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June 16, 2026

How Economists Have Shaped the US Electricity Markets: Theory, Practice, and Key Milestones

economicsmarket designelectricity marketsLMPhistory

Abstract

Few industries have been as thoroughly re-engineered by academic economics as the US electric power sector. Over roughly four decades, economists supplied the intellectual critique that dismantled cost-of-service regulation of generation, developed the pricing theory that underpins every organized wholesale market in the country, diagnosed the failures of first-generation market designs, and continue to shape the rules governing capacity, demand response, storage, and the integration of renewable energy. This survey traces that influence across four dimensions: (i) the intellectual origins of restructuring in the economics of regulation; (ii) the theoretical foundations of modern market design, most notably peak-load pricing, spot pricing, and locational marginal pricing; (iii) the institutional milestones—from PURPA (1978) through FERC Orders 888, 2000, 745, 841, and 2222—where economic ideas were translated into regulation; and (iv) the empirical and applied literature through which economists diagnosed crises (California 2000–01, Texas 2021), built market-monitoring institutions, and evaluated whether restructuring delivered its promised efficiencies. We argue that US electricity restructuring is best understood not as "deregulation" but as a sustained exercise in applied mechanism design, in which economists moved from critics of regulation to architects of institutions, and we conclude with the open design questions—resource adequacy under deep decarbonization, non-convex pricing, hybrid markets—where economic theory is once again being pressed into service.

1. Introduction

When the Federal Energy Regulatory Commission (FERC) issued Order No. 888 in April 1996, requiring open, non-discriminatory access to the interstate transmission grid, it set in motion the most consequential reorganization of the American electric power industry since the 1930s. Within a decade, two-thirds of US electricity demand was served through organized wholesale markets operated by Independent System Operators (ISOs) and Regional Transmission Organizations (RTOs), in which the price of energy is computed every five minutes at thousands of distinct network locations by solving a large-scale optimization problem whose objective function—maximization of social surplus subject to the physics of power flow—comes straight out of welfare economics.

That last fact is the central theme of this survey. In most deregulated industries—airlines, trucking, telecommunications, natural gas—economists supplied the case for competition, and markets then evolved through decentralized entrepreneurial activity. Electricity was different. Because power flows obey Kirchhoff's laws rather than contracts, because electricity was (until recently) not economically storable, and because supply and demand must balance second by second to avoid cascading blackouts, a workable electricity "market" could not simply emerge; it had to be designed. The result is that economists did not merely advocate for electricity competition—they wrote its constitution. The pricing algorithm at the heart of every US organized market (locational marginal pricing), the financial instruments that hedge congestion (financial transmission rights), the auctions that procure future capacity, the scarcity-pricing mechanisms that replace them in Texas, and the market-power mitigation machinery that polices all of the above are, to an unusual degree, the direct product of academic economic research.

This survey synthesizes that history for a general economics audience. Section 2 traces the intellectual origins of restructuring in the postwar economics of regulation and natural monopoly. Section 3 develops the theoretical core: peak-load pricing, spot pricing, and Hogan's locational marginal pricing framework. Section 4 walks through the legislative and regulatory milestones through which these ideas became law. Section 5 examines the California crisis of 2000–01, the episode in which empirical economists demonstrated their value as market diagnosticians and which permanently institutionalized economic market monitoring. Section 6 covers the resource-adequacy problem—"missing money," capacity markets, and energy-only alternatives. Section 7 surveys mechanism-design contributions: auctions, non-convex pricing, and virtual bidding. Section 8 turns to the demand side: dynamic retail pricing and the demand-response wars. Section 9 addresses the modern frontier—renewables, storage, distributed resources, and the Texas crisis of 2021. Section 10 reviews the empirical literature evaluating restructuring's effects. Section 11 discusses critiques and the emerging debate over "hybrid" markets, and Section 12 concludes.

Three caveats. First, we focus on the United States; the UK privatization of 1990, though enormously influential on American thinking (and itself heavily shaped by economists such as Stephen Littlechild), enters only as background. Second, "economists" is interpreted broadly to include the engineering-economics tradition at MIT and elsewhere—Fred Schweppe was an electrical engineer, but Spot Pricing of Electricity is a work of economics. Third, no survey of this length can be exhaustive; our aim is an accurate map of the main intellectual lineages and institutional turning points.

2. Intellectual Origins: The Economics of Regulation and Its Discontents

2.1 The old regime and its theoretical rationale

From the 1920s until the 1980s, the US electricity industry was organized around vertically integrated, investor-owned utilities holding exclusive retail franchises, with prices set by state commissions on a cost-of-service basis and wholesale/interstate matters governed by the Federal Power Act of 1935. The intellectual rationale was the theory of natural monopoly: with enormous fixed costs and (it was believed) pervasive economies of scale in generation, transmission, and distribution alike, competition was thought to be wasteful or unsustainable, and regulated monopoly the least-bad institutional response.

Economists were present at the creation of this regime—the "fair rate of return on fair value" apparatus descends from institutionalist economics and rate-base litigation of the early twentieth century—but the profession's most important contribution came later, in the form of critique.

2.2 The postwar critique

Four strands of postwar economics converged to undermine confidence in the regulated-monopoly model.

Incentive distortions. Averch and Johnson (1962) showed formally that rate-of-return regulation gives utilities an incentive to over-invest in capital—the "gold-plating" or A–J effect. Whatever the empirical magnitude of the effect (still debated), the paper reframed regulation as an incentive problem rather than an accounting exercise, and seeded the later literature on incentive regulation (Laffont and Tirole 1993) that would inform performance-based ratemaking.

Regulatory capture. Stigler (1971) and Peltzman (1976) argued that regulation is supplied to politically effective interest groups rather than in the public interest, while Demsetz (1968) asked why natural monopoly required regulation at all when the right to serve could be auctioned—franchise bidding as competition for the market. These Chicago contributions eroded the presumption that regulation reliably corrected market failure.

Evidence on scale economies. Empirical work—most influentially Christensen and Greene (1976)—found that by the 1970s most large US generating firms had exhausted economies of scale at the plant and firm level. If generation was no longer a natural monopoly, the case for regulating it collapsed, even if wires remained naturally monopolistic. This "unbundling" insight—competition where feasible (generation, retail), regulation where necessary (transmission, distribution)—became the master blueprint of restructuring.

The deregulation movement in practice. Alfred Kahn's two-volume The Economics of Regulation (1970–71) supplied the synthesis, and Kahn himself, as chairman of the Civil Aeronautics Board under President Carter, demonstrated that an academic economist could dismantle a regulatory regime from within. Airline (1978), trucking (1980), railroad (1980), and natural gas (1978–92) deregulation created both the political template and the professional confidence for tackling electricity—by common consent the hardest case.

2.3 The proximate crisis and the pivotal book

The 1970s destroyed the postwar equilibrium of the utility industry: oil shocks, the collapse of nuclear construction economics (with celebrated cost overruns and the WPPSS default), stagnating demand growth, and double-digit rate increases turned regulators and consumers alike against the incumbent model. The Public Utility Regulatory Policies Act of 1978 (PURPA), discussed in Section 4, inadvertently ran a natural experiment demonstrating that non-utility generators could build and operate power plants.

Into this environment came Paul Joskow and Richard Schmalensee's Markets for Power: An Analysis of Electric Utility Deregulation (1983), the single most influential economic analysis of electricity restructuring ever written. Joskow and Schmalensee did two things. First, they systematically dismantled the claim that the status quo was efficient, documenting the incentive problems of cost-of-service regulation. Second—and this is often forgotten—they were deeply cautious about wholesale competition, cataloguing the technical obstacles (loop flow, reliability externalities, market power in transmission-constrained regions) that naïve deregulation would encounter. The book's lasting contribution was to define the research agenda: every obstacle they identified became, over the following two decades, a design problem that economists set out to solve. Joskow's subsequent forty-year output—on transmission investment, contract structures, capacity markets, and lately decarbonization—constitutes the connective tissue of the entire field, and his role as advisor, board member, and expert in countless proceedings made him arguably the most influential single economist in the sector's history.

3. Theoretical Foundations: From Peak-Load Pricing to Locational Marginal Prices

3.1 Marginal-cost pricing and the peak-load problem

The deep theory begins in postwar France. Marcel Boiteux, an economist-engineer at Électricité de France (and student of Maurice Allais), worked out in the late 1940s and 1950s how to price electricity at marginal cost when demand varies over time and capacity is costly: off-peak users should pay energy cost only, while peak users pay energy cost plus the marginal cost of capacity (Boiteux 1949, 1956; translated and introduced to Anglophone readers largely via Nelson 1964). Steiner (1957) independently developed the peak-load pricing model in the American literature, and Williamson (1966) refined the welfare analysis. Boiteux's companion work on second-best pricing under a budget constraint (Ramsey–Boiteux pricing) became the standard framework for recovering fixed costs with minimal distortion. EDF's tarif vert, implemented in 1956, proved these were not blackboard curiosities.

Two further ingredients completed the classical toolkit. Turvey (1968) and others connected peak-load pricing to investment planning. And the theory of pricing under uncertainty with rationing—what is the efficient price when capacity is short?—pointed toward the concept that would later dominate resource-adequacy debates: the value of lost load (VoLL), the willingness of consumers to pay to avoid interruption. Efficient scarcity prices should rise toward VoLL as the system approaches involuntary curtailment; this single idea underlies everything from ERCOT's price caps to capacity-market demand curves.

3.2 Spot pricing: Schweppe and the MIT school

The decisive step from tariff theory to market design was taken at MIT in the late 1970s and 1980s by Fred Schweppe—an electrical engineer—working with economists and engineers Michael Caramanis, Richard Tabors, and Roger Bohn. Their program, culminating in Spot Pricing of Electricity (Schweppe, Caramanis, Tabors, and Bohn 1988), posed the question: what is the true marginal cost of electricity, recognizing that it varies not just by time of day but continuously, stochastically, and—crucially—by location on the network?

Their answer: the efficient spot price at each moment and each bus of the network equals the system lambda (the marginal cost of energy at the reference bus) adjusted for marginal transmission losses and the shadow prices of binding transmission constraints. Prices differ across locations whenever the network is congested, because Kirchhoff's laws prevent cheap power from reaching expensive locations. Schweppe et al. envisioned these prices as the basis for a decentralized "homeostatic" control of the power system: generators and (in principle) consumers responding to real-time prices would replicate the least-cost dispatch that central engineers had always computed—but through markets. The book was written before any institution existed to implement it; it became the technical bible of every subsequent market design.

3.3 Hogan: locational marginal pricing and financial transmission rights

The person who transformed spot-pricing theory into implementable market architecture was William Hogan of Harvard's Kennedy School. Beginning with "Contract Networks for Electric Power Transmission" (Hogan 1992), Hogan solved the problem that had stymied decentralized approaches: how to define tradable transmission rights on an AC network where power flows cannot be directed along contract paths.

Hogan's insight had two parts. First, embrace rather than fight central dispatch: let an independent system operator run a bid-based, security-constrained economic dispatch—the same optimization utilities had always solved, but with offer curves submitted by competing generators—and let the dual variables (shadow prices) of that optimization define the market-clearing locational marginal prices (LMPs) at every node. The LMP at a node decomposes exactly as Schweppe prescribed: energy plus losses plus congestion. Second, define transmission rights financially rather than physically: a financial transmission right (FTR) between nodes A and B entitles its holder to the congestion-rent difference LMP(B) − LMP(A) on a specified quantity. FTRs are simultaneously feasible whenever the underlying injections are (the "revenue adequacy" theorem), they hedge congestion risk perfectly for matching physical schedules, and they can be auctioned or allocated to historical grid users—thereby solving the political problem of transition as well as the economic problem of hedging.

This "pool-plus-FTR" or "integrated" architecture—centralized dispatch, nodal prices, financial rights, two settlements (day-ahead and real-time), co-optimized energy and ancillary services—was fought over ferociously in the 1990s against a rival "decentralized/bilateral" vision (associated with, among others, some California designers and the original UK Pool's critics), which favored self-scheduling, zonal prices, and physical rights. The verdict of experience was unambiguous. PJM abandoned zonal for nodal pricing in 1998 after gaming of zonal prices; New York launched with LMP (and its FTR variant, Transmission Congestion Contracts) in 1999; New England converted in 2003; the Midwest ISO launched nodal in 2005; California, after its crisis, reorganized around full nodal pricing in 2009; Texas converted from zones to nodes in 2010; and the Southwest Power Pool followed in 2014. Every organized US market now runs on Hogan's architecture. It is difficult to name another instance in which a single economist's design is executed, every five minutes, across most of a continental economy.

Hogan's subsequent work extended the framework to virtually every contested design margin: multi-settlement systems, FTR options and obligations, scarcity pricing via operating reserve demand curves (Section 6.4), uplift and non-convex pricing (with Gribik and Pope), transmission investment incentives, and—continuing today—pricing for decarbonized grids. Harvey and Hogan's running debate with the Berkeley empiricists over California (Section 5) also set the methodological standards for market-power measurement.

3.4 The supporting cast of theory

Three further theoretical literatures fed the design canon:

  • Auction and mechanism design. Vickrey's (1961) foundations; the Wilson–Milgrom research program on auctions with common values and multi-unit demand; and Robert Wilson's Architecture of Power Markets (Econometrica, 2002), which framed electricity design as a problem in "market architecture"—the decomposition of an economic problem into linked auction sub-markets. Wilson himself advised on power-market designs internationally and in California, and Paul Milgrom's consulting practice extended auction design into electricity procurement. The 2020 Nobel to Milgrom and Wilson cited work whose applications explicitly include electricity.
  • Supply function equilibrium. Klemperer and Meyer (1989) modeled competition in supply schedules under uncertainty—precisely what generators submit to ISOs—and Green and Newbery (1992) applied SFE to the British Pool, providing the workhorse oligopoly model for electricity markets and an early, influential warning that a duopolistic pool would price far above marginal cost. This transatlantic result shaped American thinking about market structure and divestiture requirements.
  • Contracts and vertical arrangements. Joskow's earlier empirical work on long-term coal contracts and asset specificity (in the Williamsonian tradition), and the Allaz–Vila (1993) result that forward contracting can mitigate spot market power, informed both the design of transition contracts and the enduring policy preference for high contract cover—one of the clearest lessons economists drew from comparing California (uncontracted, catastrophic) with other markets.

4. Institutional Milestones: Ideas Become Law

4.1 PURPA (1978): the accidental experiment

The Public Utility Regulatory Policies Act of 1978, passed as energy-crisis legislation, required utilities to purchase power from "qualifying facilities" (cogenerators and small renewables) at the utility's avoided cost. Avoided cost is, of course, an economist's concept—the marginal cost the utility escapes—and its implementation launched a thousand rate proceedings in which economists testified about how to measure it. PURPA's deeper significance was unintended: the wave of non-utility generation it induced (especially in California, New York, and Texas) demonstrated that independent power producers could finance, build, and operate generation, destroying the empirical premise that generation required vertically integrated monopoly. Economists, including Joskow, documented both the demonstration effect and the pathologies of administratively determined avoided-cost contracts—which, when set too high (as in California's Standard Offer 4 contracts), saddled ratepayers with above-market costs and taught a lasting lesson about administered prices versus auctions.

4.2 The Energy Policy Act of 1992 and FERC Orders 888/889 (1996)

The Energy Policy Act of 1992 created "exempt wholesale generators," freeing independent generation from the Public Utility Holding Company Act, and empowered FERC to order transmission access case by case. FERC generalized this in Order No. 888 (1996), which required all transmission-owning utilities to file open-access tariffs offering service to third parties on the same terms they provided themselves, and Order No. 889, which established the OASIS information system and functional unbundling. The economic logic—that the bottleneck monopoly (wires) must not be permitted to leverage its position into the potentially competitive segment (generation)—was the essential-facilities/vertical-foreclosure reasoning of industrial organization, argued to FERC by a small army of economists on all sides. Order 888 also blessed the recovery of "stranded costs," itself the subject of a substantial economic literature (with William Baumol, Alfred Kahn, and others debating whether recovery was efficient transition compensation or an unwarranted bailout).

4.3 State restructuring: California AB 1890 and the Northeast

Restructuring of retail markets was a state affair. California moved first and most ambitiously: AB 1890 (1996), implementing CPUC decisions shaped by years of hearings in which academic economists were central witnesses, created the Power Exchange (PX) and the California ISO (launched March 31, 1998), required the utilities to divest most fossil generation, froze retail rates at 10% below prior levels, and—fatefully—discouraged long-term contracting, pushing procurement into the day-ahead and real-time markets. The design reflected a compromise between the bilateral/decentralized school and the pool school that satisfied neither; several prominent economists (including members of what became the ISO's Market Surveillance Committee) warned before launch about the combination of tight supply, uncontracted demand, capped retail prices, and market-power exposure. Massachusetts, Rhode Island, Pennsylvania, New York, New Jersey, Maryland, Illinois, Ohio, Michigan, and Texas followed with their own restructuring statutes between 1996 and 1999, typically pairing retail choice with generation divestiture and transition-cost charges. By 2000, roughly half the states had enacted or opened restructuring proceedings.

4.4 Order 2000 (1999) and the Standard Market Design episode (2002–05)

FERC's Order No. 2000 encouraged (but did not compel) formation of Regional Transmission Organizations—independent grid operators with defined characteristics and functions. The intellectual case for the ISO/RTO institution—an independent, non-profit operator running open, bid-based markets—had been developed by Hogan, Joskow, and others as the resolution of the transmission-independence problem. In 2002, FERC proposed to go further: the Standard Market Design (SMD) NOPR would have mandated the full nodal architecture—LMP, FTRs, day-ahead/real-time settlements, market monitoring, and resource adequacy—everywhere in the country. SMD was the high-water mark of economists' direct influence on federal policy: its text reads like a summary of the design literature. It also provoked a fierce political backlash from the South and West (regions with cheap regulated power and no appetite for markets), and FERC formally withdrew the proposal in 2005. The result is today's map: organized nodal markets covering roughly two-thirds of US load (PJM, MISO, CAISO, ERCOT, NYISO, ISO-NE, SPP), with the Southeast and much of the West remaining vertically integrated—an enduring natural experiment that empiricists would later exploit (Section 10).

4.5 The later federal orders

Subsequent FERC rulemakings, each examined in later sections, continued to translate economic analysis into rules: Order 719 (2008) on demand response and ISO governance; Order 745 (2011) on demand-response compensation; Order 755 (2011) on performance-based regulation payments; Order 1000 (2011) on transmission planning and cost allocation—a subject on which Joskow and Jean Tirole had written foundational theory; Order 841 (2018) on electric storage participation; and Order 2222 (2020) on distributed energy resource aggregation. The pattern is consistent: a design question surfaces; economists write papers and file affidavits; FERC codifies a (contested) resolution; litigation and further papers follow.

5. Trial by Fire: The California Crisis and the Rise of Market Monitoring

5.1 The crisis

Between May 2000 and June 2001, average wholesale prices in California rose by a factor of five to ten relative to prior years; the state suffered rolling blackouts; Pacific Gas & Electric entered bankruptcy; Southern California Edison approached it; the Power Exchange ceased operations; and the state spent tens of billions of dollars buying power. The proximate causes included drought (reduced Northwest hydro), rising natural gas and NOx permit prices, demand growth, and a genuinely tight market. But the crisis became an economics event because of what happened on top of scarcity.

5.2 The diagnosis: economists as forensic analysts

A group of empirical industrial-organization economists—principally Severin Borenstein, James Bushnell, and Frank Wolak, working through the University of California Energy Institute and the CAISO Market Surveillance Committee (which Wolak chaired)—developed and applied a method for measuring market power directly: simulate the competitive counterfactual price by stacking actual marginal costs against actual demand (accounting for hydro opportunity costs and imports), and attribute the gap between actual and competitive prices to the exercise of market power. Their central publication, Borenstein, Bushnell, and Wolak, "Measuring Market Inefficiencies in California's Restructured Wholesale Electricity Market" (American Economic Review, 2002), found that market power accounted for a large share of the price increases during summer 2000—unilateral withholding by a handful of suppliers facing inelastic, uncontracted demand, not necessarily illegal conspiracy. Joskow and Edward Kahn (2002) reached similar conclusions with complementary methods, documenting substantial output withholding. Scott Harvey and William Hogan contested the magnitudes and the attribution in a series of papers, arguing that cost mis-measurement and operational constraints could explain much of the gap—a debate that, whatever one's verdict, hardened the methodological standards of the entire field. Subsequent enforcement actions and the Enron tapes ("Death Star," "Fat Boy," "Ricochet"—strategies that exploited precisely the seams between California's zonal market and its neighbors that the pool school had warned about) settled the public argument.

The economists' account of why California failed became canonical: (i) retail price freezes severed demand from wholesale prices, making demand almost perfectly inelastic; (ii) the utilities were prohibited/discouraged from forward contracting, leaving them exposed to spot prices and giving suppliers maximal incentive to raise them (the Allaz–Vila logic in reverse); (iii) the separation of the PX energy market from the ISO's congestion and reliability functions, and zonal rather than nodal pricing, created arbitrage seams; and (iv) soft price caps invited strategic exports and re-imports. Each element had been flagged in advance by parts of the profession; the crisis converted those warnings into design orthodoxy: contract cover matters, demand response matters, nodal beats zonal, and market power mitigation must be built in, not bolted on.

5.3 Institutionalizing economics: the market monitors

The most durable institutional legacy of California is the market monitor. Every ISO/RTO now has an independent internal and/or external market monitoring unit—Potomac Economics (led by economist David Patton) serves as independent monitor for several markets (including ERCOT, NYISO, and MISO), Monitoring Analytics (led by economist Joseph Bowring) monitors PJM, and CAISO maintains a Department of Market Monitoring and a Market Surveillance Committee that has been chaired by academic economists (Wolak, Bushnell, and colleagues). These units run conduct-and-impact mitigation screens (automatic offer-capping when suppliers with local market power bid far above reference costs), publish annual State of the Market reports dense with concentration and price-cost-margin analysis, and refer cases to FERC enforcement. Market monitoring is applied industrial organization practiced as a permanent regulatory function—a professional niche that simply did not exist before economists created it.

6. Resource Adequacy: Missing Money, Capacity Markets, and Scarcity Pricing

6.1 The "missing money" problem

In the theoretical ideal, energy-only markets finance capacity through scarcity rents: prices spike toward the value of lost load in shortage hours, and the expectation of such rents induces efficient investment in exactly enough capacity that the marginal plant recovers its fixed costs. In practice, US markets systematically suppress those rents: offer caps (long $1,000/MWh in the East), out-of-market reliability actions by operators who dispatch reserves rather than let prices rise, and mitigation rules together truncate the right tail of the price distribution. The resulting shortfall between what generators need to cover fixed costs and what suppressed energy prices deliver was dubbed the "missing money" problem—a term popularized through the work of Peter Cramton and Steven Stoft and central to Joskow's influential treatments (e.g., Joskow 2008). The diagnosis reframed reliability from an engineering mandate into a pricing failure, and the profession split over the remedy: fix the energy prices (scarcity pricing) or bolt on a separate market for capacity.

6.2 Capacity markets and the demand-curve innovation

The Eastern ISOs chose capacity markets: mandatory forward auctions in which load-serving entities procure enough accredited capacity to meet a reserve-margin target. Early "vertical demand" designs (a fixed requirement, price collapsing to zero when supply barely exceeded it) proved pathologically volatile and manipulable. The fix—first implemented in NYISO in 2003 and now universal—was the sloped administrative demand curve: a downward-sloping schedule anchored at the estimated "cost of new entry" (CONE) that makes the capacity price a smooth function of the surplus margin. The demand curve is pure economic engineering—an administratively constructed marginal-value schedule for reliability—and its parameters (CONE, the shape and anchor points) are set through recurring proceedings that are essentially econometric litigation. Cramton and Stoft's design work (much of it commissioned by the ISOs), together with Joskow's analyses, shaped PJM's Reliability Pricing Model (implemented 2007) and ISO-NE's Forward Capacity Market (first auction 2008), including features such as three-year-forward procurement, locational capacity zones, and—later—"pay for performance" penalty structures (ISO-NE, and PJM's Capacity Performance reforms after the January 2014 polar vortex exposed the weakness of capacity that fails to show up). The subsequent generation of disputes—minimum offer price rules (MOPR) aimed at state-subsidized entrants, buyer-side market power, and the accreditation of intermittent and duration-limited resources—has kept capacity-market economics among the most litigated areas of the field.

6.3 The energy-only alternative: ERCOT and the operating reserve demand curve

Texas took the other road. ERCOT—intrastate, outside FERC jurisdiction, restructured under Senate Bill 7 (1999)—runs an energy-only market with no capacity mechanism and, historically, a high offer cap (reaching $9,000/MWh). Its signature mechanism, adopted in 2014, is the Operating Reserve Demand Curve (ORDC), based directly on William Hogan's proposal ("Electricity Scarcity Pricing Through Operating Reserves," 2013): a real-time price adder equal to the loss-of-load probability (as a function of the current reserve level) multiplied by the value of lost load, so that prices rise smoothly and automatically toward VoLL as reserves shrink—administratively replicating the scarcity rents that an ideal market with responsive demand would generate. The ORDC is perhaps the purest example in any industry of a formula from an economics working paper being written into the settlement software of a major market. The 2021 crisis (Section 9.4) subjected the design to its most severe test.

6.4 The unresolved debate

The capacity-versus-energy-only debate remains live and has been sharpened by decarbonization. Capacity-market advocates emphasize investment-risk reduction and political robustness (regulators will never tolerate true VoLL pricing for long); energy-only advocates (Hogan, and in a different register Wolak, who is skeptical of both constructs and emphasizes contracting obligations) counter that capacity markets pay for "iron in the ground" rather than performance, invite endless administrative gaming, and mute the scarcity prices needed to reward flexibility and demand response. The rise of storage and renewables—whose capacity value (measured by effective load-carrying capability, ELCC, another economics-adjacent construct) depends on penetration—has turned resource-adequacy design into one of the most active current research areas (Section 9).

7. Mechanism Design in the Engine Room: Auctions, Non-Convexities, and Virtual Bidding

7.1 The market as an optimization problem

An ISO's day-ahead market is a sealed-bid, multi-unit, multi-product auction cleared by security-constrained unit commitment and economic dispatch—a mixed-integer program whose scale (tens of thousands of constraints, thousands of resources) makes it among the largest auctions run anywhere. The economic questions are classic mechanism design: What prices support the efficient allocation? What are the incentives to bid truthfully? How should linked products (energy, regulation, spinning reserve) be co-optimized? Economists—often working with operations researchers—have supplied the answers now embedded in the software.

7.2 Non-convexities and uplift: the pricing frontier

Power plants have non-convex costs—start-up costs, minimum run levels, minimum up/down times—so a Walrasian equilibrium supporting the efficient commitment may not exist: at the LMP, some committed units lose money and some uncommitted units would profit. US markets patch this with "uplift" or make-whole side payments, which are discriminatory, opaque, and blunt price signals. The theoretical response has been one of the liveliest applied-theory literatures of the past two decades: O'Neill, Sotkiewicz, Hobbs, Rothkopf, and Stewart (2005) showed how to construct market-clearing prices with non-convexities using integer-activity prices; Gribik, Hogan, and Pope (2007) proposed convex hull pricing ("extended LMP"), which minimizes total uplift by pricing off the convex envelope of the cost function. Variants of these ideas have been implemented: MISO adopted approximations of convex-hull pricing, and FERC's fast-start pricing orders (2016–2020) pushed ISOs to let inflexible fast-start units set prices. This is an area where economic theory, operations research, and settlement software co-evolve in real time.

7.3 Virtual bidding and the two-settlement system

Hogan's multi-settlement architecture separates a financially binding day-ahead market from real-time balancing. To keep the two aligned, markets admit virtual (convergence) bidding: purely financial positions that arbitrage expected day-ahead/real-time spreads. The theory says arbitrageurs should converge the two prices, improving unit commitment; the empirical literature broadly confirms it while documenting nuances—Jha and Wolak's work on California finds convergence bidding improved price convergence and productive efficiency, while episodes like the JP Morgan make-whole manipulation cases (settled with FERC in 2013) and studies of loss-related arbitrage in MISO illustrate how financial products interact with market seams. The design of FTR auctions, their chronic revenue underperformance relative to auction prices, and the question of who should bear FTR-portfolio default risk (brought to a head by the 2018 GreenHat default in PJM) have similarly been analyzed principally by economists.

7.4 Procurement auctions and default service

Beyond ISO markets, economists designed the auctions through which restructured states procure default retail service—most prominently New Jersey's Basic Generation Service descending-clock auction, designed with the involvement of auction economists (including Ausubel and Cramton's circle) and running annually since 2002, and Illinois' procurement events. Milgrom's and Wilson's broader auction-design consulting practices, celebrated in the 2020 Nobel citation, include electricity procurement among their applications. Contract design for renewable procurement (indexed PPAs, contracts-for-differences) is the current frontier of this tradition.

8. The Demand Side: Dynamic Pricing and the Demand-Response Wars

8.1 The economists' oldest complaint

From Boiteux onward, economists have insisted that the demand side is half the market: if retail consumers face time-invariant prices, the price elasticity that should discipline wholesale markets is absent, scarcity cannot clear the market efficiently, and (as California proved) the system is fragile. Borenstein's work in the 2000s (e.g., "The Long-Run Efficiency of Real-Time Electricity Pricing," 2005; Borenstein and Holland 2005 on the distortions when only some customers face real-time prices) made the modern welfare case for dynamic retail pricing; Wolak designed and evaluated field experiments (including in Anaheim and internationally) measuring household response to critical-peak pricing; and a large subsequent experimental literature (including Jessoe and Rapson's work on information feedback) quantified how technology (smart meters, automation) raises effective elasticity. Actual adoption remains limited—default flat tariffs persist almost everywhere—which economists attribute to political economy and behavioral frictions rather than to the economics; the gap between the theory's clarity and retail practice is a standing embarrassment the profession continues to probe (including through work on the distributional effects of dynamic pricing).

8.2 Order 745 and EPSA v. FERC: economists on both sides

Wholesale demand response—paying consumers to curtail—produced the sector's most famous economics dispute. FERC Order 745 (2011) required ISOs to pay demand response the full LMP. Alfred Kahn, in one of his final interventions, filed in support of full-LMP compensation; William Hogan argued forcefully that the correct payment is LMP minus the retail rate the customer avoids ("LMP−G"), since paying full LMP to someone who also saves the retail price double-compensates curtailment and subsidizes inefficient demand reduction. The dispute—at bottom about the definition of the counterfactual and the treatment of the retail-rate distortion—went to the Supreme Court as FERC v. Electric Power Supply Association (2016), where the Court upheld FERC's jurisdiction and Order 745. Economists' briefs and papers populated both sides; the episode is now a teaching case in how second-best reasoning cuts in opposite directions depending on which distortion one takes as fixed.

9. The Modern Frontier: Renewables, Storage, Distributed Resources, and Texas 2021

9.1 Zero-marginal-cost entry and price formation

Subsidized and mandated wind and solar—driven by production tax credits, investment tax credits, and state renewable portfolio standards—entered wholesale markets in volumes that transformed price formation: negative prices in windy regions (a predictable consequence of the PTC paying generators to produce, analyzed early by economists), the California "duck curve," depressed mid-day energy prices, and merit-order displacement of thermal units. The economics literature responded on several fronts: measuring the market value decline of variable renewables as penetration rises; quantifying the emissions and price effects of renewable entry; analyzing how out-of-market subsidies interact with capacity markets (the MOPR wars); and pressing the first-best alternative—carbon pricing—in ISO markets, including formal proposals for carbon-adder designs in NYISO and PJM analyzed by economists at Resources for the Future and elsewhere. The broad professional consensus that technology-neutral carbon pricing dominates technology-specific mandates has had, it must be said, limited legislative success; economists have therefore increasingly turned to analyzing second-best instrument design (clean-energy standards, ELCC-based accreditation, hybrid procurement).

9.2 Storage and distributed resources: Orders 841 and 2222

FERC Order 841 (2018) required ISOs to create participation models letting storage set prices as both buyer and seller; Order 2222 (2020) extended participation to aggregations of distributed energy resources. Both orders resolve questions economists had framed: storage arbitrage and its welfare effects, the double-charging of storage for transmission, and the treatment of behind-the-meter resources. A growing empirical literature (on ERCOT and CAISO battery fleets) now measures how quickly storage competes away its own arbitrage margins—a clean test of entry economics playing out in real time.

9.3 Transmission, again

Transmission planning and cost allocation—the subject of Joskow and Tirole's theoretical work on merchant transmission and of Hogan's beneficiary-pays principle—returned to the center with Order 1000 (2011) and Order 1920 (2024), which require forward-looking regional planning with benefit-based cost allocation. The "beneficiary pays" standard that courts (notably the Seventh Circuit in the Illinois Commerce Commission cases, in opinions by Judge Posner—an economist-judge) have enforced is straight cost-benefit economics.

9.4 Winter Storm Uri (February 2021): stress-testing the energy-only design

The Texas blackout of February 2021—days of rotating outages, prices administratively held at the $9,000/MWh cap for over four days, roughly 200+ deaths, and tens of billions of dollars of financial redistribution—triggered the most intense economic post-mortem since California. The economics discussion separated several issues: the failure was primarily one of supply availability (unweatherized gas supply and generation) rather than market design per se; scarcity pricing performed as designed but the duration of cap-level prices exposed the absence of retail hedging (the Griddy customers on wholesale pass-through rates) and raised the question whether VoLL-level prices sustained for days are politically or contractually tolerable; and the PUCT's decision to hold prices at the cap after load shed ended became a celebrated dispute about out-of-market intervention. Peter Cramton, then an ERCOT board member (who, with other out-of-state directors, resigned after the storm), Hogan, Wolak, Bushnell, and many others produced dueling analyses; the aftermath brought a lower price cap, a modified ORDC, weatherization mandates, and a new Performance Credit Mechanism proposal—each debated in explicitly economic terms. Uri also revived academic interest in the interaction between gas and electricity market design, and in mandatory retail/load-serving hedging obligations of the kind Wolak has long advocated.

9.5 Resource adequacy for a decarbonized grid

The current research frontier asks whether the LMP-plus-scarcity architecture, designed for a fuel-burning fleet with meaningful marginal costs, remains adequate for a system dominated by zero-marginal-cost, weather-driven, and duration-limited resources. Questions under active study by economists include: price formation when the marginal resource is storage or curtailed renewables (opportunity-cost pricing); capacity accreditation via marginal ELCC; long-duration adequacy and tail risk (climate-correlated outages); the financing of capital-intensive clean firm resources under volatile revenue streams (motivating contract-for-differences and reliability options, the latter a Cramton–Stoft design adopted in Colombia and ISO-NE's FCM in modified form); and whether organized markets should evolve toward centralized long-term procurement—"hybrid markets"—a debate joined by Joskow (whose recent papers argue the pure energy-market model is under increasing strain), Schmalensee, Wolak, Hogan, and a younger generation. The wheel, in other words, is turning again, and economists are once more on both sides of it.

10. Did It Work? The Empirical Assessment Literature

Restructuring created a natural experiment—organized-market regions versus traditionally regulated regions; divested plants versus utility-retained plants—that empirical economists have mined for two decades. The headline findings:

  • Operating efficiency. Fabrizio, Rose, and Wolfram (AER, 2007) found that investor-owned plants in restructuring states reduced labor and nonfuel operating expenses several percent relative to those in non-restructuring states—evidence that competition (or its anticipation) sharpened cost discipline. Davis and Wolfram (AEJ: Applied, 2012) found that divestiture of nuclear plants to independent merchant operators raised capacity factors by roughly 10 percentage points, a large efficiency gain concentrated in reduced outage durations. Cicala (AER, 2015) showed deregulated plants procured coal more cheaply once cost pass-through incentives were removed.
  • Dispatch efficiency. Cicala (AER, 2022) used the staggered expansion of ISO markets to estimate that market-based dispatch reduced production costs on the order of billions of dollars per year by reallocating output toward lower-cost plants and increasing gains from trade across utility boundaries—the cleanest evidence that the LMP machinery does what its designers promised.
  • Investment and technology mix. Merchant investment responded to price signals with technology choices (fast, modular gas; later renewables and batteries) very different from the regulated era's, and the literature documents both the responsiveness and the boom-bust cycles that pure merchant exposure produces.
  • Retail competition. The retail literature is more mixed: evidence from Texas and elsewhere documents meaningful search frictions, price dispersion, and confusion pricing in residential retail choice (with Hortaçsu, Madanizadeh, and Puller's 2017 study of Texas a benchmark), tempering the more expansive claims for retail liberalization even where wholesale gains are accepted.
  • Prices. Simple regulated-versus-restructured retail price comparisons are confounded (restructured states were high-cost to begin with; gas price cycles dominate), and the profession has largely converged on the view that the welfare gains of restructuring show up in costs, dispatch, and plant performance rather than in unambiguous retail price declines—an honest, if politically unsatisfying, verdict.

Alongside evaluation, electricity became empirical IO's favorite laboratory: because engineering marginal costs are measurable, researchers can compute markups directly rather than infer them, and the industry has consequently generated foundational studies of oligopoly bidding (Wolfram on the England–Wales pool; Hortaçsu and Puller on ERCOT bidders' deviations from optimal bidding), forward contracting, auction behavior, and environmental policy interactions. The methodological traffic runs both ways: electricity data disciplined IO theory, and IO tools staffed the market monitors.

11. Critiques, Countercurrents, and the Limits of Design

An honest survey must record that economists' stewardship of electricity restructuring has critics, including within the profession.

First, the promised consumer savings were oversold in the 1990s political campaigns, and the profession's more careful voices (Joskow prominent among them) spent years distinguishing what the evidence supports from what advocates claimed. Second, complexity itself is a cost: the layered edifice of energy, ancillary, capacity, FTR, and virtual products—each patching the previous layer's incentive problems—has been criticized (from the left as designed-for-traders opacity, from parts of the engineering community as fragile, and by public-power advocates as an expensive detour). Third, the governance critique: ISO stakeholder processes and FERC litigation allocate rents through processes in which well-funded incumbents are structurally advantaged—a Stiglerian observation that sits uncomfortably with the design tradition's technocratic self-image. Fourth, the decarbonization critique: state clean-energy policies now drive most investment, and the resulting collision between subsidized entry and market price formation (MOPR, hybrid-market proposals) suggests to some scholars that the 1990s architecture is being quietly superseded by a return to planned procurement with markets relegated to short-run balancing—"markets for dispatch, planning for investment." Whether that constitutes the failure of the design program or its adaptive success is perhaps the central interpretive question of the field's next decade, and—fittingly—it is being argued out by the same cast of economists, their students, and their students' students.

12. Conclusion

The arc surveyed here runs from Boiteux's peak-load tariffs at EDF, through the Chicago and MIT critiques of regulation, Schweppe's spot prices, and Hogan's contract networks, to the five-minute nodal prices that today clear most American wholesale electricity. Along the way economists built institutions (ISOs, market monitors, capacity auctions), fought and refereed crises (California, Uri), created a permanent professional apparatus of market design and surveillance, and produced one of empirical economics' richest bodies of evidence on what competition and regulation each do well. Three lessons generalize beyond electricity. First, where physics or technology preclude decentralized exchange, markets are engineered artifacts, and the quality of the engineering—the mechanism design—determines whether competition delivers its textbook benefits. Second, transitions are governed by second-best problems (stranded costs, retail-price distortions, subsidized entry) at least as much as by first-best blueprints, and the profession's most valuable interventions have often been diagnostic rather than architectural. Third, market design is never finished: each solved problem (transmission access, congestion, missing money) exposes the next (non-convexities, accreditation, deep decarbonization). Forty years in, the US electricity markets remain what they were at the start—the most ambitious ongoing experiment in applied economics anywhere in the world.

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