Many factors go into electricity rate setting, but the economic guidance is short-run marginal cost.
Economists can be so judgy. We don’t just study how the world is, like scientists, engineers, and even historians. We also have a whole paradigm for analyzing how the world should be — whether outcome A is “better” than outcome B — known as welfare economics. It’s a logical and powerful analytical approach, based on the idea that it is good to enable voluntary transactions that make the economic pie larger. But when it comes to human happiness, it leaves a lot out, like consumer rationality, equity, and political practicality.
In the electricity sector, welfare economics concludes that the price of energy at any time and location should equal the societal short-run marginal cost (SSRMC) of supplying electricity. “Societal” because generating electricity creates environmental externalities and the price the customer faces should reflect those externality costs as well as the direct costs of generating and delivering electricity. “Short-run marginal” because some things can’t be adjusted quickly — like generation and transmission capacity — and consumers are making decisions now about how much to use, so the price should reflect the additional cost from delivering a little more electricity (or savings from delivering a little less) at that time and place, given the actual constraints the producer faces.
The idea behind P=SSRMC is that setting a higher price will discourage some use that the consumer values more than the cost of producing it. If SSRMC=6 cents for an additional kWh right now and I would value that kWh at 9 cents — whether to cool the house more with A/C, heat some water for tea, or light up a dark room — then my use of the electricity would create 3 cents of economic value (or gains from trade). But if the price is set at P=14 cents, well above SSRMC, that’s more than my value and I won’t buy the additional kWh. As a result, the 3 cents of potential economic value will never be created, what economists call deadweight loss. The opposite problem occurs if price is set below SSRMC, creating an incentive to consume even when the customer values the extra kWh less than SSRMC.
If you are interested in a bit more explanation on the general idea, I can offer a screencast video on the topic recorded for my course on Energy & Environmental Markets (in five bite-size pieces, parts 1, 2, 3, 4, and 5). This idea of economically efficient electricity pricing is also the basis for the paper that Jim Bushnell and I put out last fall (and the blog I wrote about it at that time) comparing P to SSRMC for residential customers across the country.
Still, applying the P=SSRMC concept to electricity pricing discussions runs into a lot of headwinds. Some are based on misunderstandings of microeconomics, while others highlight factors left out by a narrow economic analysis of should.
Let’s start with laying out what the argument does and does not rest on. It assumes that customers have a good idea of the price when they make a consumption decision, that they are able to rationally process that information, and that they have some ability to adjust their consumption. While these assumptions may have seemed pretty strong for residential customers 10 years ago, they have probably been a decent fit for the two-thirds of U.S. consumption from commercial and industrial customers for a long time. And going forward, as we have smarter appliances and homes, residential customers will be more able to observe (or have an Internet-connected device observe) and respond to electricity price variation.
The argument does not rest on a perfectly competitive market among sellers, which is just a context in which efficient pricing is more likely. It also does not rest on the ability to adjust every input incrementally. So-called “lumpy investment” raises difficult calculations about when to make those investments, but it does not change the economic efficiency of setting P=SSRMC given whatever investment exists. Nor does efficient pricing ignore the environment; that first “S” is there for exactly that reason.
Skeptics of SSRMC pricing sometimes assert that it causes boom/bust cycles in industries. The primary cause of boom/bust cycles, however, is the difficulty of predicting demand combined with the need for long-run investments in order to produce supply. As a result, sellers frequently wish they had made more or less investment, and supply is frequently abundant or scarce relative to demand. Not allowing price to adjust to those supply/demand mismatches – which is known as “price stabilization” to those most fond of the practice — means that when there is abundance, excess supply goes to waste or when there is scarcity, supply is allocated in some other arbitrary fashion, such as long lines or side payments to those who control the allocation. U.S. lessons in the failure of price stabilization include warehouses full of surplus cheese and the gas lines of the 1970s and after Superstorm Sandy, an experience relived recently in Mexico.
In electricity, pricing without regard to SSRMC has resulted in the need to build massive excess capacity so that the system can still meet demand – which is critical for grid stability – without help from any adjustment by customers. In the future, it would lead to curtailment of abundant renewable electricity at times it would have been costless for consumers to use the energy, thereby discouraging efficient investment in storage and in electrification of home energy use.
The LRMC Mirage
Some SSRMC detractors argue that the right pricing standard is long-run, not short-run, societal marginal cost. Long-run marginal cost is the additional cost of providing one more unit of output if all inputs were adjusted optimally, including capital investments that in reality take years to change. The SLRMC approach would set price too high in the middle of the night as if increasing consumption at that time required building more capacity, even though it doesn’t. Likewise, it would dictate keeping prices high to cover past capacity investments, even if the system is overbuilt and has plenty of unused capacity. During a demand spike that strains capacity, it would set price too low, as if the scarcity problem could be solved by instantaneously building more capacity, even though that’s not possible. You won’t find SLRMC pricing in an economics textbook (except when SLRMC happens to equal SSRMC), because it’s not based in economics.
A somewhat more credible justification for smoothing prices, such as SLRMC does, is that consumers are not very sophisticated and will incorrectly take short-term price variation as the right signal for making long-term capital investments. So it is better to send them a price signal that reflects the long-term average additional cost of them consuming more. That is a serious argument, for which there is virtually no serious evidence. In the meantime, the technology for receiving and responding to short-term price variation continues to improve, so the cost of hiding that information from customers has increased.
The most compelling argument for allowing price to depart from SSRMC is that in most cases it simply won’t raise enough revenue overall to cover the utility’s costs. That’s not true everywhere, particularly where highly-polluting generation means that prices should be set well above the private marginal cost of the utility. In those cases, however, regulators have generally been reluctant to acknowledge the unpriced external costs of the pollution.
Still, most electricity is sold by utilities that have enough embedded fixed and sunk costs — transmission and distribution lines, wildfire mitigation, billing systems, and stranded investment in nuclear plants or early high-cost renewables — that pricing at SSRMC will leave them with a revenue shortfall. And that will only be worse if/when we get to a world where generators have to pay taxes/fees for their environmental externalities.
Of course, there are other ways to cover the costs left uncovered by P=SSRMC, as Meredith pointed out a few weeks ago. There are few free lunches in the world, however, and covering utility-related costs from other tax revenues is not one of them. Whether it is income taxes, sales taxes, or property taxes, they still create price distortions and deadweight loss.
Likewise, the different ways of covering the revenue shortfall impose different burdens across the population, by income, by location, and by racial/ethnic identification. These too are important issues that are omitted by the standard welfare economics of electricity pricing.
Perhaps more economists need to ratchet down the judgyness and recognize that economic efficiency within one market it is not the only factor that should determine pricing. At the same time, perhaps policymakers need to take more seriously the economic damage that results when prices depart significantly from SSRMC. It’s not the only thing that matters in price setting, but ignoring it is inefficient and costly, and will become more so as consumers have more technology and options for responding to prices.
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Suggested citation: Borenstein, Severin. “Pricing for the Short Run”, Energy Institute Blog, UC Berkeley, August 19, 2019, https://energyathaas.wordpress.com/2019/08/19/pricing-for-the-short-run/
Severin Borenstein is Professor of the Graduate School in the Economic Analysis and Policy Group at the Haas School of Business and Faculty Director of the Energy Institute at Haas. He received his A.B. from U.C. Berkeley and Ph.D. in Economics from M.I.T. His research focuses on the economics of renewable energy, economic policies for reducing greenhouse gases, and alternative models of retail electricity pricing. Borenstein is also a research associate of the National Bureau of Economic Research in Cambridge, MA. He served on the Board of Governors of the California Power Exchange from 1997 to 2003. During 1999-2000, he was a member of the California Attorney General's Gasoline Price Task Force. In 2012-13, he served on the Emissions Market Assessment Committee, which advised the California Air Resources Board on the operation of California’s Cap and Trade market for greenhouse gases. In 2014, he was appointed to the California Energy Commission’s Petroleum Market Advisory Committee, which he chaired from 2015 until the Committee was dissolved in 2017. From 2015-2020, he served on the Advisory Council of the Bay Area Air Quality Management District. Since 2019, he has been a member of the Governing Board of the California Independent System Operator.