Shouldn’t a 2000-square-foot house in San Francisco cost the same as in Omaha? If you answered yes, then time-varying electricity pricing won’t make much sense to you either. And you are probably puzzled, or outraged, at how much more expensive wrapping paper is on December 15 than on January 1.
But if you recognize that a house in San Francisco is fundamentally a different product than that same home dropped into Omaha, then you will have no problem understanding why electricity should cost more at some times than at others. It’s the scarcity, of course.
If you are a reader of this blog then you already know that electricity is really costly to store, so a kilowatt-hour (kWh) in the middle of the night is fundamentally a different product than a kWh at 3pm on a hot weekday afternoon. People want a lot more kWhs on hot weekday afternoons, just as a lot more people want that house in SF than in Omaha, at least compared to the much more constrained SF supply.
If you forced the price of a house in SF to be as low as in Omaha, then you’d have many more people demanding SF houses than there are homes to be had. At Omaha prices, I know some people who would keep a place in SF just for weekends when they come into “the city” for culture (yes, here in the Bay Area we call San Francisco “the city”…apologies to New Yorkers and Londoners). You’d have to use some sort of lottery system to allocate the houses, or you’d have to scrutinize each buyer’s “need” for a house in SF or, as often happens with rent control, buyers would have to make a little “side payment” to the seller to be the one who gets the place.
And if you forced the price of a house in Omaha to be as high as in SF, there would be a lot of nice, but empty, homes in Omaha. Pure waste. In the longer run, the good citizens of Omaha would just be crowded into smaller houses than they’d like — and should be able to afford — given the wide open plains of the Midwest.
As bad as a housing shortage is, nothing creates a political firestorm like a shortage of electricity and the blackouts that follow. So, in electricity markets where all kWhs are priced the same, we avoid the blackouts by building scads of extra houses, uh, electricity generators. Someone has to pay for all that extra capacity; it gets rolled into the price of all the kWhs that are sold. And that too is a waste.
For decades, economists have argued that electricity prices should vary over time the way house prices vary across cities. With the smart meters that most residential customers in the U.S. now have – installed over the last decade — the technology is in place to do it.
But some people just hate, hate, hate time-varying pricing. They want their electricity rate to be the same morning, noon and night, winter and summer, rain or shine or heat storm. Some economists have fumbled this problem saying, “too bad, these prices reflect the real cost, so deal with it.” A decade ago, I was one of them.
That’s not the right answer. Prices vary for many things, but if you hate that volatility there is often an option to avoid it. The cost of having a car to drive today depends on whether yours was stolen yesterday, but you can pay someone to make that cost variation go away. Just as an insurance broker can offer you a product that eliminates (or greatly reduces) the cost variation caused by the risk of having your car stolen, a utility can offer you a product that eliminates the variation in your cost of electricity.
Insurance isn’t free and neither would be the option to buy electricity at a flat price. If you want that time-invariant price, you’d be pooled with other people who want it. Who would those people be? Well, they’d disproportionately be people who consume a lot of electricity at expensive times, those hot summer afternoons.
Would that make the time-invariant pricing option unaffordable? No. My own research has shown that even with a lot of this sort of “adverse selection” the flat price would increase by less than five percent. And a not-quite-released study by my colleagues at the Energy Institute and at Lawrence Berkeley National Lab (LBNL), which Catherine previewed in a blog in 2013, showed that there might not be much adverse selection at all.
One key to a smooth transition would be to design rates that fairly reflect the cost of serving each type of customer, those who stick with flat rates and those who go with, and respond to, time-based variation. It’s easy to do, but regulators would have to resist pressure from some “consumer groups” who fight time-varying pricing, essentially arguing that we should continue screwing the majority of low-income customers in order to protect a few low-income customers whose bills would go up (and not by much, even for them).
From the study by Catherine et al, it’s clear that another key is making time-varying pricing the default: you can actively choose to be on the flat rate, but if you do nothing you default to time-varying pricing. Defaults matter, because some people don’t pay attention and because some people who are unsure of which option to choose – whether it is retirement saving, electricity pricing, or getting a flu shot – go with the default option. And the study by Catherine et al shows that customers who defaulted onto the time-varying pricing overwhelmingly stuck with it even though they had the option to leave at any time.
Time-varying electricity pricing has been a good idea for a long time, but it matters now more than ever. That’s because transitioning to greater use of solar and wind power will mean that it won’t just be demand that fluctuates in ways that are difficult to predict, it will also be supply. We can manage that uncertainty the old-fashioned way, by building more and more excess capacity, or the new techy but very expensive way, by investing in storage capacity, as Catherine discussed a couple years ago.
Or we can first take the common-sense approach of using prices to let customers know when there is plenty of electricity available or when there is a potential shortage. We’ll still need some extra capacity and some electricity storage, but not as much. The savings from sending price signals would likely be at least hundreds of millions of dollars each year in California. One study from LBNL found time-varying pricing would dramatically increase the value of wind and solar power as penetration of those sources increased, a topic Meredith blogged about a year ago.
And, as electric vehicles roll out, the opportunity to respond to time-varying pricing will expand exponentially. Cranking up your Tesla –uh, I mean Leaf or Fiat 500– charging when the wind is blowing, is technology that has already arrived. There really is an app for that. We just have to start using these technologies to save money and at the same time lower the cost of integrating renewable generation.
Most San Franciscans don’t want to live in Omaha, and I bet most Omahans don’t want to live in San Francisco. The lower house prices in Omaha are one reward for not trying to be another tech worker in the city (…by the bay). Charging your car or running your laundry at lower cost should be your reward for using electricity when the wind is blowing or sun is shining.
But if you don’t like that, no problem, there should be a flat-price option for you to choose instead. Think of it as Topeka.
Note: After writing most of this blog, I found out that the California Public Utilities Commission will hold a forum to discuss time-varying pricing and other rate design issues tonight (Nov 16) in Stockton, CA.
Severin Borenstein is E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business. He has published extensively on the oil and gasoline industries, electricity markets and pricing greenhouse gases. His current research projects include the economics of renewable energy, economic policies for reducing greenhouse gases, and alternative models of retail electricity pricing. In 2012-13, he served on the Emissions Market Assessment Committee that advised the California Air Resources Board on the operation of California’s Cap and Trade market for greenhouse gases. Currently, he chairs the California Energy Commission's Petroleum Market Advisory Committee and is a member of the Bay Area Air Quality Management District's Advisory Council.