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 test”What 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 < 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

10. 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

11. 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

17. 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 < 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. ENDOF PRESENTATION

26. The underlying theory

27. 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

30. 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 < 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 <see previous comments on incentives for TSOs> • 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