Are Residential Electricity Prices Too High or Too Low? Or Both?
Abstract
Advocates of market mechanisms for addressing greenhouse gasesand other pollutants typically argue that it is a necessary step in
pricing polluting goods at their social marginal cost (SMC). Elec-
tricity prices, however, deviate from social marginal cost for many
reasons, some of which cause prices to be too low{such as pollution
externalities{and others cause prices to be too high{such as recov-
ery of xed costs. Furthermore, because electricity is not storable,
marginal cost can
uctuate widely within even a day, while nearly
all residential retail prices are static over weeks or months. We
study the relationship between residential electricity prices and so-
cial marginal cost, both on average and over time. We nd that
while the dierence between the standard residential electricity rate
and the utility's average (over hours) social marginal cost is rela-
tively small on average in the US, there is large regional variation,
with price well above average SMC in some areas and price well
below average SMC in other areas. Furthermore, we nd that for
most utilities the largest source of dierence between price and
SMC is the failure of price to re
ect variation in SMC over time.
In a standard demand framework, total deadweight loss over a time
period is proportional to the sum of squared dierences between a
constant price and SMC, which can be decomposed into the compo-
nent due to price deviating from average SMC and the component
due to the variation in SMC. Our estimates imply that if demand
elasticity were the same in response to hourly price variation as
to changes in average price, then the sales-weighted average share
of deadweight loss attributable to the failure to adopt time-varying
pricing is 62%, with the remainder attributable to the gap between
price and average SMC. These deadweight loss shares, however,
vary dramatically across utilities and regions, and are sensitive to
demand elasticity assumptions.