and blunt instruments, like command and control regulation, to get results that maximize social welfare. By placing an appropriate price on carbon, we will take a major step in the direction of getting the price of electricity right by reflecting the social cost of the GHGs used to generate electricity in the price of electricity. We can complete the process of getting the price of electricity right by encouraging electric utilities to charge prices that reflect the highly variable social cost of electricity at different times.

The demand for electricity varies over a wide range depending on factors like weather. The demand on a hot summer day can be many times the demand on a cool fall day. We do not yet have an economic way of storing large quantities of electricity. As a result, we must attempt to build an infrastructure that can accommodate periods of high demand with a necessarily corresponding surplus of infrastructure during times of low demand. That infrastructure includes peaking generators that are less efficient than base-load generators but that can be turned on and off quickly in response to changes in demand, spinning reserves that must continue to operate at times when they are not needed in order to be able to respond rapidly to changes in demand, and transmission lines that have insufficient capacity at times of high demand and excess capacity at times of low demand.

As a result of the highly variable demand for electricity over time and the absence of an economic method of storing electricity, the social cost of providing electricity to consumers can vary by a factor of 100 to 1 in some locations. That social cost includes the cost of building and using peaking plants, the cost of spinning reserves, the cost of having to divert transmission capacity from one customer to another or to replace an efficient generating plant with a less efficient generating plant at times when transmission capacity is scarce, and, with the adoption of a carbon tax, the social cost of the GHGs emitted in the process of providing electricity to consumers.

Over the last two decades, we have restructured the wholesale electricity market in most regions of the country to create a wholesale market in which the wholesale price of electricity reflects the widely varying cost of supplying electricity in market conditions that change quickly over time. We have left in place, however, a system in which retail prices are flat and do not vary with the changes in market conditions that yield widely varying social costs. As a result, we send misleading price signals to retail customers that induce them to use too much electricity at times when providing electricity has  high social costs and too little electricity at times when providing electricity has much lower social costs.

We can correct that market error by adopting real-time pricing at the retail level—that is a pricing system in which the retail price of electricity reflects the highly variable social cost of electricity at different times. Like a carbon tax, real-time pricing would create a variety of healthy market-based incentives. It would encourage customers to change their temporal pattern of electricity use so that they use less electricity at times when its production and delivery requires high social costs and more electricity at times when its production and delivery require much lower social costs. Real-time prices would also send more accurate price signals about the need for increased transmission capacity, and more accurate price signals about the value of storage. Those price signals would provide market-based incentives to expand transmission capacity where it would reduce social costs and not where it would yield a net increase in social costs. Equally as important, they would create incentives to develop economic ways of storing electricity that would allow utilities to equate the supply and demand of electricity at lower social cost.    

Experiments and studies have produced findings that adoption of real-time pricing reduces both each customer’s total cost of electricity and the total social cost of providing electricity, including emissions of GHGs, by 10 to 15 percent. Some customers oppose adoption of real-time pricing because they fear it will increase their total cost of electricity and/or because they fear that it will allow invasions of their privacy. The first concern has been contradicted by the many studies that have found that real-time pricing reduces the total cost of electricity to all customers, while the second concern can be eliminated by imposing restrictions on the use and distribution of the customer-specific data that real-time pricing will make available to utilities.

The conditions for adopting real-time pricing are ideal today for four reasons.

First, the restructuring of the wholesale market that has occurred over the last two decades makes it easy to adopt real-time pricing at the retail level. We need only to allow utilities to adopt retail prices that reflect the constantly varying prices that they pay at wholesale.

Second, over the last few years, many utilities have installed smart meters—meters that can record electricity used in each time period. Those meters are a necessary precondition for adoption of real-time pricing.

Third, recent advances in devising economic methods of storing electricity in bulk are encouraging, but adoption of real-time pricing would increase dramatically the incentives to devote major research and development efforts to the search for economical methods of storing electricity. As Paul Joskow at MIT has explained in his excellent article in the May 2011 issue of American Economic Review, we must implement methods of economically storing electricity if we want to make variable sources of electricity, like wind and solar, available on an economic basis.

Fourth, we have a particularly good opportunity to use increased electricity transmission capacity to reduce social costs today. The relatively sparsely populated midwest has enormous potential to produce wind power that can displace much of the coal power that is the source of a high proportion of the electricity provided on the densely populated east coast. We do not have nearly enough transmission capacity to allow that displacement of high emission fuels with zero emissions wind-power, however. Adoption of real-time pricing, along with a carbon tax, would provide far more accurate price signals that reflect the high social value of construction of the additional transmission capacity that is a prerequisite to obtaining the large reductions in social costs that are potentially available through replacement of high emission generating fuels with zero emissions wind-power in the most densely populated region in the U.S.

We have never had conditions as good as the present conditions to adopt two market-based, efficient, and effective methods of mitigating climate change—implementation of a carbon tax and adoption of real-time pricing. If everyone who wants to minimize the devastating costs of adapting to a changed climate becomes actively involved in efforts to adopt these two methods of mitigation, the prospects for success have never been better.