The Economics of Electricity Reliability

The physics of an electrical grid requires that the supply injected into the grid is always in balance with the quantity consumed. If that balance is not maintained, cascading outages are likely to disrupt supply to all consumers on the grid. In the past, vertically integrated monopoly utilities have ensured that supply is adequate to meet demand and maintain grid stability, but with deregulation of generation, assuring adequate supply has become much more complex. The unique characteristics of electricity distribution means that there are immense potential externalities among market participants from supply shortfalls. In this paper, we discuss the institutions that US electricity markets have developed to avoid such destabilizing supply shortfalls when there are multiple generators and retailers in the market. Though many of the markets rely on standardized requirements for supplier reserves, we conclude that recent technological progress may steer future evolution towards a system that relies to a greater extent on economic incentives.