Prices can play the same role in the market for electricity. However, throughout the developed world, the central role of prices in electricity is limited to wholesale markets and retail markets involving commercial and industrial customers. The residential market, in contrast, predominantly uses flat-rate pricing, which ignores the temporal variation in the cost of providing electricity. In the United States, residential sales account for roughly a third of national electricity consumption and a somewhat greater proportion of peak demand. Thus a large amount of economic efficiency is lost in the power sector.

“Smart meters” that measure a consumer’s use of electricity by time of day and the nation’s move toward developing a “smart grid” that would more efficiently transmit and distribute power during times of peak use make time-varying pricing of electricity technically feasible. But despite the emergence of these technologies, long-standing resistance to time-varying pricing has grown more intense. Various groups opposed to the rollout of dynamic prices have united under the banner of consumer protection to demand that flat-rate pricing of electricity remain the norm. They are not opposed to “opt-in” time-of-use or dynamic pricing, but under no condition will they countenance default or universal application of dynamic pricing.

Their concerns are voiced forcefully in a whitepaper, “The Need for Essential Consumer Protections,” produced by several parties including, notably, the Consumers Union, a group that has not been involved in electricity rate-making proceedings. One of the big issues cited in the whitepaper is the adverse impact that dynamic pricing could have on low income customers. Recall that low income customers in all states are beneficiaries of a federal program known as the Low Income Home Energy Assistance Program. In addition, in states such as California and Pennsylvania and in the District of Columbia, low income customers also get a discount on the price of electricity. The concerns about adverse bill effects voiced in the whitepaper are presumably incremental to the discounts being offered through such programs.

Alternative reality | It remains to be seen what effect this whitepaper will have on state regulators, who hold the key to allowing or denying any changes in rate design. Suppose the whitepaper’s arguments are accepted not only by state regulators but by policymakers in all halls of government, who then proceed to apply them to the entire U.S. economy. An alternative reality would emerge, quite different from the real world that exists today. What would the alternative reality look like?

For one thing, parking meters in inner cities would charge the same hourly rate all day long, every day of the year, instead of the current system where meters commonly do not charge after work hours or on weekends. The consequence would be that motorists would have a tough time finding parking during working hours, an inferior outcome than what we have in the real world.

In the alternative reality, airline prices would be the same regardless of when you booked your flight or when you flew. Business travelers needing to book a seat at the last minute would be disappointed and vacationers looking for special deals would find none, again an inferior outcome as compared to the real world. The same uniformity would be applied to hotel rates and car rentals. It would not matter whether you checked in on a weekday or a weekend.

The San Francisco–Oakland Bay Bridge would revert back to charging the same rates around the clock as it was doing prior to July 1 of this year. In London, where congestion pricing was instituted in 2003, there would be no additional fee of £8 to park during the daytime hours on weekdays.

Grocery shoppers would expect to pay the same price for produce regardless of whether it is in-season or out-of-season. When filling up for gas at the pump, motorists would pay the same price year round. Moviegoers would pay the same price for a matinee as for the late show. There would be no more early bird specials at restaurants and parking garages. And so on.

Would prices for various goods and services be higher or lower, on average, in the alternative reality we have just sketched than in the real world? The alternative reality would be characterized by excess capacity and poor load factor, because prices would no longer be used to spread out periods of intense demand. As a result, the alternative reality would be a world of higher prices.

The conclusion is that flat-rate pricing for everyone leads to high prices for everyone. That may well be the world’s worst-kept secret. By comparing outcomes in the alternative reality to the real world, we have rediscovered a well-known truth: “There is no free lunch.”

By contrast, time-varying prices, whether simple time-of-use or fully dynamic, act like a shock absorber. They help reduce or eliminate the need for expensive peaking capacity and lower (average) costs for everyone.

Dynamic pricing and the poor | So why do we have hardly any residential electricity consumers on dynamic pricing, despite the reduction in advanced metering infrastructure costs that has occurred during the past decade? Even when smart meters have been shown to be cost-effective, policymakers are often stumped by the popular argument that time-varying prices will harm low income customers and those on fixed incomes.

It does not seem to matter that little empirical evidence is presented to buttress the argument. Nor does it matter that there is plenty of evidence to the contrary. Instead, the media headlines talk about low-income customers being forced by high prices to unplug their appliances during peak periods, endangering their health and possibly killing themselves.

If society is concerned about the plight of its less fortunate members and regards certain items as necessities, it could provide an income subsidy to the poor through an “earned income tax credit.” This would allow them to afford the necessities of life. However, in the current era of fiscal difficulty and budget deficits at both the federal and state levels, it may be difficult to fund the tax credits.

A second-best solution would be to design a product-specific subsidy for electricity, similar to food stamps. The disadvantage of this approach is that it may encourage over-consumption of electricity, just as food stamps are sometimes criticized for encouraging unhealthy eating. However, food stamps recognize that the laws of demand and supply are not suspended for the poor. They have to shop wisely among the various food items in the grocery store and they also have to factor in seasonal price variation.

With our hypothetical “energy stamps,” all electricity customers would face time-varying rates and have an incentive to use less energy during peak hours and more energy during off-peak hours. Low income customers would be able to offset any increase that occurs in their utility bill by using the stamps. While this would not be a first-best solution in terms of ensuring economic efficiency, it would be a pragmatic second-best solution.

Of course, government agencies would still have to figure out how much to pay the recipients, establish who would be a recipient, identify the program administrator, and establish a funding mechanism. Those are important tactical questions that can be resolved if governments agree on strategy — that the poor need to be given a safety net that allows them to consume a certain amount of electricity.

Energy stamps would allow for the universal application of dynamic pricing to electricity. They would help improve system load factors and costs. Lower prices would ensue for all customers and that would be the best form of consumer protection.

Readings

• “The Ethics of Dynamic Pricing,” by Ahmad Faruqui. Electricity Journal, July 2010.
• “The Need for Essential Consumer Protections: Smart-Metering Proposals and the Move to Time-Based Pricing,” published by AARP, National Consumer Law Center, National Association of State Utility Consumer Advocates, Consumers Union, and Public Citizen. August 2010.