Like other goods with fixed capacity, electricity is subject to peak-load demand. Most users prefer to use power at certain times of the day, especially when the rate charged is flat throughout the day. But the marginal cost of meeting peak-load demand is very high. The average wholesale price of electricity was estimated to be 33% higher than what it would have been in June 2000 if the peak demand were just 5% lower (WSJ 8/22/02).

It doesn't make sense to build enough capacity to meet short-duration peak-load demand when this capacity stays idle for the much longer off-peak hours. Utilities in Pennsylvania, Washington, Wisconsin and Florida have started introducing variable-rate pricing that charges more at peak hours than off-peak hours. For example, Gulf Power of Pensacola, Florida charges a flat rate of 6.3 cents per kilowatt hour for most of its customers. But its customers on variable rates pay 3 different rates, ranging from 4.2 cents a kilowatt hour on nights, weekends and holidays, to 10 cents on weekday afternoons in the summer. Such variable rates should save money if users are willing to shift their power demand from peak to off-peak hours. And if users shift their demand load, the peak-load demand should fall. Already, with just one-third of its customers participating in this voluntary variable rate program, the peak-load demand for Puget Energy Inc., Washington has been cut by 5% in less than 2 years.

Variable-rate pricing would work only if customers are in a position to take advantage of it. A dummy thermostat that cannot automatically adjust according to the variable rates would save money, but only at the expense of too much creature comfort. A dynamic thermostat that could adjust continually to real-time pricing would reduce peak-load demand more effectively and save even more money for users. Indeed, Allegheny Energy Inc., Maryland is testing programmable thermostats that receive real-time pricing via the Internet.

Because marginal cost is higher than average cost after capacity production is reached, variable-rate pricing would reduce user waste and increase business profitability by forcing users to equate marginal benefit with higher marginal cost instead of the lower average cost of power generation (see Untangling Marginal vs Average Value).

In other words, marginal-cost pricing (that is, load pricing) is a way to force consumers to internalize the external congestion cost¹ at peak hours.

Thus, with smart technology in the form of dynamically programmable thermostats, marginal cost pricing of electricity has finally moved from a textbook theory into marketplace reality.