Increasing the Price Sensitivity of the Demand for Hourly Electricity

This Won't be Boring!

As the Summer Heat starts to cook us, there will be plenty of news media discussion about the reliability of the power grid. A cliche story is that if there is rising demand and unreliable supply then there can be hours and days when people and firms do not have access to the grid’s electricity. If they do not have easy access to backup power, their quality of life and productivity and even their survival can be affected. The rise of electric vehicles and electric homes only exacerbates this challenge.

Econ 101 offers an easy blackboard solution. When demand is rising, if supply is limited then price should rise so that supply and demand are in balance. As more of us have real time monitors on our homes, cars, home charging stations and firms, we know in real time what is the price per kwh for the next hour. We are adults and we can choose how much power to consume. Many state PUCs have chosen to not treat people and firms as adults and have artificially protected them using price ceilings.

Imagine a Milton Friedmanish economy where consumers were exposed to real time price spike risks. They would adapt to anticipated huge bills by making pro-active investments in energy efficient durables that can be operated during those times. This aggregate demand would provide an incentive for entrepreneurs to invest more time and effort designing energy efficient products.

You might argue that it takes time and effort to manage your home’s energy consumption. While this is currently true, Google owns the Nest . It can manage such activities for you. These engineering solutions become more viable if the price of electricity, water and natural gas can get very high.

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Suppose we acknowledge that incumbent firms and households have a property right to not be exposed to dynamic pricing that reflects hourly scarcity. In this case, an opt-in incentive program could be introduced to encourage a subset of those who are quite price sensitive to opt in. As we discuss in this piece, they could receive an upfront payment in return for facing market prices for water, natural gas and electricity. The incentive should be targeted at those who are large consumers and likely to be price sensitive.

By the logic of revealed preference, they would only opt in if they expect that the incentive will make them better off.

As more and more households and firms are exposed to dynamic pricing, they have greater incentives to invest in durables and behavioral change that makes them more price sensitive. In this sense, the shape of a firm' or household’s demand for electricity is not a law of physics. They choose how price sensitive they are and if they are given an incentive to become more price sensitive (by buying green durables) then they will be more price sensitive. If enough consumers make these investments then the aggregate demand for electricity and water becomes more price sensitive.

This would mean that society’s resilience will increase because smaller changes in price would be needed to keep aggregate supply and demand in balance.

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A NEW IDEA

Many economists are writing papers these days about building codes and they role that they play in protecting homes from fire risk. Studies document that older homes face more fire risk and impose social costs on nearby neighbors as fires rage and can accelerate as old homes act as fuel for the fire.

Real estate developers are required to comply with building codes. These codes do impose costs on developers relative to what their construction costs would be if they did not have to comply with the codes.

IMAGINE if real estate developers in Texas know that any new housing unit they build will be required to face dynamic hourly pricing for water, natural gas and electricity.

The buyers of these units will be aware of this. The developer will optimize the construction of the building and the durables and windows built into the structure. Why? The selling price of the final good will be lower if the home’s expected present discounted value of operating cost is very high. Websites such as Redfin and Zillow would publicize what is the annual expected operating cost. A competition would arise in building “Green Homes”. Such developers might build in Solar Panels and other self-protection strategies to reduce the likelihood that owners of the property are exposed to really high bills.

Over time, this pricing policy would begin to affect more and more of the stock of housing and the overall demand price elasticity would further increase and the overall economy would be better able to adapt to supply shocks. This matters in an economy where more and more of our power is generated by renewables and summer heat is getting more severe.

While I have focused on the residential sector, the same ideas apply to the industrial and commercial sectors.