The California Independent System Operator's (CAISO's) tumultuous days of August 2020 highlight the need to better reflect consumer preference in power system reliability. Incorporating consumer preference differentiation within and across customer segments will benefit electricity consumers and make CAISO's job less challenging when temperatures and electricity demand soar.

There is no silver bullet solution to California's recent power supply constraints and resulting blackouts. The supply crunch has exposed a range of issues, including the need to better reflect consumer preferences within reliability mechanisms. Yet the wider issue of consumer preference is often lost within discussions of demand response. While demand response is an important part of this conversation, overlooking broader consumer preference dynamics is to the detriment of both consumers and overall social welfare.

Globally, electric reliability is treated as quasi-public good, which has led to charging government planning agencies with setting a standard level of service for all consumers. This approach made sense in the past when consumers were relatively homogenous and relied entirely on the grid. Yet today, consumer preferences are arguably more diverse than ever. Coupled with the rapid growth of distributed resources such as solar PV and batteries, the traditional treatment of electric reliability has become inefficient.

As seen in the case of California, within the current centralized model of dealing with system reliability, the financial impact of outages falls almost entirely on consumers, who are unable to transfer the risk of outages to those who are best positioned to manage it — the utility companies.  Policy makers could replace the existing inefficient reliability provision mechanism with an insurance market for reliability, an arrangement which allows consumers to choose from different levels of coverage to insure themselves against the risk of blackouts (the details for this idea were separately addressed by OIES).

Consumer choice and economic protection

The essence of this approach is to give choice to consumers as well as provide them with economic protection with respect to their service reliability, and at the same time, guide investment for reliability provisions based on consumer preference. For example, an incumbent utility can serve as the "insurer of last resort." These insurers would have a financial incentive to help limit outages, as long as the cost of reducing outages is lower than projected insurance payouts to consumers.

Consumers that choose to insure for higher levels of compensation (such as critical infrastructure providers) would rationally be disrupted, or disconnected, last in such an arrangement. On an aggregate level, an insurance market for reliability would contribute to building an efficient level of resiliency in a power system.

Equity is an important issue in the context of a reliability insurance market. Any approach to reliability must ensure low-income households or communities, who are unable to invest in self-generation or pay for insurance premiums, do not receive an inadequate level of service. The government can, for example, offer safety net subsidies for reliability insurance to fuel-poor consumers, similar to existing schemes in Europe. Alternatively, regulation could specify minimum service levels at affordable rates for ‘essential use'.

Nonetheless, an insurance market for reliability is likely to solve one of the existing equity issues in the electricity market. Under the current distributed energy resource schemes in California and across the United States, low-income customer segments that do not own self generation facilities are likely providing a cross-subsidy to consumers that may place a higher value on reliability and thus invest in off-grid solutions. This is because costs related to taxes, generation capacity, network capacity, legacy events and policy and administration are mostly fixed, and therefore do not vary with consumption levels. In most places, including California, utility companies bill grid-connected consumers for a number of these charges.

However, these fixed costs are typically recovered through volumetric tariffs on a $/kWh basis. Accordingly, those with self-generation can lower their power consumption from the grid, thereby reducing their contribution to paying the fixed costs that are baked into volumetric tariffs. Consumers that enjoy the benefits of self-generation are often those that place a high value on reliability, and those that can afford the upfront investment costs of system installation. This cross-subsidy will only increase in the short-term as additional high- and middle-income consumers adopt onsite generation options as these options become increasingly viable and mainstream.

An insurance market for reliability, however, would help deliver additional levels of customer differentiation based on consumer reliability preferences that are revealed by the consumers themselves, as opposed to being estimated by a government planning agency. Such a system may help provide the basis to allocate fixed costs, particularly reliability-related fixed costs, to reflect consumer reliability preferences.