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Introduction to the special issue “The regional integration of energy markets”
Energy Policy 85 (2015) 421–425
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Energy Policy journal homepage: www.elsevier.com/locate/enpol
Introduction to the special issue “The regional integration of energy markets”
The spatial organization of the electricity industry is key in the current policy-making debate in many parts of the world. This concern results from a combination of policy and technological considerations. Policy-wise, the drives towards market integration and towards increased penetration of renewable energy sources are possibly the two most prominent on-going industry transformations. Technology-wise, the transition to a decentralized regime is triggered by the introduction of combined-cycle gas turbines and further pushed by the development and diffusion of renewables. Motivated by the relevance of geography in shaping the regulatory approaches to the electricity industry, we have collected articles that deal with the regional integration of electricity markets and the related policy-making issues. After reviewing the main motivations behind market integration policies, in this short essay we discuss some critical issues in policy design, involving spatial patterns in electricity production, the exercise of market power across transmission bottlenecks, and the associated distributional issues. The last section offers a summary of the articles appearing in the special issue, along with a sketch of their main implications for energy policy.
The integration of electricity markets across regional areas1 lies at the heart of the European Union (EU) energy policy and plays a significant role in the United States.2 Fostering regional integration is based on the presumption that increased cross-border trade enhances welfare. Integration increases productive efficiency by expanding the reach of the most efficient plants, and it improves allocative efficiency by inducing competition even among producers that are geographically separate (Borenstein et al., 2000; Wolak, 2015). Research on energy policy seeks to understand what institutional settings and resource endowments (in both financial and knowledge terms) are best suited to deliver given policy goals. With respect to market integration, energy policy is complementary to broader domains of macroeconomic policy and foreign relations. Indeed, interconnection shortages may stem
from geopolitical tensions, as with the isolated Israeli grid (Yasner, 2012). At the EU borders, the Baltic countries are linked with Russia, as a heritage of the Soviet Union, but lack interconnection with their EU partners.3 Physical bottlenecks may also be symptoms of economic backwardness and Dutch disease phenomena related to fossil fuels, as with the lack of transport capacity and synchronization between the transmission grids of Lybia and the Maghreb (Sapio, 2014).4 Overcoming such barriers is the object of large-scale interconnection projects such as those envisioned in the Mediterranean Solar Plan (Jablonski et al., 2012; Escribano, 2010), within the broader goal of building electricity highways running from the North Sea to Northern Africa (Sanchis et al., 2015; Trieb and Müller-Steinhagen, 2007). The EU process of integration with countries in the Middle East and North Africa (MENA) illustrates how physical integration may involve harmonizing the legal architectures, e.g. the extension of the European framework to neighboring countries (Cambini and Franzi, 2013; see also Escribano and San Martin (2012) on Morocco's Advanced Status with the EU for energy cooperation). Nonetheless, economically advanced countries with stable political systems suffer from relevant shortages in transport capacity as well: the Spain–France interconnection is a case in point. Energy policy assumes a primary role in preventing these shortages. For instance, it can stimulate alternatives to regulated investments, which may slow down in times of tight public budgets or because of regulatory capture by power generating companies in physically constrained market zones. At the same time, direct public investments are required, since grid externalities prevent merchant investors from fully appropriating the returns from network upgrades (Bushnell and Stoft, 1997). The other key issue in energy policy is public support of renewable energy sources. In the European Union, the 2009 Third Energy Package mandates the adoption of National Renewable Energy Action Plans to reach legally binding targets coherent with the EU-wide goals of 20% penetration rate in gross final energy consumption, 20% energy saving, and 20% greenhouse gas emissions reduction by 2020. Site specificities, which are pervasive in
1 By region we mean, depending on the specific context, a power market zone, an administrative subdivision of a country, or an aggregate of countries sharing common political and economic institutions. 2 Glachant (2004), Meeus et al. (2005), Glachant and Lévêque (2009), and Glachant and Ruester (2014) have assessed the process of building a single market for electricity in the EU.
3 This issue is tackled in the 2030 Climate-Energy Package approved by the Energy Council in October 2014. 4 By Dutch disease, economists mean a mechanism through which an increase in revenues from natural resources (e.g. oil or natural gas) causes a relative appreciation of a nation’s currency, thus a loss in international competitiveness in manufacturing and, in turn, a deterioration in macroeconomic conditions.
1. Geography and energy policy goals
http://dx.doi.org/10.1016/j.enpol.2015.07.035 0301-4215/& 2015 Published by Elsevier Ltd.
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network industries (Glachant, 2002), are essential features of transactions involving renewable energy. Indeed, the availability and capacity factors of renewable sources are highly dependent on local climate and orography. Sites with high potential for renewable energy tend to be spatially concentrated. Wind and hydropower facilities, in particular, tend to be located quite far from consumption points. If not associated with the complementary investments in transmission, the ensuing geographical discrepancies between demand and supply can give rise to bottlenecks and thus to cross-regional differences in electricity prices (see, among others, Førsund et al. (2008) for the case of Norway; Baldick (2012) on Texas; Kunz (2013) on Germany). The policy goals of market integration and de-carbonization are tightly related and highly interdependent. While market integration requires an expansion of the grid, the impact of green power penetration is ambiguous. Transmission lines are needed in order to deploy renewable energy available in remote locations. Yet distributed generation facilities, such as micro-wind turbines, can partly substitute for investments in transport capacity by decentralizing the production–consumption loop. The intermittency of wind and solar power calls for new technical solutions to the problem of power transmission. These solutions include smart grids, which would overcome the current difficulties in the integration of renewables within grids conceived under a centralized generation regime (Neuhoff, 2011; Lo Schiavo et al., 2013). Pending these developments, national electricity markets will have to increasingly rely on ancillary services that are not traded across borders, such as the provision of electricity or load to the network at short notice (Zachmann, 2011). Reconciling the goals of regional integration and de-carbonization is therefore a difficult challenge (Glachant and Ruester, 2014).
2. Geography and the decentralized energy paradigm In a longer-term perspective, the interdependency between market integration and de-carbonization policies is shaped by the co-evolution of energy institutions and technology that since the 1980s has transformed the power industry into a highly decentralized system. Under the centralized technical control that ruled power systems since the times of Edison and Insull (Granovetter and McGuire, 1998), electricity was produced by plants exploiting economies of scale and could be considered, within each country, as a spatially homogeneous, standardized service. Investments in new generation, transmission, and distribution infrastructures were centrally coordinated. The growing sensitivity to environmental issues, the progress in information and communication technologies, as well as the fall in the minimum efficient scale following the introduction of combined-cycle gas turbines have been powerful drivers in the transition to a decentralized and deregulated regime, in which facilities along the power supply chain are unbundled.5 Drawing on the seminal work of Dosi (1982, 1988), Künneke (2008) has interpreted the increasingly distributed technical control in electricity systems as a transition between technological paradigms (from centralized to decentralized). Technological paradigms in the power supply chain differ in terms of the spatial patterns of energy generation, transmission, and distribution, as well as with respect to cost structures and to the degree of involvement and reactiveness of energy users (with the emergence of prosumers in the decentralized paradigm; see also SchleicherTappeser (2012)). 5 See Joskow (1997) on the role of the 1978 PURPA in kick-starting the deregulation process in the United States.
Decentralization, however, does not mean that the costs and benefits of running the system are evenly spread among market players. Decentralizing electricity transactions, away from the previous hierarchical governance, has opened up opportunities for strategizing across transmission bottlenecks. Early evidence on this dates back to the California electricity crisis (Cicchetti et al., 2004). Liu and Hobbs (2013) have shown how strategic congestion and the generators' anticipation of the moves by the transmission system operator sustain collusive outcomes. Unbundling makes it harder to coordinate generation and transport investments and to internalize the interdependencies between the market integration and de-carbonization processes (see Pollitt (2008) on the pros and cons of unbundling). The interplay between technical change in electricity generation, transmission constraints and the governance of electricity transactions, described in the above discussion, is typically overlooked in the design of market surveillance policies. The detection of anti-competitive behaviors draws on a comparison between price offers and the underlying marginal costs of power generation. Correct inference on marginal costs requires that the strategic use of congestion by power generating companies be thoroughly understood and accounted for by regulatory bodies (see Bigerna et al. (2015)).
3. Spatial sources of redistribution and uncertainty in the electricity system The foregoing considerations warn against taking market integration as a process with linear, unambiguous effects. The welfare improvements may not be proportional to the size of the invested resources, and distributional issues do matter. The literature on the effects of the expansion of the grid, while it tends to emphasize its benefits over the costs, is not uncontroversial. The large majority of the simulation analyses (including Wolak (2015), Valeri (2009), Boffa et al. (2010), de Nooij (2011)), as well as the bulk of theoretical results (Borenstein et al., 2000) suggest that the net benefits from interconnection are positive, because it reduces the total generation cost and, at the same time, it improves competition. In general, it is deemed that the interconnection projects that come at no cost (for instance, changes in the cross-border capacity allocation mechanisms, and market coupling to make more interconnection capacity available holding the infrastructural level constant) are welfare-enhancing. However, there are exceptions, as well as cases in which market integration may even deteriorate welfare. Examples include the inefficient arbitrage in the Anglo-French Interconnector (Bunn and Zachmann, 2010), the pro-collusive effects of removing transport barriers (Boffa and Scarpa, 2009), and the increasing prices in a regulated monopoly on the export side integrating with a competitive market in the importing country (Billette de Villemeur and Pineau, 2012). Even when the net welfare effect of market interconnection is positive, there are important spatial distributive consequences from the interconnection decision, involving producers and consumers depending on their location (in particular, depending on whether they are on the side of the bottleneck with “cheap” or “expensive” generation assets). This affects the value of interconnection for the regions connected, as well as the incentives to undertake interconnection both for transmission system operators (TSOs) and for private (merchant) investors. Similar consequences follow when we consider energy systems that are increasingly rich in renewables. Under full physical integration among regions and countries, all energy producers are exposed to competition and all energy users, regardless of their location, benefit from the lower prices guaranteed by greater
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renewable energy (RE) penetration. Indeed, renewables are found to reduce the amount of highly priced fossil-fueled electricity, yielding a downward pressure on the market-clearing price (the so-called merit order effect, see Saenz de Miera et al. (2008), Sensfuss et al. (2008), Twomey and Neuhoff (2010) among others). Yet distributional issues matter in imperfect markets lacking physical integration. By supporting RE producers located in favorably endowed, but physically constrained zones, policy-makers end up picking winners (i.e., the power generating companies and the consumers who, thanks to their locational advantage, benefit the most from the merit order effect) in stark contrast with the level playing field principle of competition policy. Ironically, despite the efforts towards purely market-driven energy trading, the geopolitics of fossil fuels affects the relative price of conventional technologies and thus the relative advantage of regions with high de-carbonization potentials and the associated energy flow patterns. For instance, forecasts of the directions of the energy flows after the integration between the EU and MENA grids have yielded opposite results (renewables flowing from MENA to the EU according to L'Abbate et al. (2014); Maghreb countries remain net importers in Brand and Zingerle’s (2011) simulations) under different scenarios on the government attitudes towards fossil fuels in the southern Mediterranean. Expanded supply from renewables may also affect welfare by altering the spatial distribution of risk. Intermittency in non-dispatchable renewables, such as wind power, results in higher volatility of wholesale power prices (Nicolosi and Fürsch, 2009; Ketterer, 2014 among others), but mostly in spatially constrained zones of the transmission grid. From the viewpoint of a transmission system operator, too, the intermittency of RE sources can be regarded as spatial risk, as it makes it hard to forecast where a certain amount of power is going to be produced and which lines will be put under pressure. Indeed, what is hard to forecast is the interplay among local weather and the technical parameters of the generating facilities. Storage technologies would allow for temporal and spatial smoothing of energy supply (see Beaudin et al. (2010), Sioshansi (2011), Whittingham (2012)), yet Knightian uncertainty on innovation in energy storage adds to the abovementioned spatial risk. The design of transmission investment policies will have to account for the mentioned spatial risks and uncertainties.
4. Outline of the articles and policy implications This Special Issue of Energy Policy is devoted to an analysis of the various effects of interconnection and market integration (or lack thereof) in the current policy context, which is characterized by a significant policy drive towards renewable energy sources. A key objective in this endeavor is to provide some guidance on how energy policy should be reformed, in order to deliver higher efficiency in the spatial organization of the electricity sector while achieving satisfactory levels of reliability, security of supply, and environmental sustainability. The special issue begins with an analysis of the relationship between interconnection and competition. This includes the leading article by Wolak (2015) and the subsequent piece by Bigerna et al. (2015). We then move to an analysis of incentives to invest in the transmission network, with a particular focus on the role for private, or merchant, investors (see Boffa et al. (2015), and Rubino and Cuomo (2015)). Next, we consider the evidence and the policies concerning the relationship between decentralized power generation, including renewables, and the spatial patterns of electricity transmission and distribution (see Anaya and Pollitt (2015), Sapio (2015)). The special issue finally provides an overview of the regional economics literature focusing on the
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interdependencies between decarbonization and local economic development (Balta-Ozkan et al., 2015). Frank Wolak, “Measuring the Competitiveness Benefits of a Transmission Investment Policy: The Case of the Alberta Electricity Market”, quantifies the competition benefits associated with a transmission grid expansion policy through an empirical analysis on data from the Alberta power exchange concerning the 2009– 2011 period. Wolak simulates changes in the residual demand faced by the strategic suppliers, as a result of a transmission expansion policy that causes strategic suppliers to perceive a very small frequency and duration of transmission congestion. He finds that the estimated competitive benefits are economically significant, and recommends that the pro-competitive effect be taken into account in the analysis of the grid expansion projects. In “Marginal cost and congestion in the Italian electricity market: An indirect estimation approach”, Simona Bigerna, Carlo Andrea Bollino and Paolo Polinori (BBP) build an indirect measure of marginal costs for the main Italian generating companies, that takes congestion into account. Using the individual bids in the Italian Power Exchange for the 2004–2007 period, the estimation procedure allows a match to the Lerner index in each market zone. The estimated marginal cost curve for Enel, the former monopolist, is flat, whereas U-shaped curves are found for its competitors. The analysis in BBP emphasizes the nexus between the intensity of market power exercise, the available transmission capacity, and the frequency of bottlenecks. “Strategic investment in Merchant Transmission: the Impact of Capacity Utilization Rules”, by Federico Boffa, Viswanath Pingali and Francesca Sala (BPS), provides an analysis of the incentives for private parties to invest in merchant interconnection infrastructure, and of the ensuing welfare consequences, under two capacity utilization rules (must-offer versus non-must-offer) and under several modes of competition. BPS show that, when there are demand fluctuations and the generation market is competitive, the non-must-offer rule induces more merchant investments, but reduces capacity utilization. They also find that the must-offer rule is welfare-enhancing when generators in the two nodes have different levels of efficiency, and there is market power in the inefficient node. Finally, the must-offer rule helps mitigate collusion. Thus, the impact of capacity utilization rules on merchant investments and on welfare crucially depends on the mode of competition. There is no “one size fits all” market design rule. Alessandro Rubino and Michael Cuomo, in “A regulatory assessment of the Electricity Merchant Transmission Investment in EU”, assess the adequacy of the European Union legal framework for interconnection among member states, through a critical analysis of the five existing merchant lines in the EU. Based on the collected evidence from the case studies at hand, Rubino and Cuomo argue that merchant lines will not significantly contribute to the 2020 objectives and are not suited to interconnection across the EU external borders, e.g. with MENA countries. “Integrating distributed generation: Regulation and trends in three leading countries”, by Karim Anaya and Michael Pollitt, explores the recent trends in the development and integration of distributed generation in Germany, Denmark, and Sweden, with a focus on the regulation of grid access for renewables. The regulatory regime in Germany appears to be the most favorable and, together with the Danish one, it implements the most sophisticated support schemes; upgrade costs are socialized. The issue of integration of DG technologies remains problematic and needs to be tackled, in order to avoid pressures on connection costs and thereby on system-wide costs. The econometric analysis performed by Alessandro Sapio in “The effects of renewables in space and time: A regime switching model of the Italian power price” aims at assessing whether the congestion bottleneck that frequently separates Sicily from
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mainland Italy has been exacerbated by the impetuous diffusion of renewable energy in southern and insular Italy. Regime-switching estimates show that renewables have reduced, on the margin, the congestion frequency in import (from the peninsula to Sicily), but not in export. Such a congestion-relief effect is mainly due to wind power and apparently has more to do with the shortage of conventional energy supply in Sicily than with distributed generation, which is scarcely diffused in Sicily. Finally, Nazmiye Balta-Ozkan, Tom Watson and Elisabetta Mocca, in “Spatial uneven development and low carbon transitions: insights from urban and regional planning”, review the literature on the interdependencies between decarbonization and local economic development from a regional studies perspective. As shown by the authors, a regional perspective to energy policy and research allows for the integration of macro- and micro-economic approaches to managing the low-carbon transition and is justified by five trends: spatial concentration of green technologies; geographical differences in urbanization rates, which are key for distributed generation; spatially uneven potentials for renewable energy generation; interactions between agglomeration economies and transmission constraints; geographical fragmentation in the governance of the liberalized electricity markets. Taken together, the papers in this special issue show that the policy and the technological changes that have shaped the new geography of the energy markets require policymakers to reconsider many aspects of the spatial organization of the power supply chain. We may broadly classify the policy insights emerging from the special issue into three main groups, concerning power market competition, the development of new skills by regulatory and policy-making bodies, and the coordination among policy domains. With regard to power market competition, the special issue contributes to the unsettled debate on the welfare benefits from interconnection. The leading article by Wolak emphasizes the economically significant pro-competitive effects of interconnection. It calls for their explicit consideration in the cost-benefit analysis preliminary to the approval of interconnection projects, thereby moving beyond the cost savings criteria that have guided the industry under the regulated, vertically integrated regime. Other articles in this special issue explore alternative routes towards improved competition, that do not rely on expanded transmission capacity. One is adequately crafting the capacity utilization rules, in order to deter capacity withholding. An alternative solution is increasing the rate of renewable energy penetration, to the extent that it relieves congestion. These solutions improve welfare only under certain conditions, as their effects depend on the relative efficiency of the generation capacity across nodes (in Boffa et al.) and on the mix of locally available inputs for power generation (in Sapio). Relatedly, Boffa et al.'s remarks on the lack of a superior set of rules couples with Anaya and Pollitt’s evidence that support schemes (for distributed generation) differ across economically integrated countries, with no dramatic divergence in the overall efficiency of the involved energy systems. The drivers and the moderating factors influencing regulated investments are yet another set of crucial issues for market integration. Rubino and Cuomo's case studies cast doubts on the role of merchant investors in interconnection projects, at least in the EU-MENA context. If regulated investments still hold the lion's share in the future, political economy issues may take on a prominent position in the energy policy debate. Policy tools will have to be designed or strengthened in order to mitigate regulatory capture and other rent seeking activities that may cause public under-investment in transport capacity (Knittel, 2006). However, the skills in performing market analyses available to public agencies are no less relevant. Even if the personnel in the regulatory bodies are perfectly aligned with public interest, they may fail to
fully or correctly internalize the pro-competitive effects of market integration. A first reason is cultural inheritance across technoeconomic regimes. Wolak's concern is with regulators who may only focus on costs savings when assessing an interconnection project, based on a logic that is obsolete under the deregulated, decentralized power supply paradigm. A second reason is that no one really knows what is the “true” electricity market model: errors in estimating market power are inevitable. Bigerna et al.'s results imply that energy regulators should consider investing in the development of market monitoring tools that treasure the wealth of information embodied in congestion patterns. It is worth noting that Bigerna et al. provide one of the possible algorithms to estimate the marginal costs from market data, conditional on the specific theoretical assumptions. Energy economists may discover empirically superior models, while policy-making and regulatory agencies may exploit their first-hand information to come up with even more precise tools to assist market surveillance activities. As a bottom line, shaping incentives and building capabilities are both key in fostering market competition. To conclude this brief detour of insights for energy policy research, Balta-Ozkan et al.'s wide-ranging discussion illustrates how an interdisciplinary take on energy policy can help shaping ideas on the coordination of policy domains that turn out to be complementary in the long term. The nexus between energy policy goals, urban planning, and the spatial distribution of economic activities (as influenced by industrial policy) bears a strategic relevance that is seldom recognized in the academic literature (see, however, Nijkamp (1983)). Nonetheless, in studying the “big picture” one should not forgo the careful examination of the single “brush strokes”, since often the effectiveness of the various rules depends on the specific details of the market design.
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Federico Boffa n, Alessandro Sapio Faculty of Economics and Management, Free University of Bolzano, Piazzetta dell’Università 1, Brunico 39031, Italy Department of Business and Economic Studies, Parthenope University of Naples, Via Generale Parisi, 13, Napoli 80132, Italy E-mail address: [email protected] (F. Boffa)
Available online 5 August 2015
n
Corresponding author.
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Energy Policy journal homepage: www.elsevier.com/locate/enpol
Introduction to the special issue “The regional integration of energy markets”
The spatial organization of the electricity industry is key in the current policy-making debate in many parts of the world. This concern results from a combination of policy and technological considerations. Policy-wise, the drives towards market integration and towards increased penetration of renewable energy sources are possibly the two most prominent on-going industry transformations. Technology-wise, the transition to a decentralized regime is triggered by the introduction of combined-cycle gas turbines and further pushed by the development and diffusion of renewables. Motivated by the relevance of geography in shaping the regulatory approaches to the electricity industry, we have collected articles that deal with the regional integration of electricity markets and the related policy-making issues. After reviewing the main motivations behind market integration policies, in this short essay we discuss some critical issues in policy design, involving spatial patterns in electricity production, the exercise of market power across transmission bottlenecks, and the associated distributional issues. The last section offers a summary of the articles appearing in the special issue, along with a sketch of their main implications for energy policy.
The integration of electricity markets across regional areas1 lies at the heart of the European Union (EU) energy policy and plays a significant role in the United States.2 Fostering regional integration is based on the presumption that increased cross-border trade enhances welfare. Integration increases productive efficiency by expanding the reach of the most efficient plants, and it improves allocative efficiency by inducing competition even among producers that are geographically separate (Borenstein et al., 2000; Wolak, 2015). Research on energy policy seeks to understand what institutional settings and resource endowments (in both financial and knowledge terms) are best suited to deliver given policy goals. With respect to market integration, energy policy is complementary to broader domains of macroeconomic policy and foreign relations. Indeed, interconnection shortages may stem
from geopolitical tensions, as with the isolated Israeli grid (Yasner, 2012). At the EU borders, the Baltic countries are linked with Russia, as a heritage of the Soviet Union, but lack interconnection with their EU partners.3 Physical bottlenecks may also be symptoms of economic backwardness and Dutch disease phenomena related to fossil fuels, as with the lack of transport capacity and synchronization between the transmission grids of Lybia and the Maghreb (Sapio, 2014).4 Overcoming such barriers is the object of large-scale interconnection projects such as those envisioned in the Mediterranean Solar Plan (Jablonski et al., 2012; Escribano, 2010), within the broader goal of building electricity highways running from the North Sea to Northern Africa (Sanchis et al., 2015; Trieb and Müller-Steinhagen, 2007). The EU process of integration with countries in the Middle East and North Africa (MENA) illustrates how physical integration may involve harmonizing the legal architectures, e.g. the extension of the European framework to neighboring countries (Cambini and Franzi, 2013; see also Escribano and San Martin (2012) on Morocco's Advanced Status with the EU for energy cooperation). Nonetheless, economically advanced countries with stable political systems suffer from relevant shortages in transport capacity as well: the Spain–France interconnection is a case in point. Energy policy assumes a primary role in preventing these shortages. For instance, it can stimulate alternatives to regulated investments, which may slow down in times of tight public budgets or because of regulatory capture by power generating companies in physically constrained market zones. At the same time, direct public investments are required, since grid externalities prevent merchant investors from fully appropriating the returns from network upgrades (Bushnell and Stoft, 1997). The other key issue in energy policy is public support of renewable energy sources. In the European Union, the 2009 Third Energy Package mandates the adoption of National Renewable Energy Action Plans to reach legally binding targets coherent with the EU-wide goals of 20% penetration rate in gross final energy consumption, 20% energy saving, and 20% greenhouse gas emissions reduction by 2020. Site specificities, which are pervasive in
1 By region we mean, depending on the specific context, a power market zone, an administrative subdivision of a country, or an aggregate of countries sharing common political and economic institutions. 2 Glachant (2004), Meeus et al. (2005), Glachant and Lévêque (2009), and Glachant and Ruester (2014) have assessed the process of building a single market for electricity in the EU.
3 This issue is tackled in the 2030 Climate-Energy Package approved by the Energy Council in October 2014. 4 By Dutch disease, economists mean a mechanism through which an increase in revenues from natural resources (e.g. oil or natural gas) causes a relative appreciation of a nation’s currency, thus a loss in international competitiveness in manufacturing and, in turn, a deterioration in macroeconomic conditions.
1. Geography and energy policy goals
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network industries (Glachant, 2002), are essential features of transactions involving renewable energy. Indeed, the availability and capacity factors of renewable sources are highly dependent on local climate and orography. Sites with high potential for renewable energy tend to be spatially concentrated. Wind and hydropower facilities, in particular, tend to be located quite far from consumption points. If not associated with the complementary investments in transmission, the ensuing geographical discrepancies between demand and supply can give rise to bottlenecks and thus to cross-regional differences in electricity prices (see, among others, Førsund et al. (2008) for the case of Norway; Baldick (2012) on Texas; Kunz (2013) on Germany). The policy goals of market integration and de-carbonization are tightly related and highly interdependent. While market integration requires an expansion of the grid, the impact of green power penetration is ambiguous. Transmission lines are needed in order to deploy renewable energy available in remote locations. Yet distributed generation facilities, such as micro-wind turbines, can partly substitute for investments in transport capacity by decentralizing the production–consumption loop. The intermittency of wind and solar power calls for new technical solutions to the problem of power transmission. These solutions include smart grids, which would overcome the current difficulties in the integration of renewables within grids conceived under a centralized generation regime (Neuhoff, 2011; Lo Schiavo et al., 2013). Pending these developments, national electricity markets will have to increasingly rely on ancillary services that are not traded across borders, such as the provision of electricity or load to the network at short notice (Zachmann, 2011). Reconciling the goals of regional integration and de-carbonization is therefore a difficult challenge (Glachant and Ruester, 2014).
2. Geography and the decentralized energy paradigm In a longer-term perspective, the interdependency between market integration and de-carbonization policies is shaped by the co-evolution of energy institutions and technology that since the 1980s has transformed the power industry into a highly decentralized system. Under the centralized technical control that ruled power systems since the times of Edison and Insull (Granovetter and McGuire, 1998), electricity was produced by plants exploiting economies of scale and could be considered, within each country, as a spatially homogeneous, standardized service. Investments in new generation, transmission, and distribution infrastructures were centrally coordinated. The growing sensitivity to environmental issues, the progress in information and communication technologies, as well as the fall in the minimum efficient scale following the introduction of combined-cycle gas turbines have been powerful drivers in the transition to a decentralized and deregulated regime, in which facilities along the power supply chain are unbundled.5 Drawing on the seminal work of Dosi (1982, 1988), Künneke (2008) has interpreted the increasingly distributed technical control in electricity systems as a transition between technological paradigms (from centralized to decentralized). Technological paradigms in the power supply chain differ in terms of the spatial patterns of energy generation, transmission, and distribution, as well as with respect to cost structures and to the degree of involvement and reactiveness of energy users (with the emergence of prosumers in the decentralized paradigm; see also SchleicherTappeser (2012)). 5 See Joskow (1997) on the role of the 1978 PURPA in kick-starting the deregulation process in the United States.
Decentralization, however, does not mean that the costs and benefits of running the system are evenly spread among market players. Decentralizing electricity transactions, away from the previous hierarchical governance, has opened up opportunities for strategizing across transmission bottlenecks. Early evidence on this dates back to the California electricity crisis (Cicchetti et al., 2004). Liu and Hobbs (2013) have shown how strategic congestion and the generators' anticipation of the moves by the transmission system operator sustain collusive outcomes. Unbundling makes it harder to coordinate generation and transport investments and to internalize the interdependencies between the market integration and de-carbonization processes (see Pollitt (2008) on the pros and cons of unbundling). The interplay between technical change in electricity generation, transmission constraints and the governance of electricity transactions, described in the above discussion, is typically overlooked in the design of market surveillance policies. The detection of anti-competitive behaviors draws on a comparison between price offers and the underlying marginal costs of power generation. Correct inference on marginal costs requires that the strategic use of congestion by power generating companies be thoroughly understood and accounted for by regulatory bodies (see Bigerna et al. (2015)).
3. Spatial sources of redistribution and uncertainty in the electricity system The foregoing considerations warn against taking market integration as a process with linear, unambiguous effects. The welfare improvements may not be proportional to the size of the invested resources, and distributional issues do matter. The literature on the effects of the expansion of the grid, while it tends to emphasize its benefits over the costs, is not uncontroversial. The large majority of the simulation analyses (including Wolak (2015), Valeri (2009), Boffa et al. (2010), de Nooij (2011)), as well as the bulk of theoretical results (Borenstein et al., 2000) suggest that the net benefits from interconnection are positive, because it reduces the total generation cost and, at the same time, it improves competition. In general, it is deemed that the interconnection projects that come at no cost (for instance, changes in the cross-border capacity allocation mechanisms, and market coupling to make more interconnection capacity available holding the infrastructural level constant) are welfare-enhancing. However, there are exceptions, as well as cases in which market integration may even deteriorate welfare. Examples include the inefficient arbitrage in the Anglo-French Interconnector (Bunn and Zachmann, 2010), the pro-collusive effects of removing transport barriers (Boffa and Scarpa, 2009), and the increasing prices in a regulated monopoly on the export side integrating with a competitive market in the importing country (Billette de Villemeur and Pineau, 2012). Even when the net welfare effect of market interconnection is positive, there are important spatial distributive consequences from the interconnection decision, involving producers and consumers depending on their location (in particular, depending on whether they are on the side of the bottleneck with “cheap” or “expensive” generation assets). This affects the value of interconnection for the regions connected, as well as the incentives to undertake interconnection both for transmission system operators (TSOs) and for private (merchant) investors. Similar consequences follow when we consider energy systems that are increasingly rich in renewables. Under full physical integration among regions and countries, all energy producers are exposed to competition and all energy users, regardless of their location, benefit from the lower prices guaranteed by greater
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renewable energy (RE) penetration. Indeed, renewables are found to reduce the amount of highly priced fossil-fueled electricity, yielding a downward pressure on the market-clearing price (the so-called merit order effect, see Saenz de Miera et al. (2008), Sensfuss et al. (2008), Twomey and Neuhoff (2010) among others). Yet distributional issues matter in imperfect markets lacking physical integration. By supporting RE producers located in favorably endowed, but physically constrained zones, policy-makers end up picking winners (i.e., the power generating companies and the consumers who, thanks to their locational advantage, benefit the most from the merit order effect) in stark contrast with the level playing field principle of competition policy. Ironically, despite the efforts towards purely market-driven energy trading, the geopolitics of fossil fuels affects the relative price of conventional technologies and thus the relative advantage of regions with high de-carbonization potentials and the associated energy flow patterns. For instance, forecasts of the directions of the energy flows after the integration between the EU and MENA grids have yielded opposite results (renewables flowing from MENA to the EU according to L'Abbate et al. (2014); Maghreb countries remain net importers in Brand and Zingerle’s (2011) simulations) under different scenarios on the government attitudes towards fossil fuels in the southern Mediterranean. Expanded supply from renewables may also affect welfare by altering the spatial distribution of risk. Intermittency in non-dispatchable renewables, such as wind power, results in higher volatility of wholesale power prices (Nicolosi and Fürsch, 2009; Ketterer, 2014 among others), but mostly in spatially constrained zones of the transmission grid. From the viewpoint of a transmission system operator, too, the intermittency of RE sources can be regarded as spatial risk, as it makes it hard to forecast where a certain amount of power is going to be produced and which lines will be put under pressure. Indeed, what is hard to forecast is the interplay among local weather and the technical parameters of the generating facilities. Storage technologies would allow for temporal and spatial smoothing of energy supply (see Beaudin et al. (2010), Sioshansi (2011), Whittingham (2012)), yet Knightian uncertainty on innovation in energy storage adds to the abovementioned spatial risk. The design of transmission investment policies will have to account for the mentioned spatial risks and uncertainties.
4. Outline of the articles and policy implications This Special Issue of Energy Policy is devoted to an analysis of the various effects of interconnection and market integration (or lack thereof) in the current policy context, which is characterized by a significant policy drive towards renewable energy sources. A key objective in this endeavor is to provide some guidance on how energy policy should be reformed, in order to deliver higher efficiency in the spatial organization of the electricity sector while achieving satisfactory levels of reliability, security of supply, and environmental sustainability. The special issue begins with an analysis of the relationship between interconnection and competition. This includes the leading article by Wolak (2015) and the subsequent piece by Bigerna et al. (2015). We then move to an analysis of incentives to invest in the transmission network, with a particular focus on the role for private, or merchant, investors (see Boffa et al. (2015), and Rubino and Cuomo (2015)). Next, we consider the evidence and the policies concerning the relationship between decentralized power generation, including renewables, and the spatial patterns of electricity transmission and distribution (see Anaya and Pollitt (2015), Sapio (2015)). The special issue finally provides an overview of the regional economics literature focusing on the
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interdependencies between decarbonization and local economic development (Balta-Ozkan et al., 2015). Frank Wolak, “Measuring the Competitiveness Benefits of a Transmission Investment Policy: The Case of the Alberta Electricity Market”, quantifies the competition benefits associated with a transmission grid expansion policy through an empirical analysis on data from the Alberta power exchange concerning the 2009– 2011 period. Wolak simulates changes in the residual demand faced by the strategic suppliers, as a result of a transmission expansion policy that causes strategic suppliers to perceive a very small frequency and duration of transmission congestion. He finds that the estimated competitive benefits are economically significant, and recommends that the pro-competitive effect be taken into account in the analysis of the grid expansion projects. In “Marginal cost and congestion in the Italian electricity market: An indirect estimation approach”, Simona Bigerna, Carlo Andrea Bollino and Paolo Polinori (BBP) build an indirect measure of marginal costs for the main Italian generating companies, that takes congestion into account. Using the individual bids in the Italian Power Exchange for the 2004–2007 period, the estimation procedure allows a match to the Lerner index in each market zone. The estimated marginal cost curve for Enel, the former monopolist, is flat, whereas U-shaped curves are found for its competitors. The analysis in BBP emphasizes the nexus between the intensity of market power exercise, the available transmission capacity, and the frequency of bottlenecks. “Strategic investment in Merchant Transmission: the Impact of Capacity Utilization Rules”, by Federico Boffa, Viswanath Pingali and Francesca Sala (BPS), provides an analysis of the incentives for private parties to invest in merchant interconnection infrastructure, and of the ensuing welfare consequences, under two capacity utilization rules (must-offer versus non-must-offer) and under several modes of competition. BPS show that, when there are demand fluctuations and the generation market is competitive, the non-must-offer rule induces more merchant investments, but reduces capacity utilization. They also find that the must-offer rule is welfare-enhancing when generators in the two nodes have different levels of efficiency, and there is market power in the inefficient node. Finally, the must-offer rule helps mitigate collusion. Thus, the impact of capacity utilization rules on merchant investments and on welfare crucially depends on the mode of competition. There is no “one size fits all” market design rule. Alessandro Rubino and Michael Cuomo, in “A regulatory assessment of the Electricity Merchant Transmission Investment in EU”, assess the adequacy of the European Union legal framework for interconnection among member states, through a critical analysis of the five existing merchant lines in the EU. Based on the collected evidence from the case studies at hand, Rubino and Cuomo argue that merchant lines will not significantly contribute to the 2020 objectives and are not suited to interconnection across the EU external borders, e.g. with MENA countries. “Integrating distributed generation: Regulation and trends in three leading countries”, by Karim Anaya and Michael Pollitt, explores the recent trends in the development and integration of distributed generation in Germany, Denmark, and Sweden, with a focus on the regulation of grid access for renewables. The regulatory regime in Germany appears to be the most favorable and, together with the Danish one, it implements the most sophisticated support schemes; upgrade costs are socialized. The issue of integration of DG technologies remains problematic and needs to be tackled, in order to avoid pressures on connection costs and thereby on system-wide costs. The econometric analysis performed by Alessandro Sapio in “The effects of renewables in space and time: A regime switching model of the Italian power price” aims at assessing whether the congestion bottleneck that frequently separates Sicily from
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mainland Italy has been exacerbated by the impetuous diffusion of renewable energy in southern and insular Italy. Regime-switching estimates show that renewables have reduced, on the margin, the congestion frequency in import (from the peninsula to Sicily), but not in export. Such a congestion-relief effect is mainly due to wind power and apparently has more to do with the shortage of conventional energy supply in Sicily than with distributed generation, which is scarcely diffused in Sicily. Finally, Nazmiye Balta-Ozkan, Tom Watson and Elisabetta Mocca, in “Spatial uneven development and low carbon transitions: insights from urban and regional planning”, review the literature on the interdependencies between decarbonization and local economic development from a regional studies perspective. As shown by the authors, a regional perspective to energy policy and research allows for the integration of macro- and micro-economic approaches to managing the low-carbon transition and is justified by five trends: spatial concentration of green technologies; geographical differences in urbanization rates, which are key for distributed generation; spatially uneven potentials for renewable energy generation; interactions between agglomeration economies and transmission constraints; geographical fragmentation in the governance of the liberalized electricity markets. Taken together, the papers in this special issue show that the policy and the technological changes that have shaped the new geography of the energy markets require policymakers to reconsider many aspects of the spatial organization of the power supply chain. We may broadly classify the policy insights emerging from the special issue into three main groups, concerning power market competition, the development of new skills by regulatory and policy-making bodies, and the coordination among policy domains. With regard to power market competition, the special issue contributes to the unsettled debate on the welfare benefits from interconnection. The leading article by Wolak emphasizes the economically significant pro-competitive effects of interconnection. It calls for their explicit consideration in the cost-benefit analysis preliminary to the approval of interconnection projects, thereby moving beyond the cost savings criteria that have guided the industry under the regulated, vertically integrated regime. Other articles in this special issue explore alternative routes towards improved competition, that do not rely on expanded transmission capacity. One is adequately crafting the capacity utilization rules, in order to deter capacity withholding. An alternative solution is increasing the rate of renewable energy penetration, to the extent that it relieves congestion. These solutions improve welfare only under certain conditions, as their effects depend on the relative efficiency of the generation capacity across nodes (in Boffa et al.) and on the mix of locally available inputs for power generation (in Sapio). Relatedly, Boffa et al.'s remarks on the lack of a superior set of rules couples with Anaya and Pollitt’s evidence that support schemes (for distributed generation) differ across economically integrated countries, with no dramatic divergence in the overall efficiency of the involved energy systems. The drivers and the moderating factors influencing regulated investments are yet another set of crucial issues for market integration. Rubino and Cuomo's case studies cast doubts on the role of merchant investors in interconnection projects, at least in the EU-MENA context. If regulated investments still hold the lion's share in the future, political economy issues may take on a prominent position in the energy policy debate. Policy tools will have to be designed or strengthened in order to mitigate regulatory capture and other rent seeking activities that may cause public under-investment in transport capacity (Knittel, 2006). However, the skills in performing market analyses available to public agencies are no less relevant. Even if the personnel in the regulatory bodies are perfectly aligned with public interest, they may fail to
fully or correctly internalize the pro-competitive effects of market integration. A first reason is cultural inheritance across technoeconomic regimes. Wolak's concern is with regulators who may only focus on costs savings when assessing an interconnection project, based on a logic that is obsolete under the deregulated, decentralized power supply paradigm. A second reason is that no one really knows what is the “true” electricity market model: errors in estimating market power are inevitable. Bigerna et al.'s results imply that energy regulators should consider investing in the development of market monitoring tools that treasure the wealth of information embodied in congestion patterns. It is worth noting that Bigerna et al. provide one of the possible algorithms to estimate the marginal costs from market data, conditional on the specific theoretical assumptions. Energy economists may discover empirically superior models, while policy-making and regulatory agencies may exploit their first-hand information to come up with even more precise tools to assist market surveillance activities. As a bottom line, shaping incentives and building capabilities are both key in fostering market competition. To conclude this brief detour of insights for energy policy research, Balta-Ozkan et al.'s wide-ranging discussion illustrates how an interdisciplinary take on energy policy can help shaping ideas on the coordination of policy domains that turn out to be complementary in the long term. The nexus between energy policy goals, urban planning, and the spatial distribution of economic activities (as influenced by industrial policy) bears a strategic relevance that is seldom recognized in the academic literature (see, however, Nijkamp (1983)). Nonetheless, in studying the “big picture” one should not forgo the careful examination of the single “brush strokes”, since often the effectiveness of the various rules depends on the specific details of the market design.
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Federico Boffa n, Alessandro Sapio Faculty of Economics and Management, Free University of Bolzano, Piazzetta dell’Università 1, Brunico 39031, Italy Department of Business and Economic Studies, Parthenope University of Naples, Via Generale Parisi, 13, Napoli 80132, Italy E-mail address: [email protected] (F. Boffa)
Available online 5 August 2015
n
Corresponding author.