Making the Best of the Second-Best: Welfare Consequences of Time-Varying Electricity Prices

Abstract

In electricity markets, the price paid by retail customers during periods of peak demand is far below the cost of supply. This leads to overconsumption during peak periods, requiring the construction of excess generation capacity compared to first-best prices that adjust at short time intervals to reflect changing marginal cost. This paper investigates the response of infrequently studied small commercial and industrial establishments to a four-hour increase in retail electricity prices invoked by individual utilities during peak demand periods 15 times per year. This policy intends to reduce electricity consumption when generation costs are highest. I find that the approximately tripled prices reduce establishment peak electricity usage by 13.5%. Us-ing a model of capacity investment decisions, I find that the program delivers 44% of the benefits of the first-best policy of continuously varying prices and suggest two sim-ple improvements in program design that could nearly double these welfare gains.