Cross-border Effects of Capacity Remuneration Schemes in Interconnected Markets: Who is Free-riding?

• Author: Lambin, Xavier

1. INTRODUCTION

   Since the liberalization process began in the early 90s, the European power sector has been increasingly exposed to market-based mechanisms, to replace national planning. Investments are increasingly market-driven, spot prices are supposed to induce a socially optimal capacity mix and adequacy level. However, the power market is still exposed to many constraints. The upstream market has so far remained very concentrated, while demand remains largely inelastic, requiring the implementation of numerous regulatory firewalls such as price caps, in a move to tame market power abuse. Regulators and researchers (Cramton and Stoft, 2006) have observed that the price signal alone does not generate the "adequate" level of capacity, as defined by their Security of Supply (SoS) standards. As a consequence, capacity remuneration mechanisms (CRMs) to directly remunerate installed capacity (and not only energy), are implemented or considered in the US and in Europe. In Europe, this leads to a patchwork of assorted and complex market designs--see Appendix A for a summary of current schemes in Europe. These regulatory interventions have so far been designed in an uncoordinated manner, as the combined effects of unprecedented penetration of renewable energy sources and low demand have pushed regulators to find a quick fix to support capacity. This regulatory intervention is very complex and somewhat controversial even when only one market is considered. Furthermore CRMs ignore cross-border effects or at best take imports into account in an implicit manner. We show this may prove very costly in the long run.

   A specific concern is that consumers in a market without a CRM may free-ride on capacity payments by their neighbors who have a CRM. This paper proves that cross-border effects do exists, and they might be far from negligible. However it shows that the problem in the long-run does not lie so much in capacity free-riding (at the expense of consumers or producers in the market with a CRM), but rather in unfair investment competition (at the benefit of producers and in turn consumers in the market with a CRM). We will compare the benchmark case of an Energy-Only market without a support scheme (market "EO"), with a market providing a Capacity Market (market "CM") and with an energy-only market endowed with a Strategic Reserve (market "SR").

   This paper focuses on the effect of capacity support schemes on investment in the long-run. Our main contribution to this heated debate is to provide an analytically rigorous discussion of the impact of CRMs in one market on a neighbouring market. The paper uses a highly stylized model that abstracts from many real life complications to focus on the key economic mechanisms. To focus on the main insights, no account is made of risk aversion, imperfect reliability of assets and we assume perfect competition (see e.g. Fabra (2018) for a discussion of the impact of market power on CRMs). Hence we model a market without any imperfection--except that policy makers want more demand coverage than what emerges without intervention.

   We find several results. First, by construction of a model without risk-aversion nor any other imperfection, the Energy-Only market maximizes expected net surplus. The intuition for this result is that capacity payments are uniform: every Mega Watt of installed capacity receives the same per unit capacity payment, even though only a fraction of installed capacity is used in (almost) every state of the world. Therefore, the total capacity payment, which is proportional to total installed capacity, exceeds the net surplus generated by additional capacity, which is proportional to capacity actually used. To avoid the uniform payment issue, policy makers in some countries implement strategic reserves. Then, if Strategic Reserves and Capacity Markets lead to the same Security of Supply, hence the same installed capacity, they lead to the same expected net surplus. (1) The direct, upfront cost of capacity support is greater when the Security of Supply standards are met with Capacity Markets instead of a Strategic Reserve. However the energy prices are (weakly) higher with a Strategic Reserve. Hence, the higher upfront cost of implementing support through a capacity market (relative to a strategic reserve) is offset indirectly, through smaller electricity bills.

   Second, if markets EO and CM are interconnected, CM will export to EO, possibly at high prices: capacity in CM gets more profitable and the capacity payment can be scaled down. Conversely, investing in EO is less profitable due to CM's large (supported) operational capacity and less capacity will be built there. Market CM is thus better off when it has an energy-only neighbor than when it is isolated. EO is indifferent in terms of welfare, even though its SoS may be degraded if transmission system operators (TSOs) are allowed to reduce export capacity. If EO's SoS reaches unacceptably low levels, the energy-only market might be forced to implement a CRM as well.

   Third, if TSOs are not allowed to reduce export capacity, the CRM merely displaces capacity, but has no long-run effect on Security of Supply. In that case, a market willing to increase its SoS through a capacity market will have an incentive to decrease its interconnection capacity with neighbors.

   Finally, the Online Appendix (2) shows that implementing a capacity market in a market interconnected with a strategic reserve market yields similar results to the CM/EO case: CM's support scheme is alleviated by additional revenues when it exports at high prices to SR. If TSOs can reduce export capacity, SR has to build up strategic reserve by an amount equivalent to the increment of capacity in CM following the implementation of the capacity market, in order to maintain its SoS level. Table 1 summarizes the cross-border effects of CRMs, when there are no explicit corrective transfers from one scheme to the other, price cap is set at a (common) Value of Lost Load (VoLL), demand is perfectly symmetric (i.e. there are no aggregation gains) and TSOs are allowed to reduce export capacity:

   The remainder of the paper is organized as follows. Section 2 reviews the literature. Section 3 outlines the benchmark model, when markets are isolated from one another. Section 4 analyses interconnected markets in the simple case when demand is same in both markets. We observe that an energy-only market endures decreased SoS when its neighbor implements a capacity market. Possible solutions to mitigate this effect are analyzed in Section 5. Section 6 concludes. Appendix C shows the results of section 4 carry over to non-symmetric demands. While the main text focuses on the interaction between an Energy-only market and a Capacity Market, the Online Appendix allows for all combinations with a strategic reserve.

2. LITERATURE REVIEW

   The internal energy market, advocating coordination between member states and energy market coupling, is a pivotal instrument to meet the European commission's target in terms of affordability, security, sustainability of power supply (see European Commission, 2010). National markets are now requested to better integrate with neighbors, in order to gain efficiency through increased competition and diversification effects (Creti and Fumagalli, 2010; Jamasb and Pollitt, 2005). However, the conflicts between national market designs and the internal energy market have not eased.

   The need for an assessment of cross-border effects of capacity remuneration schemes has been repeatedly stressed by many regulators (ACER, 2013; CEER, 2013; RAP, 2013), market makers (TSOs), participants and institutions (IEA, 2014). Following concerns that "capacity mechanisms may unduly favour particular producers or technologies and that they may create obstacles to trade in electricity across borders", the European commission carried out an inquiry of eleven mechanisms proposed by member states (European Commission, 2016b).

   Quite surprisingly, relatively little has been done yet on the research side. Many discussions focus on the short-term (usually positive) cross-border effects of CRMs, while discussions on investment incentives should arguably focus on the long-run effects. Hence, our research is in sharp contrast with conventional wisdom, and previous research based on dynamic arguments (see concerns expressed in Eurelectric, 2016) or focusing on the transition period (Bhagwat et al., 2014; Bhagwat et al., 2017). In these agent-based models, the authors observe that CRMs yield positive benefits to neighbors, at the expense of local consumers. This contrasts with the results of the present paper that focuses on the long-run equilibrium. While transitory periods are important we believe regulation aimed at promoting long-term investments should be analyzed on the ground of long-run effects. We show that these effects may be unexpectedly damaging, with negative externalities yielded to neighbors of CM. A hint of our results can be found in the empirical literature, that shows cross-border trade may be inefficient when market designs differ (McInerney and Bunn, 2013; Viljainen et al., 2013).

   Even though this phenomenon will likely expand very fast in Europe in the next decade, few natural experiments of interconnected markets with different designs are available. Researchers are thus essentially left with two options: simulations and theoretical models. Simulations provide sensible estimates of the magnitude of potential inefficiencies. However, sensitivity to assumptions and the various channels through which the inefficiency arises are often hard to grasp. The present paper is analytical and fills this gap by identifying clearly the effect of interconnections and sharing rules in case of concomitant scarcity.

   A notable and inspiring effort to address long-run cross-border inefficiencies by Gore and Meyer (2015) studies the interaction between an...