Carnegie Mellon Electricity Industry Center

2009-10 Seminars

The Smart Grid, Entry, and Imperfect Competition in Electricity Markets

Hunt Allcott
Columbia University

Abstract:
Most US consumers are charged a near-constant retail price for electricity, despite substantial hourly variation in the wholesale market price. The Smart Grid is a set of emerging technologies that will facilitate "real time pricing" for electricity and increase price elasticity of demand. This paper simulates the effects of this increased demand elasticity using counterfactual simulations in a structural model of the Pennsylvania-Jersey-Maryland electricity market. The model includes a different approach to the problem of multiple equilibria in multi-unit auctions: I non-parametrically estimate unobservables that rationalize past bidding behavior and use learning algorithms to move from the observed equilibrium counterfactual bid functions. This routine is nested as the second stage of a static entry model that captures an important institution called the Capacity Market, which acts in equilibrium as a minimum constraint on system capacity and transfers the shadow price to capacity owners.

There are three central results. First, I find that an increase in demand elasticity could actually increase wholesale electricity prices in peak hours, contrary to predictions from short run models, while decreasing Capacity Market prices and total entry. Second, although the increased demand elasticity from the Smart Grid reduces producers' market power, in practice this would be a second-order channel of efficiency gains relative to forestalled entry. Third, I find that the gross welfare gains from the Smart Grid, under the assumed demand parameters and before subtracting out the initial infrastructure costs, are about 10 percent of total wholesale electricity costs.