1 IDEI, The economics of electricity markets Investment in transmission Issues for discussion Ignacio J. Pérez-Arriaga Comillas University (Madrid) Toulouse,

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IDEI, The economics of electricity markets

Investment in transmissionIssues for discussion

Ignacio J. Pérez-ArriagaComillas University (Madrid)

Toulouse, June 3, 2005

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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

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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

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

The “regulatory test”What is a “justified” investment?

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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 ofGenerators: 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

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Investment in new facilitiesApproaches (the regulatory context)

1 System Operator proposes reinforcement plan, to be authorized by regulator; construction may be assigned by a competitive auction

2 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)

3 Coalitions of network users proposes reinforcements, to be authorized by regulator; regulated remuneration of total costs; construction is assigned by competitive bidding

4 Risk investments: same as above, but coalition bears total costs & regulated remuneration covers partial costs

5 Merchant lines (remuneration based on market value of their transmission services)

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Investment in new facilitiesApproaches (comments)

1 SO + Regulator: May result in overinvestment if regulator fails to set limits in the authorization process

2 Private licensed company: May result in underinvestment unless very careful incentive schemes are implemented

3 Coalitions of network users: Only lines with clear beneficiaries will be built. May be a complement to 1

4 Risk investments: Same as 3, but more acute. Good to promote investment in underdeveloped networks

5 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

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Option 1System Operator + RegulatorRegularly, the System Operator must propose a

plan for reinforcements of the transmission network after taking into consideration (justified) any proposals

made by the network usersRegulatory authorities approve the plan &

authorize construction of individual new facilitiesConstruction, 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 performanceMay be complemented by options 3, 4 & 5

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Option 2: Private firm & global regulated remunerationA 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 accountactual new investmentseconomic lives & depreciation of existing

investmentseconomic health of transmission companyexpected 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 biddingpay as bid to winner limited duration of license; auction for the next periodset availability targets & penalties (credits) according to performancecharge 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 BIf 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

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Option 5Merchant linesBasic 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 revenuesHigh exposure to risk reliability lines potential for market power abuse

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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?

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1 SO + Regulator: No problem, use operation criteria when simulating the system to decide on investment

2 Private licensed company: No problem, if there is a suitable grid code to comply with

3 Coalitions of network users: No guarantee

4 Risk investments: No guarantee

5 Merchant lines: No guarantee

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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 signalsin 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”

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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

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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

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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)

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(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

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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 ofGenerators: 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

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The need to identify beneficiariesBasically 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

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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 costsFrequently 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

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Theoretical results on cost recovery of transmission networks

SHORT-TERM MARGINAL COSTS (NODAL PRICES)

LONG-TERM MARGINAL COSTS

RELIABILITY CONSTRAINTS

ANY OTHER DIRECT CONSTRAINT

INCREASING RETURNS TO SCALE

DISCRETE NATURE OF NETWORK INVESTMENTS

NETWORK PLANNING “ERRORS”

TOTAL COST OF NETWORK INFRASTRUCTURE

100%

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InvestmentNature of transmission costs

Actual transmission network costsInfrastructure 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

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The underlying theoryLong-term signals (2)

Cost causality in transmission can be identified (conceptually): relate to the criteria for expansion of the

transmission networktraditional setting: cost minimizationliberalized 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 madelong-term investment decisions are not distorted

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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

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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 distortionin the split of charges to generation / consumersamong generators / consumers

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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 rulesnetwork investment cost < savings in operation costswill increase the net benefit of

Generators: income from nodal prices – operation costs – network charges

Consumers: utility – cost of purchasing electricity – network chargesif the residual network cost is allocated pro rata of the economic benefits

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Which are the incentives from locational signals for the different

parties in the current design of the EU Internal Electricity Market?

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Short-term incentive-based pricing

Incentives 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

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Incentives for consumers

Same considerations apply to consumers

But, in most countries, the mandatory uniform tariff limits the application of any locational economic signals

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Incentives 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?

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(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 consumersset 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

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Long-term incentive-based pricing

Incentives for generatorsGenerators 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

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Long-term incentive-based pricing

Incentives for consumersL 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

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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 facilitiesApproaches1 System Operator proposes reinforcement plan, to be

authorized by regulator; construction may be assigned by competitive bidding

2 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)

3 Coalitions of network users proposes reinforcements, to be authorized by regulator; regulated remuneration of total costs; construction is assigned by competitive bidding

4 Risk investments: same as above, but coalition bears total costs & regulated remuneration covers partial costs

5 Merchant lines (remuneration based on market value of their transmission services)

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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)

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(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

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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

Documents

1 IDEI, The economics of electricity markets Investment in transmission Issues for discussion Ignacio J. Pérez-Arriaga Comillas University (Madrid) Toulouse,