Cross-border Effects of Capacity Remuneration Mechanisms: The Swiss Case.

• Author: Zimmermann, Florian

1. INTRODUCTION

   European electricity markets are becoming more and more integrated as a consequence of internal market guidelines and the so-called Energy Union Strategy of the European Commission (1997, 2003, 2009). Integration of the electricity markets is mainly driven by two intertwined processes: On the one hand, European markets are more tightly linked by implicit auctions and combined by the so-called Price Coupling of Regions run by eight European power exchanges (EPEX SPOT, 2018). On the other hand, the physical transmission grid is expanded and, in particular, the interconnectors will be further enhanced according to the Ten-Year Network Development Plan of the European Network of Transmission System Operators (ENTSO-E, 2018a).

   As a result, various cross-border effects can be observed: Energy flows from market areas with higher prices to those with lower prices result in a convergence of electricity prices in connected market areas, given that sufficient interconnection capacity is available. Price convergence stops, if the available interconnector does not allow any further flow of electricity and, in this case, a certain price difference remains. However, an additional interconnection line between two market zones can increase price assimilation, resulting in positive welfare effects (Ringler et al., 2017).

   In the case of a small country neighbored by large markets (asymmetrical market areas), the cross-border price effect can be strong. Therefore, as a case study, Switzerland serves as a useful example for analyzing the impact of large neighboring markets on a smaller one. The analysis by Dehler et al. (2016) shows a strong interdependence of the wholesale electricity prices of Switzerland and its neighbors (Austria, France, Italy, and Germany) due to a tight connection between the electricity grids. For instance, the electricity price decline between 2011 and 2016 in the Central Western European countries driven by a renewable energy sources (RES) expansion and low prices for the EU ETS emission allowance resulted in lower prices also in the Swiss electricity market. This price decline can be welcomed from the consumer perspective but has a lowering effect on producer's rent and the profitability of power plants (Bublitz et al., 2017; Hirth, 2018; Kallabis et al., 2016). This might yield not only for thermal capacities but also for the dominant hydropower plants in Switzerland.

   These developments are expected to intensify in the near future (e.g., Perez-Arriaga and Batlle, 2012), as some neighboring countries changed the design of their wholesale electricity markets in the past few years, which can put additional pressure on Swiss wholesale electricity prices. For instance, Germany is planning to introduce a strategic reserve (SR) to ensure generation adequacy in times of scarcity (BMWi, 2017). Also, France has implemented a capacity remuneration mechanism (CRM), a decentralized capacity market, to ensure generation adequacy and incentivize demand-side management (DSM) measures in peak load times (Bublitz et al., 2019). As the yearly traded volume in the French and German electricity markets is considerably larger than in other European markets, their decisions strongly influence the neighboring markets, especially the comparatively small ones. In this context, the question arises as to whether the Swiss market also requires new instruments to ensure long-term generation adequacy by incentivizing national (re-) investments.

   Therefore, the goal of this study is to investigate the cross-border effects of CRMs on electricity prices, investments, and thus on the long-term generation adequacy in such connected market areas by applying a power market model based on agent-based simulation using Switzerland as a case study. This approach allows the consideration of individual decisions of market players and the analysis of market equilibria based on these decisions.

   The remainder of the paper is structured as follows: Section 2 summarizes the current literature on cross-border effects with regard to CRMs and deduces the research gap in this context. Section 3 describes the applied simulation approach focusing on modeling CRMs in an electricity market model. The results, including investments, price impact, and generation adequacy, are discussed in Section 4. Finally, in Section 5, the methodology is critically evaluated, and the main conclusions as well as policy implications are derived in Section 6.

2. LITERATURE REVIEW

   One of the difficulties encountered in the analysis of cross-border effects is the large number of possible influences, such as the number and the market sizes of the countries considered. In addition, the levels of competition and the respective market designs can influence the results (Meyer and Gore, 2015). Thus, it is difficult to derive general conclusions. This fact might serve as an explanation of why the literature predominantly focuses on a single market scenario, and the research on spillover effects of capacity remuneration mechanisms is lagging behind (Lorenczik, 2017). However, without a sound theoretical framework on cross-border effects, ensuring generation adequacy at a regional level in an efficient manner remains a major challenge (Glachant et al., 2017). This is further complicated by the fact that cross-border effects can emerge in a non-linear manner (Boffa et al., 2010).

   A question frequently examined in the literature is whether free-riding occurs if a neighboring country introduces a CRM. For example, Bhagwat et al. (2014, 2017) study cross-border effects in two symmetrical market areas differing only in their design. Whereas an EOM does not limit the effectiveness of the neighboring capacity market or SR, vice versa, two effects can be observed: On the one hand, the consumers in the EOM are free-riding on the consumers in the neighboring market where a CRM is implemented. On the other hand, the dependence of the EOM on the neighboring markets is increasing. Similarly, Meyer and Gore (2015) find that the unilateral implementation of a CRM, either in the form of reliability options or a SR, weakens investment incentives in the neighboring market. Cepeda and Finon (2011) analyze the cross-border effects of three different market designs (EOM, price-capped EOM, forward capacity market). They find that in the long-term, the market area with an EOM does not benefit from the adjacent market area where a price-capped forward capacity market is implemented, and even negative externalities can arise in the form of a higher average price and lower reliability.

   Lorenczik (2017) observes that the negative effect of price caps intensifies if a market is connected to neighboring markets and, thus, generation capacity and welfare further decrease. Yet, vice versa, national price caps do not seem to have a significant adverse effect on neighboring countries. Contrary to other studies, it is claimed that capacity payments do not exert a significant positive effect on the security of supply in neighboring countries.

   Not only between markets with and without a CRM, spillover effects can occur, but also between markets with different CRMs (Lambin and Leautier, 2019). In a scenario where a SR is introduced in one market and a capacity market in the other, Bhagwat et al. (2014, 2017) observe negative spillover effects of the capacity market on the SR resulting in, e.g., a lower reserve margin in the market with the SR. Elberg (2014) investigates two symmetrical market areas in which either a SR or capacity payments have been implemented. On an isolated basis, both mechanisms lead to an efficient outcome. However, in a combined evaluation, the SR shows worse results due to redistribution effects, as the consumer welfare decreases in the area of the SR, whereas it increases in the adjacent area.

   In some cases, CRMs are also investigated in real-world case studies. For example, Ochoa and Gore (2015) investigate the welfare and security of supply in the Finnish electricity market considering potential benefits and risks arising from the connection to the Russian market. In case the electricity imports from Russia would be reliably available, an expansion of transmission capacities would be recommended. However, as their reliability is doubtful, it is recommended to build up national generation capacities and maintain a SR. In another analysis, Ochoa and van Ackere (2015b) examine cross-border effects between Colombia-Ecuador and France-Great Britain. They conclude that the potential benefits are strongly linked to market complementarity and that policy measures to exploit these benefits without distorting market signals must be carefully evaluated, especially if large seasonal storage capacities exist, which might be used extensively during shortage situations in the neighboring country and subsequently are unavailable for national usage. In a follow-up study, Ochoa and van Ackere (2015a) once again analyze the markets of Colombia--Ecuador and find that the relative market sizes and the size of transmission capacities have a significant influence on potential cross-border benefits.

   One of the remaining key challenges in evaluating generation adequacy is to assess the contribution of neighboring countries in order to avoid over- or undercapacities. Mastropietro et al. (2015) investigate possibilities to remove barriers preventing foreign participants in Europe from participating in external capacity mechanisms without reducing the short-term efficiency of the electricity market. They propose that capacities should be procured via zonal auctions, which take into account the maximum transmission capacity of the interconnection, and that capacities should not be allowed to participate in different national CRMs. Finon (2014) investigates the differences between explicit and implicit cross-border participation. In the long term, he states that excluding cross-border participants...