Using the Price Mechanism to Boost Allocative Efficiency: ‘Smart’ Electricity Meters

The price mechanism should help the economy to allocate resources more efficiently. Scarcity drives up prices, sending a signal to the economy – giving firms an incentive to produce more, and households the motivation to ration their consumption.Could ‘smart’ electricity meters, linked to dynamic electricity prices, achieve something similar?

Wouldn’t it make sense if electricity prices altered, almost by the minute? The Economist poses this question. Britons are used to paying variable prices for hotel rooms, train tickets and telephone calls. Now some hope that smart electricity meters, which the government wants installed in every home by 2020, will help energy suppliers charge in a similar way. Boosters say dynamic pricing could keep down bills and help save the planet. How?

Flexible pricing could discourage power use at peak times, thereby bringing down the overall cost of generation by cutting the need for power stations that run only a few hours each day. Similarly, off peak pricing would encourage us to run our washing machines and dishwashers when demand was low, making more efficient use of the economy’s generating capacity.

Controlling energy use would also help network operators handle fluctuations in renewable power, which rises and falls depending on how windy or sunny it is. These problems will get more serious if the UK continues to adopt more renewable energy, which is less reliable than the conventional sort. When electricity becomes abundant we should gorge on it. When it becomes scarcer we should sharply ration consumption. That’s allocative efficiency in action; where the user is charged the marginal cost of each unit.

In fact, some Britons have been using cheaper off-peak power since the late 1970s, when “Economy 7” tariffs were created to encourage overnight demand for power from nuclear power stations. Smart meters, which are to rolled out over the next five years, are meant to save suppliers money by wirelessly transmitting meter readings, and to provide households with information that can help them to use less power. What excites energy experts is that, by recording full details of energy consumption, they could also make it easier for suppliers to create several peak and off-peak periods during each day, or even let prices float freely depending on the weather. Last month Ofgem, the energy regulator, said it was mulling reforms that could enable rates to change every half-hour.

Will this happen? Economists tend to be fans of such schemes (such as road pricing, which never seems to arrive). Critics point out that high charges at peak times could affect the poorest families disproportionately, because they already use power only when it is essential. And some fear that, without stronger competition, energy firms would use dynamic tariffs to raise prices, not just to even out demand. Enthusiasts say variable pricing will work best when people can set gear such as freezers, boilers and air-conditioners to respond automatically to pricing signals broadcast to their smart meter, in exchange for a discount from their supplier. Fridges need not run constantly to keep their contents fresh, for example; clever ones might perhaps turn themselves off during peak demand periods.

Could you see this working? I can’t – yet. But the widespread adoption of electric cars might make a difference, perhaps.