It was detailed earlier that the REACT system has the potential to enable significant cost savings to both producers and consumers of electricity. This section will detail the economic theory behind the inefficiencies of the current power industry and how the REACT system can contribute to reducing these inefficiencies.

3.1 Fluctuations in Demand for Electricity Reflected in Past Usage Patterns

From past data, demand varies through the course of a year in a trend that is highly correlated with seasonal changes. In addition, even within the span of a day, demand fluctuations that are largely driven by consumers’ living patterns can be substantial (14). These fluctuations are further exacerbated by highly unpredictable one-off events that are capable of inducing large demand fluctuations within a short span of time.

These large variations in the demand for electricity, as reflected in past usage patterns, have drastic implications for the industry of electricity generation and transmission, both in the long-run and the short-run.

3.2 Interactions Between Electricity Aggregate Supply and Aggregate Demand

Fig 6 provides a representation of the Aggregate Supply (AS) of electricity in an economy, and the possible positions of the Aggregate Demand (AD) curve due to the demand fluctuations aforementioned.

In the AS curve, as quantity supplied increases, price increases in a step-wise fashion. The vertical section of the curve represents the electricity production capacity of the economy. In the AD curve, since price is inversely related to quantity demanded, the quantity demanded increases as price decreases. The density gradient depicted in Fig 6 reflects the probability density corresponding to the position of the demand curve.

3.2.1 Long-run Implications

Suppliers of electricity in an economy have a responsibility to cater to demand peaks, despite these peaks occurring substantially less frequently than the mean demand. In addition, suppliers need to provide a safety margin for improbable periods of strong demand peaks. If demand fluctuates substantially, the probability density corresponding to the position of the demand curve is more spread out, forcing suppliers to invest substantial capital on peak electricity generation and transmission infrastructure. The implication is that electricity production capacity, as represented by the vertical portion of the AS curve, will be far from the more probable positions of the AD curve. This overcapacity will be substantially underutilized as demand peaks are infrequent, leading to economic inefficiency.

3.2.2 Short-run Implications

Under the fixed-price contract, fluctuations in demand have severe short run economic implications. In Fig 7, we assume that at time t=t0, the market is able to operate at the equilibrium price P0 and quantity Q0. Under the fixed price contract, a decrease in demand from AD0 to AD1 is not accompanied by a corresponding price decrease that brings the market to its new equilibrium, thus inducing under-consumption. This results in an economic inefficiency known as deadweight loss, which is represented in Fig 7 by the shaded area. An increase in demand accompanied by a failure for the price to adjust would result in a similar loss due to over-consumption.

In general, the more volatile the demand for electricity, the greater will be the shifts in the demand curve, and hence, the larger the deadweight loss to the economy.

3.3 The Impact of REACT

3.3.1 Allowing Price Adaptability

The impact of REACT and RTP would be to allow the market to employ price signals to bring the market to its equilibrium price and quantity through a feedback mechanism. In Fig 7, if the price were free to adjust, a decrease in demand would bring about a price decrease, which would then provide a signal to consumers to increase their quantity demanded, hence eliminating under-consumption and bringing the market to its new equilibrium. Hence, negative feedback bringing the market back to its equilibrium would eliminate deadweight loss due to a failure of the market to operate at equilibrium.

3.3.2 Reduction of Demand Volatility

Real-time price changes drive opposite changes in the quantity of electricity demanded, culminating in a negative feedback mechanism that promotes stability and reduces consumption volatility. However, the potential of RTP cannot be completely fulfilled without a complementing system providing an automatic response that adjusts consumption patterns. This is because a large part of consumers’ demand is fundamentally very inflexible even in the presence of real-time price signals, since it is impractical to continually monitor and adapt to price changes. The significance of the REACT system would be to reduce this inflexibility by not only providing real-time price signals, but also automatically redistributing consumption to non-peak periods, thereby reducing the volatility of electricity demand.

Fig 8 shows the benefits of a decrease in demand volatility. Firstly, a decrease in demand volatility would allow the electricity production capacity of the economy to be substantially closer to the market equilibrium level, thereby reducing capacity underutilisation. In addition, lower demand volatility would mean that future capacity can be expanded at a slower pace to meet long-term growing demand.

3.3.3 Reduction of Demand Price Inelasticity

As mentioned earlier, a large part of consumers’ electricity demand is fundamentally inflexible. To quantify this, economists employ a measure known as the price elasticity of demand, which describes the responsiveness of consumption levels to price changes. The more responsive consumption levels are as prices vary, the greater the price elasticity.

A significant impact of the REACT system is to increase the price elasticity of demand for electricity, which is demonstrated in Fig 9. AD2 is the more price elastic than AD1 because its quantity demanded is more responsive to price changes. Assuming the initial price and quantity demand are at P0 and Q0 respectively, when price increases to P1, the quantity demanded for AD2 makes a more responsive change by falling to Q2, while that of AD1 only falls to Q1. This demonstrates that with a demand that has higher price elasticity, market price signals would be able to induce larger changes in the quantity demand, and hence, these price signals will have a greater impact in tapering peak consumption, while increasing non-peak consumption, thereby producing a flatter aggregate electricity consumption pattern.

3.3.4 Environmental Impact

Besides direct cost savings to consumers and producers of electricity, the REACT system has the potential to enable numerous environmental benefits. According to a report by the Climate Group, power generation creates about 25% of the greenhouse gases (15). The problem with renewable energy sources is that they tend to be unpredictable in supply, so power companies have faced challenges in making them a substantial part of total capacity. However, with the REACT system in place in every household, the unpredictable supply would be mitigated by the ability of consumers to respond to sudden changes in capacity. This would make it more feasible for sustainable energy production methods to be used in the future. Furthermore, by providing customers monthly feedback of their consumption patterns and by giving energy-saving suggestions, the REACT system will be able to encourage end-users to save energy.