The Answer Is Transaction Costs

Current Event: Smart Grids, DERs, and the Economics of Energy

• Michael Munger

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Unlock the secrets of the energy market evolution with economist Professor Lynn Kiesling, who brings her expertise on transaction costs and the digital transformation of the electricity industry to our table. Our energized discussion orbits around the innovative world of Distributed Energy Resources (DERs), where we explore the shift from consumers to proactive producers, thanks to technologies like rooftop solar panels and home energy storage. Professor Kiesling, drawing from her academic journey and reverence for Ronald Coase's work, delves into the institutional structure of production within firms and imparts her wisdom on navigating the complex regulatory frameworks that shape our smart grid technologies.

Also, 4 new TWEJ's, and a letter. It's the January TAITC!

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If you have questions or comments, or want to suggest a future topic, email the show at taitc.email@gmail.com !


You can follow Mike Munger on Twitter at @mungowitz


Mike Munger:

This is Mike Munger of Duke University, the knower of important things. The sharing economy combines two features the commodification of excess capacity and the substantial reduction of transaction costs. These two factors, combined in the Kiesling matrix, are changing the world. You already know about Uber and Airbnb. Both of those commodify excess capacity. I have a car in a few minutes. You need a ride, but we need to reduce the transaction costs of being able to get access to that safely, reliably and conveniently. Well, that's what the sharing economy does. But what about DERs Distributed energy resources, rooftop solar, local storage, switches that change you from being a user to a producer and back again seamlessly, with no lag? Local nuclear and sharing capacity. Today's interview takes up these topics with the source, lynn Kiesling herself. Four new twedges plus this month's letter and more Straight out of Creedmore. This is Tidy C.

Mike Munger:

Lynn Kiesling works on regulation, market design and the economics of digitization and smart grid technologies in the electricity industry. She directs the Institute for Regulatory Law and Economics in the center of law, business and economics at Northwestern University, as well as being a research professor at University of Colorado, denver, a member of the external faculty of the Santa Fe Institute and a senior fellow at the American Enterprise Institute. In addition to academic work, lynn serves as a member of the US Department of Energy's Electricity Advisory Committee, after having been a member of the National Institute of Standards and Technology's Smart Grid Advisory Committee and the Grid-Wise Architecture Council.

Mike Munger:

So far, I've made a point of interviewing people who are smarter and better informed than I am, and that win streak continues this month as I get to talk to Lynn Kiesling. My guest this month on the answer to transaction costs is Lynn Kiesling. I ask guests to do their own introduction because it's interesting to hear how people define themselves rather than me give some long, boring thing. So, professor Kiesling, please tell us how you came to be interested in the subject of transaction costs, how you became one of Ronald Coase's foremost fan girls and how it is that we can apply transaction cost analysis to the energy field.

Lynne Kiesling:

All of that in my introduction. Thank you, professor Munger. Thank you for inviting me. I'm thrilled to be here. Yes, there is nothing higher on my list of things I care about than Koss and transaction costs, and so you and your wonderful podcast have been a great addition to the ecosystem. So thank you for that. I should introduce myself and then we can get into the nuts and bolts of your question.

Lynne Kiesling:

I'm an economist, and if you ask me first and foremost, what are the things professionally that matter to me about my identity, it's always I am an economist. We get a lot of grief from a lot of people for a lot of good reasons, but I do. I think the analytical frameworks and the logical structure that economics gives you for thinking about the world is something that I find captivating and thrilling, even when we oversimplify it so that it's actually wrong. But that's why I knew I was going to become an economist from the first time that I saw in difference curves and generally equilibrium in an Edgeworth box like this. I want to do this and I focus on my areas of interest in economics are called industrial organization, which is about firms, the organizational structure, firms, how they operate, how they compete with each other. So there's strategic interaction, but then there's also institutional analysis, and that's where Coast comes in by starting in 1937 and then for most of the next century, finding us that the answer is transaction costs. And so the institutional structure of production, to use his phrase is really important and changes the kind of outcomes you get.

Lynne Kiesling:

Rather than just having a representative firm that produces quantity Q and price, and they can either choose the price P at which to sell their quantity Q, or they see the prices out in the market and choose a quantity Q to sell, coast tells us that the world is much richer than that and that it's about how do we organize production in terms of the decision making process, and there's multiple ways of thinking about that. Right, there's how do you put the inputs together in order to produce some valuable output, and then there's also the within the firm, what Oliver Williamson would call hierarchy within the firm. Why do you organize production the way you do within firms? Why do firms exist and why do you have management? Why do you have employees and rules and divisions? What does? Why do corporate forms? Why do corporate structures take the forms they do? Those kind of questions.

Mike Munger:

I have to ask. I've always wondered this about you. You have almost an engineering background. Your yeah your study of economics at Northwestern is that's real micro? You really were looking at microeconomic mathematical models and all the questions you just asked. The answer is well, they optimize and so we use calculus to solve that problem. And if the problems well specified, we know the answer. None of that's even interesting, and yet somehow you became interested in COS. It seems to me, like you know, you've wandered into paths of apostasy, given your Northwestern background.

Lynne Kiesling:

I what you say is true, but I will give a lot of compliments and credit to my Northwestern graduate education and and some shout outs to some of my most influential professors. The PhD program in Northwestern is extremely quantitative and very deep theory. And now you know I'm as old as dirt. So I was in, I was in graduate school my first year. Then the PhD program was 1987. So you know we were not quite. We were right in the throes of the heady enthusiasm about game theory. We hadn't quite gotten to the heady enthusiasm about causal inference or whatever. So it was all about game theory. And of course Northwestern is known as comparative advantage in game theory. So I learned a lot of game theory.

Lynne Kiesling:

It's true I'm not a theorist and so you know the theory stuff was always a bit of a struggle for me. But the my fields. I chose my fields because they were things that really just grabbed my attention and wouldn't give it up. My primary field was economic history and in part that was I took John Moe Kier's European economic history class as a first year grad student, in part because the fall theory classes had just so completely been. You know, no, seeing the forest for the trees You're just in there focusing on the bark on the trees, and I needed some context to remind me why I wanted to become an economist. And so I took Joel's class and it just, you know, it was when he was in the middle of writing Lever of Riches, and so it was all about the role of technological change and economic growth and these industry by industry over centuries, different examples of agricultural productivity through technological change, and you know, iron making and textile manufacturing and so on and so on, transportation. And so working with Joel was really was really a revelation and and just one of the biggest honors of my life. And so that you know, when you work in economic history you've already mentioned Doug North you know you develop a fundamental part of the methodology and part of the focus is that appreciation for the role of institutions.

Lynne Kiesling:

And then my other main field was industrial organization, and then my third field was what we called information theory and space leading mechanism design. So auction theory. Get both in IO and in information. We had a lot of auction theory, and so it was to their great credit, whether it was, you know, bill Rogers and or Rob Porter, or or, at the time, deborah Aaron, who was one of my professors and she was fantastic and I think she now is a principal at a consulting firm. But they I remember them specifically for being fantastic about pointing out the coast literature right, so that that, yes, part of the mechanism design process is thinking about the institutions. And so we read coasts, we read Joscow, we read Williamson, and so I give a lot of credit to my Northwestern professors for not just being the math jockeys.

Mike Munger:

Well, but the you raise an important question and it does start to take us in the direction of your actual current expertise and contributions Mechanism design. I've heard Eric Masken in an interview describe mechanism, the problem of mechanism design, as being different from a lot of the rest of economics, and most of economics would take the institutions more or less as given. We have property rights, we have systems for adjudicating disputes. Mechanism design says what institutions can we design to get outcomes that we want, and one of the things that you have been a pioneer in is thinking about energy markets in that way.

Mike Munger:

I think a lot of people naively think that markets are what happens when the government does nothing, and even if that were true, that's not going to happen in energy markets because they're not going to do nothing. So what we have is a system, people find themselves within this system, there's institutions, there's incentives, there's culture, and the system works itself out. So mechanism design takes a step back and says how can we either design or identify sets of rules, property rights, ways of communicating information that get us closer to the results that we want? And so how is it you became interested in energy, then, and what do you see as the contribution of the energy economics field, that other people who are interested in that but don't know much about it. What sort of courses, what sort of things should they be taking in order to move in that direction?

Lynne Kiesling:

Yeah, your point and Eric's overall observations about mechanism design. I mean it's very insightful because and I'm going to combine it and one of the things that I think I like doing, one of the things I like about what we do as academics and intellectuals, is combining. I think that there's a lot of value in us combining sets of ideas that haven't encountered each other before, and so I'm going to combine your observation with Thomas Sol's framework and in a conflict of visions that he uses a little differently, but I want to take what you just said and think of it in his kind of constrained vision framework that it would be really fantastic if we could have a full-on free market in energy. I would love that. I think, just philosophically that would be great.

Lynne Kiesling:

Realistically and this is where the constrained visions come in and where I think, if we want to have conversations both we have pluralist conversations with people who see the landscape differently but then also have ideas that are going to be meaningful to other people, others than just yourself is taking that constrained vision and recognizing, exactly as you said, that the government isn't going to leave energy industries alone anytime soon, whether it's because of the size and scope of the infrastructure, the size and scope of the national security implications or the perceived ubiquitous importance of energy in our everyday lives, and so I think of it in that kind of sole, constrained visions, in the sense that you have to take realistic perspectives on what is possible and this is again a variation of your, and maybe we can discuss this if you want your directionless destination, on a framework that I may want as a destination as little government involvement in industries and energy markets as possible. We are nowhere near that right now.

Mike Munger:

So the question- and we're not moving in that direction.

Lynne Kiesling:

And we're not moving in that direction, and so the question is what can you do to move in that direction? And so I see mechanism design as an analytical framework that we can use to take what is inherently an anti-market landscape and inject market analytics and market processes and market thinking into it.

Mike Munger:

We've been pretty abstract so far. Can you say a bit about some of you? You hold a number of positions. You work with a number of organizations. How exactly have you been able to take that abstract goal that you just talked about, and what kinds of organizations do you actually work on? You have three or four affiliations. That, I think would be. It's really very interesting the ways you've been able to make contributions that are. Some of them are academic, but some of them are outside of traditional academic. So if you could say something about that, yeah, and let's fold that in with the.

Lynne Kiesling:

If you're a student and you're interested in energy, what kind of classes do you want to take? That kind of thing? Because I think I mean energy questions are some of the most important and interesting and thorny, I mean, and especially if you're a kind of market oriented quote unquote free market person. They're thorny precisely because it's not just, it's not just how many libertarians doesn't take the screw to light, build none the market will provide. It's really a lot of very hard, challenging questions. And so if you want to think about exactly what it is that market processes do and why they're valuable, why they're important, energy is a great place to look. And so one of the things that you were looking at was my first electricity work was as an undergrad, which I don't know.

Lynne Kiesling:

If you know, my mother worked for a utility, a vertically integrated, regulated well in at the time they were all vertically integrated and regulated, and I had to write a senior honors thesis and it was. I had to do econometrics. Since I needed data, she says, let me ask. And she did so. I used electricity data from the 1970s and demonstrated some correlations econometrically about what happened to the approved regulated rates in response to the oil price shocks in 73, 74, and 79, 80. And the data came on punch cards. Back to the oldest dirt comment. And I had to. You know, I marched over to the computer lab and gave them my stack of cards and you know, 12 hours later I came back and had a data set. So there you go.

Lynne Kiesling:

And my undergraduate professors were great at having me read like classic things that I think people don't read anymore but that you know probably you and I. You know average Johnson 1962, which is like one of the famous papers in electricity regulation and the logic is really straightforward. It's hard to show empirically but the logic is really straightforward that if you have a regulated industry and that industry is regulated based on their rate of return on capital, that they're going to have an incentive to have a more capital intensive production structure than other industries and more, more capital intensive than they then would be their equilibrium production structure. Otherwise, and like Balmall and Bradford on the theory of the second best, you know all those kind of classic things and my undergrad professors had me read those. So that's one thing I would definitely recommend to students is, if you have the chance, to get good advice from your professors, you know, really. You know, take them up on that and read the things that they suggest you read. Because you know, here I am, you know, 40 years later and like, wow, I still remember reading Balmall and Bradford and that was great.

Lynne Kiesling:

But so to go back to your question about in organizations and then come forward to classes that students should take, you know, I so I've been thinking about energy for a long time. When I was a PhD student I worked on technology adjacent questions, but they were more institutional, you know, having to do with the 1860s in Britain, not directly about energy, and I always maintained an interest. And then in 2000, 2001, when the California, but yeah, and this is after some states in the US had undergone regulatory restructuring and had created wholesale power markets, and California did this and did so in an epically bad way, as California's want to do, and and they were suffering consequences of it with blackouts and price spikes. And so then I returned into doing more kind of policy analysis and market design analysis. And you know I have always and I was on the, I had returned to Northwestern by then, I was on the teaching faculty and but I've also always had, as you said, a couple of other different affiliations.

Lynne Kiesling:

You know, in the early 2000s, like right after Vernon Smith won the Nobel Prize for experimental economics, he and I were working together to try to work with federal and state regulators to get them to use experimental economics to test that their regulatory and market design proposals before they actually implemented them, which is one of the things California didn't do.

Lynne Kiesling:

And more recently I've been working with a co-author in a Slack National Laboratory, david Chassan, and so you know we have a very collaborative relationship. He's more of an engineer, I'm more of an economist, so I find I work across a lot of different policy groups and I also am currently serving on the Department of Energy's electricity advisory committee, which is basically a group of diverse group of people from with different roles, informing the DOE's Office of Electricity and, you know, giving them recommendation and guidance. So yeah, I do a lot of different things and it's it's really fun. It's not a conventional academic go work your face off for six years and get tenure and then do that for the rest of your life path but but it's been really gratifying.

Mike Munger:

One of your most cited papers was on the grid wise testbed demonstration project, which I didn't even know what it was, and so the the a lot of these are very highly applied, but some of your work also has been pretty theoretical. If someone wanted to be you, what kind of classes is there some path that leads there? Is it just a high wire act?

Mike Munger:

It's a high wire act is a good way to put it, after you get out of grad school, work with a Nobel Prize winner that that's pretty hard to yeah, working with Vernon was a treat which will not surprise anyone who has ever met Vernon.

Lynne Kiesling:

So if you're interested in energy things I mean not every, not every place has an energy economics class and not and you don't have to be an econ major to do energy stuff right, there's, there's. You could be a poly side major and do energy stuff. You can do public policy, environmental studies, but I do think, having a nice breadth of both. What has worked for me in my case was taking classes in industrial organization and also learning about industries and firms and markets and then teaching I. I developed an interest after graduate school in environmental economics, so I taught environmental economics, I taught energy economics and then combined those fields with understanding of firms and markets and industries.

Lynne Kiesling:

Whether it's through actually taking classes or or some other way, I think that's the, that's the combination, because the then that positions you well, especially if you're listening to a podcast called the answers transaction costs, and you can. You can think well, to think about the institutions, and you know it's. It's really the institutions that are important, whether it's the, the market institutions, the regulatory institutions, the within firm, you know hierarchical institutions, and all of those are really valuable lenses through which to look at at energy questions, and the energy questions are just going to get more and more big and important. Hopefully they will get more nuanced because for the past couple of decades, especially where energy intersects with climate and so the globalization of the climate questions and yet has has made things difficult. But but it's a really ripe area for for future interests for students, I think.

Mike Munger:

Well, I've, I've, I have talked your ear off and asked you to go. I think the way that you found is a bit unusual, but perhaps we can move then in the direction of the specific work that you have done that I was glad to at least watch and participate in. There's a. Ronald Coase always said that the way economists should do things was to go and look at what people actually do, and so Hayek claimed that if we look at the institutions that emerge over time, they probably would tell us something important about how things work. Lynn Ostrom would was kind of the Darwin of institutions. She went around the world and look for the strange beaked finches of institutions which, if you look at how they're adapted to local conditions, the fact that they're an algorithm means that they're doing something useful. That's not necessarily the same with energy institutions, though, and you've already given the Averton Johnson example. Given the regulatory structure, the emergent institutions might be quite pathological, and so designing policies I'm always a little worried about calling it design Imagining alternative institutional arrangements is something that you have made some important contributions in, and I warned you at the outset, there were two concepts I wanted you to talk about so that someone who's looking at this area would have some understanding of be able to translate it, because even though the words are English, it doesn't appear to be written in English.

Mike Munger:

Those two concepts are smart. So smart grid, the, the not just smart things in my house, but a smart grid and then distribute it. Obviously, if we're going to have some centralized generation process, we then have to distribute the energy over the grid, but if generation and storage is itself distributed, how are we going to manage that? And you contributed something to some of my work years ago now where you noted that there's two really important different things going on at the same time when it comes to the sharing economy. One is the commodification of excess capacity. So five excess capacity rather than just paying to store it, I need to be able to sell parts of it off if I can reduce the transaction cost, which is the other part. So the commodification of excess capacity and the reduction of transactions costs somehow those are connected to distributed energy resources has been one of your insights, and so I realized that question was laden with jargon, but if you could de-stify it for us a bit, I'd appreciate it.

Lynne Kiesling:

Yeah, there's a lot in there. Let's start with. Let's start with Hayek, since you mentioned Hayek, and then we'll end with smart and distributed the and this is your point is a really important one, and I think not enough people appreciate it, which is that you know when we're thinking about markets and how markets emerge, and you know they don't just kind of emerge de novo. Always it's, you know, markets emerge within particular social contexts and those social contexts have kind of preexisting relationships and institutions. And in the case of and that's why you know and again, this is what the kind of idealized, you know constrained vision versus some kind of idealized vision, you know that when I think about that kind of idealized markets concept and when we read Hayek, and we think about Hayek and then the emergence of markets as an organic process and you invoked Darwin and an evolutionary process, and that's, I think, very compatible with what I have in mind, and for various reasons, and some of these we may want to dig into in more depth if you like, but I think there are a lot of reasons why, when we talk about human institutions, you know social institutions such as market rules, legal frameworks that enable us to live and work together piece of Lee that they don't always have that kind of simple fitness inference that we can get from Darwin, and I think even Hayek recognized that that just because something evolves into a particular form doesn't mean that that form is the most fit and going to be kind of healthy and beneficially adaptive to all the people. And in part that's because of, you know, our big brain stones and the fact that we, you know, we can form coalitions. We, you know, this is where the political economy comes in and public choice comes in. We form coalitions, we have particular interests, we can do things to try to further our interests in ways that are much more involved than other species. And so, you know, design, design with when we talk about institutions, design is always going to be part of the story, whether it's, you know, private, kind of private individuals interacting and forming institutions, or, you know, bringing in the state as an actor.

Lynne Kiesling:

So I've taken to talking about institutions as hybrid. You know the, the, the kind of. You said you don't like to use the word design, and I don't either, and so that's why I've come to think about what we see when we talk about, you know, regulation, political economy, is these hybrids of partially planned, partially unplanned, partially designed, partially emergent, and that the, the land and the emergent kind of, you know, interact with each other over time, and so it's a lot more nuanced and difficult institutional landscape, and that's why I get you know, ostrom's work was so profound. And so that means, when you come into a landscape like let's put ourselves in, say, 2004, you're in a world in the electricity industry where you've got a hundred years worth of government regulation, right. So, and that regulation takes a particular form. It's called rate of return regulation. It's mostly implemented at the state level, but then there are are certain transactions that cross state boundaries. Those are deemed to be under federal jurisdiction. So of course, now you've got a two-layered regulator. That itself causes lots of problems. It also solves some problems, but it causes more problems than it solves. And and and so you, you're coming into this with this complicated regulatory landscape and with these firms in this industry that have been regulated for a century, and the way they make their profit is by investing in stuff. And so you know, the more you know up to you know, up to the, say, early 2000s, the more iron you put in the ground, the more power plants you build. The more wires you string, the more holes and towers you build, the more substations you build, the more profit you're going to earn, because then that enables you to serve more people. And the more people you serve and the more electricity you serve to them, the more money you make.

Lynne Kiesling:

This gets more complicated for various reasons, but one in particular is the tensions that are brought in because of the environmental impact of energy, of electricity production, right. So electricity generation from fossil fuels generates a whole bunch of what the environmental protection agency defines as pollutants, so sulfur dioxide, particulate matter, nitrogen oxide, et cetera. And then there's greenhouse gases, and you know greenhouse gases don't fit neatly in that category, although the EPA and some others have really tried to shoehorn them in, but they don't fit there well. And of course the regulation of greenhouse gases has been contentious at the federal level. So you have states out, kind of out, you know, rolling their own thing with respect to greenhouse gas policy and doing these things called renewable portfolio standards and that sort of stuff.

Lynne Kiesling:

So you get this really complicated patchwork landscape across the states. But what it does mean is that you get more. You know the space that the regulator has to inhabit is more complicated. It used to just be okay, what should be, what should the rate of return be, that the utilities get on their assets. But now it's like, oh, we have to think about greenhouse gases and this and that and the other, and then layer on top of that the fact that for about the past what would you say 25 years we've been digitizing.

Mike Munger:

It's hard to know when it would start, because it required a combination of the ability to write and sell apps and to have little local, the somewhere probably around 3G, so phones that could communicate over 3G, which I think was in the early 2000s, so nearly 25 years.

Lynne Kiesling:

And then we get the iPhone in 2008. So yeah, so let's call it 20 years. We've really been digitized, the economy itself has been digitizing, and this is some of the stuff that you write so brilliantly about. And so you take this digitization that's I mean, it's starting in the 1950s, but it really kicks in in the early 2000s and so you kind of look around, you're like, wow, this digital economy. There's this great service called Amazon. I order a lot of stuff and, boom, it shows up at my door. I can go look on Zillow and look at all the different house prices and all the places I might want to live, like Aspen, colorado, of course. What you look at the house prices, then you abandon all thoughts of Aspen.

Lynne Kiesling:

But so, from Amazon to Zillow, we have a digitizing economy, and the electric system is itself inherently analog and mechanical. It's all dials and switches, and so the digitization that really starts in the mid 2000s is a striking difference. And this kind of gets to your mention of the Gridwise Olympic Peninsula project, which is a lead into the idea of a smart grid. Because I'll give you the answer up front Smart basically just means able to take a direction and act on it. So it's a digital. We're moving towards automation. Smart involves automation.

Mike Munger:

But it's not just a direction. Then it could be a contingent direction. It can actually execute a sequence of instructions. There's a light switch responds to my directions. But if a smart light switch can respond to contingent instructions in ways that I don't have to look at again, yes, exactly, and so that was in the Gridwise Olympic Peninsula project.

Lynne Kiesling:

That was the type of intelligence that we were working on was this idea of embedding digital intelligence in the decision making process between the electricity consumer and the rest of the grid, including the producers. So the idea just give you a simple description of what we did in that project, and then that is an illustration of this idea of contingent directions and smart grid. So the idea was and this was in the Olympic Peninsula in Washington state, in the Pacific Northwest in the US there's an area served by a utility and the wholesaler, bonneville, which is a federal hydroelectric power producer, sells power to this local utility to sell on to its customers, and they're forecasting demand growth. People are moving to the area. It's a beautiful area. If you've ever been in the Olympic Peninsula if you haven't, you should go, because it's glorious and just beautiful. It's hilly, very mountainous, but they were worried about demand growth. And what's the traditional kind of 20th century way that you respond to demand growth, especially if you're a regulated utility? You build more stuff. But here are people moving to this glorious, pristine area precisely because it's glorious and pristine and you can't build more stuff. And so what are you going to do? And so the utility and Bonneville approached the engineers I worked with and asked them this question, and they said, well, if we can't build more stuff, then we have to work on making demand more flexible. And some people, I think like these days, like to characterize that as curtailing demand or cutting back your demand. And I'm like, yeah, but that's not what we were doing at all, because what we were doing was using market clearing price signals as the way to make demand more flexible.

Lynne Kiesling:

So send you a price signal, or actually, more importantly, send your thermostat a price signal without your having to be involved at all, and you've told your thermostat your preferences.

Lynne Kiesling:

And so this is where the contingent direction that you mentioned comes in. So you can basically say, well, if the price goes from here to here, if the price goes above, I set a trigger price, the price goes above this price, then turn my heating down from 76 degrees to 72 degrees, so turn my temperature down so I'm not using as much electricity for heat. But what controls the device is the price signal and the device behaves in response to the price signal according to your preferences that you have already told your thermostat. And that's kind of out at the edge of the network. That's the idea of intelligence, of a smart grant where you can give devices instructions. They can interact with each other in ideally, in my case, in a market process and as their demand and supply characteristics change. That's going to allow for price discovery to happen. So it's a very Hayekian process that price discovery happens as the conditions change and you use that changing discovered price as the control signal to tell the thermostats what to do.

Mike Munger:

So you've elaborated how digitization helps in the reduction of transaction costs. So the two sort of most quotidian examples were Amazon and Zillow. I have this digital process where I can identify this information, and these smart thermostats are able to exercise contingent directions in a way. That's very simple. But digitization also does the other thing, which allows the commodification of excess capacity. So if I have some local generating or storage ability, I may switch back and forth not the amount that I'm demanding, I switch back and forth between being a supplier and a demander. I may be able to supply to the grid in the afternoon and demand from the grid in the morning if it's cold, and so I wanted to emphasize both parts of these and have you talk a little bit about the commodification of excess capacity, because that's closer to the DERs, or distributed energy resources, that you've been working on more recently.

Lynne Kiesling:

Yeah, exactly, and this is actually current project, which is a follow on from the Olympic Peninsula project, and through this work we've contributed to creating a field called Transactive Energy. Right, so it's beautiful.

Mike Munger:

My work here is done.

Lynne Kiesling:

And, yeah, Coase would be happy. And so we've been. Since the mid-2000s we've been developing Transactive Energy and different people have different ways of different flavors of it that they've developed. What my co-author, Dave Chasson, and I have very much emphasized and you know, to his great credit, because he's an engineer and a physicist straight he's not an economist but he really, when we started working together, he really glommed on to the idea of price discovery and that, in a complex system of systems, which is what the electric system is right is. You know, you have all these humans around the edge of the network, you know, living their best lives and not wanting to be energy managers, but they want to be comfortable and, to quote Amory Lovins, you want to have cold beer and warm showers, and so you know, for us, consuming electricity is a derived demand. I don't wake up in the morning like, oh, I'm going to consume something that's delicious electricity today and so you know we're out here living our best lives and using electricity to do it, but we are constantly, you know, having changing circumstances and you have these, you know, complex system systems that are the electric system when you think in terms of the infrastructure, producers, consumers, and so if you're going to have a resilient, efficient system out of that price, discovery as a process for enabling the devices to communicate to each other makes a lot of good intuitive sense. So so we've been, you know, carrying that idea of having the devices submit bids. You know, we Dave was really inspired week Vernon and Bart Wilson and I went out and did a study session with them out in the Pacific Northwest and did a double auction and so introduce them to experimental economics and the whole idea of, you know, having buyers submit bids and seller submit offers all simultaneously and you get this very information rich environment and that really inspired this idea of transactive energy. And so fast forward to today, and we're in year two of a five year Department of Energy Energy funded connected communities project where we're building out a transactive energy platform with a, an electric cooperative in New Hampshire and and an energy efficiency agency in Maine.

Lynne Kiesling:

And now, you know, in 2005, when we first started doing this, it was all thermostats. Now, you know, digitization has progressed, the technological change in the energy space has progressed, so that now we have electric vehicles, we have batteries and the batteries fascinating from precisely the point of view that you described, because you can. You know it used to be in the old analog. You know one way electric grid, here's a power plant. Power plant pushes current down a set of wires. You flip the switch, your light goes on, and so you have one role in that and you're the consumer. And there's one action you can take on off, on off, on off With a battery. You can be a producer or a worker. Well, not really. Batteries don't produce energy. Right, you can provide energy that you have.

Mike Munger:

You can be a seller at the margin over a period Exactly.

Lynne Kiesling:

Exactly so. If you have previously used energy, stored energy in your battery, you can then sell that stored energy to someone else. So you can either be a buyer or a seller, depending on your what's going on with you, your opportunity costs, or you know what the prices are doing, you know. So you know, sure I may want to keep my battery at like 80% charge, just just in case for backup, because you know, who knows, you know bad weather, whatever I, batteries are, batteries are insurance Right, and so I might want to keep it at a high charge just for insurance purposes. That's the whole reason I bought the thing. But if there's a price out there that's high enough that that can induce me to discharge down to, say, 40%, and I can take that that amount of energy and sell it to someone else and that's a win-win.

Mike Munger:

And there are. We could talk about this all day and I'm sorry to put you through all this, but there there's one more concept in the interest of time that I think we if you've studied energy at all you just take for granted. But one of the things that the capital intensive system was able to use to justify much larger investment was the problem of peak load, and the problem of peak load is that we have to be able not to have brownouts at whatever the time of maximum use is going to be. Most of that capacity is going to be unused most of the time.

Mike Munger:

If you have two more things if you have local storage capacity and you have local generation, where people have, maybe, solar panels on their roof, we're used to thinking of storage as being expensive because it's expensive to generate at the margin. Once you have solar panels, it costs almost nothing to generate that and then put it into a battery, and so people are likely to start investing in excess capacity in batteries. If you say it's insurance, that's right, but if I get a battery that's twice as large as I need, then if I go to 50%, that's all the insurance that I need. The other part of it I can then sell back to the system, which we no longer have to worry so much about peak load problems. There's a lot more redundancy and resiliency in the system.

Lynne Kiesling:

Yes, resilience is precisely the concept that the electricity industry is moving towards. Is thinking about resilience? In that old analog system that you described, with peak demand, there are some generators. If you're in the system where you have just these big power plants, there are some generators that get built and these are big, expensive pieces of machinery and millions of dollars and they may run four hours out of the year, so four hours out of the 3,760 hours in a year, and they're sitting idle the rest of the time.

Lynne Kiesling:

And one of the debates that goes on currently in energy is aren't batteries and solar more expensive than the old centralized power plants?

Lynne Kiesling:

I'm like well, compared to what Maybe unlike, and the argument is usually because the capacity factors or how many hours out of the year the wind turbines run or the solar PV runs, capacity factors are maybe only like 30, 40% max, and that's really probably 30 to 35%, if I'm being more realistic, and so you can really only use those, expect to rely on them like a third of the time, whereas a coal-fired power plant or natural gas power plant you flip the switch and in a couple hours off you go. But there's also that opportunity cost of the fact that that stuff gets built and then it just sits there, except for four hours of the year when you need it. So that peaking phenomenon in electric systems that don't use prices to try to flatten demand over time is a very costly way to just let assets invest in assets and let them sit idle. I mean they may make a return on investment because those four hours they get paid an absolute ton of money.

Mike Munger:

Avoiding rolling blackouts is really worth a lot, both just in money and in terms of what the politicians are willing to pay to make sure that doesn't happen. So we've arrived now at the original destination that I was hoping for. Digitization is allowed for two things. One is demand management, so you get smart system demand management, where people put directions into the system. The other is supply management, where we're able to smooth out what would have been the big problems in the requirements for supply and, as a result, we're on the verge of well, the I think a number of people.

Mike Munger:

I have friends in Chicago and in New York. When Airbnb was legal in New York, they had a much bigger, nicer apartment than they would have had, because a month of the year they would go somewhere else and rent out their apartment, and that meant they had a nicer apartment. They had excess capacity. They would rent out part of it.

Mike Munger:

Electricity may start to work the same way, where we get endogenous increases in distributed energy resources in neighborhoods, where people, just for their own selfish reasons, are going to invest in more generation and more storage, but the result is there's a lot more resilience in the system. So it's actually an example of something that looks like an invisible hand mechanism, if we're able to free up that sort of creative energy. And so the regulatory problems that we're going to face. On that, some of your contributions, I think moving in that direction have been really important so that, if you wanted to say something more just about the future of regulation, it's sort of from 10,000 feet how should regulators be thinking about this? That over the next decade we can remove the impediments?

Lynne Kiesling:

And so we've arrived. Because we talked about smart being kind of digitally enabled, automated, responsive devices to price signals, and I should say that there are other parts of a smart grid. I just described the price responsive, transactive stuff around the edge, but within the guts of the grid there's also really awesome technologies for automating fault detection in wires, automating fault repairs even in wires, which is pretty cool. There are these, you can do these phaser measurement units, pmus and kind of distribution system automation and digitization. So there's all kinds of stuff within the guts of the grid that are also part of the smart grid. But for me, what really characterizes the smart grid is the stuff at the edge. And then we get the decentralization that you've just alluded to. And I think you know one thing with Serena Kim, who's at North Carolina State, and Rimbau Tadonis, who's at Gettysburg College and spending this year on leave at Slack National Laboratory, working with my co-author, dave Chathson, and some engineers at the University of Colorado, denver, we have a National Science Foundation funded research project on what we call vehicle grid integration, and so it's basically going into the in-depth study of the kind of things that you're describing, that if you have bi-directional charging of electric vehicles and you can integrate electric vehicles into your building systems as well as into the overall power grid. How can those electric vehicles serve as an energy resource so that they're useful other than just for you for driving? And if we do a good job of that kind of technology and regulatory and market design and pricing allowing, for you know you send a price signal to my EV and you know if the market price is above my trigger price, then I'll discharge and sell out of my battery. If the market price is below the price at which I'm willing to buy, charge my battery, then you might see more people and this is your point about the commodification of excess capacity that you might see more people at the margin choosing to buy an electric vehicle because they can commoditize it and that'll help pay the car payment and that's a good thing. And by so doing they will create this network of this basically distributed storage network and it's like a yeah, it's a resilience. It's kind of like wetlands are an ecosystem. It's like a sponge that allows for you to absorb the kind of natural fluctuations and some of it.

Lynne Kiesling:

I know some of the objections to electric vehicles are because of the tax credits and the government subsidies that, oh, they're just. It's just a government trying to get us to do what they want us to do, and I'm somewhat sympathetic to. I'm certainly sympathetic to critiques of subsidies, absolutely sympathetic to critiques of subsidies. One thing, though, that I think is important here is to bring in some of that.

Lynne Kiesling:

Jim Buchanan and Craig Stubblebine the Buchanan and Stubblebine 1962, I think externality paper, which not enough people have read. But they have this and they're. They're talking about externalities, and they make this distinction and say that, you know, not every externality, if not not every externality, needs to be internalized in order to get to the efficient outcome. Right, so not every externality is Pareto relevant, and I think about that a lot when I think about electric vehicles, because I think a lot of people are going to buy electric vehicles because they're, because of their preferences for whether it's a kind of a resilience or a self-reliance, especially once you get bi-directional charging and you know if we have an outage and I can run my house off of my car for four hours, you know that's awesome, but that's going to be the primary thing. That's Pareto relevant, and the other stuff, you know, may or may not, at the margin, influence my decision of whether or not to purchase it. So I use that Pareto relevant framing from Buchanan and Stubblebine to think about this a lot. Yep, that is.

Mike Munger:

I thought that might appeal to you, absolutely appeals to me. A lot of externalities are in for a marginal, and so we don't need to internalize them. I'll certainly put up a link to that in the show notes. Well, I want to thank you, lynn. This has been terrific. You touched on far more than I thought you'd be able to get to, but I guess I shouldn't be surprised, because you are quite a polymath in addition to being. I didn't mean to insult you by calling you an engineer, but you're.

Lynne Kiesling:

You know, I've learned a lot of engineering along the way. It's it's hard stuff.

Mike Munger:

Engineering is something that we have to do a better job of. When it comes to engineering institutions and in the energy field, it's clear that we're not going to move in the direction. It's not even clear what would have. The transition to a market process for energy would be pretty wrenching, and so, at the margin, you're you're moving towards improving a lot of things. Is there? Is there any one thing that you think is important that the government of state should consider doing tomorrow?

Lynne Kiesling:

Other than than allowing retail competition and retail choice and removing entry barriers in all parts of production and consumption of electricity. Other than that, no to your earlier question about you know, what should regulators be thinking about? And this is you know, one of the hats I wear is I direct a center called the Institute for Regulatory Law and Economics and we started in 2004. And I've been the director since 2017, 2018. And we do an annual workshop for state public utility commissioners and staff and to teach them about some of these foundational principles of you know, supply and demand markets.

Lynne Kiesling:

What does the natural monopoly theory models say? What does regulatory theory say? Shumpeterian dynamism, you know the perennial gale of creative destruction and why the natural monopoly model is not always correct or useful. So, institutional and organizational economics, public choice theory, clay Christiansen's innovators dilemma, you know, and because a lot of regulators come into the job as lawyers and it's a very technologically turbulent time and they're being asked to make decisions based on a lot of stuff that isn't just the rate of return, regulation stuff, and so I think the better economic fundamentals that they're familiar with, the more they think about you know, costs and high it can shumpeter and market process and double auction and how digitization can allow you to have more markets because it reduces transaction costs. But they may not be introducing retail competition in their states anytime soon. But they will be introducing dimensions of market liberalization where they didn't exist before.

Mike Munger:

That's a terrific place to end. I really appreciate you being a guest on Tidey C. Lynn Kiesling, thanks very much.

Lynne Kiesling:

Thank you for inviting me. I had a great conversation with you.

Mike Munger:

Whoa. That sound means it's time for the twedges. These weeks economics jokes. First twedge comes from Bill Hesley, the insurance insider. He notes that electric companies have a new practice of sending these colorful monthly evaluations of your energy uses. How much electricity did your house use last month compared to other houses last month and compared to your own use the same month from the previous year? Now Bill points out that this violates a fundamental premise of microeconomics you can't make interpersonal utility comparisons. See, electric companies are utilities. You can't make interpersonal utility comparisons. Good one, bill. What do wind turbines think of energy efficiency? Well, they're big fans, of course. I think that's the worst thing I've ever heard. How marvelous.

Mike Munger:

Third, when Albert Einstein died, he met three people who said they were scientists. They're all waiting in the long queue outside the pearly gates To pass the time. Einstein asked people what were their IQs and said he would be able to tell them what their profession was. The first replied 190. Wonderful, exclaimed Einstein. You must be a physicist. We can discuss the contribution made by Ernest Rutherford to atomic physics into my theory of general relativity. Second answered 150. Good, good, said Einstein. I look forward to discussing the role of nuclear-free legislation in the quest for world peace and the problem of controlling proliferation. The third scientist mumbled that his IQ was 94. Einstein looked down for a second, paused and then said so what is your forecast for inflation next year? The story being, einstein didn't really think much of economists.

Mike Munger:

Fourth, I asked ChatGPT to tell me a joke about electricity and economics. Here it is. Why did the wind turbine and the solar panel start a comedy duo? Because they wanted to show everyone the difference in their personalities. The wind turbine said I always blow people away. And the solar panel replied well, I prefer to use my sunny disposition. Now that's a terrible joke, but Russ Roberts on Econ Talk has made that has actually used that parable about the man who was in the coat and the wind and the sun were arguing about who was stronger and the wind said I'll blow his coat off. But the wind blowing just made the man pull his coat tighter around him, whereas the sun beat down and the man took off his coat by persuasion. So I guess the ChatGPT sort of borrowed that in a way. That's well even less funny.

Mike Munger:

It's time now for this month's letters. This letter is from SS. Ss says it might be worth a line or two on the podcast to talk about Shohei Otani's new baseball contract and the transaction costs that are involved in it. He links to an article from Reason Magazine and I'll put up the article in the show notes. In the article, eric Berm talks about the way that the Shohei Otani contract was structured.

Mike Munger:

Baseball superstar Shohei Otani signed a new 10-year contract this week with the Los Angeles Dodgers, who have promised to pay an eye-popping $700 million. But unlike most contracts in sports, that $700 million won't be doled out over the 10-year term of the deal. As a result, both Otani and the Dodgers are poised to be tax Dodgers. Well sorry, some of the taxes they might otherwise be obliged to pay on the record-breaking deal will be deferred. 29-year-old Otani will collect $2 million in each of the next 10 years. The rest of the $68 million salary will be deferred for a decade and the Dodgers will owe it to him in annual installments starting in 2034. By the time Otani collects the last of those payments in 2043, he'll be 49 years old and almost certainly well into retirement, Because he'll be playing most of his games in high-tax California. Taking most of his pay via what's effectively a fixed annuity gives Otani the possibility of avoiding some massive tax payments. By the time he starts receiving the $68 million payment, he may be able to avoid state income taxes entirely. That's what the money is for by living someplace like Florida or by moving back to Japan.

Mike Munger:

End of quotation from the article. Well, the reason that that is interesting, and why it has to do with transaction costs, is that having to structure a contract that way it's only being done as a way of reducing tax liability, and so there's this never-ending arms race between the tax authorities and people who are trying to pay workers money. You're just trying to come up with a contract that makes both parties better off, but the contract is distorted in this case, dramatically distorted by being concerned about taxes. So a tax system imposes an additional cost beyond the tax revenue in the forms of distortions and transaction costs that are imposed on renegotiating and jiggering the contract, so the cost of tax systems far exceeds their revenues. Thanks for that letter, ss.

Mike Munger:

It's time for Book of the Month. I couldn't narrow it down, so there are two this time Christopher De Hamels the manuscripts club from Penguin Press, published in 2023, and Branko Milanovic visions of inequality from the French Revolution to the end of the Cold War, from Belknap Press, also published in 2023. The next episode will be released on Tuesday, february 27th. Back to the last Tuesday of the month, we'll talk about ransomware, the problem of insurance in digital spaces and have more Book of the Months Plus, we'll have four more hilarious twedges. We'll see you next time on TidyC.