IDEI, The economics of electricity markets

1
IDEI, The economics of electricity markets

• Investment in transmission
• Issues for discussion
• Ignacio J. Pérez-Arriaga
• Comillas University (Madrid)

Toulouse, June 3, 2005
2
Investment in transmissionWhich is the objective?

• Regulatory framework should be such that all
  transmission facilities that meet a prescribed
  social welfare efficiency criterion (which must
  include economic implications of quality of
  supply) are
• built at optimal times
• properly operated maintained
• at minimum cost for its users

3
Investment in transmissionIssues for discussion

• How can justified transmission investment needs
  be identified? What is justified? Who
  identifies?
• How to achieve consistency between operation
  investment criteria? Same decision maker?
• How to incentivise building needed transmission
  investment? Agents depend on regulatory framework
• How to determine the beneficiaries of an
  investment to make them pay for it? Pricing may
  affect investment decisions

4
The regulatory testWhat is a justified
investment?

• Investment optimality according to traditional
  regulation
• Invest in network assets only while the the
  additional network investment cost is still
  smaller than the additional saving in system
  operation costs (generation costs, loss of
  supply)
• This definition is consistent with the one
  adequate for a context of competition
• Invest so that the net aggregated benefits (once
  network charges are included) of all network
  users (i.e. generators consumers) are
  maximized
• Technical reliability rules have to be met in any
  case

5
A useful property

• An economically justified network investment
  under traditional network expansion rules
• network investment cost lt savings in operation
  costs
• will increase the net benefit of
• Generators income from nodal prices operation
  costs network charges
• Consumers utility of electricity use cost of
  purchasing electricity at nodal prices network
  charges
• if the residual network cost is allocated pro
  rata of the economic benefits of each network user

6
Investment in new facilitiesApproaches (the
regulatory context)

• System Operator proposes reinforcement plan, to
  be authorized by regulator construction may be
  assigned by a competitive auction
• A private company is awarded the transmission
  license and is regulated as a monopoly subject
  to grid code remuneration based on some price
  control scheme (e.g. RPI-X)
• Coalitions of network users proposes
  reinforcements, to be authorized by regulator
  regulated remuneration of total costs
  construction is assigned by competitive bidding
• Risk investments same as above, but coalition
  bears total costs regulated remuneration covers
  partial costs
• Merchant lines (remuneration based on market
  value of their transmission services)

7
Investment in new facilitiesApproaches (comments)

• SO Regulator May result in overinvestment if
  regulator fails to set limits in the
  authorization process
• Private licensed company May result in
  underinvestment unless very careful incentive
  schemes are implemented
• Coalitions of network users Only lines with
  clear beneficiaries will be built. May be a
  complement to 1
• Risk investments Same as 3, but more acute. Good
  to promote investment in underdeveloped networks
• Merchant lines Cannot be trusted to develop a
  sound network, since transmission revenues from
  nodal prices in a well developed network will
  grossly under recover transmission costs. May be
  a complement to 1 or 2

8
Option 1System Operator Regulator

• Regularly, the System Operator must propose a
  plan for reinforcements of the transmission
  network
• after taking into consideration (justified) any
  proposals made by the network users
• Regulatory authorities approve the plan
  authorize construction of individual new
  facilities
• Construction, operation maintenance of each
  facility are allocated in a competitive auction
• pay as bid to winner
• limited duration of contract auction for the
  next period?
• set availability targets for each facility
  penalties (credits) according to the actual
  performance
• May be complemented by options 3, 4 5

9
Option 2 Private firm global regulated
remuneration

• A private company is awarded the transmission
  license and regulated as a monopoly
• Must follow prescribed design requirements (grid
  code)
• Incentives to meet performance targets (warning
  separate clearly from incentives to System
  Operator)
• Global remuneration (RPI-X) for the complete
  network, while taking into account
• actual new investments
• economic lives depreciation of existing
  investments
• economic health of transmission company
• expected efficiency improvements
• Concern optimality of investments in general
  will not be attained determining remuneration
  becomes an art

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Option 3Users have the initiative (A B)

• Initiative of proposal of network reinforcements
  corresponds to coalitions of network users
• OPTION A coalition builds pays the
  reinforcement, which needs authorization from
  regulator
• OPTION B after a quasi-judiciary process
  (coalitions pro against, evaluation by system
  operator) regulator decides whether reinforcement
  is justified or not.
• If justified, it is built under competitive
  bidding
• pay as bid to winner
• limited duration of license auction for the next
  period
• set availability targets penalties (credits)
  according to performance
• charge cost to all users with general allocation
  method

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Option 4Users have the initiative (C)

• OPTION C risk investments
• Quasi-judicial process as in option B
• If the reinforcement is found justified
• the proprietary coalition is selected (a specific
  auction procedure is followed)
• assign construction by competitive bidding
• apply regulated tariffs (attenuated, according to
  the line utilization) to all network users
• financial rights on the congestion rents of the
  reinforcement (firm transmission rights) are
  given to its owners

12
Option 5Merchant lines

• Basic idea Regulate the transmission activity as
  any other competitive business ? merchant lines
• Remuneration comes from congestion rents
• Network capacity may even be bid in a short-term
  market (possible with DC lines)
• Firm Transmission Rights (FTRs), may be seen not
  only as a risk hedging mechanism, but also as an
  incentive for investment
• Difficulties
• insufficiency (in general) of market driven
  revenues
• High exposure to risk
• reliability lines
• potential for market power abuse

13
Investment in transmissionIssues for discussion

• How can justified transmission investment needs
  be identified?
• How to achieve consistency between operation
  investment criteria?
• How to incentivise building needed transmission
  investment?
• How to determine the beneficiaries of an
  investment to make them pay for it?

14
How to achieve consistency between operation
investment criteria?

• SO Regulator No problem, use operation
  criteria when simulating the system to decide on
  investment
• Private licensed company No problem, if there is
  a suitable grid code to comply with
• Coalitions of network users No guarantee
• Risk investments No guarantee
• Merchant lines No guarantee

15
Investment in transmissionIssues for discussion

• How can justified transmission investment needs
  be identified?
• How to achieve consistency between operation
  investment criteria?
• How to incentivise building needed transmission
  investment?
• How to determine the beneficiaries of an
  investment to make them pay for it?

16
Objectives in transmission pricing

• To ensure that the transmission network charges
  that are levied to the network users
• recover the complete regulated costs of the
  transmission network of each country/TSO or that
  merchant lines (if any) are attractive
  economically
• send efficient economic signals
• in the short-term (for operation decisions)
• in the long-term (for investment location
  decisions)
• are non discriminatory
• are easy to understand implement, perceived
  as fair

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Can pricing / remuneration provide right
incentives for network investment?

• Network users may receive signals that make them
  to act so that the operation of the system is
  efficient
• losses
• congestions
• Network users may receive siting signals
  commensurate with the incurred transmission costs
• for siting new generators loads / retiring
  existing ones
• to promote new investments, in some regulatory
  schemes
• System Operators, transmission network planners
  potential network investors may receive
  adequate signals so that optimal network
  investment happens or appropriate regulation
  makes it happen

18
Can pricing / remuneration provide right
incentives for network investment?

• Who are the network investors / planners? It
  depends on the specific regulation, at national
  or regional (multinational) levels
• System Operators, with some degree of regulatory
  supervision, either national or EU
• Coalitions of network users, subject to
  regulatory approval
• Merchant investors, subject to regulatory
  authorization
• The regulatory treatment of the remuneration of a
  new line the pricing access schemes depend on
  the adopted approach

19
Can pricing / remuneration provide right
incentives for network investment?

• Adequate remuneration of transmission depends on
  who is really responsible for the development of
  the network
• If the transmission firm is active, (i.e takes
  responsibility for network development) then the
  remuneration must refer to an efficient well
  adapted network performance-based economic
  incentives to invest make sense
• If the transmission firm is passive, (i.e does
  not take responsibility for network development)
  then the remuneration must refer to the actual
  network incentives must basically depend on the
  availability of the network equipment, although
  mild incentives to improve operation can also
  make sense

20
Can pricing / remuneration provide right
incentives for network investment?

• Merchant investors will collect just congestion
  rents (or their expected values, via capacity
  contracts or firm transmission rights of some
  kind)
• then they cannot be trusted to build all the
  required transmission infrastructure (maybe some,
  if subject to the appropriate access pricing
  conditions)
• Coalitions of network users may promote, even
  invest at some risk, in specific infrastructures,
  but not in those whose benefit is widely
  dispersed (probably the majority in well
  developed networks)

21
(continuation)

• ?There is a major role for regulated / planned
  investment (use the EU market as an example)
• presented by TSOs (individually or jointly)
  belonging to a systematic plan
• authorized by the involved regulators TSOs that
  examine implications at EU level of the
  reinforcements
• included in the inter-TSO payment scheme, so the
  costs are rightly shared among the users
• ?Doors could be open for investment at risk
• who can exploit the existing incentives in
  transmission pricing be subject to some
  regulatory oversight, such as priority rules and
  open access conditions

22
Investment in transmissionIssues for discussion

• How can justified transmission investment needs
  be identified?
• How to achieve consistency between operation
  investment criteria?
• How to incentivise building needed transmission
  investment?
• How to determine the beneficiaries of an
  investment to make them pay for it?

23
A useful property (regarding beneficiaries)

• An economically justified network investment (for
  instance, under traditional network expansion
  rules
• network investment cost lt savings in operation
  costs)
• will increase the net benefit of
• Generators income from nodal prices operation
  costs network charges
• Consumers utility of electricity use cost of
  purchasing electricity network charges
• if the residual network cost (trasnmission
  cost minus any revenues from nodal prices) is
  allocated pro rata of the economic benefits of
  each network user

24
The need to identify beneficiaries

• Basically no need for existing lines existing
  network users
• although adequate network charges may be relevant
  for plants that are close to retirement
• But sound economic signals are convenient /
  necessary when the investment decision on new
  generation projects may depend on transmission
  charges / signals
• Example 1 60.000 MW of proposed connection of
  wind generators plus 50.000 of CCGT in Spain,
  some requiring transmission expansion
• Example 2 Decisions about investment-at-risk
  versus planned investment in new lines for
  distant generation projects in Peru

25
END OF PRESENTATION
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The underlying theory
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The underlying theoryShort-term signals

• Nodal prices
• are energy prices that internalize the network
  effects losses congestions
• provide correct economic signals for system
  operation
• result in a net surplus, which in practice
  happens to be insufficient to recover total
  network costs
• Frequently a uniform energy price is adopted
  then the signals of losses congestions must be
  separately sent
• Note that persistent short-term signals
  constitute valid signals for long-term decisions,
  such as siting

28
Theoretical results on cost recovery of
transmission networks
TOTAL COST OF NETWORK INFRASTRUCTURE
100
SHORT-TERM MARGINAL COSTS (NODAL PRICES)
LONG-TERM MARGINAL COSTS
ANY OTHER DIRECT CONSTRAINT
INCREASING RETURNS TO SCALE
DISCRETE NATURE OF NETWORK INVESTMENTS
NETWORK PLANNING ERRORS
RELIABILITY CONSTRAINTS
29
InvestmentNature of transmission costs

• Actual transmission network costs
• Infrastructure costs
• investment capital costs
• operation maintenance costs
• Costs incurred because of the existence of the
  network
• Ohmic losses (generation costs)
• Costs of redispatch that are incurred to
  eliminate violations of transmission constraints
  (generation costs)
• Some of the costs of ancillary services
• reactive power / operating reserves / black start
  capability

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The underlying theoryLong-term signals (1)

• First priority is to charge network users so that
  regulated transmission costs are fully recovered
• Special treatment for risk investments (e.g.
  merchant lines)
• How to assign the residual network cost (or
  complementary charge) to network users?
• Long-term network charges should not be
  transaction-based
• On the basis of cost-causality (responsibility in
  network costs)
• Try to minimize economic distortion
• of short-term signals (e.g. avoid /kWh charges)
• use Ramsey-pricing principles, if needed

31
The underlying theoryLong-term signals (2)

• Cost causality in transmission can be identified
  (conceptually)
• ? relate to the criteria for expansion of the
  transmission network
• traditional setting cost minimization
• liberalized setting maximization of aggregated
  benefit of consumers and producers
• ? assign cost responsibility to the beneficiaries
  of each network asset, i.e. those for whom the
  investment is made
• long-term investment decisions are not distorted

32
The underlying theoryLong-term signals (3)

• Time differentiation is needed in the structure
  of network charges
• since they should reflect the diversity in
  economic impact of network use at different times
• Geographical differentiation is needed in the
  structure of network charges
• since they should (in general) contain location
  signals
• note that geographical must be understood from
  an electrical viewpoint

33
The underlying theoryLong-term signals (4)

• Determination of responsibility in investment
  and/or benefits is difficult ? Use only in
  practice as a reference for a simpler proxy
• use electric usage as a proxy
• but keep in mind that this is again an ambiguous
  concept
• when allocation to investment responsibility /
  beneficiaries does not make sense at all or just
  for a fraction of the network ? recur to
  Ramsey-like ideas (second best) to minimize
  distortion
• in the split of charges to generation / consumers
• among generators / consumers

34
The underlying theoryLong-term signals (5)

• Do nodal prices plus adequate complementary
  charges provide sufficient investment signals for
  transmission?
• An economically justified network investment
  under traditional network expansion rules
• network investment cost lt savings in operation
  costs
• will increase the net benefit of
• Generators income from nodal prices operation
  costs network charges
• Consumers utility cost of purchasing
  electricity network charges
• if the residual network cost is allocated pro
  rata of the economic benefits

35
Which are the incentives from locational signals
for the different parties in the current design
of the EU Internal Electricity Market?
36
Short-term incentive-based pricingIncentives for
generators

• Unless signals internalizing losses congestions
  are received, the dispatch of generation will be
  inefficient
• EU-wide loss signals are missing in the current
  design
• A few countries / TSOs apply domestic loss
  signals
• An EU-wide coordinated congestion management
  scheme is the only way to guarantee system
  security to avoid inefficiency opportunistic
  behavior

37
Short-term incentive-based pricingIncentives for
consumers

• Same considerations apply to consumers
• But, in most countries, the mandatory uniform
  tariff limits the application of any locational
  economic signals

38
Short-term incentive-based pricingIncentives for
System Operators

• Transmission System Operators are responsible for
  network maintenance, provision of operation
  reserves of different types, reactive power
  support, black start capability they manage
  network constraints and may influence network
  losses
• System security efficiency would greatly
  benefit from a good performance of TSOs
• Is it possible to find the right equilibrium
  between efficiency security when designing
  performance-based incentives for TSOs?

39
(continuation)

• Several regulatory approaches are possible
• Avoid economic incentives that could turn out to
  be perverse
• Consider TSOs as neutral professional firms,
  regulated as monopolies to perform its assigned
  tasks, under strict cost-of-service regulation
  transparency ? trust on their professionalism
  respect for public opinion regulatory peer
  supervision
• Introduce some reduced economics incentives so
  that efficiency gains are shared with consumers
• set annual cost targets for each service that can
  be controlled by TSOs let them share some of
  the gains / losses
• Apply a merchant philosophy of provision of these
  services
• This is considered to be unreasonable most of
  these costs are beyond the control of the TSOs
  they are volatile most important, there is often
  a conflict between cost reduction security

40
Long-term incentive-based pricingIncentives for
generators

• Generators might be subject to local G tariffs,
  which
• will have to comply with some EU-wide
  harmonization conditions (level structure) ,
  eventually, may even become a fully harmonized
  pan EU G tariff
• at least will internalize the effect of the
  inter-TSO payment scheme
• besides, generators will experience the long-term
  effect of any persistent short-term signal of
  losses or congestion
• The relevance of these locational signals, when
  compared to other considerations that influence
  long-term decisions such as siting or active
  promotion of network investments, will depend
  much on the specific cases

41
Long-term incentive-based pricingIncentives for
consumers

• L tariffs (which will internalize the effect of
  the inter-TSO payment scheme) would have to
  absorb the differences between the harmonized G
  tariffs the regulated national transmission
  costs
• However, in most countries, mandatory uniform
  tariffs for consumers prevent the application of
  locational signals
• Consumers will also experience the long-term
  effect of any persistent short-term signal of
  losses or congestion, if they are applied to them
• It is doubtful the relevance of these locational
  signals (if any) when compared to other
  considerations that influence long-term decisions
  of consumers, such as siting or active promotion
  of network investments

42
Incentive-based pricingIncentives for network
investors

• Who are the network investors / planners? It
  depends on the specific regulation, at national
  EU levels
• System Operators, with some degree of regulatory
  supervision, either national or EU
• Coalitions of network users, subject to
  regulatory approval
• Merchant investors, subject to regulatory
  authorization
• The regulatory treatment of the remuneration of a
  new line the pricing access schemes depend on
  the adopted approach

43
Investment in transmission facilitiesApproaches

• System Operator proposes reinforcement plan, to
  be authorized by regulator construction may be
  assigned by competitive bidding
• A private company is awarded the transmission
  license and is regulated as a monopoly subject
  to grid code remuneration based on some price
  control scheme (e.g. RPI-X)
• Coalitions of network users proposes
  reinforcements, to be authorized by regulator
  regulated remuneration of total costs
  construction is assigned by competitive bidding
• Risk investments same as above, but coalition
  bears total costs regulated remuneration covers
  partial costs
• Merchant lines (remuneration based on market
  value of their transmission services)

44
Incentive-based pricingIncentives for network
investors

• Merchant investors will collect just congestion
  rents (or their expected values, via capacity
  contracts or firm transmission rights of some
  kind)
• then they cannot be trusted to build all the
  required transmission infrastructure (maybe some,
  if subject to the appropriate access pricing
  conditions)
• Coalitions of network users may promote, even
  invest at some risk, in specific infrastructures,
  but not in those whose benefit is widely
  dispersed (the majority in the EU)

45
(continuation)

• ?There is a major role for regulated / planned
  investment
• presented by TSOs (individually or jointly)
  belonging to a systematic plan ltsee previous
  comments on incentives for TSOsgt
• authorized by the involved regulators some
  supra-national experts group that examines
  implications at EU level of the reinforcements
• included in the inter-TSO payment scheme, so the
  costs are rightly shared among the users
• ?Doors could be open for investment at risk
• who can exploit the existing incentives in
  transmission pricing be subject to some
  regulatory oversight, such as priority rules and
  open access conditions

46
Other issues concerns

• Locational signals generation investment
• More of an access than a pricing issue
• In non-well-meshed systems new generators want to
  be protected from potential future congestions ?
  obtain FTRs to hedge
• How good is the proxy network use to cost
  causality? Is there a metric of network usage
  with sound economic properties?
• Should any previous conclusions be changed
  because of market power considerations?
• Changing sound rules does not seem to be the
  right approach to address market power