Achieving Decentralized Coordination In the Electric Power Industry

For the past century, the dominant business and regulatory paradigms in the electric power industry have been centralized economic and physical control. The ideas presented here and in my forthcoming book, Deregulation, Innovation, and Market Liberalization: Electricity Restructuring in a Constantly Evolving Environment (Routledge, 2008), comprise a different paradigm – decentralized economic and physical coordination – which will be achieved through contracts, transactions, price signals and integrated intertemporal wholesale and retail markets. Digital communication technologies – which are becoming ever more pervasive and affordable – are what make this decentralized coordination possible. In contrast to the “distributed control” concept often invoked by power systems engineers (in which distributed technology is used to enhance centralized control of a system), “decentralized coordination” represents a paradigm in which distributed agents themselves control part of the system, and in aggregate, their actions produce order: emergent order. [1]

Dynamic retail pricing, retail product differentiation and complementary end-use technologies provide the foundation for achieving decentralized coordination in the electric power industry. They bring timely information to consumers and enable them to participate in retail market processes; they also enable retailers to discover and satisfy the heterogeneous preferences of consumers, all of whom have private knowledge that’s unavailable to firms and regulators in the absence of such market processes. Institutions that facilitate this discovery through dynamic pricing and technology are crucial for achieving decentralized coordination. Thus, retail restructuring that allows dynamic pricing and product differentiation, doesn’t stifle the adoption of digital technology and reduces retail entry barriers is necessary if this value-creating decentralized coordination is to happen.

This paper presents a case study – the “GridWise Olympic Peninsula Testbed Demonstration Project” – that illustrates how digital end-use technology and dynamic pricing combine to provide value to residential customers while increasing network reliability and reducing required infrastructure investments through decentralized coordination. The availability (and increasing cost-effectiveness) of digital technologies enabling consumers to monitor and control their energy use and to see transparent price signals has made existing retail rate regulation obsolete. Instead, the policy recommendation that this analysis implies is that regulators should reduce entry barriers in retail markets and allow for dynamic pricing and product differentiation, which are the keys to achieving decentralized coordination.

THE KEYS: DYNAMIC PRICING, DIGITAL TECHNOLOGY

Dynamic pricing provides price signals that reflect variations in the actual costs and benefits of providing electricity at different times of the day. Some of the more sophisticated forms of dynamic pricing harness the dramatic improvements in information technology of the past 20 years to communicate these price signals to consumers. These same technological developments also give consumers a tool for managing their energy use, in either manual or automated form. Currently, with almost all U.S. consumers (even industrial and commercial ones) paying average prices, there’s little incentive for consumers to manage their consumption and shift it away from peak hours. This inelastic demand leads to more capital investment in power plants and transmission and distribution facilities than would occur if consumers could make choices based on their preferences and in the face of dynamic pricing.

Retail price regulation stifles the economic processes that lead to both static and dynamic efficiency. Keeping retail prices fixed truncates the information flow between wholesale and retail markets, and leads to inefficiency, price spikes and price volatility. Fixed retail rates for electric power service mean that the prices individual consumers pay bear little or no relation to the marginal cost of providing power in any given hour. Moreover, because retail prices don’t fluctuate, consumers are given no incentive to change their consumption as the marginal cost of producing electricity changes. This severing of incentives leads to inefficient energy consumption in the short run and also causes inappropriate investment in generation, transmission and distribution capacity in the long run. It has also stifled the implementation of technologies that enable customers to make active consumption decisions, even though communication technologies have become ubiquitous, affordable and user-friendly.

Dynamic pricing can include time-of-use (TOU) rates, which are different prices in blocks over a day (based on expected wholesale prices), or real-time pricing (RTP) in which actual market prices are transmitted to consumers, generally in increments of an hour or less. A TOU rate typically applies predetermined prices to specific time periods by day and by season. RTP differs from TOU mainly because RTP exposes consumers to unexpected variations (positive and negative) due to demand conditions, weather and other factors. In a sense, fixed retail rates and RTP are the end points of a continuum of how much price variability the consumer sees, and different types of TOU systems are points on that continuum. Thus, RTP is but one example of dynamic pricing. Both RTP and TOU provide better price signals to customers than current regulated average prices do. They also enable companies to sell, and customers to purchase, electric power service as a differentiated product.

TECHNOLOGY’S ROLE IN RETAIL CHOICE

Digital technologies are becoming increasingly available to reduce the cost of sending prices to people and their devices. The 2007 Galvin Electricity Initiative report “The Path to Perfect Power: New Technologies Advance Consumer Control” catalogs a variety of end-user technologies (from price-responsive appliances to wireless home automation systems) that can communicate electricity price signals to consumers, retain data on their consumption and be programmed to respond automatically to trigger prices that the consumer chooses based on his or her preferences. [2] Moreover, the two-way communication advanced metering infrastructure (AMI) that enables a retailer and consumer to have that data transparency is also proliferating (albeit slowly) and declining in price.

Dynamic pricing and the digital technology that enables communication of price information are symbiotic. Dynamic pricing in the absence of enabling technology is meaningless. Likewise, technology without economic signals to respond to is extremely limited in its ability to coordinate buyers and sellers in a way that optimizes network quality and resource use. [3] The combination of dynamic pricing and enabling technology changes the value proposition for the consumer from “I flip the switch, and the light comes on” to a more diverse and consumer-focused set of value-added services.

These diverse value-added services empower consumers and enable them to control their electricity choices with more granularity and precision than the environment in which they think solely of the total amount of electricity they consume. Digital metering and end-user devices also decrease transaction costs between buyers and sellers, lowering barriers to exchange and to the formation of particular markets and products.

Whether they take the form of building control systems that enable the consumer to see the amount of power used by each function performed in a building or appliances that can be programmed to behave differently based on changes in the retail price of electricity, these products and services provide customers with an opportunity to make better choices with more precision than ever before. In aggregate, these choices lead to better capacity utilization and better fuel resource utilization, and provide incentives for innovation to meet customers’ needs and capture their imaginations. In this sense, technological innovation and dynamic retail electricity pricing are at the heart of decentralized coordination in the electric power network.

EVIDENCE

Led by the Pacific Northwest National Laboratory (PNNL), the Olympic Peninsula GridWise Testbed Project served as a demonstration project to test a residential network with highly distributed intelligence and market-based dynamic pricing. [4] Washington’s Olympic Peninsula is an area of great scenic beauty, with population centers concentrated on the northern edge. The peninsula’s electricity distribution network is connected to the rest of the network through a single distribution substation. While the peninsula is experiencing economic growth and associated growth in electricity demand, the natural beauty of the area and other environmental concerns served as an impetus for area residents to explore options beyond simply building generation capacity on the peninsula or adding transmission capacity.

Thus, this project tested how the combination of enabling technologies and market-based dynamic pricing affected utilization of existing capacity, deferral of capital investment and the ability of distributed demand-side and supply-side resources to create system reliability. Two questions were of primary interest:

1) What dynamic pricing contracts do consumers find attractive, and how does enabling technology affect that choice?

2) To what extent will consumers choose to automate energy use decisions?

The project – which ran from April 2006 through March 2007 – included 130 broadband-enabled households with electric heating. Each household received a programmable communicating thermostat (PCT) with a visual user interface that allowed the consumer to program the thermostat for the home – specifically to respond to price signals, if desired. Households also received water heaters equipped with a GridFriendly appliance (GFA) controller chip developed at PNNL that enables the water heater to receive price signals and be programmed to respond automatically to those price signals. Consumers could control the sensitivity of the water heater through the PCT settings.

These households also participated in a market field experiment involving dynamic pricing. While they continued to purchase energy from their local utility at a fixed, discounted price, they also received a cash account with a predetermined balance, which was replenished quarterly. The energy use decisions they made would determine their overall bill, which was deducted from their cash account, and they were able to keep any difference as profit. The worst a household could do was a zero balance, so they were no worse off than if they had not participated in the experiment. At any time customers could log in to a secure website to see their current balances and determine the effectiveness of their energy use strategies.

On signing up for the project, the households received extensive information and education about the technologies available to them and the kinds of energy use strategies facilitated by these technologies. They were then asked to choose a retail pricing contract from three options: a fixed price contract (with an embedded price risk premium), a TOU contract with a variable critical peak price (CPP) component that could be called in periods of tight capacity or an RTP contract that would reflect a wholesale market-clearing price in five-minute intervals. The RTP was determined using a uniform price double auction in which buyers (households and commercial) submit bids and sellers submit offers simultaneously. This project represented the first instance in which a double auction retail market design was tested in electric power.

The households ranked the contracts and were then divided fairly evenly among the three types, along with a control group that received the enabling technologies and had their energy use monitored but did not participate in the dynamic pricing market experiment. All households received either their first or second choice; interestingly, more than two-thirds of the households ranked RTP as their first choice. This result counters the received wisdom that residential customers want only reliable service at low, stable prices.

According to the 2007 report on the project by D.J. Hammerstrom (and others), on average participants saved 10 percent on their electricity bills. [5] That report also includes the following findings about the project:

Result 1. For the RTP group, peak consumption decreased by 15 to 17 percent relative to what the peak would have been in the absence of the dynamic pricing – even though their overall energy consumption increased by approximately 4 percent. This flattening of the load duration curve indicates shifting some peak demand to nonpeak hours. Such shifting increases the system’s load factor, improving capacity utilization and reducing the need to invest in additional capacity, for a given level of demand. A 15 to 17 percent reduction is substantial and is similar in magnitude to the reductions seen in other dynamic pricing pilots.

After controlling for price response, weather effects and weekend days, the RTP group’s overall energy consumption was 4 percent higher than that of the fixed price group. This result, in combination with the load duration effect noted above, indicates that the overall effect of RTP dynamic pricing is to smooth consumption over time, not decrease it.

Result 2. The TOU group achieved both a large price elasticity of demand (-0.17), based on hourly data, and an overall energy reduction of approximately 20 percent relative to the fixed price group.

After controlling for price response, weather effects and weekend days, the TOU group’s overall energy consumption was 20 percent lower than that of the fixed price group. This result indicates that the TOU (with occasional critical peaks) pricing induced overall conservation – a result consistent with the results of the California SPP project. The estimated price elasticity of demand in the TOU group was -0.17, which is high relative to that observed in other projects. This elasticity suggests that the pricing coupled with the enabling end-use technology amplifies the price responsiveness of even small residential consumers.

Despite these results, dynamic pricing and enabling technologies are proliferating slowly in the electricity industry. Proliferation requires a combination of formal and informal institutional change to overcome a variety of barriers. And while formal institutional change (primarily in the form of federal legislation) is reducing some of these barriers, it remains an incremental process. The traditional rate structure, fixed by state regulation and slow to change, presents a substantial barrier. Predetermined load profiles inhibit market-based pricing by ignoring individual customer variation and the information that customers can communicate through choices in response to price signals. Furthermore, the persistence of standard offer service at a discounted rate (that is, a rate that does not reflect the financial cost of insurance against price risk) stifles any incentive customers might have to pursue other pricing options.

The most significant – yet also most intangible and difficult-to-overcome – obstacle to dynamic pricing and enabling technologies is inertia. All of the primary stakeholders in the industry – utilities, regulators and customers – harbor status quo bias. Incumbent utilities face incentives to maintain the regulated status quo as much as possible (given the economic, technological and demographic changes surrounding them) – and thus far, they’ve been successful in using the political process to achieve this objective.

Customer inertia also runs deep because consumers have not had to think about their consumption of electricity or the price they pay for it – a bias consumer advocates generally reinforce by arguing that low, stable prices for highly reliable power are an entitlement. Regulators and customers value the stability and predictability that have arisen from this vertically integrated, historically supply-oriented and reliability-focused environment; however, what is unseen and unaccounted for is the opportunity cost of such predictability – the foregone value creation in innovative services, empowerment of customers to manage their own energy use and use of double-sided markets to enhance market efficiency and network reliability. Compare this unseen potential with the value creation in telecommunications, where even young adults can understand and adapt to cell phone-pricing plans and benefit from the stream of innovations in the industry.

CONCLUSION

The potential for a highly distributed, decentralized network of devices automated to respond to price signals creates new policy and research questions. Do individuals automate sending prices to devices? If so, do they adjust settings, and how? Does the combination of price effects and innovation increase total surplus, including consumer surplus? In aggregate, do these distributed actions create emergent order in the form of system reliability?

Answering these questions requires thinking about the diffuse and private nature of the knowledge embedded in the network, and the extent to which such a network becomes a complex adaptive system. Technology helps determine whether decentralized coordination and emergent order are possible; the dramatic transformation of digital technology in the past few decades has decreased transaction costs and increased the extent of feasible decentralized coordination in this industry. Institutions – which structure and shape the contexts in which such processes occur – provide a means for creating this coordination. And finally, regulatory institutions affect whether or not this coordination can occur.

For this reason, effective regulation should focus not on allocation but rather on decentralized coordination and how to bring it about. This in turn means a focus on market processes, which are adaptive institutions that evolve along with technological change. Regulatory institutions should also be adaptive, and policymakers should view regulatory policy as work in progress so that the institutions can adapt to unknown and changing conditions and enable decentralized coordination.

ENDNOTES

1. Order can take many forms in a complex system like electricity – for example, keeping the lights on (short-term reliability), achieving economic efficiency, optimizing transmission congestion, longer-term resource adequacy and so on.

2. Roger W. Gale, Jean-Louis Poirier, Lynne Kiesling and David Bodde, “The Path to Perfect Power: New Technologies Advance Consumer Control,” Galvin Electricity Initiative report (2007). www.galvinpower.org/resources/galvin.php?id=88

3. The exception to this claim is the TOU contract, where the rate structure is known in advance. However, even on such a simple dynamic pricing contract, devices that allow customers to see their consumption and expenditure in real time instead of waiting for their bill can change behavior.

4. D.J. Hammerstrom et. al, “Pacific Northwest GridWise Testbed Demonstration Projects, volume I: The Olympic Peninsula Project” (2007). http://gridwise.pnl.gov/docs/op_project_final_report_pnnl17167.pdf

5. Ibid.