Grupo 5 Chapter 4 - Problems of Transmission Investment in a Deregulated Power Market (42)

8/14/2019 Grupo 5 Chapter 4 - Problems of Transmission Investment in a Deregulated Power Market (42)

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CompetitiveElectricity Markets

and Sustainability

Edited by

Franois LvqueProfessor of Law and Economics, Centre of IndustrialEconomics (CERNA),cole des mines de Paris, France

Edward ElgarCheltenham, ! "#orthampton, M$, S$


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% Franois Lvque &''(

$ll ri)hts reserved* #o part o+ this publication may be reproduced, stored ina retrieval system or transmitted in any +orm or by any means, electronic,mechanical or photocopyin), recordin), or otherise ithout the prior

permission o+ thepublisher*

-ublished byEdard El)ar -ublishin) Limited

.lensanda /ouseMontpellier -aradeCheltenham.los .L0' 1$!

Edard El)ar -ublishin), 2nc*3illiam -ratt /ouse4 5eey Court#orthamptonMassachusetts '1'('

S$

$ catalo)ue record +or this bookis available +rom the 6ritish Library

Library of Congress Cataloguing-in-Publication Data

Competitive electricity markets and sustainability 7 edited by Franois Lvque

p* cm* 82ncludes biblio)raphical re+erences and inde9*1* Electric utilities* &* Competition* :* Electric tilities;Finance*Electric utilities? 2* Lvque, Franois, 140@8

/54(A0*$&C0@@ &''(:::*@4: &:8dc&&

&''('111:&

2S6#=1:B 4@A 1 A


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Contents

List of !ures viList of tables viiList of contributors viiiPreface by "ean #yrota 9iiiAc$nowled!ements 9v

1 2nvestments in competitive electricity marketsB an overvie 1Fran%oisL&'ue

-$D 2 2#ESDME#D 2# .E#E$D2#

& 2nvestment and )eneration capacity &1Ric*ard +reen

: .eneration technolo)y mi9 in competitive electricity markets 0or punish? suchmodifications by allocatin) transmission ri)hts to investors* $2erformancebased re!ulation (P5R) a22roac* ould induce investment by a +or=profitoner o+ the transmission system >a transco? by adGustin) its profit level onthe 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 +rameork o+ a

holesale poer market based on publicly knon nodal prices >/o)an,144&K /arvey et al*, 144(?* Dhat is, at each relevant point >node? in thenetork, 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

poer, 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 adGustedeach time there is a chan)e in supply or demand*

Such a pricin) system automatically prices the use o+ the transmissionsystem even thou)h it applies directly only to ener)y transactions* 2+ the

price at node A is &'7M3h and at node % is :'7M3h, then the price totransmit ener)y +rom A to % is 1'7M3h, hile the price to transmit it+rom % to A is ne)ative 1'7M3h* $lthou)h nodal prices have somepeculiarproperties, it is important to understand that they are simply theresult 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 bothcompetitive, nodal prices are simply the standard competitive market

prices and have all theproperties e9pected o+ such prices* E9cept henprices are determined somehat arbitrarily because a vertical supply

coincides ith a vertical demand curve, competitive nodal prices areunique* $lthou)h they are o+ten calculated +rom bids in a centraliedauction, they are not the product o+ any special rules o+ calculation but arethe prices at hich a ell=arbitra)edbilateral market ould arrive i+ thetransmission 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 first to, 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 &'7M3h andmuch more at


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Problems of transmission in'estment in a dere!ulated 2ower mar$et A4

Transmissionconstraint

$50

$30

$20

Congestionrent (CR)

Congestion cost (CE)

Remote supply

Netlocal

demand

200 400 600 800 !000 "#

Fi!ure 678 9efinin! con!estion rent and con!estion cost

+unction +or the load pocket in question* Suppose that local load is fi9ed at1,''' M3 and that the pocket contains ('' M3 o+ :'7M3 )eneration

and &'' M3 o+ 0'7M3h )eneration* Dhe Inet local demandJ curve shosthe demand +or imported poer net o+ hat ould be purchased locally>Fi)ure


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$"# Constraint $"# Constraint

RentCost

%emand Cost toconsumers

&upply &upply

"#'

Fi!ure 67: Cost to consumers com2ared wit* con!estion cost and rent

"#'

;able 678 ;*ree 'iews of con!estion

Con)estion >redispatch? costCon)estion rentCost o+ con)estion to load

CECRCL

@,'''7h4,'''7h

&','''7h

Finally, there is the cost of con!estion to load >CL? >see Fi)ure


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The &ero-congestion 'allacy

6ecause transmission con)estion imposes costs, one recurrent vie holdsthat it should simply be eliminated* Dhis is no the policy o+ the $lberta)ov= ernment >see 6o9


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4& In'estment in transmission

$"#Constraint Net local

demand

Remotesupply

$"# Constraint

Net localdemand

Remotesupply

-oss o7 load"#'

Congestion"#'

Fi!ure 67< Relations*i2 of con!estion to a transmissioncause reliability2roblem

Dhe +allacy o+ eliminatin) all con)estion may arise +rom con+usionbeteen 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 isnot associated ith unreliability* 2t is simply the result o+ havin) morethan 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 >seeFi)ure


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ation o+ )eneration sunk costs* 2n the lon) run, internal capacity ill retireand eventually the )eneratin) capacity in the load pocket ill a)ainrecover its fi9ed costs* -erhaps the savin)s +rom the line ill amount to&


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* 4+3 %.:1N1N/ TD. R.NT,- C&T :

TR,N&"1&&1N -1N.& 1N $DRT'e cost o7 a particular transmission line mig't e $500!000!000!ut See 6o9


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$s lon) as additional capacity saves more in ener)y production costs thanthe cost o+ the additional capacity, the line should be lar)er* Since the costo+ additional capacity is 07M3h, the line should be e9panded until thesavin) +alls to 07M3h on avera)e* 3hen the capacity is three=quarters o+the ay +rom


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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 theavera)e

price differential*

#tatic o2timal transmission result (one line) 2n an optimal one=linenetork, the mar)inal cost o+ line e9pansion equals the all=hour avera)eabsolute nodal price differential beteen the ends o+ the line* 2n otherords, the mar)inal cost o+ e9pansion equals the avera)e con)estion rent*

2n a netork, thin)s are a bit more comple9* 2+ e have to lines +rom A to% and poer tends to flo equally on each, but A has much less capacitythan %, hen line Abecomes con)ested it ill limit the flo on line %* Dhis

limitation is not a physical restriction, rather the system operator illbe+orced to limit the total flo on both lines to protect the eaker line* 2+ lineA is e9panded by 1 M3, this ill increase the use+ulness o+ line % by 1M3* Consequently the value o+ e9pandin) A is tice hat ould becomputed+rom the flo on A times the con)estion price o+ A*

#tatic o2timal transmission result (networ$) Let dbe the poer distri=bution +actor on line A8% calculated as the +raction o+ poer floin) onthat line hen poer is inGected at A and ithdran at %* Dhen, in anoptimal netork, the mar)inal cost o+ e9pandin) the constrained line

equals the avera)e con)estion rent divided by d*

"ptial Transission (Dynaic)

-oer systems are dynamic* Load )rosK )enerators are built andare retired* Dhis dramatically increases the comple9ity o+ the optimaltransmission8investment problem* Do illustrate this, consider the simpleste9ample o+ a dynamic investment problem* Suppose transmission linescome in to sies, ('' M3 at a rental cost o+ 07M3h and 1,''' M3 at a

cost o+


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$3!600'

&a;ings 7rom uilding!000@"# lines

$2!400'

$!800'

$!200'&a;ings 7rom uilding600@"# lines

$600'

4 8 2 6 20 24 28 32

Fi!ure 676 A 2ositi'e 2resent 'alue is not sufficient

Fears

lon) run* Dhe choice beteen the to strate)ies depends on the discountrate, but as can be seen +rom Fi)ure ii? build lar)e lines at optimalintervals* Even i+ there had been uncertainty in this e9ample, each set o+

proGects could have been evaluated to find 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 loest cost is chosen, this consti=tutes a complete dynamic analysis* n+ortunately the selected proGectmay not be the best choice* Dhis is not because e9pected net present cost is


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the ron) criterion, but because the set o+ choices as unnecessarilyrestricted*

6esides sets o+ proGects, there are also investment strate)ies* ne suchstrate)y mi)ht be to build a small line no and then ait until loadincreased by ('' M3 and build another small line i+ the ait as ei)htyears or more and build a lar)e line i+ it as ei)ht years or less* $ strate)yis different +rom a specific Iset o+ proGectsJ because it aits +or more in+or=

mation and then chooses one proGect or another* Ouite o+ten, some strat=e)y ill be more cost effective than any specificplan*For e9ample, consider a system ith no transmission, one city and apos=

sible remote coal plant ith a 0' per cent chance o+ bein) built* 2+ it isbuilt,the most efficient transmission proGect ould start no and have a net

present value o+ &'' million* 2+ the coal plant is not built, this proGectould have a net present value o+ minus 1'' million* 6ecause there is a 0'

per cent chance that the coal plant illbe built, buildin) the line ould havean e9pected net present value o+ 0' million >>&'' 8 1''?7&?*

2+ the line ere started a year later it ould have a >current? net presentvalue 1A' or minus 4' million dependin) on hether the coal plant is oris not built* 3aitin) a year and then buildin) the line thus has an e9pectednet present value o+ i+ the coal plant is built? plus 0' percent o+ ', i+ the coal plant is not built* Dhis strate)y has an e9pected

present value o+ 4' million hich is


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&* CSD ECEP F -D2M$LD$#SM2SS2# 2#ESDME#DS

Dhe previous section demonstrated that the optimal )rid ill suffer con)es=tion hich ill result in the collection o+ con)estion rents and that theserents are related to the cost o+ the )rid* Dhis raises the question o+ to hate9tent con)estion rents on the optimal netork ill cover the cost o+ thatnetork* Do consider this question it is use+ul to e9pand the notion o+con)estionrent* Dhe con)estion rent collected on a one=line netork is C

R>L$6?

= >P68P$?, here = is the poer flo +rom A to % on the line beteenA

and %* Dhis is the tradin) surplus collected i+ = is sold at A and purchasedat %* E9pandin) this concept to the entire )rid results in definin) the con=)estion rent +or the )rid to be the revenue +rom sellin) all ener)y inGections attheir nodal prices and purchasin) all ener)y ithdraals at their nodal

prices* 2+ >i is the net ener)y ithdraal at node i and Pi is the price at node

i,then the con)estion rent +or the netork + is CR>+? >i Pi*

Considerin) only lossless netorks, it is possible to decompose the set o+net ener)y ithdraals into a set o+ bilateral trades each ith one inGection>ne)ative ithdraal? and one ithdraal o+ equal ma)nitude* Eachbilateral

trade +rom node A to node %, hich can be any to nodes on the netork,has associated ith it a con)estion rent, CR>5$6? = >P68P$?, here = isno the ma)nitude o+ the inGection and ithdraal o+ bilateral trade %*

#ote that one possible decomposition o+ the net nodal ener)y ith=draals into bilateral trades corresponds e9actly to the poer flos on theindividual lines* 5oin) so associates ith each line a con)estion rent equalto the lineJs flo times the price at the ithdraal node minus the price atthe inGection node*

;*e lossless con!estionre'enue result 2+ the set o+ all bilateral trades, 5,sums to the total net ener)y ithdraals +rom the netork, 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 >+? CR >L? CR>5?*

$ll Lines $ll Drades

ProofB Since the inGections o+ bilateral trades are paid the nodal priceand ithdraals are char)ed the nodal price, the net revenue collected at

a node is the nodal price times the sum o+ ithdraals minus the sum o+inGections* Since these to sums add up to the net ithdraal, the netrevenue collected +rom bilateral trades at node i is Gust >i Pi, and overall nodes bilateral tradin) revenues sum to the con)estion rent calculated


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+or the entire netork* Dhat con)estion rents on lines sum to the samevalue depends on these poer flos summin) to the net ithdraals onthe netork* Dhis +ollos +rom conservation o+ ener)y in a losslessnetork* Dhe net poer flos on lines into a node must sum to the netithdraal +rom the )rid at that node*

Dhis result demonstrates that the tradin) revenue that is collected +rombuyin) and sellin) poer in a con)ested netork ith nodal prices >even i+these prices are not the competitive prices? ill e9actly cover the con)estedrents calculated on a line=by=line basis* Dhis assumes that there is no poerloss, so that the poer that flos out o+ one end o+ a line equals the poerthat floed into the other end* >2n reality losses are typically 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 netork

ere to cover the cost o+ the transmission netork* Dhe above result makesit reasonable to investi)ate this question by lookin) at the cost=recoveryproperties o+ con)estion rent +rom a sin)le line*

Congestion +ents +ecover Linear LineCosts

Suppose the cost o+ a transmission line is strictly proportional to theme)aatt capacity o+ the line, so that cost is )iven by C c =, here c isin 7M3h and = is in M3* 2n this case, accordin) to the static optimaltransmission 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, therevenue +rom the line,P=, ill equal the cost o+ the line c =* 2n the optimalone=line >lossless? netork ith linear costs, con)estion rents ill cover thecost o+ transmission capacity e9actly*

#ot surprisin)ly this result e9tends to netorks* 2+ the poer distribu=tion +actor on the ==M3 line +rom A to % is d, then hen line A8% is con=)ested, it controls the poer flo o+ =7d* 2+ the con)estion price +rom A to% isP, then the con)estion rent associated ith this constraint isP =7d

and the benefit o+ increasin) the lineJs capacity isP =7d* 2n this ay thecost recovery o+ constraints in a netork can be seen to be analo)ous to thecost recovery o+ a sin)le line in a one=line netork* $n optimally con=structed netork ith linear cost +unctions and no losses, ill recover itsfi9ed costs throu)h mar)inal=cost >competitive? pricin)*

Congestion +ents and ,'ied.-cost

+ecovery

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


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pendent ill be called Ifi9edJ costs in this chapter* Dhe linear=cost +unctionGust considered has no fi9ed=cost component, so to add realism, consider oneo+ the +orm C f c =* 2n this case, the same first=order conditions illdetermine the optimal transmission system, so con)estion rents ill recover

c =, but notf* 2n other ords all costs that areproportional to capacity illbe recovered, but none o+ those that are independent o+ the lineJs capacityill be recovered +rom con)estion rent in an optimally sied 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 ispro=

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 sociallyoptimal level,-C ill equal the avera)e con)estion rent, hich is paid onthe hole line capacity, so revenue isR >a7&??17& C7&* 2n other ords,

at the socially optimal level o+ investment the line provides a con)estionrent o+ e9actly hal+ o+ hat it costs* Dhis is true re)ardless o+ ho lar)e orsmall the optimal line is*

Lumpy technolo)y also e9hibits fi9ed costs and, at least, limited returnsto scale* 6ut the to concepts, returns to scale and lumpy technolo)y, can

be use+ully distin)uished* Fi)ure


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1'' M3* 2n this sense, the cost o+ this technolo)y is all fi9ed* n a smallscale, up to 1'' M3, there are returns to scaleK over lar)e chan)es incap=acity, there are no returns to scale*

:* D$#SM2SS2# -L$##2#. 32D/ SD$DE.2C.E#E$D2# 2#ESDME#D

nder a plannin) approach, no per+ormance=based incentive mechanismsare 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 >2S? or by a transco, and payments +orthe 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 atransco that ons and operates the )rid, but that there is an 2S hichoperates the holesale ener)y market* 6ecause -6 is not used +or lon)=run investments does not mean it ould not be used +or the day=to=dayoperation o+ the )rid, but the problems o+ efficient )rid operation ill not

be discussed in this chapter >Qosko, &''


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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 only17M3h hile i+ it is in the most remote location it mi)ht be &'7M3h*Suppose that the most remote location is the indiest and it is no moree9pensive to build ind )enerators there than closer in* 3hat is the effecto+ a ero con)estion policy on the location o+ this ind +armN

Clearly, it is most profitable +or ind )enerators to locate in the mostremote location hether or not the benefit o+ more ind comes close tooffsettin) the e9tra cost o+ transmission* Moreover, since ind poer hasnearly ero mar)inal cost, it is alays Iin meritJ, and consequently trans=mission capacity must be built to accommodate the indiest hour o+ theyear* Dhe last me)aatt o+ such transmission capacity ill have almost no

value* >ne can be sure that a ero=con)estion re)ulation ill be violated inpractice simply because addin) capacity to a remote location to capture onehour o+ supply makes so little sense*? Dhis illustrates the +undamentalpointo+ the strate)ic )eneration investment problem*

#trate!ic !eneration in'estment 2roblem Dhe policy o+ the transmissionplanners influences the distribution o+ installed )eneration* /ence,plan=nin) policies cannot be appropriately compared on a static model o+ )en=eration and transmission but must be compared usin) a )ame=theoreticapproach that reco)nies )eneration investment strate)ies*

Dhis problem complicates transmission plannin) in a market environmentbecause 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) to )roups o+ plan=ners, one o+ hich +orecasts )eneration investment, and the other o+ hichtakes the +orecast and plans the Ibest poer linesJ +or that predicted invest=ment* Dhe only communication necessary beteen the to )roups ouldbethe trans+er o+ +orecasts +rom the first )roup to the second*n+ortunately,the strate)ic )eneration investment problem shos that this ill notork*

First, the strate)ic investment problem tells us that the +orecaster illneed to kno hat policy the transmission planners ill +ollo* Dhis isnecessary 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 theirpolicy*


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The Difficultyof Ipleenting Siultaneous "ptii0ation

Dhere is one obvious hope +or resolvin) this chicken=and=e)) problem* 2+ theplanners choose the Itruly bestJ transmission investment policy 8 call thisthe ideal transmission plannin) policy 8 this rule should induce )eneratorsto make the best possible investment decisions* 2n this case, transmissioninvestment policy should be optimal +or the implied )eneration investmentincentives, and these should be optimal +or the transmission policy* 6ut thisdoubly optimal system deserves a closer look as it involves more than tech=nical difficulties*

$t the opposite end o+ the spectrum +rom the ero=con)estion policy, isthe ideal plannin) policy* Dhis requires the planner to estimate +uture load)roth and then plan both )eneration and transmission simultaneously tominimie the total e9pected present cost o+ delivered poer*: 2deal plan=nin) is e9tremely difficult, but, besides the technical difficulty, another

problem blocks our path*

;*e ideal transmission 2lannin! 2olicy -lan transmission and )enera=tion to)ether and optimie both +or e9pected load )roth, then buildthat transmission and hope the market induces suppliers to invest inoptimal )eneration*

2n principle, this policy orks because, )iven optimal transmission,investors ill find the co=optimied )eneration to be their optimal strate)y*6ut, both Goint optimiation and any real markets +or )eneration are subGectto error* Consequently, there ill be times hen ideal optimiation directsthat )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 themarket decides not to build )eneration at location R, the planners illbeseverely embarrassedby their line to nohere*

Dhe problem to +ocus on is not the error, but the IembarrassmentJ*

Errors are taken into account by our theory o+ minimiin) e12ectedcost* DheIembarrassmentJ causes a more +undamentalproblem* 2t prevents planners+rom adoptin) the ideal transmissionplannin) policy*

-lanners ill not undertake a proGect that can lead to such an embar=rassin) situation* 2nstead, they ill simply attempt to optimie 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 difference, but it does* Dhestrate)ic )eneration problem tells us that as soon as the )enerators realiethe actual plannin) policy is no lon)er the ideal plannin) policy, they ill


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no lon)er invest optimally +or that policy* 2nstead they ill invest optimally+or the ne policy, and that is an entirely different matter*Dransmissionplanners ill not build +or theoretically determined +uture

)eneration investments but ill instead build +or )eneration as determinedby )eneration investors* Dhis means that )eneration investors can manipu=late the transmission planners by their selection o+ )eneration investmentsites* Dhey ill learn hat policy the planners are usin) and )ame that

policy* Dhis is the strate)ic )eneration investment problem*

Strategic /anipulation of "ptial Transission Planning

/avin) )iven up on the ideal transmission plannin) policy, the questionbecomes, hat is the best realistic plannin) policyN Dhere are manychoices,but only a +e can be stated simply* ne o+ these, the Mero=con)estion

policy, has already been ruled out* Can e find a better oneN Dhe ne9t=bestpractical alternative ill be considered* Dhis specifies that the plannershould optimie transmission takin) )eneration and anticipated )enerationas )iven* Dhis ill be called the Ipractical plannin) policyJ*

;*e 2ractical 2lannin! 2olicy 6uild the transmission system that isoptimal )iven actual and anticipated )eneration*

2+ planners +ollo the practical plannin) policy, and )eneration decidesmistakenly or perversely to locate in a remote re)ion here +uel is cheapbuttransmission is so e9pensive that the combination is uneconomical, the

planners may ell have to build accommodatin) transmission*< $lthou)hthe result may not be optimal, it ill be +ar more sensible than buildin) tothe point o+ ero con)estion* Do analyse the plannerJs choice, consider thenet social benefit o+ a transmission and )eneration proGect*

Dhis proGect consists o+ remote )eneration hich Ie9portsJ poer over atransmission line to the central market* #et social benefit consists o+ >i? thenet benefit to consumers, >ii? )eneration profits and >iii? transmissionprofits* Do simpli+y the calculation, assume that the entire proGect is smallcompared ith the central market and that lon)=run supply in the centralmarket is very elastic* Dhis implies that the remote )eneration proGectill not chan)e the price paid by central consumers, and as a consequenceit ill be o+ no net benefit to them* Dhe proGect, i+ efficient, ill dis=

place central production ith cheaper remote production and delivery,but

the savin)s ill be entirely captured by the investors* $s a consequence netsocial benefit reduces to )eneration profits plus transmissionprofitsB#et Social 6enefit .eneration -rofits Dransmission -rofits*


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$ssume that remote )enerators are paid one price and central consumersare char)ed a hi)her price hich creates con)estion rent* From this, the costo+ the transmission investment can be subtracted to find transmission

profits, hich can be ne)ative or positiveB#et Social 6enefit .eneration -rofits >Con)estion ents 8

Line Costs?*

2n effect, remote )eneration is payin) the con)estion rents because thecentral 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)hcon)estion rents, then net social benefit equals )eneration profits, andprofitma9imiation by )enerators ill ma9imie net social benefit* 2n this casesuppliers 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 coverline costs +or the optimal line* Consequently i+ transmission costs are linear,the practical plannin) policy ill induce optimal )eneration investmentand the optimal transmission investment +or )eneration* Dhe combinedsystem 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 ero=con)estion policy, the ind +arm could locate as +aras it liked +rom the central market ith complete impunity* nder the prac=

tical plannin) policy, the planner ill build only the optimal transmissionline and the +urther +rom the central market that the ind +arm locates, thesmaller ill be that line* Dhe mar)inal cost per M3 o+ line capacityincreases rou)hly inproportion to the len)th o+ the line +or any line capa=city* Since the optimal line capacity occurs at the point here the mar)inalcost o+ line capacity equals the avera)e con)estion rent, the lon)er theoptimal line, the )reater the avera)e con)estion rent* Since the ind +armill pay these rents, it ill care ho lon) the line is*

Dhis is )ood nes* Dhe practical plannin) policy should not only buildmore economic lines +or e9istin) )eneration, but also induce the e9istenceo+ a more efficient spatial distribution o+ )eneration* Dhe combined savin)should be si)nificant and perhaps enormous* 6ut this does not imply thatthe induced )eneration investment ill be optimal under the practical plan=nin)policy*

Suppose the cost o+ transmission is c $, hich implies that +or anoptimal line, con)estion rent is e9actly hal+ the total cost o+ the line* Dheind=+arm investors ill realie that they must pay only hal+ the cost o+the line since, under the e9ampleJs assumptions, the only transmission costthey pay is the


25/48

con)estion rent* 3hen they differentiate profit ith respect to distance, 1,+rom the central market in order to optimie their location, their value +orthe dC

R7d1 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 aline that is optimal +or )eneration located too +ar aay, but the result illbe a combined )eneration=transmission proGect that is suboptimal*

Dhe obvious remedy +or this problem is to char)e )eneration thedifference beteen the con)estion rent and the cost o+ the line* Dhis impliesa char)e that varies by location and some measure o+ a )eneratorJs sie,butthat is quite different +rom a con)estion char)e* Dhe need +or such char)eshas lon) been reco)nied >6runekree+t et al*, &''


26/48

Sto+t,144@K 6orenstein et al*, &'''?, and second it provides reliability*.eneration market poer is aparticularly knotty problem because ener)ysuppliers are knon to lobby )overnment bodies in an attempt to blocktransmission investment that is not in their interest* $ny attempt toreduce market poer ith transmis= sion is likely to be the tar)et o+supplier lobbyin)*

2n spite o+ these difficulties, transmission investment is not alays asdifficult to finance as many assume* +ten con)estion rents are vieed asthe sole source o+ remuneration to merchant transmission* 2n +act, linesmay be built ithout any assumption o+ con)estion income* 2+ there is acheap but remote area +or )eneration investment, the suppliers that locatethere may build lines simply to brin) their poer to market* Dhey ill stillhave +ree=rider problems and the like, but they ill be motivated byotherthan +uture income +rom con)estion rents* Similarly a city may find local

supply too e9pensive and may build transmission out to the lar)er netorksimply to access cheaper poer 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 +orbuild=in) lines, ri)hts to ne lines should be )iven to investors to encoura)e suchinvestment and internalie the lineJs benefits to the e9tent possible*Dransmission ri)hts can protect an investor +rom con)estion cost that

ould otherise have been paid i+ the investor used the line and can provideincome to the e9tent others use it hen it is con)ested* $nother benefit o+transmission ri)hts is to cause ne)ative e9ternalities to be internalied*6e+ore turnin) to the di

ffi

culties o+ merchant investment, it is orthhileunderstandin) ho transmission ri)hts should be )ranted in return +orinvestment and hat use+ul role they canplay*


27/48

Transission +ights

6ecause alternatin) current >$C? transmission lines are so thorou)hly inte=)rated ith the poer )rid, their oners )enerally cannot be )ivenphysicalcontrol or the ri)ht to char)e anyone ho uses the line* For e9ample, almostany poer flo +rom one point to another on a poer system causes somepoer to flo on most transmission lines in the )rid, althou)h the amountthat flos on remote lines is too small to matter* $C poer lines are insomeays like a set o+ connected ater pipes ithout valves beteen them*-ushin) ater +rom one point to another affects the flo in almost everypipe*6ecause o+ such physical comple9ities, the standard proposal is to reard theinvestor in a transmission line ith a set o+ financial ri)hts, not physicalri)hts*

Dhe standard financial transmission ri)ht is a con)estion revenue ri)ht>C? hich is defined by a quantity, =, source and sink, A and %, and a

set o+ time intervals, ;* $t any point in time durin) ;, the C pays >P68P$?=, hich is the con)estion price +rom A to % times the me)aatt quan=tity o+ the ri)ht* Dhe payment has nothin) to do ith actual poer flosassociated ith the oner o+ the ri)ht*

$lthou)h Cs can, in principle, be privately issued, they are )enerallyissued by the 2S and that ill be assumed throu)hout this discussion*Consequently, at any point in time, there is a ell=defined set o+ Cs,R,

that have been issued* $n importantproperty o+ R is its +easibility, hich isdefined as +ollos* Correspondin) to every C there is an ima)inarypoer flo o+ = M3 +rom A to %, durin) time intervals ;* Dhis ima)inarypoer flo has nothin) to do ith actual flos on the )rid* Since every Cin this set corresponds to an ima)inary poer flo, e define R to be a+easible set o+ ri)hts i+ the correspondin) set o+ ima)inary poer floscould takeplaceon the system ithout violatin) any reliability constraint* Dhis has nothin)to do ith load or )eneration and concerns only the transmission system*

Dhe +olloin) procedure can be used, at least in principle, to reardinvestors in transmission up)rades* First, sell a set o+ Cs, in an auctionthat does not ithhold any +easible C* Dhis should leave no valuableC unallocated* 3hen a transmission up)rade is completed the systemshould be able to accommodate more poer flo reliably, and thisshould

e9pand the +easible set o+ Cs* Dhe investor is alloed to claim any set o+Cs hich, combined ith the e9istin) set, +orms a +easible set in theup)raded system* Dhis allos the investor a certain amount o+ choice andit accounts, to some e9tent, +or positive e9ternal affects o+ the up)rade*

Dhere is one more rule* 2+ the Iup)radeJ has actually reduced the +easible seto+ Cs, the investor must take counter=flo Cs such that the ne allo=cated set is +easible* Dhese ill have ne)ative financial value and illprop=erly discoura)e any system don)rades, provided that the initial set o+


28/48

Cs matched the actual flos on the system >6ushnell and Sto+t, 144(and 144@?* ni+yin) these to rules, the reard +or a modification o+ thetransmission system is thisB

Feasible CRR allocation rule for rewardin! transmission in'estment Dhemodifier o+ a transmission system must take +rom the 2S a set o+ Cssuch that to)ether ith the pre=e9istin) Cs the ne complete set is a+easible set on the modified system*

Dhis approach to reardin) investment has several advanta)es* First, i+ thepre=e9istin) set o+ Cs matches the flos on the system, it makes itunprofitable to dama)e the system* Second, it )ives the investor thema9imum possible con)estion rent hile treatin) others +airly* Dhird, +or+easible sets o+ ri)hts, the cost to the 2S o+ payin) Cs is never morethan the con)estion rent collected*0 n+ortunately there are also a numbero+ drabacks* First, the aarded Cs do not adequately compensate

investors* Second, to live up to its potential, the set o+ Cs that the 2Smakes available needs to be quite comple9* For e9ample, the investormay ant north8south ri)hts at some times and south8north ri)hts atothers* Dhird the results assume investors have no market poer in theener)y market*

"ther Styles of +ights

Dhere are a number o+ other styles o+ transmission ri)hts >/o)an, &''&K

.ribik et al*, &''


29/48

A 00 "# B

500 "# 500 "#

C

Fi!ure 67 02tion ri!*ts reduce t*e feasible set of ri!*ts

not e9ercised, the other ould correspond to a flo that ould load theA8% line to its limit*

#o, the poer flos used to compute the +easibility o+ a set o+ FDsare purely ima)inary, so the same +easibility rule could be used ith optionsas ith FD obli)ations* 6ut in this case, to 0,'''=M3 o2tions, one +romA to C and the other +rom C to A ould be +easible >because these flos

cancel?* Dhe option in the con)ested direction, +rom A to C, ould earn apayment o+ 0,''' M3 times the con)estion price hile the 2S ouldcollect only a con)estion payment o+, at most, ('' M3 +rom A to C* Sincethe counter=flo option ould not have a ne)ative value and ould pay the2S nothin), the 2S ould find itsel+ short o+ con)estion rent by


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-QM ebsite states that IFinancial Dransmission i)hts >FDs? Tare pro=videdU to assist market participants in hed)in) price risk hen deliverin)ener)y on the )rid* * * * Dhe FDs 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 poer is another area o+ concern ith transmission ri)hts>Qosko and Dirole, &'''?* Dhis also is not closely related to transmissioninvestment* 2+ an ener)y supplier has market poer in a load pocket, it canenhance its poer by purchasin) transmission ri)hts into the pocket* Dheseri)hts ill pay more hen it raises the local price o+ ener)y, hich makesits e9ercise o+ market poer more

profitable*Do date, the main use o+ financial transmission ri)hts has been as a sub=

stitute +or prior ri)hts held by transmission oners* Dhis has been quiteuse+ul because o+ the compatibilitybeteen Cs and nodal pricin)* Dhissubstitution and the more )eneral use o+ transmission ri)hts has also pro=vided a use+ul hed)in) mechanism +or nodal price differences, that is, con=)estion rents* Dhe value o+ Cs in this re)ard is still not elldocumented,

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, andat least-QM and #P2S have rules in place to this effect, there does not seem tobe any documented instance o+ Cs playin) a si)nificant role in any mer=chant transmission proGect*

The Parado- of Transission +ights

Dhe appeal o+ reardin) transmission investment ith Cs comes inpart+rom their properties in an idealied orld o+ per+ect competition* 2n this

economic model, mar)inal investments are alays possible and their cost islinear* Consequently a line may be up)raded by one me)aatt +or 171'' thecost o+ a 1'' me)aatt up)rade* Moreover, any investor can up)rade anylineK there is no onership o+ the transmission path* Dhis brin)s per+ectcompetition to each line in the system* 2n such a system the con)estion rentthat ould be earned by a mar)inal up)rade o+ a transmissionpath oulde9actly equal the value o+ the up)rade in reducin) the redispatch costcaused by con)estion* For e9ample, i+ a line is con)ested +or 1,''' hours

per year ith a price differential o+ 1'7M3h, then a 1 k3 >171,''' o+ a

M3? up)rade o+ the line ould save 1' 171,''' 1,''', or 1' per yearin redispatch cost by alloin) cheaper )eneration to substitute +or moree9pensive )eneration* Similarly, i+ the investor is )ranted a C +or 17k3in the direction o+ the con)estion, the investor ill earn 1' per year,e9actly hat the line is orth*


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2nvestment on every path ill proceed as lon) as the mar)inal investmentcosts less than the con)estion rent earned by that investment* 6ecause thisequals 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 lineneeds a 0'=M3 e9pansion because o+ a ne load* Some investor may build

:' M3 o+ the e9pansion, but at that point +urther investment may becomeunprofitablebecause it loers the con)estion rent on the :' M3 o+ trans=mission ri)hts received +or the initial investment* 2n the real orld thisould most likely stop investment be+ore the optimal transmission capac=ity is achieved, but in the idealied orld o+ per+ect competition, someother investor ill continue the investment, perhaps +or another 1' M3*Dhen as this investorJs stake in hi)h con)estion rents discoura)es +urtherinvestment, yet another investor ill take over the proGect* 2n this ayevery last kiloatt o+ economic investment ill be made*

nder the heroic assumptions o+ per+ect competition, reardin) 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 realisticassumptions, hich include market poer, payin) investors more henthere is more con)estion on their line results in ithholdin) o+ investmentand 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* 2nthis 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 investmentincentive*

+eturns to Scale and ,Iupiness.

eturns to scale, as discussed above, means that optimal transmissioninvest= ments ill simply not )enerate enou)h con)estion rent to pay +orthemselves* bviously, this means that merchant investors ill build lessthan the socially optimal level o+ investment >Qosko, &'':K Qosko and

Dirole, &''


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$"#

30

4

Rent

-ump

%emand

Cost

&upply

2 -umps

"#'

Fi!ure 674 02timal in'estment in lum2 tec*nolo!y may be2referable

can ask the questionB ould merchant investors underinvest in linear lumpytechnolo)yN Fi)ure 5C? cable hich is likely to become con)ested in the comin)


33/48

+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 identicalcable ill soon be added* Dhis one ill not be con)ested +or perhapsanother &' years* Even hen a lumpy transmission investment can e9pect+ull recovery o+ its costs +rom con)estion rents over the lon) run, the costrecovery may ell not be)in +or years and ill be very slo hen itstarts* 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)e5C lines or aluminum8irconium ires, comes on the market be+ore hi)hlevels o+ con)estion kick inN 3hat i+ load )roth is sloer thananticipatedN 3hat i+ )as pipelines are built to +uel ne )eneration thatcompetes ithpoer imported on the transmission line >6arthold, &'':?N

Dhis investorJs payment stream does not mirror the stream o+ socialbenefit hich results +rom the elimination o+, or reduction in, previous con=)estion rents* 6ecause that benefit stream starts out at the rental cost o+ theline, it is +ar less risky than the stream o+ con)estion rent* isk is costly, somerchant investment based on collectin) con)estion rents +rom Csissued in return +or the investment ill be much more costly than a sociallysponsored investment in the same proGect* Lo=risk investin) is cheaperthan hi)h=risk investin)*

$ simple e9ample may help e9plain the relationshipbeteen the socialbenefit stream and the con)estion rent stream on a lumpy transmissioninvestment* Suppose load in a load pocket takes on values beteen R and

R &'' M3 ith a uni+orm probability distribution* Suppose the pricedifference beteen supply +rom the load pocket and e9ternal supply is&'7M3h* Suppose additional transmission costs 07M3h and comes in1''=M3 lumps* 3hen should transmissionbebuiltN

nly hen the present line is con)ested ould a ne line add value*3hen the line is con)ested hal+ the time, as shon in Fi)ure


34/48

R V&'' se o+ ne line

E9istin) line

R

Load duration 1

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

the line ill earn 07M3h, e9actly enou)h to cover its cost* >Dhis e9ampleassumes a ero discount rate*? $t least in this case o+ lumpy investment,optimal investin) ill be rearded ith e9actly the ri)ht level o+ con)estionrents*

#ote the differencebeteen the social benefit +rom a transmission up)radehich starts out coverin) the rental cost o+ the line on day one and the streamo+ con)estion rents hich flo to the merchant investor* Dhese start out atero and only reach the break=even point hal+ ay to the point in time henthe ne9t investment ill be made and rent ill a)ain drop to ero* $lsonotethat, as shon in Fi)ure a declinin)mar)inal cost curve? underpay optimal investin)* Dhe main problem ithlumpy investments is that they pay off merchant investors very late,hich

makes them e9tremely risky +or a merchant investor even thou)h risk insocial benefit 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 contemplated it is o+tennoted that many ill benefit +rom such a proGect in the initial years but allill attempt to avoid payin) +or it* $s soon as the line is completed certain


35/48

&'7M3h

Social bene+it

0 Costo+ line

Con)estion ent

time

Fi!ure 67B In'estors s*ould not ca2ture full social benefi

t

loads ill find their prices reduced and certain suppliers ill find they cansell at a hi)her price* 6oth ill ant the line to be built, but all ill antothers to pay +or it* Fi)ure


36/48

Dhe principal ar)ument +or efficiency in such a market is that suppliersith market poer still minimie costs, )iven their output* 6ut this ar)u=ment also holds +or suppliers ho do not decide hat transmission isneeded but simply respond to an auction held by the system operator +orthe provision o+ certain transmission capacity* ntil some means can be+ound o+ tailorin) the e9ercise o+ market poer to provide the ri)ht level o+fi9ed=cost recovery only on efficient transmission investments, the ar)u=ment +or the deliberate introduction o+ market poer as a method o+ induc=in) investment is eak to non=e9istent*

/i-ing Planned and /erchant Transission

Dhe possibility o+ planned transmission both discoura)es and threatensmerchant transmission* 6e+ore a merchant line is built, potential sub=scribers to the proGect ould pre+er to induce the planners to build the lineand 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 useo+ the line* Essentially, this e9acerbates the +ree=rider problem*

nce a merchant line has been built, those ho have not pre=paid +or itsuse ill still ish to encoura)e the planners to build a competin) line, asactually happened in $ustralia >Firecone, &'':K Littlechild, &''


37/48

$nother proposal +or separation as made several years a)o in theconte9t o+ the $lberta market >Sto+t, &''&?* Dhat market, to a )reatere9tent than most, +ails to send adequate locational si)nals +or )enera=tion investment and, like all poer markets, lacks proper real=timedemand elasticity* Consequently, transmission investment is occasionallyrequired +or reliability purposes* 2t as proposed that the planners buildonly +or reliability, and that hen such a proGect is undertaken,merchant invest= ment be alloed to e9pand the proGect +or theincremental cost o+ thee9pansion, thus avoidin) si)nificant fi9ed costs* Do +urther+acilitatemerchant investment, it asproposed that the transmission administrator>planner? also +acilitates Goint investments by Goinin) merchant proGectsunder certain circumstances hen lumpiness is a problem* Dhe transmis=sion administrator ould buy a part o+ the line and keep it out o+ use untila ne party decided to purchase it* Dhisproposal as not vieed 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 theadvanta)e o+ not dependin) on or blessin) the e9ercise o+ market poer*

0* -EFM$#CE=6$SE5 E.L$D2# FD$#SM2SS2# M#-L2ES >D$#SCS?

Dhe plannin) process provides non=directive and )enerally eak incentives*-lanners kno that i+ they do a demonstrably poor Gob, they may findthemselves out o+ ork* Dhis provides an incentive and most en)ineers areactually 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 theplannin) approach lacks )ood incentives* /oever, these incentivesmay

differ +rom a pure incentive to minimie the total cost o+ delivered poerand 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 determinemonetary reards +or minimiin) total cost* Dhese reards cannot easily

be applied to individuals, so the standard approach is to apply them to theprofits o+ a re)ulated monopoly, a transco*

$ny re)ulation o+ a monopoly provides financial incentives, but o+tenthese have not been e9plicitly desi)ned or even considered* Dhe incentives

o+ cost o+ service re)ulation are usually poorly thou)ht out and derivemainly +rom unintentional la)s in rate settin) and the subGective applica=tion o+ rules such as the requirement that investments must be Iused anduse+ulJ* 3hen financial incentives are e9plicitly desi)ned, the re)ulation iscalled Iper+ormance=based re)ulationJ>-6?, or Iincentive re)ulationJ*


38/48

A Direct Approach to P%+ for Transission

Investent

2+ it is assumed that poer is available to all customers at the competitiveprice, then the obGective o+ transmission investment is the minimiation o+the total cost o+ delivered poer* 3ithout the assumption o+ availability,cost could be minimied by ma9imiin) blackouts, and in the limit,deliverin) nopoer at all* 6ecause o+ occasional blackouts >load=sheddin)events?, the cost=minimiation +rameork must be maintained byassi)nin) a cost toIunserved loadJ* $ssumin) that this assi)nment o+ cost can be accomplished,the )oal o+ transmission investment is total cost minimiation*

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 fi9ed but )enerous sum, R, per me)aatt o+ delivered poer lessthe cost o+ con)estion >CE, the redispatch cost? and less the cost o+

unserved >lost? load, CLL* 2n most poer systems, 1'7M3 hour o+ deliv=ered poer ould be more than sufficient +or R*4 Dhe transcoJs profitsould then beB

-rofit R 8 CE8 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 notkeep the con)estion rent* 2+ the transco can reduce the sum o+ CE and CLL

by more than 1 by investin) and thereby raisin) C; by 1, it ill find itprofitable to do so and this ill be beneficial to society* /ence this incent=ive mechanism ali)ns the transcoJs incentives ith social el+are* $nyreduction in CE CLL C; increases the social surplus by the sameamount, and this amount )oes into the pocket o+ the transco*

#ote that this incentive scheme properly reards IeffortJ hich has anon=monetary cost to the transco and is consequently not observable by there)ulator* 2+ the transco can increase its monetaryprofit, as defined above,by 1', but only by e9pendin) 4 orth o+ unobservable effort, it illpayit to do so, as it should, since this is socially beneficial* $s ill be seenshortly, this property is shared only by hat are called Ihi)h=poeredJincentive mechanisms*

Dhis scheme presents three difficulties, measurin) CE and CLL, andsettin) R* Con)estion costs, CE, are the difference beteen the actual pro=duction cost o+ ener)y and the loer cost that could be achieved ithoutany transmission limits* Dhis difference can be +airly ell appro9imated inany system ith centralied biddin) and nodal pricin)* ccasionally theremay be some difficulty ith knoin) ho much certain )enerators could


39/48

produce ere they not constrainedby the transmission system, but mostsystems have on record a realistic estimate o+ each )eneratorJs outputcapacity 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 +orsuch an estimate is probably a +actor o+ three* 2n other ords, i+ it is esti=mated to be 10,'''7M3h, there is probably only a (A per cent chance>rou)hly? that the true value is beteen 0,'''7M3h and


40/48

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 thepoer o+ the incentive mechanism* Many types o+ -6 are +orms o+ price=cap re)ulation includin) the mechanism Gust described, thou)h it is a rathernon=standard price=cap incentive* 2n that scheme, R can be thou)ht o+ asthe fi9ed part o+ a to=part transmission price, the other part bein) thecon=)estion price* Dhere are to standard ays o+ reducin) the poer o+ a

price=cap incentive* First, the cap, R in this case, can be resetperiodically* Dhe more +requently it is reset, the loer the poer o+ theincentive itpro=vides* Second, profits under the mechanism can be shared beteen themonopolist and the consumers* Dhe smaller the share kept by the mono=

polist, the loer the poer o+ the incentive* 2n both cases, loer poer illcorrespond to loer in+ormation rents paid to the transco*

Consider the periodic resettin) o+ the price cap* 3hen the price cap isreset, the obGective is to provide the monopolist ith a certain alloed rateo+ 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+ thetranscoJs

costs >C;? ill be correctly anticipated and covered by the alloed 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)erevenues* Dhese intra=period chan)es in e9penditure >C;? and revenue >R8CE8 CLL? result in profit deviations +rom the tar)eted alloed rate o+ returnand this provides some incentives +or both cost minimiation and beneficialinvestment* Dhe lon)er the period beteen rate cases, the )reater the pro=

portion o+ e9penditures +or hich the price=cap mechanism can provide anincentive* $t one e9treme lies pure price=cap re)ulation and at the other

pure rate=o+=return re)ulation* 2n beteen e find 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) toachieve a loer=poered incentive and loer in+ormation rents*2nvestment costs are o+ten incurred over a much shorter period o+time than the

benefits +rom the investment* /ence the reset period may be lon) relative tocosts but short relative to benefits* 2n this case a loer proportion o+ coststhan revenues ill be captured in the resettin) process* Dhis ill tend to dis=coura)e efficient investment* Dhis is related to the ell=knon incentive

problems that occur shortly be+ore a rate case* $t this time, it becomesadvanta)eous to make costs appear hi)h and revenues appear lo* $lso the

incentive +or investment is diminished shortly be+ore a rate case, becausethe re)ulator may vie such e9penditures as already paid +or*-rofit sharin) avoids these timin) issue because it does not make peri=odic adGustments,but instead shares profit in some fi9edproportion on a


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continuous basis* Economic profit, +or e9ample R 8 CE 8 CLL 8 C;,accounts +or a normal rate o+ return on investment >in C;?, so profitsharin) can never prevent a supplier +rom achievin) a normal rate o+return, it ill only brin) it closer to that level*1' 2+ unshared profit, , is

ma9imied by a certain investment strate)y, then hal+ o+ the unsharedprofit, 7&, ill also be ma9imied by e9actly the same investment strate)y*Consequently, i+ there ere no in+ormation problem ith computin) ,profit sharin) ould leave the transcoJs behavior unchan)ed* Dhis ouldbe ideal* Dhe e9cess ealth trans+erred by the hi)h profits o+ pure price=capre)ulation could be reduced by any amount simply by settin) the sharin)parameter appropriately and this ould cause no loss o+ efficiency* 6utthere are in+ormationproblems, and the +undamental trade=off o+ re)ula=tion ensures that, i+ the poer o+ the incentive is )reatly reduced, efficiencyill suffer* Dhat is true hether the incentiveJspoer is reduced throu)h

periodic resettin) o+ the cap, as previously described, or throu)h continu=ous profit sharin), but it is easier to e9plain the effect in the continuousprofit=sharin) conte9t*Do )limpse the contradiction inherent in i)norin) the in+ormationproblem, consider, the case in hich the dollar=valued economic profit, ,

divided by the invested capital needs to equal 0' per cent +or the initialdetermination o+ R in order to avoid any si)nificant probability o+ bank=

ruptcy* 2+ the normal rate o+ return on equity is 10 per cent, then themonopolist ill start out makin) a (0 per cent rate o+ return on equity*11

Do reduce this, consider aprofit=sharin) ratio o+ 1 per cent +or the transcoand 44 per cent +or load* Dhis reduces to 71'' and brin)s the initial

return on equity to 10*0 per cent* 2+ the transco raises to 1'' per cent itha superb effort, it ill receive 1( on equity and i+ it per+orms terribly,lettin) +all to ' per cent, it ill still receive 10 per cent on its equity* Eventhou)h it pre+ers 1( to 10 per cent, this limited reard is not likely toinduce theeffort level required to raise divided by invested capital +rom ' per cent

by 1'' per cent*Dhe important point about effort is that it is a real cost that is not

included in C; because it is not monetied* 2t is a cost that does not appearon the books* 2t ill, o+ course, affect costs that do appear on the books*Effort ill reduce these costs +or the same level o+ transmission per+or=mance or increase per+ormance +or the same level o+ monetary cost* Lacko+ effort raises monetary cost relative to per+ormance* Lack o+ effort, likeeffort, can take many +orms* 2t can take the +orm o+ I)old=platin)J officesand equipment or Ishirkin)J by mana)ement and orkers* 2nefficiente9penditures 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+ effortK +or e9ample, the transco can subcontract a Gob to someone


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ho pays a kickback to someone at the transco* $s the reards +or effort>)ood behavior? +all, all types o+ unanted behavior ill increase*

-rofit sharin) on a 0'70' basis takes aay hal+ o+ , hich means it takesaay hal+ o+ revenues minus costs* 2+ effort had a monetary value, then a1' effort that produced an 11 revenue ould increase by 1 be+oreprofit sharin) and by only '*0' a+ter profit sharin)* 2n either case the effortis orthhile and ill be induced* 6ut because the effort )oes unobserved,its cost is not shared by the profit=sharin) mechanism, and so the result o+the 1' effort is an a+ter=sharin) revenue o+ 0*0' hich +ails to compen=sate +or the 1' effort* Consequently, ith 0'70' profit sharin) such effortsill not be undertaken* $ 1' effort that produced a :' increase inrevenue ould still pay off even a+ter profit sharin) alloed the transco tokeep only10 o+ the revenue* So profit sharin) does not eliminate the incentive toprovide unmeasured but costly effort, it only reduces it* $s the share o+profits kept by the transco decreases toards ero, the incentive to e9pendeffort decreases toards non=e9istent* Dhis e9plains hy profit sharin) islimited as a means to control in+ormation rents*

Difficultieswith P%+ for Transcos

Dhe price=cap mechanism Gust described is most likely impractical becauseit suffers +rom at least to severe difficulties* First, Gust as ith merchanttransmission the transcoJs investments ill pay off ith very lon) la) timesand 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 +orseveral more there ill be little or no return on the investment and finally,1' or 10 years a+ter the start o+ the proGect, si)nificant payback illbe)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 lessbecausethe societal payback starts immediately upon completion o+ the line at arate equal to the rental cost o+ the line*

Second, transmission investments are ti)htly linked to reliability >Creet al*, &''


43/48

Dhe motivation +or up)radin) a transmission path, hich typicallyinvolves several lines, is con)estion on that path and the con)estion cost,C

E, that it causes* 6ut this cost can be reduced in to ays, first by a

physical up)rade, and second by re=ratin) the path to a hi)her capacity*Dhesecond approach is +ar cheaper, in +act is almost +ree, but it decreasesreliability* n+ortunately path ratin)s are not easily audited as they aresomehat controversial even amon) en)ineers* Dhis is because they are not

based primarily on hard data, such as the temperature at hich a iremelts* 2nstead, ratin)s must couple hard data ith somehat subGectivedata, includin) probabilities o+ contin)encies such as line and )eneratorouta)es*1: $ny poer+ul incentive to up)rade lines ill also be apoer+ul

incentive to cut corners on contin)ency ratin)s* Consequently i+ there arestron) incentives to up)rade lines, there must also be heavy penalties +orcuttin) corners on path ratin)s* Since path ratin)s are too difficult +orre)ul=ators to monitor, these penalties must instead be applied directly toblack=outs hich are very costly but occur very rarely* 2mposin) the cost o+ lostload, CLL, is such a penalty, but as e9plained, it introduces severe risks andould be e9tremely controversial* Dhe dan)er o+ de)radin) reliabilityappears to create severe difficulties +or desi)nin) a use+ul -6 incentive +or

up)radin) lines*$ third difficulty, less severe than the first to, +aced by any transco pro=

posal is the +undamentalplannin) problem described above* $ny realistictransco incentive ill induce the transco to invest in the lines that areoptimal +or e9istin) )eneration, not +or optimal )eneration* Dhe conse=quence ill be that )eneration investors ill build )eneration based on thetranscoJs response* For this circularity to produce the efficient outcome,thechar)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+ -6 alternatives +or transcos have been su))ested, includ=in) some by o)elsan) based on the price=cap tradition, and hich arerevieed by osellWn >&'':? and o)elsan) >&''


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(* C#CLS2#

Currently, holesale poer markets are under)oin) a slo and inefficient

development process marked by such events as the Cali+ornia meltdon,the overbuildin) o+ )as=fired )eneration in lar)e parts o+ the eastern nitedStates, the lar)est blackout in S history, and the complete redesi)n o+ the6ritish market* 2n particular the )eneration investment problem seems toremain +ar +rom solved, thou)h some reasonable incentive mechanismsseem to be on the drain) board*

Moreover, it should be reco)nied that transmission investment iscrucial to the +unctionin) o+ the ne ener)y markets* Dhe less con)estion,the less market poer in holesale ener)y markets >Sto+t, 144@K

6orenstein et al*,&'''K .ilbert, et al*, &''&?* For e9ample, San Francisco and #e Pork bothsuffer +rom serious market poer because both have limited transmissionand must rely +or si)nificant portions o+ their ener)y on local suppliers* Dhemore transmission into these cities, the more competition in the holesaleener)y market* Moreover, in every market in the nited States, there arenumerous e9amples o+ )eneration units under Ire)ulatory must runJ con=tracts* Dhese )ive the market administrator the ri)ht to require the plant torun and in return provide re)ulatory payments hich are o+ten substantial*Such contracts e9ist lar)ely here these )enerators have e9treme market

poer 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 asmall amount and thereby reduce market poer belo the level that ould

be +ound under an optimied netork* Dhis is because, at optimal invest=ment, the derivative o+ total system cost ith respect to increased capacityis ero* Dhat is the first=order condition +oroptimality*

#either a merchant approach nor a -6 approach is conducive to alle=

viatin) holesale market poer problems by overbuildin) the netork*6oth have biases toards underinvestment, and both are likely to beerraticin their behavior durin) the decades it ill take to tame the likely flas intheir desi)ns* ate=o+=return re)ulation is more adaptable* -rovidedthe

re)ulator declares in advance that a line ill be considered Iused=and=use+ulJ, it should not be difficult to )et the transco to build it*#either a merchant approach nor a transco7-6 approach has yetbeen

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 illrequire a level o+ understandin) and subtlety that is not yet apparentamon) re)u=lators, at least in the nited States* .iven these difficulties and the poor


45/48

record o+ the ener)y market dere)ulationprocess, it appears to be too earlyto be)in any policy initiatives based on either o+ these approaches* 3ithtransmission investment costs amountin) to only :8A per cent o+ the retailcosts >Qosko and Dirole, &''&?, it is better to rely on a relatively sa+eapproach to transmission investment, even thou)h it is a bit less efficientthan 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 alloed and re)ulated only li)htly >6runekree+t,

&''le)itimate reasons?, but also to e9ercise monopsonypoera)ainst )eneration in the hi)h=cost re)ions* For years to come, transmission

investment appears to be the knottiest problem in the dere)ulationprocess*

#DES

1* eturns to scale imply that transmission investment costs are non=conve9* Lumpinessre+ers to havin) to buy an inte)er number o+ transmission lines selected +rom a small seto+ available capacities, but it is better understood as simply re+errin) to a cost +unctionith a fluctuatin) slope*

&* Dhis is not as bad as it sounds, because ith )roth, almost any line that saves more

thanits 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+ poer, so it should be determined simultaneously,but this complication illbei)nored*


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a re)ion o+ the S +rom Michi)an to 3ashin)ton 5C, to !entucky* 2t includes144@? addresses reliability in a +ranchise transco conte9t*1:* Stability ratin)s, thou)h more firmly based in physics, also involve subGective Gud)ments

as to ho close is too close to the point o+ instability*

EFEE#CES6arthold, L** >&'':?, I3hither E/N 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 effects o+ transmission

capacity in a dere)ulated electricity industryJ,"ournal ofEconomics, 34 >&?, &4&''


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.ribik, -aul *, 5* Shirmohammadi, Q*S* .raves and Q*.* !ritikson >&''


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.LSS$P $#5 SPM6LS

CE

Con)estion cost* E9cess cost o+ ener)y +rom dispatchin) out o+ meritorder because o+ transmission constraints*CR Con)estion rent* evenue +rom ener)y inGections at nodal prices lessrevenue +rom ener)y ithdraals 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)ulatedtransco* 2ncludes the annualied costs o+ capital and maintenance*C Con)estion revenue ri)ht hich pays >P6 D P$? =, durin) time

periods ;*FD -QMJs financial transmission ri)ht* Dhe obli)ation variety is the

same as a C e9cept that the revenues are adGusted +or any revenuesurplus or insufficiency in total con)estion rents* Dhe option variety omitsthe ne)ative payments possible ith an obli)ation*+ Dhe transmission )rid*2S ne o+ several Iindependent system operatorsJ that run markets inthe S* Dhey have no sitched status to become Ds, >re)ional trans=mission or)aniations? in keepin) ith the Federal Ener)y Ce)ulatoryCommissionJschan)in) terminolo)y*? Dhe capacity in M3 o+ a transmission line*#P2S Dhe #e Pork 2ndependent System perator*P$ ,P6 #odal ener)y prices at nodes A and %*PL -rice in the local re)ion-QM Dhe 2S no covers Michi)an, -ennsylvania, 3ashin)ton 5C,Dennessee and more, ith

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Grupo 5 Chapter 4 - Problems of Transmission Investment in a Deregulated Power Market (42)

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