Transaction Costs, the Knowledge Problem, and the Digitalization of the Distribution Grid
By Lynne Kiesling
The electricity distribution grid is becoming increasingly digital. According to the International Energy Agency’s report on digitalization in energy, utilities were leaders in the 1970s in introducing digital monitoring, and now digital technologies have spread throughout the distribution grid and around its edge, in the form of intelligent home energy management systems, microgrids, and increasingly autonomous vehicles. Digitalization is creating a more decentralized grid architecture.
Digitalization can have significant operational benefits, including the automation of fault detection and repair, increased reliability, increased asset life cycles due to more consistent capacity utilization, improved customer services, and higher ability and lower cost of DER interconnection. A recent World Economic Forum analysis suggested that between 2016 and 2025 digitalization in electricity could create up to $1.5 trillion in new value in 11 different areas (including asset life cycle, grid optimization, and customer services).
Digitalization will have another effect in electricity that we’ve experienced in other parts of the economy, from Amazon to Zillow – falling transaction costs. From online shopping to online banking, digital technologies have reduced the costs of engaging in commercial exchange, unleashing new value creation and accounting for an increasing share of US gross domestic product (and that Bureau of Economic Analysis estimate doesn’t account for how digitalization has transformed various sectors of the economy, so it’s an underestimate).
The economist Ronald Coase argued that transaction costs play vital roles in shaping our commercial and regulatory institutions. In his earliest work (one of the 3 papers for which he was cited in his Nobel Prize), Coase argued that transaction costs determine the boundaries of firms and the extent of vertical integration – when transaction costs are high, it’s cheaper to bundle transactions and functions together within firms rather than using markets and contracts. Electric utilities have been vertically integrated since their inception for reasons that fit with Coase’s transaction cost model.
Digital technologies reduce transaction costs, and the research following Coase in transaction cost economics suggests that when transaction costs fall, vertically integrated firms should unbundle because it’s now cheaper to use markets and contracts. A Coase-style transaction cost model is very useful for understanding the value creation from wholesale market liberalization and generation unbundling in the 1990s, and will be similarly useful as we explore the effects of digitalization and decentralization today. We will discuss this idea and its implications in several sessions at the IRLE workshop.
By reducing transaction costs, digital technologies make it easier and cheaper to use markets to coordinate the consumption and investment decisions of many people. When a system becomes more decentralized, markets are a valuable way to communicate and coordinate. Why are markets such important institutions for social coordination? Markets are decentralized processes that create and reveal decentralized, private knowledge.
People make choices based on their individual perception of their own “circumstances of time and place,” to quote the economist F.A. Hayek from “The Use of Knowledge in Society,” one of our suggested readings. That knowledge of their personal, private perception is unknowable in any other way. Markets and the price system provide a way for people to make choices in a decentralized system, and in the process they signal their actions and their valuations to others.
One exciting frontier for digitalization in electricity is how digital technologies enable the synthesis of decentralized coordination using market processes with the physical reality of an electricity distribution grid. Using markets for decentralized distribution coordination in a way that maintains system balance while also increasing both DER interconnection and capacity utilization is a topic that we will explore in the IRLE workshop.