Merchant and regulated transmission: theory, evidence and policy

Stephen Littlechild

9 Feb 2012

Abstract

Economists acknowledge the problems of regulated transmission buthave different views on the likely efficiency of merchant transmission. This paper firstexamines the evidence on alleged market failure and regulatory failure as experienced in practice in Australia, where there have been both regulated and merchant interconnectors. Merchant transmissionhas generally not exhibited the standard examples of market failure but regulated transmission generally has exhibited the standard examples of regulatory failure. Imperfect information – more specifically, in the form of lack of coordination – has often been a challenge whatever the approach. Experience in Argentina suggests that transactions costs are not a barrier to negotiation and efficient investment determined by users. Policy shouldseek to improve the regulatory framework and to remove barriers toprivate initiatives. An important role for regulation is to facilitate coordination between potential providers and users of transmission lines.

  1. Introduction

Electricity transmission used to be classified as a natural monopoly thatneeded to be regulated. Merchant transmission challenged this. Throughout its brief but eventful life, merchant transmission has been and continues to be controversial, in both theory and practice. Regulators internationally are now considering what role it should play in the provision of additional transmission, and what modifications to the regulatory framework are thereby indicated. But economic analysis is perhaps not keeping pace with these practical developments.

Traditionally, transmission expansions were proposed by the incumbent vertically-integrated utility, approved by the regulatory body and financed by an addition to the rate base: so-called regulated transmission. With the advent of electricity competition, explorations of optimal transmission pricing policy led to financial transmission rights and the possibility of competitive provision of transmission, financed by locational price differentials: so-called merchant transmission. (Hogan 1992, Chao and Peck 1996, Bushnell and Stoft 1996, 1997) Suggestions were made for the regulation of transmission companies. (Léautier 2000, 2001, Vogelsang 2001) However, changes in transmission technology were argued to shift the balance of advantage in favour of a market-based approach.(Rotger and Felder 2001) Hogan (1999, 2003) suggested that only ‘large and lumpy’ transmission investments should be regulated, with everything else left to the market.

Joskow and Tirole (2005) (henceforth J&T) argued that the conditions required for merchant transmission investment to be optimal were not likely to be met in practice. Problematic aspects included wholesale market power, lumpiness of investment, strategic behaviour and difficulties of coordination. Admittedly the ‘regulated Transco’ model had various inefficiencies in practice, but it was unlikely that policymakers could rely primarily on the merchant model. Joskow (2005) argued that merchant transmission might be a complement but not a substitute for regulated transmission, was likely to make only a very small contribution, and efforts to debate its role had been a distraction.

European economists entering the debate took a more pragmatic and eclectic stance. Brunekreeft et al (2005) suggested that different solutions might be appropriate in different circumstances. For example, merchant transmission would be more viablein the US, with nodal pricing and financial transmission rights, whereas zonal pricing in Europe and Australia would restrict merchant investment to interconnectors between adjacent markets, with remaining investment being carried out by a regulated Transco. (See alsoBrunekreeft 2005) Rious (2006) suggested that merchant investment would be efficient where economies of scale were small relative to the size of market, where DC transmission had a cost advantage over AC transmission, and where differential prices could expect to be maintained, as in New York but not Australia. Competition for the market, along lines suggested by Demsetz (1968), could be useful in radial but not meshed networks.

In 1998 two merchant interconnectors were proposed in Australia (DirectLink and Murraylink), which came into operation in 2000 and 2002, respectively. But both subsequently applied for transfer from merchant to regulated status,in Murraylink’s case just two weeks after it came into commercial operation. By 2006, both merchant interconnectors had become regulated interconnectors.

Léautier and Thelen (2009) surveyed 16 restructured jurisdictions. They suggested that merchant investment has played a very limited role so far because (1) upgrades to existing capacity are not candidates while new interconnectors face regulatory and environmental barriers, and (2) merchant investment is not financially viable since a higher return is required for the risk involved, and construction reduces the price differentials that are the basis of potential revenue.

At first sight thisstudy and the experience in Australia might appear to constitute fairly convincing empirical evidence that the sceptics about merchant transmission were right. However, some questions remain. The argument was that the scope for merchant transmission was limited, and/or that it was not efficient – but why would it be unprofitable? And even if merchant transmission is inefficient compared to some ideal, is it obvious that regulated transmission is better?

There is also another puzzle. The literature just cited might suggest that transmission investment would be either regulated or (to a smaller extent) merchant. However, in practice a significant amount of new transmission investment has involved what have been called ‘private initiatives’ (Joskow 2005 p. 23) or ‘non-traditional transmission development’ (Coxe and Meeus 2010). The latter use a two-by-two matrix to characterise transmission investment. Traditional regulated investment is incumbent-driven and tariff-financed, and is still the norm. But an increasing number of projects in the US and Europe are new entrant-driven, or contract-financed, or both.[1]

The pressures for transmission expansion and the option of merchant or private initiative investment are causing the Federal Energy Regulatory Commission (FERC) to reconsider itstraditional open accesstransmission policy. (FERC 2011a)EU regulators, too, faced with ineffective unbundling and insufficient new interconnectors, are allowing incumbent transcos exemption from EC rules on third party access in order to encourage investment. De Hauteclocque and Rious (2009) urge instead that dominant generators be allowed to make merchant investments, relying where necessary on the powers of the new Agency for the Cooperation of Energy Regulators (ACER) to address any competition concerns. Hogan et al (2010) proposea new regulatory mechanism aimed at combining the best properties of the merchant and incentive regulation approaches.

These developments suggest a third question: is it possible that regulated transmission has greater limitations, and that variants of merchant transmission (such as private initiatives and non-traditional developments) have fewer limitations, than were identified in the initial debate on regulated versus merchant transmission?

There seems to be common ground on the likely need for more transmission investment and the possibility that some form of merchant investment – if widely defined - could play a role somewhere. However, there is apparently little agreement among economists as to whether this could or should be a relatively small or large role, and what kinds of policies are best suited to delivering this. The analytic literatureis somewhat separate from the papers debating concrete issues of policy, and there is relatively little incorporation of empirical evidence into the theoretical papers.

The aim of this paper is to shed light on these issues by using a different approach from that adopted in the previous literature, andby using this approach to examine two sets of empirical evidence. Most of the analytic papers seek to characterise an optimal solutionand to establish whether merchant transmission involves a departure from this. However, many of the features that are problematic for merchant transmission present problems for regulated transmission too. There is an alternative ‘comparative institutions’ approach (Coase 1955, Demsetz 1969, Kahn 1979) which has recently been powerfully expounded by Joskow (2009, 2010). This accepts that market and regulated approaches are both imperfect, and tries to identify and compare the pros and cons of each approach. In this way the evidence of experience to date is more easily considered and evaluated, in order to inform a general policy stance.

The first part of the present paper applies this comparative institutions approach to experience with merchant and regulated transmission in Australia, where there is a direct comparison between the two types of interconnector. It seeks to identify how far the main market failures and regulatory failures, as predicted in theory, were experienced in practice.

One of the frequently alleged market failures isthat transactions costs constitute an obstacle to the market reaching an efficient outcome. Australian experience sheds little light on this. The second part of the paper therefore examines experience in Argentina, whose ‘beneficiaries pay’ approach to transmission expansion is not simple merchant transmission, but could arguably be placed in the ‘new entrant-driven tariff-financed’ category of non-traditional transmission development.

Section 2 identifies five potential imperfections of market transmission and seven potential imperfections of regulated transmission. Section 3 briefly describes the four merchant and regulated interconnectors in Australia. Section 4 assesses how far the merchant interconnectors were subject to market failure and Section 5 assesses how far the regulated interconnectors were subject to regulatory failure. Section 6 sets out the argument that market coordination is precluded by transactions costs, and examines the evidence from Argentina and (briefly) North America. Section 7 concludes.

  1. The potential imperfections of market and regulated transmission

The concept and main forms of market failure are well-known.J&T suggest various types of imperfection that they argue to be inconsistent with reaching an efficient outcomein the specific context of merchant transmission. Some of these imperfections apply also to regulated investment.For example, market power in the importing wholesale market can increase prices there and over-incentivise investment in transmission. But this is equally a problem for regulated transmission seeking to build the ‘efficient’ amount of transmission. In both cases, proponents of new transmission lines have to conjecture what factors have led to observed prices in the past andjudge how far these factors will continue to obtain in the future. There seems no reason to believe that regulated interconnectors are systematically better at analysing these factors than merchant interconnectors.[2]

The potential imperfections of merchant transmission that cause most concern seem to be the following:

1) lumpiness, leading to lower capacity and output because of the need to cover costs by locational differentials in prices;

2) market power associated with a transmission expansion, reflected in lower capacity and output, delayed investment and higher prices;

3) imperfect information, resulting in misjudgements about what, where and when to build transmission;

4) transactions costs, resulting in inability to address problems associated with coordination andthe aggregation of stakeholder preferences, negotiations between market participants,network deepening investments,gaming between interdependent entities and projects, and the separation of ownership and control;

5) other factors including long lead times and lack of forward markets and commitment, leading to difficulty of financing merchant interconnectors, lack of credibility vis a vis shorter projects, and regulatory uncertainty and opportunism.

J&T say that “In principle, a regulated Transco model can deal directly with issues associated with lumpy investment, market power in wholesale power markets, gaming behaviour of merchant investors and stochastic attributes of transmission capacity.” (p. 262)But they immediately note that whether it can do so in practice is another matter.[3]In a more general context, Joskow (2010) identifies five types of potential regulatory imperfection. We may combine these suggested regulatory failures as follows:

1) imperfect information - about the regulated firms and also about the customers to be protected - leading to misjudgements about when, where and how to build transmission;

2) bureaucratic costs andtime-consuming decision-making;

3) problems of multiple regulatory jurisdictions;

4) less incentive to efficient construction costs, and conservatism with respect to new technologies and new and better ways of regulating;

5) interest group capture;

6) political influence;

7) the possibility of inadequate resources to do the regulatory job well and consequent reliance on regulated firms.

How significant have these twelve potential imperfections beenin practice?

  1. Four regulated and merchant interconnectors in Australia[4],[5]

Electricity privatisation and competition began to develop in Australia during the 1990s, albeit on a somewhat piecemeal basis with varying enthusiasm in the different states. In 1996 a National Market Management Company (NEMMCO) was set up to be the short-term operator of the proposed National Electricity Market (NEM).

In 1997, the New South Wales (NSW) and Queensland governments announced a new regulated line between those two states, called QNI. This was anoverground alternating current (AC) interconnector over a distance of about 550 km with a design capacity of 1000 MW south to NSW and 750 MW north to Queensland.

In 1998 a new entrant TransEnergie Australia (a subsidiary of the transmission entity of the Canadian publicly-owned Hydro-Quebec) and its partner Country Energy (a state-owned corporation in NSW), proposed an unregulated (i.e. merchant) interconnector between the two states,called DirectLink. This was an underground high voltage direct current (HVDC) line, over a much shorter distance of 65 km, and with a much smaller capacity of 180 MW.

DirectLink began commercial operation in July 2000. QNI commenced commercial operation in February 2001.

Over a similar period, there were also discussions between NSW and South Australia (SA). In 1996, the respective state-owned electricity entities Transgrid and ETSA agreed to explore the feasibility of an interconnector between those states. In June 1998 NEMMCO decided thattheir proposed regulated interconnector called SANI did not pass the prescribed regulatory test. SA withdrew. On 29 October 1998TransGrid submitted a unilateral application for a revised regulatory interconnector called SNI.

On 28 April 1999 TransEnergie Australia announced its intention to build an HVDC merchantinterconnectorcalled Murraylink between Victoria and SA. It was shorter in length than SNI but along essentially the same route (the termini in Victoria and NSW being close together).

Murraylink (now jointly owned by TransEnergie and a Canadian private company SNC-Lavalin) opened for commercial operation on 4 October 2002. SNI did not go ahead.

  1. Potential failures of Australian merchant interconnectors

4.1 Lumpiness

Lumpiness does not seem to have been a factor limiting the size (or timing) of either merchant interconnector. Murraylink’s 220MW capacity was not significantly less than SNI’s 250MW. Directlink’s 180MW capacity wassignificantly smaller than QNI’s 1000/750MW. However, it was presumably constructed on the assumption that QNI would go ahead, rather than as a substitute, so it was actuallyonly a marginal increase intotal interconnector capacity. Both merchant interconnector capacities would be considered small compared to that of a new generation plant.

4.2 Market power

Did Murraylink have any market power? Did it delay investment, or restrict capacity or output, and consequently increase prices? For the most part, the answer to these questions seems to be No. As a new entrant, Murraylink had no interest in delaying investment to benefit incumbents. On the contrary, it deliberately incurred an extra cost to underground the line in order to avoid environmental objections and thereby speed up construction. And in general, a new interconnector will increase competitiveness in the market as a whole, rather than increase market power.

Three lines of argument and evidence as toMurraylink’s market power were put before the National Electricity Tribunal. 1) That it would have an 18% share of flexible supplies in SA - which it never did. 2) That there was a constraint on gas-fired generation in SA - which was soon disproved by new entry. 3) That a consultancy study (commissioned by the incumbent TransGrid)suggested that in the absence of a contract with users Murraylink would reduce its flow by an average of 15-16% - but the same study showed that if Murraylink were 75% contracted, which was its stated policy and consistent with the policies of merchant generators generally, the average reduction in flow would be negligible (about ½ % of its capacity).

In the event,Murraylink was not able to sign any contractsand during its first year of operation its overall load factor was only about 14%. This was lower than the 50% load factors of two regulated interconnectors in Australia (QNI and Heywood).This suggests that, compared to a regulated interconnector financed by other transmission revenues, Murraylink did restrict flow in an attempt to maintain adequate price differentials in order to cover its costs of construction and operation. However, it failed: it could not make enough revenue to cover its costs. There is certainly no evidence that Murraylink was able to restrict output sufficient to extract monopoly profit.

Murraylink’s low load factor probably reflectedthe very limited scope for profitable trade. It has been estimated that “such interconnectors require sustained Pool price differentials of $12 - $15/MWh even at full utilisation, to have a chance of earning a reasonable return on investment”[6]A 1997 study by London Economics had predicted a generation capacity shortage in SA and concluded that an interconnector between SA and NSW was economic. Over the four years from 1996/97 to 1999/2000 the differentials between the yearly average prices for SA and Victoriahad averaged $21 – sufficient to make the interconnector viable if it were operating at about two-thirds capacity utilisation and ignoring transmission losses. In 2000/01 the differential fell to $12, implying that Murraylink would only be viable if it were assumed to run at full capacity all the time, and again ignoring transmission losses.

In the event, however, many of the assumptions of the 1997 study, including about capacity shortage in SA, were not fulfilled. In 2001/02 the differential between SA and Victoria fell to under $1. It averaged only about $6 from 2001 to 2006 before reversing to -$6 in 2007.[7] Such differentials are far below what Murraylink would need to cover all its costs, even with operation at full utilisation and zero transmission losses.[8]Even if Murraylink could have been built without the additional cost of undergrounding, it would have had construction costs about double its prospective revenues.It is perhaps not surprising thatMurraylink applied for conversion to regulated status on 18 October 2002. Itwas accepted as a regulated interconnector on 9 October 2003.[9]