Power System Transformation toward Renewables: An Evaluation of Regulatory Approaches for Network Expansion.

• Author: Egerer, Jonas

1. INTRODUCTION

   The transformation toward a low carbon economy is one of the most ambitious projects of the European Union (EU) in the first half of the 21st century. To promote this pathway, the EU formulated binding reduction targets through 2020 with the "20-20-20" goals. (1) On a long-term perspective, the EU has set emission reduction targets of 80-95% by 2050 compared to 1990 levels (European Commission, 2011). The principal sectors for potential emission reductions are found in the energy system, with electricity being of special importance. In the electricity sector, fossil fuels are increasingly being replaced with renewable generation technologies. It is broadly accepted that the power system will have to integrate an increasing share of renewables as most EU members are making investments in new generation capacity based on wind, solar, biomass, and hydro. However, the role of conventional power generation facilities, both existing and new, during the renewable integration process is less clear. In Europe, lignite, coal, and natural gas, as well as nuclear in some countries, might build a bridge to the large-scale integration of non-conventional renewable technologies.

   Regarding infrastructure, the transformation towards a low carbon economy requires new transmission capacity different to the historically existing one. However, network planning is increasingly complex when integrating renewable electricity. The role of network regulation in a dynamic renewable-integration process is a challenging task. The owning transmission system operators (TSOs) carry out operations within the system while investments and decommissioning in renewable and conventional generation capacities, respectively, is taking place. In a system with centralized planning, the regulator should ensure that the transmission company (Transco) carries out the proposed transmission expansion. Under a more decentralized market structure, the regulator should provide investment incentives through regulatory mechanisms, such as cost-plus or incentive regulation. In any case, the regulator will require market information to carry out her responsibilities. Typical regulatory challenges include the implied impacts on network development, as well as potential under- or over-investments by network operators during the renewable integration process.

   In this paper, we address the rationale for transmission investment under a renewable integration process. (2) We isolate some basic characteristics and drivers of transmission investment in an energy transformation process characterized by network capacity expansion under the gradual substitution of conventional power (e.g., coal) with renewable energy sources (e.g., wind). In particular, we compare the relative performance of a combined merchant-regulatory price-cap mechanism, using different weights, with cost-based regulation as well as with a non-regulated approach in a dynamic system that assumes a transformation toward a power generation system with high renewable penetration.

   The remainder is structured as follows. In section 2 we carry out a literature review on the regulation of transmission investment under market and renewable integration. In section 3 we present a bi-level model for transmission investment with different regulatory schemes for the Transco in a changing market-setting under an intertemporally process of renewable integration. In section 4, we provide fundamental stylized examples helpful to understand possible drivers of network congestion changes in the context of the transformation toward renewable power. For a simple two-node network, three distinctive developments of the generation mix with different implications on network congestion are presented. In section 5, we present and discuss the results of the relative performance of a combined merchant-regulatory price-cap mechanism, a cost-based rule, and a non-regulated approach under the dynamic generation settings. The final section concludes with a discussion on avenues for further research on the appropriate definition of weights for incentive regulation under renewable integration.

2. LITERATURE REVIEW

   This paper analyzes the role of electricity transmission on the integration of renewable energy sources. This presupposes a possibility of the regulator of focusing on incentivizing investment from an independent Transco through adequate price regulation (see Vogelsang, 2001). This approach has gained importance, both in theory and practice, due to liberalization processes in various electricity systems that prioritize vertical separation, mainly between generation and transmission activities. Such unbundling measures are shown to promote investment. Pollitt et al. (2007) review the econometric evidence and the international experience with generation and transmission unbundling (New Zealand, Australia, Chile, Argentina, Nordic Countries, and the USA), concluding that, as opposed to other market architectures, the unbundling of electricity generation and transmission--together with well-regulated independent transmission system operators (ITSOs)--can deliver highly competitive energy markets and facilitate timely transmission investments. Newbery (2005) finds similar conclusions for the UK electricity market. Using OECD measures of product market reform, Alesina et al. (2005) also find that electricity investment increases as vertical integration decreases.

   The role of transmission investment as an important factor in the transformation of the whole electricity market via appropriate price signals from liberalization and regulatory reform processes is also recognized in most studies. Brunekreeft et al. (2005) and Rubio and Perez-Arriaga (2000) point out the importance of a nodal-pricing system (and complementary capacity charges) to signaling the efficient location of generation investment. That is, establishing appropriate measures for incentivizing an efficient development of transmission networks is crucial not only for the development of the grid but also for power generation, marketing, distribution, and system operation itself. Likewise, transmission planning both in centralized systems as well as incentivized transmission expansion in decentralized market architectures have relevant impacts on consumer surplus and generator surplus (see Sauma and Oren, 2007, and Rosellon and Weigt, 2011).

   A regulator has several alternatives to regulate the transmission price of a Transco in liberalized market environments. Cost-of-service (or cost-plus) regulation has been traditionally used in the practice of electricity utilities. It implies setting prices to equalize average cost, and usually goes along with a restriction on the rate of return on capital. It has a basic advantage in that it provides certainty and long-run commitment by the regulator--two crucial elements for long-run investments of utilities. However, incentives for cost minimization are almost nonexistent since the complete restitution of costs does not promote monetary expenditures for the improvement of efficiency. The other extreme of regulation, price-cap regulation, usually provides more incentives for cost minimization but at the cost of less certainty for the investing firm. This explains that price-cap schemes are usually combined in practice with cost-plus regulation. (3)

   Regarding regulation for electricity transmission investment of an independent Transco in meshed networks, there are several alternatives. Two are especially interesting for the approach used in this paper: one based on financial transmission rights (FTRs; merchant approach), and another based on the incentive price-cap regulation. The merchant approach is based on FTR auctions within a bid-based security-constrained economic dispatch with nodal pricing of an independent system operator (ISO). The ISO runs a power-flow model that provides nodal prices derived from shadow prices of the model's constraints. FTRs are subsequently calculated as hedges from nodal price differences. The ISO retains some capacity or FTRs in order to deal with externalities caused by loop-flows, so that the agent expanding a transmission link implicitly pays back for the possible loss of property rights of other agents (Bushnell and Stoft, 1997, Kristiansen and Rosellon, 2006). FTR auctions have mainly been implemented in Northeast USA (NYISO, PJM ISO, and New England ISO).

   The incentive approach relies on a price-cap on the two-part tariff of an independent Transco (Vogelsang, 2001). (4) Incentives for efficient investment result in expansion of the transmission grid through the over-time rebalancing of the fixed and variable charges of the two-part tariff. Convergence to steady state Ramsey-price equilibrium relies on the type of weights used. Transmitted volumes for each type of service are used as weights for the corresponding various prices so that the Transco's profits grow as capacity utilization and network expansion increase. In equilibrium, the rebalancing of fixed and variable charges depends on the ratio between the output weight and the number of consumers. There are two basic ways to regulate price structure: one with fixed weights (tariff-basket regulation) and another with variable weights (average revenue regulation). Under the former regime, a price cap is established over the weighted sum of prices for different products. Weights might be output (or throughput) quantities of the previous period (chained Laspeyres), quantities of the current period (Paasche), intertemporally fixed quantities (fixed Laspeyres), or projected quantities that correspond to the steady state equilibrium (ideal weights, as in Laffont et al. 1996). (5) Variable (endogenous) weights are usually associated with average-revenue regulation, which sets a cap on income per unit but does not set fixed weights that limit the relative variation of prices. Compared to tariff-basket regulation, this...