Principles for Transmission Cost Allocation

1. Principles for Transmission Cost Allocation James Bushnell University of California, Davis December, 2013

2. Outline • What’s so special about transmission? • Cost structure of energy transportation • Externalities • Spatial markets • The derived demand for transportation • Cost recovery vs. efficient pricing • fixed cost pricing vs. marginal cost (congestion) pricing • Investment and cost recovery

3. Transportation and Spatial Competition • The cost and availability of transportation determines the geographic size of a market • Crude oil markets vs. electricity markets • Cost structure for transportation in energy is unlike most markets • Marginal costs are very low, capital costs are high • Significant economies of scale;‘Lumpy’ investments • Transmission assets are immobile • Captive customers and the hold-up problem • Transportation capacity can be limited • Only matters if storage is costly

4. Transmission Pricing Policy Fights • Fight 1: How to charge for use or access to lines with periodic congestion? • Fight 2: How to charge for recovery of investmentcosts of constructing lines. • These have often been confused as the same fight. • With the same answer. • But not in New Zealand!

5. Spatial Markets with Free Transportation DN PN DS PS 12 MCN = 12 MCS = 2 + qs 7 5 QS 11 QN South North

6. 7 Spatial Markets with Free Transportation • With no congestion and no transport cost, we have one combined market DN PN DS PS 12 MCN = 12 MCS = 2 + qs 10 5 QS 11 6 QN South North

7. What is the Demand for Transportation? Ptransport 5 2 South to North Transport 5 3 Qtransport

8. MC of S to N Transport 2 .001 3 Congestion as Peak-load Pricing Ptransport 5 Demand for South to North Transport 5 Qtransport

9. Transmission Investment:Why does it have to be so difficult? • Efficient congestion prices reflect shadow value of a line • Shouldn’t this be a good signal for value of investment? • Yes!, but… • Shadow prices reflect value of a small expansion • Lumpiness (economies of scale) mean that transmission projects are almost never small • Think of a new investment that eliminates all congestion • Network externalities make it difficult to define what “expansion” is • Many projects allow an increase some combinations of injections while reducing others

10. 1 Capacity = 6 2 3 Capacity = 6 Loop Flow? Power flows in inverse proportion to the impedance (resistance) it faces Example: Nodes 1 & 2 supply only, node 3 demand only z13 z23

11. 1 Capacity = 6 Capacity = 1 2 3 Capacity = 6 Loop Flow Power flows in inverse proportion to the impedance (resistance) it faces Example: Nodes 1 & 2 supply only, node 3 demand only z12 z13 z23

12. Feasible Dispatch Sets z 2 3 • With 2 “radial” lines can send 6 MW from each source • But can’t send 7 from either source • 3rd line “expands” some possibilities but eliminates some others z 1 2 7 z 6 1 2 3 q 2 3 6 4 z 1 3 q 1

13. Feasible Dispatch Sets z 2 3 • With 2 “radial” lines can send 6 MW from each source • But can’t send 7 from either source • 3rd line “expands” some possibilities but eliminates some others z 1 2 7 z 6 1 2 3 q 2 3 4 6 z 2 3 z 1 3 q 1 z 1 3

14. Transmission Investment • Market prices can help induce efficient transmission investment • But don’t hold your breath • In most cases transmission looks a lot like a natural monopoly • And we can try to apply the principles of natural monopoly pricing to this context

15. Cost Recovery Principles • Classic natural monopoly cost-recovery problem • Marginal cost pricing efficient but doesn’t recover costs • Pricing goal should be to minimize deadweight loss • Fixed charges (two-part tariffs)? • Ramsey Pricing? • Is that fair (unfair)?

16. Average Cost Pricing Creates DWL $ A B PA = PB Fixed Costs to Recover Q

17. Ramsey Pricing reduces DWL $ A PA Fixed Costs to Recover B PB Q

18. Beneficiaries Pay • From Wikipedia • From “IntelligentUtility.com” The “beneficiaries pay” theorem adopted by FERC is unaccompanied by a definition of the range of potential transmission benefits or how to calculate them in individual cases. “User pays, or beneficiary pays, is a pricing approach based on the idea that the most efficient allocation of resources occurs when consumers pay the full costs of the goods that they consume.”

19. Ramsey Pricing reduces DWL $ A PA Fixed Costs to Recover B PB Q

20. Transmission Chickens and Eggs • For sunk (think unavoidable) transmission costs, this is a monopoly cost allocation issue. • But what if generation location decisions cause transmission to be built? • New transmission not unavoidable • Dispersed cost recover creates ability to partially “free-ride” on the network by off loading costs on other users • Can create incentives to locate in inefficient places • This perspective is one motivation for a “beneficiaries pay” (also “exacerbators”) approach.

21. Ex-Ante vs. Ex-post Determination of Benefits • Very difficult to predict benefits for the next 20 years • Even the process of prediction can drag out proceedings

22. Difficulties in Measuring Benefits • Some benefits hard to quantify • Competitive gains - avoiding market power or restrictive regulations • Reliability gains? • Value of insurance against extreme events (e.g. drought, hurricane, national security, natural disasters)

23. Difficulties in Measuring Benefits • Transmission is extremely long-lived asset • Costs of existing generation may change considerably • New generation difficult to predict • How to incorporate impact of transmission investment on new entry? • Demand growth patterns will evolve • No single entity controls these changes - decisions are amongst diverse market actors • Some benefits hard to quantify • Competitive gains - avoiding market power or restrictive regulations • Reliability gains? • Value of insurance against extreme events (e.g. drought, hurricane, national security, natural disasters)

24. North QN Flow = QN - QS Line Capacity = k South QS Linking Two Symmetric Markets • When the line has a very small capacity: Two Monopolies • When line has a very large capacity: Duopoly, but no flow on the line • How large is “large” and how small is “small”? • When line has a “medium” capacity: limited competition Inverse demand in each market = P(Q)

25. Ex-Ante vs. Ex-post Determination of Benefits • Very difficult to predict benefits for the next 20 years • Even the process of prediction can drag out proceedings • Ex-post “tracking” of benefits solves the prediction problem • But it makes the cost allocation endogenous (e.g. driven by) the actions of those using the network • Risks distorting behavior with charges sunk costs

26. Marginal and Infra-MarginalAllocation • One approach to cost recovery would be to claw back proportional surplus from users of the network • In principle this is first degree price discrimination • Close to Ramsey pricing in principle • If a firm is infra-marginal they would be ineleastic to the proposed charge (e.g. will not change their behavior) • In practice, can a claw-back not change behavior? • The trade-offs between precision and blunting endogenous incentives

27. Summary • Transmission exhibits many natural monopoly characteristics • Efficient pricing is important but usually insufficient to recover investment costs • Average cost pricing can inefficiently discourage usage of the network • What is the elasticity of the beneficiary? • Choice of pricing paradigm needs to be reconciled with investment approach • If generation leads transmission – beneficiaries pay • If transmission leads generation – ramsey pricing – • How close is that to beneficiaries pay? • How practical is it to recover benefits without disrupting behavior?