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

Hunt Allcott

NBER Working Paper No. 18071
Issued in May 2012
NBER Program(s):   EEE

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, among other effects, 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 game that models the Capacity Market, an important element of market design in some restructured electricity markets.

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 small channel of efficiency gains relative to forestalled entry. Third, I find that the gross welfare gains from moving a typical consumer to the Smart Grid, under the assumed demand parameters and before subtracting out the initial infrastructure costs, are about 10 percent of the consumer's total wholesale electricity costs.

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Document Object Identifier (DOI): 10.3386/w18071

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