Smart Grid: Can ‘Smart Metering’ Overcome the Hassle Factor? (transaction costs matter too)

When asked for conjectures about the Smart Grid, economists’ imaginations become almost indecently fertile. Writing in her blog, market-friendly Lynne Kiesling sees astounding dividends from real-time pricing and smart grid technology, preferably with competitive retail service.

Say, for example, you are on the train to work, and you get a SMS [ text message] notification that due to unexpected weather, there will be a higher-than-normal electricity price in the 9:00-10:00 hour. You may have already programmed your devices to respond to price signals, but what if the price is high enough that you want to change your settings? You can log in to your HAN [Home Area Network] from your mobile device, or from your computer at work, and change the device settings in the home through the web portal. … [i]f the home has e.g. solar PV panels the customer can program the network to reduce electricity use once the home’s consumption reaches the generation capacity of the solar resource.

But what is wrong with this picture?

Start with a seemingly unrelated question: why do department stores have sales? It’s not overstocking – this gets handled by price markdowns in the ordinary course of business. Instead think of how sales are actually staged. The January white sale discounts every bedsheet and towel in the store. Another week everything Tommy Hilfiger makes is discounted. This Saturday only, customers get 5 percent off everything in the store. Sales are a form of price discrimination. They follow the usual rule – give the discount to customers with more elastic (price sensitive) demands. You show your sensitivity by informing yourself about the upcoming sale and postponing your purchases until then. The store benefits because it makes a smaller margin over cost but from people who might not otherwise have purchased there. People who are less price-sensitive don’t look for ads in the papers and are more likely to shop on non-sale days. Much price discrimination involves small hoops like these that elastic demanders will jump through and inelastic demanders won’t. Grocery coupons provide a similar example.

That brings us back to Kiesling scenario. Say she pays $200 a month for electricity. With 700-odd hours in a month, when she is out of the house it consumes, say, 40 cents of power in an hour. In the usual morning blizzard of texts, emails, blogs, broadcast information, phone calls and newspapers she learns that unless she acts quickly she will have to pay 80 cents for power from 9 to 10 AM. (Remember this is not a recurring, programmable event.) Remotely changing the home settings involves an opportunity cost (other potentially lucrative communications or perhaps relaxation) in return for which she saves all of 40 cents. At least she is fortunate enough to be on a train – imagine doing this in your car.

No problem if she thinks the saved 40 cents is worth it. We’ve all read Free to Choose. Inelastic demanders prefer doing things other than tweaking their systems and tracking prices to save what they view as small amounts. Elastic demanders key in the new commands and benefit by their individual standards, but getting the benefit requires jumping through the hoop of becoming skillful programmers and watching for real-time price contingencies that they haven’t programmed for. (How much of your DVD recorder manual have you actually taken to heart?) Everyone faces the same real-time prices, but only those willing to take the trouble get a discount. The utility can make larger dollar profits, even if its rate of return is regulated.

This story helps to explain utilities’ infatuation with Smart Grid investments. Environmental policy and the continuing growth of non-utility power production both mean that they won’t be building as many powerplants as before. The Smart Grid hardware it installs on both sides of the meter is an alternative to rate-base generation and maintains the company’s economic and political presence. Discrimination also helps explain the seemingly inconsistent endorsement of interoperability standards by monopoly utilities. Utilities will own much of the basic hardware and earn returns on it. Customers who purchase their own gizmos to better track and adjust consumption facilitate finer price discrimination with no impact on the utility’s relationship with its other customers. This reasoning is also consistent with utilities’ tolerating and crediting home solar production, which generally occurs during peak hours.

Price discrimination also predicts that one thing will definitely not happen. Utilities will find it more than ever in their interests to keep competitive suppliers out of the retail market. Competitive sellers who offer rate plans that fluctuate less than real-time prices will attract utilities’ cash cow customers who don’t adjust to high prices, leaving them with elastic demanders who give them lower margins on low prices. Kiesling has correctly noted that a Smart Grid without retail competition creates a lot less value than one with it. The question to address is whether a large scale Smart Grid is worth having at all if that competition is absent.