In the wake of the electricity blackout, I have been disappointed that economists have contributed more noise than signal in their comments. For example, Paul Krugman wrote,

Under the old regulatory system, power companies had strong incentives to ensure the integrity of power transmission — they would catch the flak if something went wrong. But those incentives went away with deregulation: because effective competition in transmission wasn’t possible, the companies providing transmission still had to be regulated. But because regulation limited their profits, they had little financial incentive to invest in maintaining and upgrading the system. And because of deregulation elsewhere, responsibility was diffused: nobody had a strong stake in keeping the system reliable.

I have re-read this paragraph several times, and I still have no idea what Krugman is saying. Sometimes he uses his web site to clarify his thinking when his columns lack the space to explain his arguments. I hope he does so in this case.

(Brad DeLong points to a similar argument by Nathan Newman, but this also is too terse for me to grasp. When I followed the link to Newman’s dissertation chapter, I found only more turgid prose, as well as some truly eccentric accusations about the Internet.)

The first post-blackout economic analysis that makes any sense to me is this piece by Vernon Smith and Lynne Kiesling.

At the end-use customer level, the demand for energy is almost completely unresponsive to the hourly, daily and seasonal variation in the cost of getting energy from its source — over transmission lines, through the substations and to the outlet plugs. The capacity of every component of that system is determined by the peak demand it must meet. Yet that system has been saddled with a pure fantasy regulatory requirement that every link in that system at all times be adequate to meet all demand…

When the inevitable occurs, as in California, and unresponsive demand exceeds supply, demand must be cut off. Your local utility sheds load by switching off entire substations — darkening entire regions — because the utility has no way to prioritize and price the more valuable uses of power below that relic of 1930s electronic technology. This is why people get stuck in elevators and high-value uses of power are shut off along with all the lowest priority uses of energy. It’s the meat-ax approach to interrupting power flows. Between the substation and the end-use consumer appliance is a business and technology no-mans-land ripe for innovation.

Many technologies are available that provide a dual benefit — empowering consumers to control both energy costs and usage while also stabilizing the national energy system. The simplest and cheapest is a signal controlled switch installed on an electrical appliance, such as an air conditioner, coupled with a contract that pays the customer for the right to cut off the appliance for specified limited periods during peak consumption times of the day.

Smith and Kiesling are saying that incentives to prioritize energy usage could be used to prevent blackouts. For example, my electric company offers me lower rates in exchange for the ability to shut off my air conditioner for 15 minutes at a time when there is peak demand. I was not required to take this option, but I chose it. What Smith and Kiesling are saying is that these sorts of adaptations might prove to be less expensive than adding to capacity under a regime without any incentives to reduce peak-load demand.

Most of the other commentary on the blackout says that we need to throw tens of billions of dollars at new electricity infrastructure. However, the approach that Smith and Kiesling recommend seems to me to offer greater reliability sooner and with much less expense. It would have the additional benefits of conserving energy, reducing pollution, and improving homeland security.

For Discussion. How does “rate-of-return” regulation reduce the incentive of electricity suppliers to given consumers mechanisms to alter behavior to reduce peak demand?