Competitive Electricity Markets and Sustainability

Edited by

Franois Lvque
Professor of Law and Economics, Centre of Industrial Economics (CERNA), cole des mines de Paris, France

Edward Elgar
Cheltenham, ! " #orthampton, M$, S$

% Franois Lvque &''( $ll ri)hts reserved* #o part o+ this publication may be reproduced, stored in a retrieval system or transmitted in any +orm or by any means, electronic, mechanical or photocopyin), recordin), or other,ise ,ithout the prior permission o+ the publisher* -ublished by Ed,ard El)ar -ublishin) Limited .lensanda /ouse Montpellier -arade Cheltenham .los .L0' 1 $ ! Ed,ard El)ar -ublishin), 2nc* 3illiam -ratt /ouse 4 5e,ey Court #orthampton Massachusetts '1'(' S$

$ catalo)ue record +or this book is available +rom the 6ritish Library Library of Congress Cataloguing-in-Publication Data Competitive electricity markets and sustainability 7 edited by Franois Lvque p* cm* 8 2ncludes biblio)raphical re+erences and inde9* 1* Electric utilities* &* Competition* :* Electric tilities;Finance* <* 5emand=side mana)ement >Electric utilities? 2* Lvque, Franois, 140@8 /54(A0*$&C0@@ &''( :::*@4: &:8dc&& &''('111:&

2S6#=1:B 4@A 1 A<0<& 4&1 A 2S6#=1'B 1 A<0<& 4&1 < -rinted and bound in .reat 6ritain by M-. 6ooks Ltd, 6odmin, Corn,all

Contents
List of !ures List of tables List of contributors Preface by "ean #yrota Ac$nowled!ements 1 2nvestments in competitive electricity marketsB an overvie, Fran%ois L&'()ue -$CD 2 2#EESDME#D 2# .E#EC$D2F# & 2nvestment and )eneration capacity Ric*ard +reen : .eneration technolo)y mi9 in competitive electricity markets "ean,-ic*el +lac*ant -$CD 22 2#EESDME#D 2# DC$#SM2SS2F# < -roblems o+ transmission investment in a dere)ulated po,er market #te'en #toft 0 -atterns o+ transmission investments Paul "os$ow -$CD 222 CFFC52#$D2F# 6ED3EE# 2#EESDME#DS 2# .E#EC$D2F# $#5 DC$#SM2SS2F# 1A@ A@ 1:1 &1 0< vi vii viii 9iii 9v 1

( Lon)=term locational prices and investment incentives in the transmission o+ electricity .'es #meers @ Compatibility o+ investment si)nals in distribution, transmission and )eneration I!nacio P&re/,Arria!a and Luis 0lmos Inde1
'

&:'

&A4

<* -roblems o+ transmission investment in a dere)ulated po,er market

Steven Stoft
1* 2#DCF5 CD2F#
From the earliest days o+ commercial po,er production, transmission has )ro,n steadily in importance* #e, ,holesale po,er markets have sparked interest in distributed )eneration, but trade bet,een these markets has only increased the need +or transmission investment* $s ,ith )eneration, a market +or the use o+ e9istin) assets is not dicult to ima)ine, but a market to supply assetso+ istransmission more problematic* +act, bet,een thethese properties costs and2n bene ts the and discrepancies the assump= tions o+ competitive economic theory are so substantial that a market solu= tion is probably not desirable* Even incentive re)ulation may prove so di cult to desi)n so inaccurate that a plannin) solution may be pre+er= able, at least until and ,holesale po,er markets are +unctionin) eciently and the )eneration8investment problem has been solved* Dransmission, e9ceptionally hetero)eneous can returns be both to a substitute +or andan complement to )eneration, and product, suers +rom scale and lumpiness,1 as ,ell as maGor e9ternalities, both positive and ne)= ative* Dhis chapter investi)ates the e9tent to ,hich these problems can be overcome* Do simpli+y, this chapter i)nores transmission losses because they play a relatively small role in the investment problem and one similar to the role o+ con)estion, ,hich is considered* $+ter introducin) some properties o+ con)estion prices and transmission costs, three basic approaches to transmission investment are e9plored*H Three Approaches to Invest ent Dhree approaches to investment stand out as relatively distinct, althou)h many mi9tures o+ these are possible* $ 2lannin! a22roac* re+ers to a system that does not include any incentives specically tailored to the lon)=run transmission investment problem* Such an approach ,ould be carried out
H 5enitions and notations are )iven in the )lossary at the end o+ the chapter*

34

AA

In'estment in transmission

by a )roup o+ en)ineers and economists under instructions tore)ulation build an ecient system* 2n practice, it ,ould be backed by rate=o+=return ,ith a requirement that investments be Iused and use+ulJ* $ merc*ant a22roac* ,ould allo, any private company to modi+y the transmission system, subGect to certain restrictions, and ,ould re,ard >or punish? such modi cations by (P5R) allocatin) transmission ri)hts to investment investors* $ 2erformance, based ,ould induce by a t+or=pro t o,ner re!ulation o+ the transmissiona22roac* system >a transco? by adGustin) its pro level on the basis o+ the cost and per+ormance o+ the system* Congestion! The "pportunity Cost of #sing the $rid $ll three approaches ,ill be assumed to e9ist ,ithin the +rame,ork o+ a ,holesale po,er market based on publicly kno,n nodal prices >/o)an, 144&K /arvey et al*, 144(?* Dhat is, at each relevant point >node? in the net,ork, a price is established, and these prices to)ether clear the market* Dhey may be purely competitive prices or they may be distorted by market po,er, but in any case there is one price at each node and all ener)y trans= actions at a )iven node take place at that price* Dhese prices are adGusted each time there is a chan)e in supply or demand* Such a pricin) system automatically prices the use o+ the transmission system even thou)h it applies directly only to ener)y transactions* 2+ the price at node A is L&'7M3h and at node % is L:'7M3h, then the price to transmit ener)y +rom A to % is L1'7M3h, ,hile the price to transmit it +rom % to A is ne)ative L1'7M3h* $lthou)h nodal prices have some peculiar properties, it is important to understand that they are simply the result o+ the normal +orces o+ supply and demand constrained by the physical limits o+ the transmission system* 3hen these limits restrict +lo,, the system is said to be con)ested* 3hen supply and demand are both competitive, nodal prices are simply the standard competitive market prices and have all the properties e9pected o+ such prices* E9cept ,hen prices are determined some,hat arbitrarily because a vertical supply coincides ,ith a vertical demand curve, competitive nodal prices are unique* $lthou)h they are o+ten calculated +rom bids in a centraliMed auction, they are not the product o+ any special rules o+ calculation but are the prices at ,hich a ,ell=arbitra)ed bilateral market ,ould arrive i+ the transmission constraints ,ere en+orced* Dhree distinct costs associated ,ith con)estion are o+ten con+used, con= )estion rent >CR?, con)estion cost >CE?, and the cost o+ con)estion to load >CL?* Economists +ocus on the rst t,o, ,hile consumers react to the third* Consider a load pocket ,ith 1,''' M3 o+ load and a :'' M3 line into the load pocket +rom a lar)e system that could supply A'' M3 at L&'7M3h and much more at L<'7M3h* Dhese costs are represented as a Iremote supplyJ

Problems of transmission in'estment in a dere!ulated 2ower mar$et

A4

Transmission constraint $50 Remote supply $30 $20 Congestion rent (CR) Congestion cost (CE) Net local demand 200 400 600 800 !000 "#

Fi!ure 678 9enin! con!estion rent and con!estion cost +unction +or the load pocket in question* Suppose that local load is 9ed at 1,''' M3 and that the pocket contains ('' M3 o+ L:'7M3 )eneration and &'' M3 o+ L0'7M3h )eneration* Dhe Inet local demandJ curve sho,s the demand +or imported po,er net o+ ,hat ,ould be purchased locally >Fi)ure <*1?* For e9ample, at a local price o+ L<'7M3h, the load pocket ,ould consume 1,''' M3 and supply ('' M3, leavin) it ,ith a net demand o+ <'' M3* 2n other ,ords, net local demand accounts +or local supply as ,ell as local demand, and it is local supply that provides the price sensitivity o+ this Idemand curveJ and not actual demand responsiveness* Dhe con!estion cost is also called the, Iredispatch costJ because it is the e9tra cost o+ dispatchin) more e9pensive )enerators than ,ould be needed i+ the transmission system had ample capacity and did not constrain po,er trans+ers* 2n the present e9ample, 1'' M3 o+ local L0' )eneration and <'' M3 o+ local L:' )eneration must be used in place o+ 0'' M3 o+ remote L&' )eneration that ,ould have been used had there been no transmission constraint* Con)estion cost is a dead,ei)ht loss, not a trans+er payment* Con!estion rent is the amount collected by the o,ners o+ the ri)hts to the transmission line* 2n a one=line net,ork these ri)hts ,ould typically pay the o,ners an amount equal to the lineJs capacity times the dierence bet,een the prices at the t,o ends o+ the line*and 2n the o+ a price* load pocket, this is the dierence bet,een the internal price thecase e9ternal Con)estion rent is a trans+er payment +rom line user to line o,ner, as usin) the line has no actual cost*

$$"#

Constraint %emand Rent Cost &upply

$$"#

Constraint

Cost to consumers

&upply "#'

"#'

Fi!ure 67: Cost to consumers com2ared wit* con!estion cost and rent ;able 678 ;*ree 'iews of con!estion
Con)estion >redispatch? cost Con)estion rent Cost o+ con)estion to load CE CR CL L@,'''7h L4,'''7h L&','''7h

Finally, there is the cost of con!estion to load >CL? >see Fi)ure <*&?* 3ith ample transmission, the load in the pocket ,ould import A'' M3 o+ po,er and use &'' M3 +rom internal )enerators* Dhe price ,ould be set by the intersection o+ supply and demand at L:'7M3h, so the total cost o+ po,er to load ,ould be L:'7M3h 1,''' M3, or L:','''7h* 6ecause o+ the con= )estion, the price in the pocket is L0'7M3 and so load must pay L0'7M3h 1,''' M3, or L0','''7h, ,hich makes the cost o+ con)estion to load L&','''7h* Dhe three costs are sho,n in Dable <*1* $s can Frequently be seen there is no particular relationship bet,een these concepts* consumers nd it un+air that con)estion can three cost them +ar more than the Icon)estion costJ* 2t does not help that it can also cost them more than con)estion cost and rent combined ,ith the e9cess revenue accruin) to )enerators that seem to benet +rom the constraint ,ithout reason* $lthou)h the matter is beyond the scope o+ this chapter, it should be noted that i+ the transmission and )eneration markets satis+y the a9ioms o+ per+ect competition, nodal prices ,ill Gust cover the lon)=run costs the ecient mi9 o+un+air )eneration transmission* 2n other ,ords there o+ is nothin) inherently or ineand cient about the distribution o+ revenues under nodal pricin) in a con)ested system* F+ course this does not indicate that either transmission or )eneration is, or can be supplied by, a competitive market, only that any problems ,ith these costs and prices arise +rom non=competitive +eatures o+ the markets and not simply +rom the method o+ nodal pricin) or the eects o+ transmission con)estion on prices*

The &ero-congestion 'allacy 6ecause transmission con)estion imposes costs, one recurrent vie, holds that it should simply be eliminated* Dhis is no, the policy o+ the $lberta )ov= ernment >see 6o9 <*1?* $lthou)h e9amples can be manu+actured +or ,hich this is the least=cost solution, in real po,er markets such situations never e9ist* 2+ there is one hour per year in ,hich a remote )enerator is L1'7M3h cheaper than the most e9pensive local )enerator in use, and i+ 1 M3 o+ that )eneratorJs output cannot reach local load, then the line is constrained durin) that hour and the cost o+ the constraint is L1'7year* $ddin) 1 M3 o+ capac= ity to that transmission path ,ould cost +ar more than L1'7year* Eliminatin) all con)estion 8 allo,in) every last me)a,att o+ trade 8 is simply not ecient* 3hen transportation is e9pensive, it is o+ten cheaper to consume the local product than to transport a sli)htly cheaper product +rom a distance*

()* 4+

,-(.RT, R./0-,T1)N 2 34$2004! .-.CTR1C 0T1-1T1.& ,CT

,l4erta5s .lectric 0tilities ,ct too6 e77ect on 8anuary ! 996+ :rom t'e 4eginning! t'e .lectric 0tilities ,ct 'as imposed uni7orm prices (7or4idden competiti;e prices) t'roug'out t'e pro;ince+ #it' its ne< re=uirement (s'o<n 4elo<) to o;er4uild t'e grid! uni7orm prices <ill 4ecome competiti;e prices+ :rom &ection 8( ) o7 t'e .lectric 0tilities ,ct> (e) ta6ing into consideration t'e c'aracteristics and e?pected a;aila4ility o7 generating units! plan a transmission system t'at (i) is su77iciently ro4ust to allo< 7or transmission o7 00 per cent o7 anticipated in@merit electric energy re7erred to in section 3(c) o7 t'e ,ct <'en all transmission 7acilities are in ser;ice! and (ii) is ade=uate to allo< 7or transmission! on an annual 4asis! o7 at least 95 per cent o7 all anticipated in merit electric energy re7erred to in section 3(c) o7 t'e ,ct <'en operating under a4normal operating conditionsA (7) ma6e arrangements 7or t'e e?pansion or en'ancement o7 t'e transmission system so t'at! under normal operating conditions! all anticipated in merit electric energy re7erred to in clause (e)(i) and (ii) can 4e dispatc'ed <it'out constraint+

4&
$$"# Constraint

In'estment in transmission
Net local demand $$"# Constraint Net local demand

Remote supply -oss o7 load "#'

Remote supply Congestion "#'

Fi!ure 67<

Relations*i2 of con!estion to a transmission,cause reliability 2roblem

Dhe +allacy o+ eliminatin) all con)estion may arise +rom con+usion bet,een con)estion and unreliability* nreliability is the result o+ havin) too little local )eneration to meet local demand net o+ imports* Dhis can result +rom con)estion, but in almost all cases, con)estion is not associated ,ith unreliability* 2t is simply the result o+ havin) more than enou)h local )eneration, but at a cost hi)her than the cost o+ remote )eneration that could be accessed ,ith a lar)er transmission line >see Fi)ure <*:?* 2n other cases the desire to eliminate con)estion may result +rom a desire to increase local supply and thereby lo,er the local market price* For some time, this can save consumers money even i+ it raises the lon)=run cost o+ producin) and deliverin) po,er* 6ut i+ e9pandin) transmission lo,ers con= sumer costs ,ithout lo,erin) total cost, it is a +orm o+ monopsony po,er ,hich essentially e9propriates some o+ the sunk costs o+ )eneration in the import=constrained area* Suppose that )eneration 9ed costs in an import=constrained re)ion are L<','''7M3=year hi)her than in the surroundin) area, and there are 1,''' M3 o+ such )eneration installed in the load pocket* $ &'' M3 e9pansion o+ the import line may virtually eliminate e9tra 9ed >sunk? cost recovery needed by reducin) the local price to the e9ternal price* Dhis may save consumers L&'','''7year per M3 o+ ne, line* Dhis is probably much more than the cost o+ the line* Dhis appears to be a savin), lar)ely because it e9propriates L<' million per year in )eneration 9ed costs* 2t also pro= vides a le)itimate savin) by providin) )enuinely less=e9pensive e9ternal po,er to the e9pensive constrained Mone* 2+ capacity produces po,er in hal+ o+ all hours and i+ the ne, lineJs capacity is hal+ used, then each M3 o+ line provides a real savin) o+ L<','''7M3, one=+th as much as the initial savin) throu)h the e9propri=

ation o+ )eneration sunk costs* 2n the lon) run, internal capacity ,ill retire and eventually the )eneratin) capacity in the load pocket ,ill a)ain recover its 9ed costs* -erhaps the savin)s +rom the line ,ill amount to L&<','''7M3 +or the rst ve years and L<','''7M3 a+ter that* 2+ this has a present value o+ L1,&0','''7M3, then it mi)ht be thou)ht that this is the break=even point +or buildin) such a line, but that omits the impact o+ re)u= latory risk* 2nvestorsinto take account o+ the cost o+ e9propriations by +actorin) possibility Dhis e ect that ,ill not be con ned +uture to the investment load pocketdecisions* in question* 2tdemonstration is impossible to predict ,hat ,illon be,all but the resultin) premiums ,ill aectthe the cost rate o+ o+this return capital in the ainvestment ected loadrisk pockets, not Gust the ne, investment* Dhis is a consequence o+ a market=clearin) electricity price* -robably the most sensible )uess is that all o+ the money trans+erred to load +rom e9istin) )enerators ,ill be lost to load throu)h hi)her risk premiums* 2n conclusion, it is inecient to eliminate all con)estion, and it is ,ron) to +ocus on short=run consumer cost reductions ,hen plannin) transmis= sion investments* $s ,ith any type o+ productive investment, the )oal should be to minimiMe the total cost o+ production and delivery* 2+ the market is competitive or the re)ulation eective, these cost savin)s ,ill be passed throu)h to consumers* "pti al Trans ission (Static) Dhe optimal amount o+ transmission minimiMes the total cost o+ produc= in) and deliverin) electricity >6o9 <*&?* 2t can be determined in simple e9amples by usin) the standard rst=order condition o+ calculus* $t the optimum, the value o+ an additional k3 o+ transmission equals the cost o+ buildin) it* 6ecause realistic transmission cost +unctions can be quite comple9, the optimal desi)n may need to be +ound by evaluatin) many options rather than applyin) calculus*

()* 4+2

)BT1",- TR,N&"1&&1)N

Transmission in;estment s'ould not eliminate congestion+ Transmission in;estment s'ould not minimiCe s'ort@run con@ sumer costs+ Transmission in;estment s'ould minimiCe t'e total cost o7 transmission and t'e production cost o7 po<er+

()* 4+3

%.:1N1N/ TD. R.NT,- C)&T ): TR,N&"1&&1)N -1N.& 1N $$D)0R

T'e cost o7 a particular transmission line mig't 4e $500!000!000! 4ut <'en analysing po<er systems it is muc' more con;enient to t'in6 o7 renting capital t'an 4uying it outrig't+ Rental cost is natu@ rally e?pressed in $$"#'! and t'ese units are particularly con;e@ nient 7or computation+ T'is is not 'o< engineers calculate costs! 4ut it is ;ery con;enient 7or economic calculations+ /i;en t'e one@time cost o7 t'e line! its capacity! and a sa;ings per "#' o7 energy transported! it is generally impossi4le to tell <'et'er 4uilding t'e line sa;es money or not+ T'is is 4ecause one must 6no< 'o< long t'e line <ill last! its maintenance costs! and t'e de4t and e=uity costs associated <it' t'e proEect+ ,ll o7 t'ese are properly ta6en into account 4y a rental cost! and so can 4e ignored once t'e rental cost is speci7ied+ T'e one@time cost can 4e con;erted to an amortiCed annual cost! o7 say! $50!000!000$year+ ,dding maintenance o7 say 2!000!000 year and di;iding 4y 8!360 'ours$year gi;es a rental cost o7 $5!936$'+ 17 t'e line is a !000 "# line! t'en t'e cost is $5+94$"#'+ T'is is t'e cost o7 renting "# o7 t'e line 7or 'our and is independent o7 <'et'er t'e line is used or not+ &imple in;estment pro4lems o7ten in;ol;e a transmission cost 7unction suc' as C c bQ! <'ere Q is t'e "# capacity o7 t'e line+ 1n t'is case it <ill 4e con;enient to speci7y C! t'e line5s rental cost! in $$' and c in $$'! and b in $$"#'+ &ometimes c <ill 4e called t'e 7i?ed cost o7 t'e line meaning t'at it does not depend on t'e c'oice o7 capacity+

$ simple e9ample ,ill illustrate the main points* Consider a city >load pocket? that can produce po,er at a cost o+ L0'7M3h but can buy it +or L:'7M3h over a transmission line* Suppose the line can be built +or a rental cost o+ L(,'''7h plus L07M3h* /o, lar)e a line should be builtN >See 6o9 <*: on denin) the rental cost o+ transmission lines*? Do solve the above problem, the cityJs load must be specied* Suppose the peak load is A'' M3 and its minimum load is <'' M3 and it takes on intermediate values to a uni+orm distribution* Dhe savin)s +rom the line accordin) ,ill be L&'7M3h +or theprobability rst <'' M3 o+ line capacity and ,ill then decline linearly to Mero +or additional capacity up to A'' M3*

$s lon) as additional capacity saves more in ener)y production costs than the cost o+ the additional capacity, the line should be lar)er* Since the cost o+ additional capacity is L07M3h, the line should be e9panded until the savin) +alls to L07M3h on avera)e* 3hen the capacity is three=quarters o+ the ,ay +rom <'' M3 to A'' M3, load ,ill be )reat enou)h to use the last M3 o+ capacity only a quarter o+ the time* Dhus the savin)s o+ the last M3 ,ill be only one=quarter o+ L&'7M3h or L07M3h* /ence @'' M3 is the optimal capacity o+ the line* Dhis is actually bit premature* 2t is necessary to o+ check the net conclusion beneDhe t +rom the bene linea 9ed cost the that line is included* total is t positive is L>&' ,hen <'' the 1&*0 :''?7h, ,hich is L1',@0'7h, ,hile the total cost is L>(,''' 0 @''?7h, ,hich is L4,0''7h* Dhe line is ,orth buildin), but i+ the 9ed costs had been LA,'''7h, it ,ould not have been* Dhis e9ample is the basis o+ the conclusion that eliminatin) con)estion is almost never the ri)ht ans,er* $ll transmission lines are used to varyin) de)rees at dierent times o+ the day and year* Dheir ma9imum potential use ,ill occur +or only a +e, hours* Do eliminate con)estion it is necessary to build enou)h capacity to accommodate this ma9imum, but that means the last me)a,att o+ capacity is used only a tiny +raction o+ the time and it is almost never economical to build capacity +or such in+requent use* 2t mi)ht be ar)ued that the lumpiness o+ transmission investment ,ill naturally cause a choice bet,een a much=too=small line and a too=lar)e line, and that the economic choice ,ill turn out to be the too=lar)e line and no con)es= tion* 6esides the +act that this is unlikely to happen +or all lines, there is a deeper problem* $s load )ro,s, every line reaches a point ,here its capacity ,ould be e9ceeded ,ithout redispatch +or Gust a +e, hours per year* Do avoid this, a ne, line, or at least an e9pansion ,ill be needed, and con= sumers ,ill have to pay +or it* 5ue to the 9ed costs this ,ill come to at least L(,'''7h in every hour o+ the year in the above e9ample* Durn ne9t to the )eneral static optimiMation problem* Dhis asks ,hat capacity line should be built )iven the ,ay con)estion chan)es ,ith line capacity* $ small line ,ill be con)ested +requently and con)estion rents ,ill be hi)h, ,hile a lar)e=enou)h line ,ill never be con)ested* 3hat is the con= dition +or the optimally siMed lineN For simplicity assume that the line connects a local re)ion ,here the total cost o+ ener)y production is CL>=? to a remote re)ion ,here it is CR>=?, and assume that po,er is cheaper in the remote re)ions so the o, is into the local re)ion* $ 1 k3 e9pansion o+ the line ,ill increase production in the remote re)ion and decrease it in the local re)ion by 1 k3* 2+ the local mar)inal cost o+ po,er is -CL and the remote mar)inal cost, -CR, then the savin)s is the dierence* 2n a competitive market, prices equal mar)inal

costs so the savin)s is >PL 8 PR? times 1 k3* Dhe line is ,orth e9pandin) up to the point ,here the mar)inal cost o+ e9pansion is equal to the avera)e price dierential* #tatic o2timal transmission result (one line) 2n an optimal one=line net,ork, the mar)inal cost o+ line e9pansion equals the all=hour avera)e absolute nodal price dierential bet,een the ends o+ the line* 2n other ,ords, the mar)inal cost o+ e9pansion equals the avera)e con)estion rent* 2n a net,ork, thin)s to are bit more comple9* 2+ ,eA have t,o lines +rom A to % and tends a o, equally on each, has much than %,po,er ,hen line A becomes con)ested it ,illbut limit the o, on less line capacity %* Dhis limitation is not physical rather the system operator be +orced to limit theatotal o, restriction, on both lines to protect the ,eaker line* ,ill 2+ line A is e9panded by 1 M3, this ,ill increase the use+ulness o+ line % by 1 M3* Consequently the value o+ e9pandin) A is t,ice ,hat ,ould be computed +rom the o, on A times the con)estion price o+ A* #tatic o2timal transmission result (networ$) Let d o+ be po,er the po,er distri= bution +actor on line A8% calculated as the +raction o,in) on that line ,hen po,er is inGected at A and ,ithdra,n at %* Dhen, in an optimal net,ork, the mar)inal cost o+ e9pandin) the constrained line equals the avera)e con)estion rent divided by d* "pti al Trans ission (Dyna ic) -o,er systems are dynamic* Load )ro,sK )enerators are built and are retired* Dhis dramatically increases the comple9ity o+ the optimal transmission8investment problem* Do illustrate this, consider the simplest e9ample o+ a dynamic investment problem* Suppose transmission lines come in t,o siMes, ('' M3 at a rental cost o+ L07M3h and 1,''' M3 at a cost o+ L<*&'7M3h* Suppose that the po,er transmitted over the path in question starts at Mero and )ro,s by 1'' M3 per year indenitely and that the savin) +rom transmittin) this po,er is al,ays L(7M3h* Fbviously it ,ill be economical to build po,er lines* 6uildin) the (''=M3 line ,ould cost L:,'''7h, and ,hen load has )ro,n to 0'' M3, this ,ould save L:,'''7h* Dhis is the break=even point, and i+ the small line is to be built it should be built at this point in time* Dhe alternative is to ,ait another t,o years until load has )ro,n to @'' M3, at ,hich point the cost and savin)s o+ the 1,'''=M3 line ,ould be L<,&''7h* Dhe smaller lines start savin) money sooner, but lar)er lines ,ill save L1*A'7M3h in the lon) run, ,hile smaller lines ,ill save only L1*'' in the

$3!600$' &a;ings 7rom 4uilding !000@"# lines

$2!400$' $ !800$' $ !200$' $600$' &a;ings 7rom 4uilding 600@"# lines

20

24

28

32 Fears

Fi!ure 676 A 2ositi'e 2resent 'alue is not sucient lon) run* Dhe choice bet,een the t,o strate)ies depends on the discount rate, but as can be seen +rom Fi)ure <*<, it does not require a very lo, dis= count rate to make the lar)er lines the more economic choice* Dhe conclusion to dra, +rom this dynamic e9ample is that, Gust because a line is ,orth buildin), it should not necessarily be built* 2t may be better to ,ait a ,hile and build a lar)er and more economical proGect* Dhis is a result o+ the lumpiness o+ the investment decision* #ote that ,aitin) has no option value in this e9ample because the +uture is kno,n ,ith certainty* "pti al Trans ission ("ption *alue) 2n the above dynamic e9ample, t,o sets o+ proGects ,ere consideredK >i? build small lines at optimal intervals, and >ii? build lar)e lines at optimal intervals* Even i+ there had been uncertainty in this e9ample, each set o+ proGects could have been evaluated to nd its e12ected net 2resent cost o+ transmission and )eneration* 2+ all reasonable sets o+ proGects are evalu= ated in this manner and the one ,ith the lo,est cost is chosen, this consti= tutes a complete dynamic analysis* n+ortunately the selected proGect may not be the best choice* Dhis is not because e9pected net present cost is

the ,ron) criterion, but because the set o+ choices ,as unnecessarily restricted* 6esides sets o+ proGects, there are also investment strate)ies* Fne such strate)y mi)ht be to build a small line no, and then ,ait until load increased by ('' M3 and build another small line i+ the ,ait ,as ei)ht years or more and build a lar)e line i+ it ,as ei)ht years or less* $ strate)y is dierent +rom a specic Iset o+ proGectsJ because it ,aits +or more in+or= mation then cost chooses one than proGect orspeci another* Ouite o+ten, some strat= e)y ,ill and be more eective any c plan* For e9ample, consider a system ,ith no transmission, one city and a pos= sible remote coal plant ,ith a 0' per cent chance o+ bein) built* 2+ it is built, the most ecient transmission proGect ,ould start no, and have a net present value o+ L&'' million* 2+ the coal plant is not built, this proGect ,ould have a net present value o+ minus L1'' million* 6ecause there is a 0' per cent chance that the coal plant ,ill be built, buildin) the line ,ould have an e9pected net present value o+ L0' million >>&'' 8 1''?7&?* 2+ the line ,ere started a year later it ,ould have a >current? net present value L1A' or minus L4' million dependin) on ,hether the coal plant is or is not built* 3aitin) a year and then buildin) the line thus has an e9pected net present value o+ L<0* Fther proGects could be considered that delay the line +or di erent amounts time or build lines o+ dio+ erent capacity* 6ut it is quite plausible, and this o+ e9ample ,ill assume, that all speci c proGects, buildin) the line no, most valuable* 2n spite o+ this, there may be a more benecial strate)y +or is selectin) proGects* 2+ in one year, ,e shall kno, ,hether or not the coal plant ,ill be built, the strate)y o+ ,aitin) a year and then selectin) the best proGect is more valuable than any particular proGect* Dhe e9pected present value o+ this strate)y is 0' per cent o+ L1A' million >i+ the coal plant is built? plus 0' per cent o+ L', i+ the coal plant is not built* Dhis strate)y has an e9pected present value o+ L4' million ,hich is L<' million )reater than the value o+ buildin) the transmission line no,, the most valuable proGect )iven todayJs in+ormation* Dhis L<' million is called the option value o+ ,aitin) a year to decide* Dhere is o+ten a cost o+ delayin) the start o+ proGects ,ith a positive e9pected net present value, but there is also )enerally an option value to delayin) the decision to )o +or,ard ,ith a proGect* 2t is only ,hen this cost o+ delayin) is )reater than the option value o+ ,aitin) to decide that a commitment should be made* Fption value is dicult to estimate and it should be estimated +or various ,aitin) periods* 2n short, considerin) option value )reatly e9pands the number o+ possibilities that must be considered*

&* CFSD CECFEECP FFC F-D2M$L DC$#SM2SS2F# 2#EESDME#DS

Dhe previous section demonstrated that the optimal )rid ,ill suer con)es= tion ,hich ,ill result in the collection o+ con)estion rents and that these rents are related to the cost o+ the )rid* Dhis raises the question o+ to ,hat e9tent con)estion rents on the optimal net,ork ,ill cover the cost o+ that net,ork* Do consider this question it is use+ul to e9pand the notion o+ con)estion rent* Dhe con)estion rent collected on a one=line net,ork is CR>L$6? = >P6 8 P$?, ,here = is the po,er o, +rom A to % on the line bet,een A and * Dhis is thethis tradin) surplus collected i+ =results is sold in at de A and at %*% E9pandin) concept to the entire )rid nin)purchased the con= )estion rent +or the )rid to be the revenue +rom sellin) all ener)y inGections at their nodal prices and purchasin) all ener)y ,ithdra,als at their nodal prices* 2+ >i is the net ener)y ,ithdra,al at node i and Pi is the price at node i, then the con)estion rent +or the net,ork + is CR>+? >i Pi* Considerin) only lossless net,orks, it is possible to decompose the set o+ net ener)y ,ithdra,als into a set o+ bilateral trades each ,ith one inGection >ne)ative ,ithdra,al? and one ,ithdra,al o+ equal ma)nitude* Each bilateral trade +rom node A to node %, ,hich can be any t,o nodes on the net,ork, has associated ,ith it a con)estion rent, CR>5$6? = >P6 8 P$?, ,here = is no, the ma)nitude o+ the inGection and ,ithdra,al o+ bilateral trade %* #ote that one possible o+ the to net ,ith= dra,als into bilateral tradesdecomposition corresponds e9actly thenodal po,erener)y o,s on the individual lines* 5oin) so associates ,ith each line a con)estion rent equal to the lineJs o, times the price at the ,ithdra,al node minus the price at the inGection node* ;*e lossless con!estion,re'enue result 2+ the set o+ all bilateral trades, 5, sums to the total net ener)y ,ithdra,als +rom the net,ork, then the total con)estion rent is the same ,hether computed by node +or the entire )rid, +, as the sum o+ con)estion rents on all lines, L, or as the sum o+ con= )estion rents on all trades*
CR > + ?
$ll Lines

CR > L ? > 5 ?*
$ll Drades

CR

ProofB Since the inGections o+ bilateral trades are paid the nodal price and ,ithdra,als are char)ed the nodal price, the net revenue collected at a node is the nodal price times the sum o+ ,ithdra,als minus the sum o+ inGections* Since these t,o sums add up to the net ,ithdra,al, the net revenue collected +rom bilateral trades at node i is Gust >i Pi, and over all nodes bilateral tradin) revenues sum to the con)estion rent calculated

+or the entire net,ork* Dhat con)estion rents to onthe lines to the same value depends on these po,er o,s summin) netsum ,ithdra,als on the net,ork* Dhis +ollo,s +rom conservation o+ ener)y in a lossless net,ork* Dhe net po,er o,s on lines into a node must sum to the net ,ithdra,al +rom the )rid at that node* Dhis result demonstrates that the tradin) revenue that is collected +rom buyin) and sellin) po,er in a con)ested net,ork ,ith nodal prices >even i+ these prices are not the competitive prices? ,ill e9actly cover the con)ested rents calculated on a line=by=line basis* Dhis assumes that there is no po,er loss, so that into the po,er that end* o,s out o+ one end are o+ atypically line equals the po,er that o,ed the other >2n reality losses ,ell under 0 per cent on a hi)h volta)e transmission system*? 2t ,ould be desirable i+ the tradin) surplus in an optimally built net,ork ,ere to cover the cost o+ the transmission net,ork* Dhe above result makes it reasonable to investi)ate this question by lookin) at the cost=recovery properties o+ con)estion rent +rom a sin)le line* Congestion +ents +ecover Linear Line Costs Suppose the cost o+ a transmission line is strictly proportional to the me)a,att capacity o+ the line, so that cost is )iven by C c =, ,here c is in L7M3h and = is in M3* 2n this case, accordin) to the static optimal transmission result >one=line? )iven above, the mar)inal cost o+ the line, c, should equal the avera)e con)estion rent per M3h, P* $s a result, the revenue +rom the line, P=, ,ill equal the cost o+ the line c =* 2n the optimal one=line >lossless? net,ork ,ith linear costs, con)estion rents ,ill cover the cost o+ transmission capacity e9actly* #ot surprisin)ly this result e9tends to net,orks* 2+ the po,er distribu= tion +actor on the ==M3 line +rom A to % is d, then ,hen line A8% is con= )ested, it controls the po,er o, o+ =7d* 2+ the con)estion price +rom A to % is P, then the con)estion rent associated ,ith this constraint is P =7d and the benet o+ increasin) the lineJs capacity is P =7d* 2n this ,ay the cost recovery o+ constraints in a net,ork can be seen to be analo)ous to the cost recovery o+ a sin)le line in a one=line net,ork* $n optimally con= structed net,ork ,ith linear cost +unctions and no losses, ,ill recover its 9ed costs throu)h mar)inal=cost >competitive? pricin)* Congestion +ecovery +ents and ,'i-ed.-cost

3hen investin) in transmission, some costs are rou)hly independent o+ the capacity o+ the line and some are rou)hly proportional* Dhose that are inde=

pendent ,ill be called I 9edJ costs in this chapter* Dherealism, linear=cost +unction Gust considered 9ed=cost so to consider one o+ the +orm C has f no c = * 2n thiscomponent, case, the same add rst=order conditions ,ill determine the optimal transmission system, so con)estion rents ,ill recover c =, but not f* 2n other ,ords all costs that are proportional to capacity ,ill be recovered, but none o+ those that are independent o+ the lineJs capacity ,ill be recovered +rom con)estion rent in an optimally siMed system* Dhe cost +unction Gust considered is one e9ample o+ returns to scale* $nother model o+ returns to scale has a cost o+ line capacity that is pro= portional to the square root o+ capacity, C a ?17&* 2n this case the mar= )inal cost o+ capacity is -C >a7&? ? 817&* 2+ the line is built to the socially optimal level, -C ,ill equal the avera)e con)estion rent, ,hich is paid on the ,hole line capacity, so revenue is R >a7&? ?17& C7&* 2n other ,ords, at the socially optimal level o+ investment the line provides a con)estion rent o+ e9actly hal+ o+ ,hat it costs* Dhis is true re)ardless o+ ho, lar)e or small the optimal line is* Lumpy technolo)y also e9hibits 9ed costs and, at least, limited returns to scale* 6ut the t,o concepts, returns to scale and lumpy technolo)y, can be use+ully distin)uished* Fi)ure <*0 provides the basic intuition* 6oth types o+ technolo)y violate the have Inon=conve9ityJ assumption required +or per+ect competition* 6oth types a cost 9ed=cost component* Dhe lumpy technolo)y sho,n above requires a 9ed to provide its rst me)a,att o+ capacity, but the mar)inal cost o+ capacity is then Mero up to Total cost

Returns to scale

G-umpy5 tec'nology

00 "# Fi!ure 67@

Huantity

Lum2y tec*nolo!y may not e1*ibit returns to scale in t*e lon! run

1'' M3* 2n this sense, the cost o+ this technolo)y is all 9ed* Fn a small scale, up to 1'' M3, there are returns to scaleK over lar)e chan)es in cap= acity, there are no returns to scale*

:* DC$#SM2SS2F# -L$##2#. 32D/ SDC$DE.2C .E#EC$D2F# 2#EESDME#D

nder a plannin) approach, no per+ormance=based incentive mechanisms are applied to the problem o+ decidin) on lon)=lived transmission invest= ment, mainly lines and trans+ormers* Dhe plannin) mi)ht be carried out by the independent system operator >2SF? or by a transco, and payments +or the cost o+ investment ,ill be carried out under rate=o+=return re)ulation* Do simpli+y discussion, it ,ill be assumed that the plannin) is done by a transco that o,ns and operates the )rid, but that there is an 2SF ,hich operates the ,holesale ener)y market* 6ecause -6C is not used +or lon)= run investments does not mean it ,ould not be used +or the day=to=day operation o+ the )rid, but the problems o+ ecient )rid operation ,ill not be discussed in this chapter >Qosko,, &''<?* $s illustrated in the previous section, plannin) transmission investments is a comple9 problem, and is in +act +ar more comple9 than these illustra= tions su))est because o+ the comple9ity o+ the net,ork* Dhis is ,idely rec= o)niMed* $n additional complication is also reco)niMed* 6ecause )eneration is not planned, transmission planners +acin) a ,holesale po,er market must +orecast the location o+ )eneration and load many years in advance*& Dhese problems are common to all three approaches mentioned in the introduction >plannin), merchant and -6C?* nder each approach, the dynamics o+ the combined transmission7)eneration system and the option value o+ ,aitin) must be taken into account* nder each approach the investor ,ill not have control or direct kno,led)e o+ +uture )eneration investment, and under each, the comple9 cost structure and net,ork e9ter= nalities cause additional diculties* Dhis section does not +ocus on the common problems but on strate)ic issues peculiar to the plannin) process ,hen )eneration investment is dere)ulated* Strategic /anipulation of the &ero-congestion Policy Dhe possibility o+ strate)ic manipulation is particularly acute in the case o+ a Mero=con)estion policy, such as $lbertaJs* 2n the e9ample +or static trans= mission optimiMation, the optimal line siMe ,as @'' M3, and i+ an A'' M3 line had been built there ,ould never have been any con)estion* Dhis makes it appear that buildin) +or Mero con)estion ,ould not be too e9pensive* 2n

this case it ,ould require only a 1< per cent increase in transmission capac= ity* 6ut consider the case o+ a ,ind +arm that can be located at various dis= tances +rom load* 2+ it is close to load, the cost o+ transmission may be only L17M3h ,hile i+ it is in the most remote location it mi)ht be L&'7M3h* Suppose that the most remote location is the ,indiest and it is no more e9pensive to build ,ind )enerators there than closer in* 3hat is the eect o+ a Mero con)estion policy on the location o+ this ,ind +armN Clearly, it is most protable )enerators to locate in the most remote location ,hether not +or the,ind beneMoreover, t o+ moresince ,ind comes close to osettin) the e9tra cost o+or transmission* ,ind po,er has nearly Mero mar)inal cost, it is al,ays Iin meritJ, and consequently trans= mission capacity must be built to accommodate the ,indiest hour o+ the year* Dhe last me)a,att o+ such transmission capacity ,ill have almost no value* >Fne can be sure that a Mero=con)estion re)ulation ,ill be violated in practice simply because addin) capacity to a remote location to capture one hour o+ supply makes so little sense*? Dhis illustrates the +undamental point o+ the strate)ic )eneration investment problem* #trate!ic !eneration in'estment 2roblem Dhe policy o+ the /ence, transmission planners in uences the distribution o+ installed )eneration* plan= nin) policies cannot be appropriately compared on a static model o+ )en= eration and transmission but must be compared usin) a )ame=theoretic approach that reco)niMes )eneration investment strate)ies* Dhis problem complicates transmission plannin) in a market environment because the problems o+ predictin) )eneration investment and plannin) transmission +or that investment can no lon)er be separated* For e9ample, one mi)ht think that plannin) could proceed by havin) t,o )roups o+ plan= ners, one o+ ,hich +orecasts )eneration investment, and the other o+ ,hich takes the +orecast and plans the Ibest po,er linesJ +or that predicted invest= ment* Dhe only communication necessary bet,een the t,o )roups ,ould be the trans+er o+ +orecasts +rom the rst )roup to the second* n+ortunately, the strate)ic )eneration investment problem sho,s that this ,ill not ,ork* First, the strate)ic investment problem tells us that the +orecaster ,ill need to kno, ,hat policy the transmission planners ,ill +ollo,* Dhis is necessary because )eneration investors ,ill react to this policy and the +orecasters need to understand this reaction to make )ood +orecasts* Second, the planners cannot simply build the best lines +or the predicted )eneration* Dhey must choose an investment policy that induces )ood )eneration investment, so they must understand ho, )eneration investment ,ill respond to their policy*

The Diculty of I ple enting Si ultaneous "pti i0ation Dhere is one obvious hope +or resolvin) this chicken=and=e)) problem* 2+ the planners choose the Itruly bestJ transmission investment policy 8 call this the ideal transmission plannin) policy 8 this rule should induce )enerators to make the best possible investment decisions* 2n this case, transmission investment policy should be optimal +or the implied )eneration investment incentives, and these should be optimal +or the transmission policy* 6ut this doubly optimal system deserves a closer look as it involves more than tech= nical diculties* $t the opposite end o+ the spectrum +rom the Mero=con)estion policy, is the ideal plannin) policy* Dhis requires the planner to estimate +uture load )ro,th and then plan both )eneration and transmission simultaneously to minimiMe the total e9pected present cost o+ delivered po,er*: 2deal plan= nin) is e9tremely dicult, but, besides the technical diculty, another problem blocks our path* ;*e ideal transmission 2lannin! 2olicy -lan transmission and )enera= tion to)ether and optimiMe both +or e9pected load )ro,th, then build that transmission and hope the market induces suppliers to invest in optimal )eneration* 2n principle, this policy ,orks because, transmission, investors ,ill nd the co=optimiMed )eneration)iven to be optimal their optimal strate)y* 6ut, both Goint optimiMation and any real markets +or )eneration are subGect to error* Consequently, there ,ill be times ,hen ideal optimiMation directs that )eneration should be built in location R, and a correspondin) trans= mission line be built to serve that )eneration* 2+ such a line is built and the market decides not to build )eneration at location R, the planners ,ill be severely embarrassed by their line to no,here* Dhe problem to +ocus on is not the error, but the IembarrassmentJ* Errors are taken into account by our theory o+ minimiMin) e12ected cost* Dhe IembarrassmentJ causes a more +undamental problem* 2t prevents planners +rom adoptin) the ideal transmission plannin) policy* -lanners ,ill not undertake a proGect that can lead to such an embar= rassin) situation* 2nstead, they ,ill simply attempt to optimiMe their trans= mission +or )eneration that has been built, is bein) planned, or at the least, appears to be an obvious e9tension o+ an e9istin) trend* Dhey ,ill not predict optimal )eneration and build transmission +or that prediction* 2t mi)ht seem that this ,ill make no +undamental dierence, but it does* Dhe strate)ic )eneration problem tells us that as soon as the )enerators realiMe the actual plannin) policy is no lon)er the ideal plannin) policy, they ,ill

no lon)er invest optimally +or policy* di 2nstead ,ill invest optimally +or the ne, policy, and that isthat an entirely erentthey matter* Dransmission planners ,ill not build +or theoretically determined +uture )eneration investments but ,ill instead build +or )eneration as determined by )eneration investors* Dhis means that )eneration investors can manipu= late the transmission planners by their selection o+ )eneration investment sites* Dhey ,ill learn ,hat policy the planners are usin) and )ame that policy* Dhis is the strate)ic )eneration investment problem* Strategic /anipulation of "pti al Trans ission Planning /avin) )iven up on the ideal transmission plannin) policy, the question becomes, ,hat is the best realistic plannin) policyN Dhere are many choices, but only a +e, can be stated simply* Fne o+ these, the Mero= con)estion policy, has already been ruled out* Can ,eDhis nd speci a better practical alternative ,ill be considered* esoneN that Dhe the ne9t=best planner should optimiMe transmission takin) )eneration and anticipated )eneration as )iven* Dhis ,ill be called the Ipractical plannin) policyJ* ;*e 2ractical 2lannin! 2olicy 6uild the transmission system that is optimal )iven actual and anticipated )eneration* 2+ planners +ollo, the practical plannin) policy, and )eneration decides mistakenly or perversely to locate in a remote re)ion ,here +uel is cheap but transmission is so e9pensive that the combination is uneconomical, the planners may ,ell have to build accommodatin) transmission*< $lthou)h the result may not be optimal, it ,ill be +ar more sensible than buildin) to the point o+ Mero con)estion* Do analyse the plannerJs choice, consider the net social benet o+ a transmission and )eneration proGect* Dhis proGect consists remote )eneration ,hich Ie9portsJ po,er a transmission line to the o+ central #et social bene t >iii? consists o+ over >i? the net t simpli+y to consumers, >ii? market* )eneration transmission probene ts* Do the calculation, assume pro thatts the and entire proGect is small compared ,ith the central market and that lon)=run supply in the central market is very elastic* Dhis implies that the remote )eneration proGect ,ill not chan)e the price paid by central consumers, and as a consequence it ,ill be o+ no net benet to them* Dhe proGect, i+ ecient, ,ill dis= place central production ,ith cheaper remote production and delivery, but the savin)s ,ill be entirely captured pro by the $s a consequence social bene t reduces to )eneration ts investors* plus transmission protsB net #et Social 6enet .eneration -rots Dransmission -rots*

$ssume that remote )enerators are paid one price and central consumers are char)ed a hi)her price ,hich creates con)estion rent* From this, the cost o+ the can be subtracted to nd transmission pro ts, transmission ,hich can be investment ne)ative or positiveB #et Social 6enet .eneration -rots Line Costs?* >Con)estion Cents 8

2n eect, remote )eneration is payin) the con)estion rents because the central price is determined by the central market cost o+ supply* 2+ remote )eneration is required to pay the +ull cost o+ the transmission line throu)h con)estion rents, net social bene t equals )eneration pro t ma9imiMation by then )enerators ,ill ma9imiMe net social bene t* ts, 2n and thispro case suppliers ,ill invest optimally in )eneration and i+ the planners +ollo, the practical plannin) policy, the combined proGect ,ill be optimal* For linear >proportional? transmission costs, con)estion rents do cover line costs +or the optimal line* Consequently i+ transmission costs are linear, the practical plannin) policy ,ill induce optimal )eneration investment and the optimal transmission investment +or )eneration* Dhe combined system ,ill be optimal* Dhe corollary o+ this result is that ,hen transmission costs are not linear, investment is unlikely to be optimal* For e9ample, consider a)ain a ,ind +arm* nder the Mero=con)estion policy, the ,ind +arm could locate as +ar as it liked +rom the central market ,ith complete impunity* nder the prac= tical plannin) policy, the planner ,ill build only the optimal transmission line and the +urther +rom the central market that the ,ind +arm locates, the smaller ,ill be that line* Dhe mar)inal cost per M3 o+ line capacity increases rou)hly in proportion to the len)th o+ the line +or any line capa= city* Since the optimal line capacity occurs at the point ,here the mar)inal cost o+ line capacity equals the avera)e con)estion rent, the lon)er the optimal line, the )reater the avera)e con)estion rent* Since the ,ind +arm ,ill pay these rents, it ,ill care ho, lon) the line is* Dhis is )ood ne,s* Dhe practical plannin) policy should not only build more economic lines +or e9istin) )eneration, but also induce the e9istence o+ a more cient spatial distribution o+ )eneration* combined savin) should be e si)ni cant and perhaps enormous* 6ut thisDhe does not imply that the induced )eneration investment ,ill be optimal under the practical plan= nin) policy* Suppose the cost o+ transmission is c S$, ,hich implies that +or an optimal line, con)estion rent is e9actly hal+ the total cost o+ the line* Dhe ,ind=+arm investors ,ill realiMe that they must pay only hal+ the cost o+ the line since, under the e9ampleJs assumptions, the only transmission cost they pay is the

con)estion rent* 3hen they dierentiate prot ,ith respect to distance, 1, +rom the central market in order to optimiMe their location, their value +or the dCR7d1 ,ill be hal+ ,hat it should be and this ,ill cause them to locate too +ar +rom the central market* Dhe planners ,ill then be +orced to build a line that is optimal +or )eneration located too +ar a,ay, but the result ,ill be a combined )eneration=transmission proGect that is suboptimal* Dhe obvious remedy +or this rent problem iscost to o+ char)e )eneration the di erence bet,een the con)estion and the the line* Dhis implies a char)e that varies by location and some measure o+ a )eneratorJs siMe, but that is quite dierent +rom a con)estion char)e* Dhe need +or such char)es has lon) been reco)niMed >6runekree+t et al*, &''<K Eo)elsan), &''<? and has been the +ocus o+ many economic schemes, +e, o+ ,hich have been in+ormed by le)itimate economic analysis* Many o+ these )o under the name o+ IM3= mileJ char)es, thou)h the most elaborate one ,as an $lberta scheme called SEC-* 2t based locational char)es on an analysis o+ line=by=line po,er o,s that ,ould be caused by a short circuit at the location in question* 3ithout a scheme, the>independent +allback position is to char)e every M3 delivered to such the system a 9ed o+ e location? char)e per the M3h* Dhis has the advanta)e o+ preservin) short=run ciency by leavin) dis= patch una ected* 2t ,ill, ho,ever, leave the practical plannin) policy sendin) inecient lon)=run si)nals +or )eneration location* Dhese insi)hts dene a +undamental problem +or transmission plannin) in the conte9t o+ a ,holesale )eneration market that includes market= driven investmentB ;*e fundamental transmission,2lannin! 2roblem 2s there ,ith a mechanism +or collectin) transmission 9ed costs ,hich, ,hen coupled the prac= tical plannin) policy and nodal pricin) based on competitive ener)y prices, ,ill improve theand total eciency o+ the po,er systemN 6oth short= run dispatch eciency lon)=run incentives +or )eneration investment must be considered* Dhe standard o+ comparison is a per=M3h char)e on all supplied ener)y independent o+ location* $lthou)h it seems unlikely that any char)in) mechanism can be +ound that ,ill be both short= and lon)=run optimal, it does seem likely that some improvement is possible at least +or realistic net,orks* 6ecause so many erroneous collection mechanisms have already ,asted time and money, none should be seriously considered until some proo+ is )iven that they ,ill lead to improved eciency on)ross some ,ell=speci ed po,er systems* Dhese test cases can be simpli cations o+collection real po,ero+ systems, but they must include the possibility o+ locational choices +or )eneration investment*

<* MECC/$#D DC$#SM2SS2F# 2#EESDME#D

2+ transmission is not built by a public or re)ulated entity, it ,ill be built by private investors* Dhis happened be+ore the po,er industry ,as re)ulated and it happens today* 6ut the question o+ interest is ho, much ,ill be built and ho, eciently it ,ill be built* Certainly there are no easy assurances +rom theoretical economics that an unre)ulated market ,ill per+orm ,ell, and to date there is no empirical evidence +or this proposition* Dhere are, ho,ever, several theoretical reasons +or concern* Ceturns to scale su))est that investors ,ill need market po,er to leads recover their 9ed costs, but market po,er, in this industry as in all others, to underinvestment* E9ternalities )enerated by the use o+ the )rid +or trade su))est there ,ill be +ree=rider problems, ,hich ,ill e9acerbate the under= investment problem* Dransmission investment provides t,o other e9ternal= ities, the value o+ ,hich private investors ,ill not easily capture* First it reduces market po,er in the )eneration market >Sto+t, 144@K 6orenstein et al*, &'''?, and second it provides reliability* .eneration market po,er is a particularly knotty problem because ener)y suppliers are kno,n to lobby )overnment bodies in an attempt to block transmission investment that is not in their interest* $ny attempt to reduce market po,er ,ith transmis= sion is likely to be the tar)et o+ supplier lobbyin)* 2ncult spite theseas dimany culties, transmission investment is not as di to o+ nance assume* F+ten con)estion rents are al,ays vie,ed as the sole source o+ remuneration to merchant transmission* 2n +act, lines may be built ,ithout any assumption o+ con)estion income* 2+ there is a cheap but remote area +or )eneration investment, the suppliers that locate there may build lines simply to brin) their po,er to market* Dhey ,ill still have +ree=rider problems and the like, but they ,ill be motivated by other than +uture income +rom con)estion rents* Similarly a city may nd local supply too e9pensive and may build transmission out to the lar)er net,ork simply to access cheaper po,er ,ith no thou)ht o+ +uture con)estion rents* $lternatively all three motivations may coincide* $lthou)h con)estion rent may not be the primary motivation +or build= in) lines, ri)hts to ne, lines should be )iven to investors to encoura)e such investment and internaliMe the lineJs benets to the e9tent possible* Dransmission ri)hts can protect an investor +rom con)estion cost that ,ould haveothers been paid i+ ,hen the investor used the line and can provide incomeother,ise to the e9tent use it it is con)ested* $nother bene t o+ transmission ri)hts is to cause ne)ative e9ternalities to be internaliMed* 6e+ore turnin) to the diculties o+ merchant investment, it is ,orth,hile understandin) ho, transmission ri)hts should be )ranted in return +or investment and ,hat use+ul role they can play*

Trans ission +ights 6ecause alternatin) current >$C? transmission lines are so thorou)hly inte= )rated ,ith the po,er )rid, their o,ners )enerally cannot be )iven physical control or the ri)ht to char)e anyone ,ho uses the line* For e9ample, almost any po,er o, +rom one point to another on a po,er system causes some po,er to o, on most transmission lines in the )rid, althou)h the amount that someo,s on remote lines is too small to matter* $C po,er lines are in ,ays like a set+rom o+ connected pipesa ,ithout bet,een -ushin) ,ater one point ,ater to another ects thevalves o, in almost them* every pipe* 6ecause o+ such physical comple9ities, the standard proposal is to re,ard the investor ri)hts* in a transmission line ,ith a set o+ nancial ri)hts, not physical Dhe standard nancial transmission ri)ht is a con)estion revenue ri)ht >CCC? ,hich is dened by a quantity, =, source and sink, A and %, and a set o+ time intervals, ;* $t any point in time durin) ;, the CCC pays >P6 8 P , ,hich is the con)estion +rom A to to do % times me)a,att quan= $?= tity o+ the ri)ht* Dhe payment price has nothin) ,ith the actual po,er o,s associated ,ith the o,ner o+ the ri)ht* $lthou)h CCCs can, in principle, be privately issued, they are )enerally issued by the 2SF and that ,ill be assumed throu)hout this discussion* Consequently, at any point in time, there is a ,ell=dened set o+ CCCs, R, that have been issued* $n important property o+ R is there its +easibility, ,hich is de ned as +ollo,s* Correspondin) to every CCC an ima)inary ima)inary po,er o, o, o+ = M3 +rom A,ith to % , durin) time intervals ;Since *isDhis po,er has nothin) to do actual o,s on the )rid* every CCC in this set corresponds to ancorrespondin) ima)inary po,er o,, ,e dene R to be a +easible set o+ ri)hts i+ the set o+ ima)inary po,er o,s could take place on the system ,ithout violatin) any reliability constraint* Dhis has nothin) to do ,ith load or )eneration and concerns only the transmission system* Dhe +ollo,in) procedure can be used, at least in principle, to re,ard investors in transmission up)rades* First, sell a set o+ CCCs, in an auction that does not ,ithhold any +easible CCC* Dhis should leave no valuable CCC unallocated* 3hen a transmission up)rade is completed the system should be able to accommodate more po,er o, reliably, and this should e9pand the +easible set o+ CCCs* Dhe investor is allo,ed to claim any set o+ CCCs ,hich, combined ,ith the e9istin) set, +orms a +easible set in the up)raded system* Dhis allo,s the investor a certain amount o+ choice and it accounts, to some e9tent, +or positive e9ternal aects o+ the up)rade* Dhere is one more rule*must 2+ the Iup)radeJ has actually reduced the +easible set o+ CCCs, the investor take counter= o, CCCs such that the ne, allo= cated set is +easible* Dhese ,ill have ne)ative nancial value and ,ill prop= erly discoura)e any system do,n)rades, provided that the initial set o+

CCCs matched the actual o,s on the and Sto+t, and 144@?* ni+yin) these t,o rules, the system re,ard >6ushnell +or a modi cation o+144( the transmission system is thisB Feasible allocation rule for rewardin! in'estment Dhe modi er CRR o+ a transmission system must taketransmission +rom the 2SF a set o+ CCCs such that to)ether ,ith the CCCs the ne, complete set is a +easible set on the modi ed pre=e9istin) system* Dhis approach too+ re,ardin) investment has several advanta)es* First, i+ the pre=e9istin) CCCs the matches theSecond, o,s on system, it makes it unprotable set to dama)e system* it the )ives the investor the ma9imum possible con)estion rent ,hile treatin) others +airly* Dhird, +or +easible sets o+ ri)hts, the cost to the 2SF o+ payin) CCCs is never more than the con)estion rent collected*0 n+ortunately there are also a number o+ dra,backs* First, the a,arded CCCs do not adequately compensate investors* Second, to live up to its potential, the set o+ CCCs that the 2SF makes available needs to be quite comple9* For e9ample, the investor may ,ant north8south ri)hts at some times and south8north ri)hts at others* Dhird the results assume investors have no market po,er in the ener)y market* "ther Styles of +ights Dhere a number o+ other o+transmission transmissionri)hts ri)hts >/o)an, &''&K .ribik are et al*, &''<?* -QM uses styles nancial >FDCs? ,hich in their ori)inal >obli)ation? +orm are identical to CCCs e9cept that the revenue associated ,ith the entire set o+ ri)hts is adGusted to equal the con= )estion rent collected +rom the entire transmission system* Dhis correction is )enerally small* Dhe FDC option >as opposed to obli)ation?, introduced into -QM in &'':, is a +undamentally dierent +orm o+ transmission ri)ht* $t any point in time an FDC option +rom A to % pays its holder the ma9imum o+ ,hat a similar FDC obli)ation pays, or Mero* nlike FDC obli)ations, FDC options, like other options, have only non=ne)ative values* sin) FDC options instead o+ obli)ations results in a smaller +easible set o+ ri)hts because cancellation o+ ri)hts in opposite directions is not allo,ed under the normal meanin) o+ I+easibleJ* For e9ample, consider a three=node trian)ular net,ork ,ith )eneration at A and % and ,ith load at C, and ,ith a 1''=M3 line +rom A to % and t,o 0''=M3 lines to C >Fi)ure <*(?* 3ith the standard, obli)ation=style, CCCs, t,o 0''=M3 FDCs, one +rom A to C and the other +rom % to C, are simultaneously +easible* 3ith FDC options, only t,o :''=M3 FDCs are +easible because i+ one option ,ere

00 "#

500 "#

500 "#

C Fi!ure 67A 02tion ri!*ts reduce t*e feasible set of ri!*ts not e9ercised, the other ,ould correspond to a o, that ,ould load the A8% line to its limit* #o,, the po,er o,s used to compute the +easibility o+ a set o+ FDCs are purely ima)inary, so the same +easibility rule could be used ,ith options as ,ith FDC obli)ations* 6ut in this case, t,o 0,'''=M3 o2tions, one +rom A to C and the other +rom C to A ,ould be +easible >because these o,s cancel?* Dhe option in the con)ested direction, +rom A to C, ,ould earn a payment o+ 0,''' M3 times the con)estion price ,hile the 2SF ,ould collect only a con)estion payment o+, at most, ('' M3 +rom A to C* Since the counter=o, option ,ould not have a ne)ative value and ,ould pay the 2SF nothin), the 2SF ,ould nd itsel+ short o+ con)estion rent by <,<'' M3* For this reason -QM computes +easibility o+ its options ri)hts as +ollo,s* Dhe FDC auctions ma9imiMe the quote=based bid value o+ a set o+ simul= taneous +easible FDCs a,arded in the auction* Do ensure +easibility, countero, created by an FDC option bid must be i)nored ,hen the FDC bids are tested +or +easibility*( Dhere may be no economic Gustication +or the 2SF to create option ri)hts* Dhe system operator is in a )ood position to create standard CCCs because it can back them ,ith con)estion revenue ,ithout risk and conse= quently does not need to char)e any risk premium +or them* 6ut because addin) options to the mi9 reduces the total amount o+ hed)in) available, it may be better to let a private derivatives market supply CCC options i+ there is a demand +or them* Dhe motivation +or these alternative styles o+ ri)hts, and +or that matter the motivation +or transmission ri)hts in )eneral, is mainly to allo, the hed)in) o+ ener)y transactions* For e9ample, the main FDC pa)e o+ the

-QM ,ebsite states that IFinancial Dransmission Ci)hts >FDCs? Tare pro= videdU to assist market participants in hed)in) price risk ,hen deliverin) ener)y on the )rid* * * * Dhe FDCs provide a hed)in) mechanism that can be traded separately +rom transmission service* Dhis )ives all market par= ticipants the ability to )ain price certainty ,hen deliverin) ener)y across -QMJ*@ #o mention is made o+ transmission investment* Market po,er is another area o+ concern ,ith transmission ri)hts >Qosko, and Dirole, &'''?* Dhis also is not closely related to transmission investment* 2+ an ener)y supplier has market po,er in a load pocket, it can enhance its po,er by purchasin) transmission ri)hts into the pocket* Dhese ri)hts ,ill pay more ,hen it raises the local price o+ ener)y, ,hich makes its e9ercise o+ market po,er more protable* Do date, the main use o+ nancial transmission ri)hts has been as a sub= stitute +or prior ri)hts held by transmission o,ners* Dhis has been quite use+ul because o+ the compatibility bet,een CCCs and nodal pricin)* Dhis substitution and the more )eneral use o+ transmission ri)hts has also pro= vided a use+ul hed)in) mechanism +or nodal price dierences, that is, con= )estion rents* Dhe value o+ CCCs in this re)ard is still not ,ell documented, but they seem to be ,ell accepted in this role* $lthou)h their use as a partial incentive +or transmission investment has lon) been advocated, and at least -QM and #P2SF have rules o+ in CCCs place to this ea si)ni ect, there seem to be any documented instance playin) cantdoes role not in any mer= chant transmission proGect* The Parado- of Trans ission +ights Dhe appeal o+ re,ardin) transmission investment ,ith CCCs comes in part +rom their properties in an idealiMed ,orld o+ per+ect competition* 2n this economic model, mar)inal investments are al,ays possible and their cost is linear* Consequently a line may be up)raded by one me)a,att +or 171'' the cost o+ a 1'' me)a,att up)rade* Moreover, any investor can up)rade any lineK there is no o,nership o+ the transmission path* Dhis brin)s per+ect competition to each line in the system* 2n such a system the con)estion rent that ,ould be earned by a mar)inal up)rade o+ a transmission path ,ould e9actly equal the value o+ the up)rade in reducin) the redispatch cost caused by con)estion* For e9ample, i+ a line is con)ested +or 1,''' hours per year ,ith a price dierential o+ L1'7M3h, then a 1 k3 >171,''' o+ a M3? up)rade o+ the line ,ould save L1' 171,''' 1,''', or L1' per year in redispatch cost by allo,in) cheaper )eneration to substitute +or more e9pensive )eneration* Similarly, i+ the investor is )ranted a CCC +or 17k3 in the direction o+ the con)estion, the investor ,ill earn L1' per year, e9actly ,hat the line is ,orth*

2nvestment on every path ,ill proceed as lon) as the mar)inal investment costs less than the con)estion rent earned by that investment* 6ecause this equals the value o+ line e9pansion, investment ,ill proceed e9actly to the point ,here it no lon)er pays to continue investin)* Suppose a 1''=M3 line needs a 0'=M3 e9pansion because o+ a ne, load* Some investor may build :' M3 o+ the e9pansion, but at that point +urther investment may unpro table because it lo,ers the con)estion rent on the :' M3 o+become trans= mission ri)hts received +or the initial investment* 2n the real ,orld this ,ould most likely stop investment be+ore the optimal transmission capac= ity is achieved, but in the idealiMed ,orld o+ per+ect competition, some other investor ,ill continue the investment, perhaps +or another 1' M3* Dhen as this investorJs stake in hi)h con)estion rents discoura)es +urther investment, yet another investor ,ill take over the proGect* 2n this ,ay every last kilo,att o+ economic investment ,ill be made* nder the heroic assumptions o+ per+ect competition, re,ardin) invest= ors ,ith all o+ the con)estion rents provides the ideal incentive +or invest= ment >provided that the allocation o+ rents is also ideal?* nder realistic assumptions, ,hich include market po,er, payin) investors more ,hen there is more con)estion on their line results in ,ithholdin) o+ investment and too much con)estion* $s ,ill be discussed in Section 0, the e9act oppo= site payment scheme has merit ,hen the investor is a monopoly transco* 2n this case, char)in) the investor the amount o+ the con)estion rent instead o+ payin) the amount o+ the con)estion rent results in an ideal investment incentive* +eturns to Scale and ,Iu piness. Ceturns to scale, as discussed above, means that optimal transmission invest= ments ,ill simply not )enerate enou)h con)estion rent to pay +or themselves* Fbviously, this means that merchant investors ,ill build less than the socially optimal level o+ investment >Qosko,, &'':K Qosko, and Dirole, &''<?* Dhe same does not hold +or lumpy technolo)y* Consider Fi)ure <*@, ,hich sho,s transmission investment comin) in lumps* 2+ the rental cost o+ a lump o+ transmission is LA7M3h, it ,ould not be ,orth buildin) the second lump because the redispatch IcostJ trian)le that ,ould be eliminated avera)es less than LA7M3h*A Dhus the social optimum is to build only one lump and the rent on this lump ,ill be L1(7M3h ,hich pays +or the line t,ice over* Dhis sho,s that ,ith lumpy technolo)y, socially optimal invest= ment may produce more than enou)h con)estion rent to pay the cost o+ that investment* 2+ ,e call the lumpy technolo)y in Fi)ure <*0, Ilinear=lumpy technolo)yJ, indicatin) that it has constant returns to scale over a ran)e o+ lumps, ,e

$$"# 30 Rent 4

-ump %emand Cost &upply

2 -umps

"#' Fi!ure 674 02timal in'estment in lum2 tec*nolo!y may be 2referable can ask the questionB ,ould merchant investors underinvest in linear lumpy technolo)yN Fi)ure <*@ sho,s that they mi)ht invest optimally and earn ,ell above a normal rate o+ return* 2+ demand ,ere a bit )reater in the )ure, so that the intersection o+ supply and demand ,ere to the ri)ht o+ I& lumpsJ, the social optimum ,ould be t,o lumps* /o,ever, merchant investors ,ould +ailDhe to build second lump because it ,ould earn pro almost no con)estion rent* resultthe ,ould be underinvestment and e9cess ts* F+ the three possibilities, underinvestment, optimal investment and over= investment, they ,ill avoid the third* $ static analysis ,ould conclude that this should lead to too little investment on avera)e but to e9cess prots* Dhe disconcertin) aspect o+ this conclusion is that it appears that on avera)e, in +act almost al,ays, they ,ould earn above=market rates o+ return* Dhis seems unlikely* 2n a dynamic market this result appears even more suspicious* 2nvestors ,ill anticipate the possibility o+ hi)h rates o+ return and ,ill invest a little early, ,hich ,ill increase their avera)e investment and lo,er their rate o+ return* Considerin) this dynamic eect, there seems little reason to suspect that lumpy technolo)y ,ill lead to systematic underinvestment, or even that investment beconsideration* ,ron) on avera)e* Dhis is an optimistic result, but one more eect ,ill needs Lumpy investments pay least ,hen they are rst made and most Gust be+ore the ne9t investment is completed* 2n +act, many optimal transmis= sion investments lead to rent a protracted period ,ith virtually Dhis no con)estion and hence no 3hen con)estion ,hen they are rst completed* ethe ect may be dramatic* a lumpy up)rade is rst made it is common +or line to beisland almosto+ completely uncon)ested ando+ this situation may is last +or years* Dhe #antucket o the coast Massachusetts served by a sin)le direct current >5C? cable ,hich is likely to become con)ested in the comin)

+e, years +or a +e, hours in $u)ust* Dhis mi)ht cause a very partial black= out durin) the tourist season ,hich is unacceptable, so a second identical cable ,ill soon be added* Dhis one ,ill not be con)ested +or perhaps another &' years* Even ,hen a lumpy transmission investment can e9pect +ull recovery o+ its costs +rom con)estion rents over the lon) run, the cost recovery may ,ell not be)in +or years and ,ill be very slo, ,hen it starts* Dhis Iback=end loadin)J o+ the revenue stream creates )rave risks +or the investor* 3hat i+ a ne, technolo)y, such as cheaper hi)h=volta)e 5C lines or aluminum8Mirconium ,ires, comes on the market be+ore hi)h levels o+ con)estion kick inN 3hat i+ load )ro,th is slo,er than anticipatedN 3hat i+ )as pipelines are built to +uel ne, )eneration that competes ,ith po,er imported on the transmission line >6arthold, &'':?N Dhis investorJs payment stream does not mirror the stream o+ social bene t ,hich results +rom elimination o+, or reduction in, previous )estion rents* 6ecause that the bene t stream starts out at the rental cost o+con= the line, it is +ar less risky than the stream o+ con)estion rent* Cisk is costly, so merchant investment based on collectin) con)estion rents +rom CCCs issued in return +or the investment ,ill be much more costly than a socially sponsored investment in the same proGect* Lo,=risk investin) is cheaper than hi)h=risk investin)* $ simple e9ample may help e9plain relationship bet,een the social bene t stream and the con)estion rent the stream on a lumpy transmission investment* Suppose load in a load pocket takes on values bet,een R and R &'' M3 ,ith a uni+orm probability Suppose supply the price dierence bet,een supply +rom the load distribution* pocket and e9ternal is L&'7M3h* Suppose additional transmission costs L07M3h and comes in 1''=M3 lumps* 3hen should transmission be builtN Fnly ,hen the present line is con)ested ,ould a ne, line add value* 3hen the line is con)ested hal+ the time, as sho,n in Fi)ure <*A, the value added ,ill ran)e +rom Mero ,hen it is Gust barely con)ested to L&'7M3h o+ ne,=line capacity ,hen the load is at its peak value and the ne, line is +ully utiliMed* Fn avera)e, under these conditions the ne, line ,ould provide L1'7M3h o+ line capacity in social benet ,hile con)ested and L'7M3h ,hile con)ested* Consequently ,hen e9istin) line is con)ested hal+ o+ thenot time, it ,ill provide L07M3h o+ the bene t on avera)e* Since this is ,hat the line costs to build, this is the break=even point* 3hen the line is con= )ested less o+ten, investment is not ,arranted* 2+ ne, lumps o+ transmission are added at the socially optimal times, con= )estion rent Gust be+ore the ne, addition ,ill be L1'7M3h on avera)e, and Gust a+ter the ne, addition it ,ill +all to Mero* 3hen the ne, line is rst put in place the line ,ill earn nothin), but its earnin)s ,ill )ro, until the ne9t lump o+ transmission is built* 2+ the )ro,th in R is linear, then, on avera)e,

RV &''

se o+ ne, line

E9istin) line R

Load duration Fi!ure 673 02timal in'estment eliminates con!estion

the line ,ill earn L07M3h, e9actly enou)h to cover its cost* >Dhis e9ample assumes a Mero discount rate*? $t least in this case o+ lumpy investment, optimal investin) ,ill be re,arded ,ith e9actly the ri)ht level o+ con)estion rents* #ote the dierence bet,een the social benet +rom a transmission up)rade ,hich starts out coverin) the rental cost o+ the line on day one and the stream o+ con)estion rents ,hich o, to the merchant investor* Dhese start out at Mero and only reach the break=even point hal+ ,ay to the point in time ,hen the ne9t investment ,ill be made and rent ,ill a)ain drop to Mero* $lso note that, as than sho,n in Fi)ure <*4, the to social bene t o+ buildin) the line )reater its cost* 2t is normal nd such Iconsumer surplusesJ inis a much ,ell= +unctionin) market* Fbviously, this is a very narro, result, but it disproves a common vie, ,hich holds that lumpy investments inherently underpay investors similar to the ,ay in ,hich increasin) returns to scale >a declinin) mar)inal cost curve? underpay optimal investin)* Dhe main problem ,ith lumpy investments is that they pay o merchant investors very late, ,hich makes them risky +or a merchant investor even thou)h risk in social bene t e9tremely is lo,* Dhis can )reatly increase the cost o+ merchant lines rel= ative to their cost i+ built under rate=o+=return re)ulation* 'ree +iders1 3hen lar)e merchant transmission proGects are in contemplated it is o+ten noted that many ,ill bene t +rom such a proGect the initial years but all ,ill attempt to avoid payin) +or it* $s soon as the line is completed certain

L&'7M3h Social bene+it

L0 Cost o+ line

Con)estion

Cent time

Fi!ure 67B In'estors s*ould not ca2ture full social benet loads ,ill nd their prices reduced and certain suppliers ,ill nd they can sell at a hi)her price* 6oth ,ill ,ant the line to be built, but all ,ill ,ant others to pay +or it* Fi)ure <*4 illustrates such a situation* 2n the rst year a+ter the line is built, market participants ,ill benet by L07M3h o+ line capacity, yet the investors ,ill be paid ne9t to nothin) in con)estion rent* Dhis observation usually leads to the conclusion that all those ,ho bene t ,ithout payin) are directly +ree ridin)* 6ut, in this e9ample, social that is not the case* Dhe investor be the paid in +ull )ap bet,een bene t and con)estion rent ,ill is not result o+ and +ree the ridin) but is simply normal consumer surplus* F+ course, transmission proGects are likely to suer +rom the eects o+ returns to scale as ,ell as lumpiness, so it is likely that investors ,ill be underpaid i+ they but depend on con)estion rents* 2nto this case +ree ridin) a correct dia)nosis, it ,ill be e9tremely di cult assess the e9tent o+ is the +ree ridin)* 2n particular it is ,ron) to believe that investors should capture the entire consumer surplus even at the be)innin)* $n investor ,ith market po,er may be able to capture some o+ the value that ,ould other,ise accrue to +ree riders* Similarly, an investor ,ith market po,er may be able to capture part o+ the normal consumer surplus that ,ould be provided by optimal investin) and complete 9ed=cost recov= ery* 6oth reasons probably help to e9plain the many proposals to allo, the e9ercise o+ market po,er by merchant transmission investors* Some market po,er ,ould help cover investment costs, so there is some le)itimacy to the su))estion* 6ut once started do,n this path, merchant investors may ,ell ask +or more market po,er than needed to break even* -roposals to base the +undamentals o+ cost recovery on market po,er +ail to provide a ration= ale +or a market that must rely lar)ely on market po,er to cover costs* Dhe investment eciency o+ such a market is unclear at best*

Dhe principal ar)ument +or eciency in such a market is that suppliers ,ith market po,er still minimiMe costs, )iven their output* 6ut this ar)u= ment also holds +or suppliers ,ho do not decide ,hat transmission is needed but simply respond to an auction held by the system operator +or the provision o+ certain transmission capacity* ntil some means can be +ound o+ tailorin) the e9ercise o+ market po,er to provide the ri)ht level o+ 9ed=cost recovery only on ecient transmission investments, the ar)u= ment +or the deliberate introduction o+ market po,er as a method o+ induc= in) investment is ,eak to non=e9istent* /i-ing Planned and /erchant Trans ission Dhe possibility o+ planned transmission both discoura)es and threatens merchant transmission* 6e+ore a merchant line is built, potential sub= scribers to the proGect ,ould pre+er to induce the planners to build the line and spread the cost over the broader market* Dhis discoura)es participa= tion in the proGect by those ,ho should buy a lon)=run contract +or the use o+ the line* Essentially, this e9acerbates the +ree=rider problem* Fnce a merchant line has been built, those ,ho have not pre=paid +or its use ,ill still ,ish to encoura)e the planners to build a competin) line, as actually happened in $ustralia >Firecone, &'':K Littlechild, &''<?* $s the merchant line ,as a 5C line, it could directly char)e those ,ho used it >6runekree+t, &''<b?, but had it been an $C line those ,ishin) to use the path ,ould still have reason to lobby the authorities to overinvest by build= in) a second line, thus drivin) do,n con)estion rents and providin) a cheaper alternative than use o+ the merchant line* Dhis possibility is a threat to merchant investment* 6ecause merchant transmission has so +ar proven itsel+ entirely inade= quate, some have su))ested a mi9ture o+ merchant and planned transmis= sion >/o)an, 144AK Cot)er and Felder, &''1K Chandley and /o)an, &''&?* For this to succeed, the level o+ discoura)ement and threat must be reduced* Dhis can be accomplished i+ the role o+ plannin) can be dened ,ith enou)h clarity* 2+ merchant investors kno, ,hich lines ,ill and ,ill not be built by the planners, then plannin) should not discoura)e invest= ment in lines that ,ill be needed +or merchant purposes, but ,hich the plan= ners ,ill not build* Fne su))estion +or the bri)ht line bet,een planned and merchant lines is that planners ,ill build only lines ,hich ,ould require the cooperation o+ Imany partiesJ because in this case the +ree=rider problem is thou)ht to be particularly severe* 3hile this ,ould )ive merchants clear )uidance at the t,o e9tremes, there ,ould inevitably be an important middle )round o+ ambi)uity, perhaps encompassin) most transmission e9penditures*

$nother proposal +or separation ,as made several years a)o in the conte9t o+ the $lberta market >Sto+t, &''&?* Dhat market, to a )reater e9tent than most, +ails to send adequate locational si)nals +or )enera= tion investment and, like all po,er markets, lacks proper real=time demand elasticity* Consequently, transmission investment is occasionally required +or reliability purposes* 2t ,as proposed that the planners build only +or reliability, and that ,hen such a proGect is undertaken, merchant invest= ment be allo,ed to e9pand the proGect +or the incremental cost o+ the e9pansion, thus avoidin) si)nicant 9ed costs* Do +urther +acilitate merchant investment, it ,as proposed that the transmission administrator >planner? also +acilitates Goint investments by Goinin) merchant proGects under certain circumstances ,hen lumpiness is a problem* Dhe transmis= sion administrator ,ould buy a part o+ the line and keep it out o+ use until a ne, party decided to purchase it* Dhis proposal ,as not vie,ed as ideal, but only as a better alternative than the rule $lberta eventually did imple= ment, requirin) that con)estion be completely eliminated* 2t also has the advanta)e o+ not dependin) on or blessin) the e9ercise o+ market po,er*

0* -ECFFCM$#CE=6$SE5 CE. L$D2F# FFC DC$#SM2SS2F# MF#F-FL2ES >DC$#SCFS?

Dhe plannin) process provides non=directive and )enerally -lanners kno, that i+ they do a demonstrably poor Gob,,eak they incentives* may nd themselves out o+ ,ork* Dhis provides an incentive and most en)ineers are actually quite motivated by this and by pro+essional pride and a desire +or pro+essional reco)nition* Consequently, it is a mistake to believe that the plannin) approach lacks )ood incentives* /o,ever, these incentives may dier +rom a pure incentive to minimiMe the total cost o+ delivered po,er and may put too much ,ei)ht or not enou)h ,ei)ht on reducin) com= plaints about the occasional outa)e or about con)estion that inhibits trade* Consequently, it may be better to desi)n e9plicit +ormulas that determine monetary re,ards +or minimiMin) total cost* Dhese re,ards cannot easily be applied to individuals, so the standard approach is to apply them to the prots o+ a re)ulated monopoly, a transco* $ny re)ulation o+ a monopoly provides nancial incentives, but o+ten these have not been e9plicitly desi)ned or even considered* Dhe incentives o+ cost o+ service re)ulation are usually poorly thou)ht out and derive mainly +rom unintentional la)s in rate settin) and the subGective applica= tion o+ rules such as the requirement that investments must be Iused and use+ulJ* 3hen nancial incentives are e9plicitly desi)ned, the re)ulation is called Iper+ormance=based re)ulationJ >-6C?, or Iincentive re)ulationJ*

A Direct Approach Invest ent

to

P%+

for

Trans ission

2+ it is assumed that po,er is available to all customers at the competitive price, then the obGective o+ transmission investment is the minimiMation o+ the total cost o+ delivered po,er* 3ithout the assumption o+ availability, cost could be minimiMed by ma9imiMin) blackouts, and in the limit, deliverin) no po,er at all* 6ecause o+ occasional blackouts >load=sheddin) events?, the cost=minimiMation +rame,ork must be maintained by assi)nin) a cost to Iunserved loadJ* $ssumin) that this assi)nment o+ cost can be accomplished, the )oal o+ transmission investment is total cost minimiMation* Dhis )oal is easily translated into a theoretical scheme +or incentive re)u= lation >.ans and !in), &'''K Lautier, &'''?* $ monopoly transco should be paid a 9ed but )enerous sum, R, per me)a,att o+ delivered po,er less the cost o+ con)estion >CE, the redispatch cost? and less the cost o+ unserved >lost? load,be CLL * 2n than most su po,er systems, L1'7M3 hour o+pro deliv= ered po,er ,ould more cient +or R*4 Dhe transcoJs ts ,ould then beB -rot R 8 CE 8 CLL 8 C;,

,here C; the rental cost o+ the transmission system* $s ,ith a sin)le transmission line, the rental cost o+ the system includes the cost o+ capital as ,ell as maintenance* #ote that the transco does not keep the con)estion rent* 2+ the transco can reduce the sum o+ CE and CLL by more than L1 by investin) and thereby raisin) C; by L1, it ,ill nd it protable to do so and this ,ill be benecial to society* /ence this incent= ive mechanism ali)ns the transcoJs incentives ,ith social ,el+are* $ny reduction in CE CLL C; increases the social surplus by the same amount, and this amount )oes into the pocket o+ the transco* #ote that this incentive scheme properly re,ards IeortJ ,hich has a non=monetary cost to thecan transco and its is consequently by the re)ulator* 2+ the transco increase monetary pronot t, observable as ned above, by L1', e9pendin) ,orth o+ unobservable de ort, it be ,ill pay it to do but so, only as it by should, since L4 this is socially benecial* e $s ,ill seen shortly, this property is shared only by ,hat are called Ihi)h=po,eredJ incentive mechanisms* Dhis scheme presents three diculties, measurin) CE and CLL, and settin) R* Con)estion costs, CE, are the dierence bet,een the actual pro= duction cost o+ ener)y and the lo,er cost that could be achieved ,ithout any transmission limits* Dhis dierence can be +airly ,ell appro9imated in any system ,ith centraliMed biddin) and nodal pricin)* Fccasionally there may be some diculty ,ith kno,in) ho, much certain )enerators could

produce ,ere they not constrained by the transmission system, but most systems have on record a realistic estimate o+ each )eneratorJs output capacity and this should serve as an adequate pro9y +or the true value* >Losses are quite easily estimated*? Dhe cost o+ unserved load is +ar more problematic* Dhe standard error +or such an estimate is probably a +actor o+ three* 2n other ,ords, i+ it is esti= mated to be L10,'''7M3h, there is probably only a (A per cent chance >rou)hly? that the true value is bet,een L0,'''7M3h and L<0,'''7M3h* >Dhis is a purely subGective conGecture*? More problematic is the +act that this cost occurs erratically* MaGor cascadin) blackouts may happen about once every &' years and result in hal+ the load bein) lost +or si9 hours* Dhe cost o+ such a blackout ,ould be ( '*0 L10,''' per M3 o+ load ,hich is equivalent to about L@7M3h +or an entire year* 3hen such a blackout does occur it could cost the transco a yearJs revenue and result in bankruptcy* -erhaps a solution to this is to undervalue lost load by a +actor o+ 1' or &' and use a nominal value such as L1,'''7M3h* Dhis ,ould still result in a rather erratic cost stream, but it mi)ht be tolerable* Certainly, consumers ,ould pay a cant risk premium to,hether a transco under such incentive* Sometimes it si)ni ,ill also be di cult to tell loss o+ load isan due to )en=

eration or problems, and this ,ill lead to liti)ation costs and other ine transmission ciencies* Dhe problem o+ settin) R is the most +undamental problem o+ re)ula= tion* Dhe re)ulator al,ays has less kno,led)e >in+ormation? o+ the cost= minimiMin) solution than some does the re)ulated rentJ rm*+rom 6ecause o+ this, the re)ulated rm can e9tract Iin+ormation the re)ulator* 2n )eneral thebut stron)er the rent incentive, the better the per+ormance o+ the re)u= lated rm, the more it can e9tract* Dhe present scheme provides the stron)est incentiveK the transco keeps every dollar o+ cost that it saves* $s a consequence it ,ill be able to e9tract considerable rent* Speci cally, the re)= ulator kno,s that i+ it sets R belo, total cost, CE CLL C;, the transco ,ill )o out o+ business, a result that must be avoided, but it does not have a )ood estimate o+ total cost* 2ts only reasonable choice is to set R three or +our standard deviations above the cost=minimiMin) investment level o+ CE CLL C;* .iven the level o+ uncertainty in estimatin) this total, this is likely to result in an e9tremely hi)h rate o+ return +or the transco* Two Approaches to +educing Infor ation +ent Dhe advanta)e o+ the -6C scheme Gust described is that it stron)ly motivates the +or supplier to e9pend cost=savin) eort that is dicult i+ not impossible the re)ulator to observe* Dhe disadvanta)e, as ,e have Gust seen, is that it requires the payment o+ hi)h in+ormation rents* 2n the case o+ transmission

investment, these rents could be e9tremely hi)h and ,ell beyond any accept= able level* 6ecause o+ such hi)h in+ormation rents, it is desirable to reduce the po,er o+ the incentive mechanism* Many types o+ -6C are +orms o+ price= cap re)ulation includin) the mechanism Gust described, thou)h it is a rather non=standard price=cap incentive* 2n that scheme, R can be thou)ht o+ as the 9ed part o+ a t,o=part transmission price, the other part bein) the con= )estion price* Dhere are t,o standard ,ays o+ reducin) the po,er o+ a price=cap incentive* First, the cap, R in this case, can be reset periodically* Dhe more +requently it is reset, the lo,er the po,er o+ the incentive it pro= vides* Second, prots under the mechanism can be shared bet,een the monopolist and the consumers* Dhe smaller the share kept by the mono= polist, the lo,er the po,er o+ the incentive* 2n both cases, lo,er po,er ,ill correspond to lo,er in+ormation rents paid to the transco* Consider the periodic resettin) o+ the price cap* 3hen the price cap is reset, the obGective is to provide the monopolist ,ith a certain allo,ed rate o+ return durin) the ne9t period* Do this end, the values o+ CE , CLL and C; ,ill be estimated +or that period* 2+ the period is short, most o+ the transcoJs costs >C;? ,ill be correctly anticipated and covered by the allo,ed rate o+ return* Dhe lon)er the period, the more cost ,ill be saved or incurred une9= pectedly* Dhis ,ill lead to une9pected chan)es in CE , CLL ,hich ,ill chan)e revenues* Dhese intra=period chan)es in e9penditure >C;? and revenue >R 8 CE 8 CLL? result in prot deviations +rom the tar)eted allo,ed rate o+ return and this provides some incentives +or both cost minimiMation and benecial investment* Dhe lon)er the period bet,een rate cases, the )reater the pro= portion o+ e9penditures +or ,hich the price=cap mechanism can provide an incentive* $t one e9treme lies pure price=cap re)ulation and at the other pure rate=o+=return re)ulation* 2n bet,een ,e nd actual rate=o+=return re)ulation in ,hich price caps are reset rou)hly every three years* Dimin) is the maGor problem ,ith usin) periodic price=cap settin) to achieve a lo,er=po,ered incentive and lo,er in+ormation rents* 2nvestment costs are o+ten incurred over a much shorter period o+ time than the bene ts +rom the investment* /ence the reset period may be lon) relative to costsbut short relative to bene ts* 2n this case a lo,er proportion o+ costs than revenues ,illinvestment* be captured Dhis in the process* Dhis ,ill tend to dis= coura)e ecient isresettin) related to the ,ell=kno,n incentive problems that occur shortly be+ore a rate case* $t this time, it becomes advanta)eous to make costs appear hi)h and revenues appear lo,* $lso the incentive +or investment is diminished shortly be+ore a rate case, because the re)ulator may vie, such e9penditures as already paid +or* -ro t sharin) avoids these shares timin) pro issue does not make on peri= odic adGustments, but instead t because in some it 9ed proportion a

continuous basis* Economic prot, +or e9ample R 8 CE 8 CLL 8 C;, accounts +or a normal rate o+ return on investment >in C; ?, so prot sharin) can never prevent a supplier +rom achievin) a normal rate, is o+ 1' return, it ,ill only brin) it closer to that level* 2+ unshared prot, ma9imiMed by a certain investment strate)y, then hal+ o+ the unshared prot, 7&, ,ill also be ma9imiMed by e9actly the same investment strate)y* Consequently, i+ there ,ere notranscoJs in+ormation problem ,ith computin) , pro t sharin) ,ould leave the behavior unchan)ed* Dhis ,ould be capideal* Dhe e9cess ,ealth trans+erred by the hi)h prots o+ pure price= re)ulation could be reduced any amount simply by settin) the sharin) parameter appropriately andby this ,ould cause no loss o+ e ciency* 6ut there are in+ormation problems, and the +undamental trade=o o+ re)ula= tion ensures that, i+ the po,er o+ the incentive is )reatly reduced, e ciency ,ill suer* Dhat is true ,hether the incentiveJs po,er is reduced throu)h periodic o+but the it cap, as previously described, or in throu)h continu= ous pro resettin) t sharin), is easier to e9plain the eect the continuous pro t=sharin) conte9t* Do )limpse the the contradiction inherent in i)norin) the in+ormation problem, consider, case in ,hich the dollar=valued economic prot, , divided by the o+ invested capital needs any to equal per cent +or the initial determination R in order to avoid si)ni0' cant probability o+ bank= ruptcy* 2+ the normal rate o+ return on equity is 10 per cent, then the monopolist ,ill start out makin) a (0 per cent rate o+ return on equity*11 Do reduce this, consider a prot=sharin) ratio o+ 1 per cent +or the transco and 44 per cent +or load* Dhis reduces to 71'' and brin)s the initial return on equity cent* 1( 2+ the toper+orms 1'' per cent ,ith a superb eort, to it 10*0 ,ill per receive on transco equity raises and i+ it terribly, lettin) +all to ' per cent, it ,ill still receive 10 per cent on its equity* Even thou)h it pre+ers 1( to 10 per cent, this limited re,ard is not likely to induce the eort level required to raise divided by invested capital +rom ' per cent by 1'' per cent* Dhe important point about eort is that it is a real cost that is not included in C; 2t because is not monetiMed* 2t that is a costappear that does appear on the ,ill books* ,ill, o+itcosts course, ect same costs on not theper+or= books* Eort reduce these +ora the level do o+ transmission mance orraises increase per+ormance +or theto same level o+ monetary Lack o+ eort cost 2t relative Lack o+ cost* eort, like e ort, can take monetary many +orms* can take per+ormance* the +orm o+ ,orkers* I)old=platin)J ocient ces and equipment or Ishirkin)J by mana)ement and 2ne e9penditures can purchase tickets to the San Francisco .iantsJ baseball )ames as ,as done by a maGor Cali+ornia utility* I.ra+tJ is another type o+ lack o+ eortK +or e9ample, the transco can subcontract a Gob to someone

,ho pays a kickback to someone at the transco* $s the re,ards +or eort >)ood behavior? +all, all types o+ un,anted behavior ,ill increase* -ro t sharin) on a 0'70' basis takes , ,hich means takes a,ay hal+ o+ revenues minus costs* 2+ a,ay eorthal+ had o+ a monetary value, it then a L1' e ort that produced an L11 revenue ,ould increase by L1 be+ore pro t sharin) and by only L'*0' a+ter pro t sharin)* 2n either case the eort is ,orth,hile and ,ill be induced* 6ut because the e ort )oes unobserved, its cost is not shared by the prot=sharin) mechanism, and+ails so the result o+ the L1' e ort isean a+ter=sharin) revenue o+ L0*0' to compen= sate +or the L1' ort* Consequently, ,ith 0'70' pro,hich t sharin) such eorts ,ill not be undertaken* $ L1' e ort that produced a L:' increase revenue ,ould still pay o even a+ter prot sharin) allo,ed the transco in to keep only L10 o+ the revenue* So pro t sharin) does not eliminate the incentive to provide unmeasured but costly eort, it onlyMero, reduces it* $s thetoshare o+ pro tsdecreases kept by the transco decreases to,ards the incentive e9pend eort to,ards non=e9istent* Dhis e9plains ,hy prot sharin) is limited as a means to control in+ormation rents* Diculties with P%+ for Transcos Dhe price=cap mechanism described is most likely impractical because it su ers +rom at transcoJs least t,oGust severe diculties* Gust as ,ith transmission the investments ,ill payFirst, o ,ith very lon) merchant la) times and are consequently very risky >6runekree+t and Mc5aniel, &''0?* Dypi= cally, a lar)e cost must be incurred over a period o+ several years, then +or several more there ,ill be little or no return on the investment and nally, 1' or 10 years a+ter the start o+ the proGect, si)nicant payback ,ill be)in* Dhis is Gust one possibility, but a very plausible one* Dhe risk o+ this delayed payback contrasts sharply ,ith societyJs risk, ,hich is much less because the societal payback starts immediately upon completion o+ the line at a rate equal to the rental cost o+ the line* Second, transmission investments are ti)htly linked to reliability >Cre, et al*, &''<K Sun et al*, &''<?, and the reliability part o+ this mechanism, CLL, introduces severe risks and promises to be e9tremely controversial i+ attempted* Most o+ the maGor blackouts in the nited States over at least the last :0 years have been linked more to transmission problems than to )eneration problems* Dhis has tended to involve operations and invest= ments other than maGor line and trans+ormer investment, such as tree trim= min), computer systems +or state estimation, and the settin) o+ line=trip relays* 2t should be possible to desi)n a separate mechanism +or per+or= mance in these areas, but that ,ill not completely disentan)le reliability +rom line investment*1&

Dhe motivation +or up)radin) a transmission path, ,hich typically involves several lines, is con)estion on that path and the con)estion cost, CE, that it causes* 6ut this cost can be reduced in t,o ,ays, rst by a physical up)rade, and second by re=ratin) the path to a hi)her capacity* Dhe second approach is +ar cheaper, in +act is almost +ree, but it decreases reliability* n+ortunately path ratin)s are not easily audited as they are some,hat controversial even amon) en)ineers* Dhis is because they are not based primarily on hard data, such as the temperature at ,hich a ,ire melts* 2nstead, ratin)s must couple hard data ,ith some,hat subGective data, includin) probabilities o+ contin)encies such as line and )enerator outa)es*1: $ny po,er+ul incentive to up)rade lines ,ill also be a po,er+ul incentive to cut corners on contin)ency ratin)s* Consequently i+ there are stron) incentives to up)rade lines, there must also be heavy penalties +or cuttin) corners on path ratin)s* Since path ratin)s are too dicult +or re)ul= ators to monitor, these penalties must instead be applied directly to black= outs ,hich are very costly but occur very rarely* 2mposin) the cost o+ lost load, CLL, is such a penalty, but as e9plained, it introduces severe risks and ,ould be e9tremely controversial* Dhe dan)er o+ de)radin) reliability appears to create severe diculties +or desi)nin) a use+ul -6C incentive +or up)radin) lines* $ third diculty, less severe than the rst t,o, +aced by any transco pro= posal is the +undamental plannin) problem described above* $ny realistic transco incentive ,ill induce the transco to invest in the lines that are optimal +or e9istin) )eneration, not +or optimal )eneration* Dhe conse= quence ,ill be that )eneration investors ,ill build )eneration based on the transcoJs response* For this circularity to produce the ecient outcome, the char)es used to supplement the con)estion rents and provide the transcoJs revenues must be allocated in a ,ay that induces the correct location o+ )eneration* $ number o+ -6C alternatives +or transcos have been su))ested, includ= in) some by Eo)elsan) based on the price=cap tradition, and ,hich are revie,ed by CosellWn >&'':? and Eo)elsan) >&''<?* Eo)elsan)Js most recent proposal is related to these and the social surplus mechanism described above* n+ortunately this proposal is still not able to solve the investment problem takin) into account reliability and load )ro,th* /is current con= clusion is ILon) periods mark the limits o+ re)ulatory commitment and are still short relative to net,ork investments* $s a result, incentives should be +urther ,eakened by adGustments based on rate=o+= return re)ulation ,ith a Xused and use+ulY criterion*J >p*1<1?* -6C +or transcos ,ill be use+ul +or shorter=term incentives >Qosko,, &''<?, but it cannot yet be relied on to solve the lon)=term investment problems*

(* CF#CL S2F#
Currently, ,holesale po,er markets are under)oin) a slo, and inecient development process marked by such events as the Cali+ornia meltdo,n, the overbuildin) o+ )as=red )eneration in lar)e parts o+ the eastern nited States, the lar)est blackout in S history, and the complete redesi)n o+ the 6ritish market* 2n particular the )eneration investment problem seems to remain +ar +rom solved, thou)h some reasonable incentive mechanisms seem to be on the dra,in) board* Moreover, it should be reco)niMed that transmission investment is crucial to the +unctionin) o+ the ne, ener)y markets* Dhe less con)estion, the less market po,er in ,holesale ener)y markets >Sto+t, 144@K 6orenstein et al*, &'''K .ilbert, et al*, market &''&?* For e9ample, San Francisco and #e, Pork both su er +rom serious because both have transmission and must rely +or si)ni cant po,er portions o+ their ener)y onlimited local suppliers* Dhe more transmission into these cities, the more competition in the ,holesale ener)y market* Moreover, in every market in the nited States, there are numerous e9amples o+ )eneration units under Ire)ulatory must runJ con= tracts* Dhese )ive the market administrator the ri)ht to require the plant to run and in return provide re)ulatory payments ,hich are o+ten substantial* Such contracts e9ist lar)ely ,here these )enerators have e9treme market po,er durin) some hours o+ the year because o+ transmission limitations* Such situations have been numerous and problematic +rom the be)innin) and sho, no si)ns o+ disappearin)* Fortunately it is e9tremely cheap to overbuild the transmission system a small amount and thereby reduce market po,er belo, the level that ,ould be +ound under an optimiMed net,ork* Dhis is because, at optimal invest= ment, the derivative o+ total system cost ,ith respect to increased capacity is Mero* Dhat is the rst=order condition +or optimality* #either a merchant approach nor a -6C approach is conducive to alle= viatin) ,holesale market po,er problems by overbuildin) the net,ork* 6oth have biases to,ards underinvestment, and both are likely to be erratic in their behavior durin) the decades it ,ill take to tame the likely a,s in their desi)ns* Cate=o+=return re)ulation is more adaptable* -rovided the re)ulator declares inbe advance a the line ,ill be use+ulJ, it should not dicult that to )et transco toconsidered build it* Iused=and= #either a merchant approach nor a transco7-6C approach has yet been developed to the point ,here it could be considered useable in practice* 6oth appear to be in rather early sta)es o+ theoretical development* Moreover, it appears that any application o+ these approaches ,ill require a level o+ understandin) and subtlety that is not yet apparent amon) re)u= lators, at least in the nited States* .iven these diculties and the poor

record o+ the ener)y market dere)ulation process, it appears to be too early to be)in any policy initiatives based on either o+ these approaches* 3ith transmission investment costs amountin) to only :8A per cent o+ the retail costs >Qosko, and Dirole, &''&?, it is better to rely on a relatively sa+e approach to transmission investment, even thou)h it is a bit less ecient than results promised by some poorly understood theoretical approaches* Dhis is not to say that merchant transmission investment should be dis= coura)ed* 2t should be allo,ed and re)ulated only li)htly >6runekree+t, &''<a?, but,ith it cannot be depended on and should not be the +ocus o+ those concerned ensurin) sucient transmission capacity* Cate=o+=return re)ulation applied to a transco or to ,ire companies under the direction o+ an 2SF is not ,ithout its dra,backs* 6esides the +un= damental plannin) problem discussed above, there is the additional problem in the conte9t o+ a dere)ulated )eneration market that both )en= erators and load ,ill constantly lobby re)ulators +or more or less transmis= sion* 2+ the +undamental plannin) problem is not solved, some )enerators ,ill lobby +or more transmission to )et a +ree ride to market, ,hile others ,ill ar)ue +or less to keep their local price up and allo, them to e9ercise more market po,er* Load ,ill ar)ue +or more transmission +rom cheap re)ions to e9pensive ones, not Gust to save production costs and dampen market po,er >le)itimate reasons?, but also to e9ercise monopsony po,er a)ainst )eneration in the hi)h=cost re)ions* For years to come, transmission investment appears to be the knottiest problem in the dere)ulation process*

#FDES
1* Ceturns to scale imply that transmission investment costs are non=conve9* Lumpiness re+ers to havin) to buy an inte)er number o+ transmission lines selected +rom a small set o+ available capacities, but it is better understood as simply re+errin) to a cost +unction ,ith a uctuatin) slope* &* Dhis is not as bad as it sounds, because ,ith )ro,th, almost any line that saves more than its rental cost at the time it )oes into service ,ill continue to be economic in the lon) run* :* 2n +act it requires even more* Load is to a small e9tent determined endo)enously by the price o+ po,er, so it should be determined simultaneously, but this complication ,ill be i)nored* <* Dhis section concerns strate)ic manipulation by )eneration, but it assumes that the ,holesale )eneration market is in every respect competitive* Manipulation is not the result o+ market po,er, but o+ )enerationJs rst=mover advanta)e in the optimiMation )ame* 0* Dhis assumes that the set set o+ o+ +easible transmission o,s +easible is conve9, ,hich is not quite and that the that +easible ri)hts based on avera)e po,er o,s and nottrue, the po,er o,s are possible only is under ideal conditions* (* From -QMJs document IFDC market +requently asked questionsJ, updated February 1, &''0, question <4* @* Found on ,,,*pGm*com7markets7+tr7+tr*html, the ,ebsite o+ -QM 2nterconnection, a re)ional transmission or)aniMation >CDF? that coordinates ,holesale po,er tradin) in

A* 4* 1'*

a re)ion o+ the S +rom Michi)an to 3ashin)ton 5C, to !entucky* 2t includes << million customers and 1:0,''' M3 o+ )eneratin) capacity* Fn the le+t is the cost o+ L1(7M3h, but it +alls linearly to Mero be+ore reachin) the ri)ht end o+ the lump* For completeness the cost o+ replacin) losses should be included in CE* For e9ample i+ prot 1, then net operatin) revenue, R 8 CE 8 CLL, equals C; 1, ,hich
1 means that investments earnin) more& a investments normal rate still o+ return* prot is cut transmission in hal+, operatin) revenuesare still cover C; 8than , and earn 2+ more than a normal rate o+ return* Economic prot is prot above the normal rate o+ return on invested capital* 3ilson >144@? addresses reliability in a +ranchise transco conte9t* Stability ratin)s, thou)h more rmly based in physics, also involve subGective Gud)ments as to ho, close is too close to the point o+ instability*

11* 1&* 1:*

CEFECE#CES
6arthold, L*F* >&'':?, I3hither E/EN 5istributed )eneration reverses the trendJ, IEEE Power and Ener!y -a!a/ine, 22, A0* 6orenstein, S*, Q* 6ushnell and S* Sto+t >&'''?, IDhe competitive eects o+ transmission capacity in a dere)ulated electricity industryJ, "ournal of Economics, 34 >&?, &4<8:&0* 6runekree+t, .* >&''<a?, ICe)ulatory issues in merchant transmission investmentJ, Cambrid)e 3orkin) -apers in Economics, C3-E '<&&, and Cambrid)e8M2D 3orkin) -aper, :A* 6runekree+t, .* >&''<b?, IMarket=based investment in electricity transmission net= ,orksB controllable o,J, Ctilities Policy , 45 ><?, &(48A1* 6runekree+t, .* and D* Mc5aniel >&''0?, I-olicy uncertainty and supply adequacy in electric po,er marketsJ, D2LEC 5iscussion -aper, 5- &''0=''(* Dilbur) La, and Economics Center* Forthcomin) in revised and shortened versionB 01ford Re'iew of Economic Policy* 6runekree+t, .*, !* #euho and 5* #e,bery >&''<?, IElectricity transmissionB an overvie, o+ the current debateJ, Cambrid)e 3orkin) -apers in Economics, C3-E '<(:, and Cambrid)e8M2D 3orkin) -aper, ('* 6ushnell, Q* and S* Sto+t >144(?, IElectric )rid investment under a contract net,ork re)imeJ, "ournal of Re!ulatory Economics, 46, (18@4* 6ushnell, Q* and S* Sto+t >144@?, I2mprovin) private incentives +or electric )rid invest= mentJ, Resource and Ener!y Economics, 47, A081'A* Chandley, Q*5* and 3*3* /o)an >&''&?, Inde2endent ;ransmission Com2anies in a Re!ional ;ransmission 0r!ani/ation, Cambrid)e, M$B Center +or 6usiness and .overnment, Qohn F* !ennedy School o+ .overnment, /arvard niversity* Cre,, M*, -*C* !leindor+er and M* Spie)el >&''<?, ICeliability, re)ulation and trans= mission investmentJ, Ris$ -ana!ement and 9esi!n Processes Center, 3orkin) -aper '<=&'=-!, -hiladelphia* Firecone Eentures -ty Ltd >&'':?, ICe)ulatory and institutional +rame,ork +or transmission >$ustralia?B Final CeportJ, Eictoria, #ovember* .ans, Q* and S* !in) >&'''?, IFptions +or electricity transmission re)ulation in $ustraliaJ, Australian Economic Re'iew, 33 >&?, Qune, 1<08(1* .ilbert, C*, !* #euho and 5* #e,bery >&''<?, I$llocatin) transmission to miti)ate market po,er in electricity net,orksJ, "ournal of Economics, 38 ><?, (418@'4*

.ribik, -aul C*, 5* Shirmohammadi, Q*S* .raves and Q*.* !ritikson >&''<?, IDransmission ri)hts and transmission e9pansionsJ, dra+t to IEEE ;ransactions on Power #ystems, &''<* /arvey, S*, 3* /o)an and S* -ope >144(?, IDransmission capacity reservations implemented throu)h a spot market ,ith transmission con)estion contractsJ, mimeo, /arvard niversity* /o)an, 3*3* >144&?, IContract net,orks +or electric po,er transmissionJ, "ournal of Re!ulatory Economics, 9, &118<&* /o)an, 3*3* >144A?, IDransmission investment and competitive electricity marketsJ, mimeo, /arvard niversity* /o)an, 3*3* >&''&?, IFinancial transmission ri)hts +ormulationsJ, mimeo, /arvard niversity* Qosko,, -*L* >&'':?, ICemedyin) undue discrimination throu)h open access trans= mission service and standard electricity market desi)nJ, $E2=6rookin)s Qoint Center +or Ce)ulatory Studies, Re!ulatory Analysis, ':=1, 3ashin)ton, 5C, February* Qosko,, -*L* >&''<?, I-er+ormance based re)ulationJ, May >slides?, 3ashin)ton, 5C* Qosko,, -*L* and Q*Q* Dirole >&'''?, IDransmission ri)hts and market po,er on elec= tric po,er net,orksJ, Rand "ournal of Economics, 34 >:?, <0'8A@* Qosko,, -*L* and Q*Q* Dirole >&''&?, IDransmission investmentB alternative institu= tional +rame,orksJ, mimeo, Doulouse* Qosko,, -*L* and Q*Q* Dirole >&''<?, IMerchant transmission investmentJ, "ournal of Industrial Economics, 83 >&?, &::8(<* Lautier, D*=F* >&'''?, ICe)ulation o+ an electric po,er transmission companyJ, Ener!y "ournal, 54 ><?, (184&* Littlechild, S* >&''<?, ICe)ulated and merchant interconnectors in a $ustraliaB S#2 and Murraylink revisitedJ, Cambrid)e 3orkin) -apers in Economics, C3-E '<1', and Cambrid)e8M2D 3orkin) -aper, :@, May* CosellWn, Q* >&'':?, I5ierent approaches to,ards electricity transmission e9pan= sionJ, Re'iew of Networ$ Economics, 5 >:?, &:A8(4* Cot)er, Q* and F* Felder >&''1?, I-romotin) ecient transmission investmentB the role o+ the market in e9pandin) transmission in+rastructureJ, sponsored by DransZner)ie S Ltd, #ovember, 3estborou)h, M$* Sto+t, S* >144@?, IDhe eect o+ the transmission )rid on market po,erJ, Lawrence 5er$eley National Laboratory >or$in! Pa2er, L6#L8<'<@4, 6erkeley, C$* Sto+t, S* >&''&?, I$ proposal +or lon)=run and short=run con)estion mana)ement in $lbertaJ, 5efore t*e Alberta Ener!y and Ctilities 5oard, File #o* 1A':=<, March <* Sun, /*, M* San+ord and L* -o,ell >&''<?, IQusti+yin) transmission investment in the marketsJ, Electricity ;ransmission in 9ere!ulated -ar$ets, 5ecember 1081(, Carne)ie=Mellon niversity, -ittsbur)h, -$* Eo)elsan), 2* >&''<?, IDransmission pricin) and per+ormance=based re)ulationJ, Electricity ;ransmission in 9ere!ulated -ar$ets, 5ecember 1081(, Carne)ie= Mellon niversity, -ittsbur)h, -$* 3ilson, C* >144@?, I2mplementation o+ priority insurance in po,er e9chan)e marketsJ, Ener!y "ournal, 42 >1?, 1118&:*

.LFSS$CP $#5 SPM6FLS

CE Con)estion cost* E9cess cost o+ ener)y +rom dispatchin) out o+ merit order because o+ transmission constraints* CR Con)estion rent* Cevenue +rom ener)y inGections at nodal prices less revenue +rom ener)y ,ithdra,als at nodal prices* CL Con)estion cost to load* E9cess cost o+ ener)y to load due to trans= mission constraints* CLL Cost o+ unserved >lost? load* C; Dhe rental cost o+ the transmission system paid by a re)ulated transco* 2ncludes the annualiMed costs o+ capital and maintenance* CCC Con)estion revenue ri)ht ,hich pays >P6 D P$? =, durin) time periods ;* FDC -QMJs nancial transmission ri)ht* Dhe obli)ation variety is the same asor a insu CCC e9ceptinthat revenuesrents* are adGusted +or variety any revenue surplus ciency totalthe con)estion Dhe option omits the ne)ative payments possible ,ith an obli)ation* + Dhe transmission )rid* 2SF Fne o+ several Iindependent system operatorsJ that run markets in the S* Dhey have no, s,itched status to become CDFs, >re)ional trans= mission or)aniMations? in keepin) ,ith the Federal Ener)y Ce)ulatory CommissionJs chan)in) terminolo)y* ? Dhe capacity in M3 o+ a transmission line* #P2SF Dhe #e, Pork 2ndependent System Fperator* P$ , P6 #odal ener)y prices at nodes A and %* PL -rice in the local re)ion -QM Dhe 2SF no, covers Michi)an, -ennsylvania, 3ashin)ton 5C, Dennessee and more, ,ith << million consumers and 1:0,''' M3 o+ )en= eratin) capacity* PR -rice in the remote re)ion = Dhe me)a,att o, named in a CCC, or on a line* R Dhe re)ulated price paid to a transco per M3h o+ delivered po,er* CDF Ce)ional transmission or)aniMation* Dhe ne, name +or an 2SF in the S* ; Dhe time period covered by a CCC, +or e9ample, peak hours durin) &'1'* Dransco $ re)ulated monopoly transmission company* >i Dhe net po,er ,ithdra,al at node i*