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Transmission pricing

Written by Thomas-Olivier Léautier

This FSR topic of the month explores governments’ intervention in four aspects of the power industry. The first two posts have pointed out the absence of strong justification for governments’ intervention in the generation segment of the power industry, and the damages these interventions create. By contrast, this post discusses how European governments could increase net surplus by intervening in transmission pricing. Sadly, they show little inclination to do so.

The transmission grid is the core of any power system. It improves economic efficiency and reliability. By connecting producers and consumers, the grid makes economic exchanges possible, hence increases the net surplus. By offering multiple paths for these exchanges, it lowers the probability of failure of (parts of) the system, hence increases expected net surplus.

Engineers, economists, and policy makers have long recognized the central role of the transmission grid. When the industry was restructured in the 1990s, stakeholders devoted significant attention to the grid, in particular transmission pricing. The issue differs from standard transportation pricing problems since transmission lines are sometimes congested (or constrained): when a line’s transfer capacity limit is reached, it is impossible to increase the power flowing on it.

After a few years of a technical – yet lively – debate, most observers agreed that the correct approach is – somehow surprisingly — not to price usage of the transmission grid, rather to let energy prices vary across locations and times, to reflect marginal losses and congestion costs. This approach, known as “nodal pricing”, has been adopted in all markets except Europe, where a variation known as “zonal pricing” has been implemented. In essence European power exchanges recognize the existence of transmission constraints between countries, but ignore constraints within each country. The task of managing within-country congestion is left to the national Transmission System Operators (TSOs).

“Zonal pricing” could work if within-country congestion was negligible. Alas, this is not the case today, and the situation is likely to worsen, as new Renewable Energy Sources (RES) are constantly added to the grid. Since Not In My Back Yard (NIMBY) considerations make massive expansion of the grid unlikely in the short-term, congestion, both between- and within-countries will increase over the next 10 years. A recent academic study[1] finds that the adoption of nodal pricing would reduce system variable costs (mainly fuel) from €0.8 – €2.0 billion depending on the penetration of wind power.

How do policy makers respond to this situation? The European Commission, through various arms, has been pushing for increased market integration. Imperfect as it is, “zonal pricing” is a significant improvement compared to previous practices. It is the result of a concerted and sustained effort to “couple” national markets, which deserves to be applauded.

However, the process appears to be stalling today. While the European Commission has launched a recent initiative for further integrate regional markets as a precursor to full market integration[2], few TSOs and market participants are enthusiastic supporters of nodal pricing, as this would require significant changes to their market making software and operations.

This situation looks like a standard case of market failure: nodal pricing increases net surplus, but imposes private costs on industry participants. Government intervention is legitimate, even required, to push the industry towards a more efficient market organization. However, most national governments refuse to entertain nodal prices, as these would recognize that the value of electric power is not uniform within each country. To maintain the fiction of equal prices throughout their country, they prefer to increase the cost to consumers by up to € 2.0 billions per year. A valuable opportunity for government intervention thus goes unfulfilled.

[1] Karsten Neuhoff et al., 2013. Renewable electric energy integration: Quantifying the value of design of markets for international transmission capacity, Energy Economics, 40, pp 760-772.

[2] https://www.entsoe.eu/Documents/Publications/Position papers and reports/entsoe_pp_regions_1604_web.pdf