Merchant Transmission Investment [report]

Paul Joskow, Jean Tirole
2003 unpublished
contracts, congestion management, nodal pricing, physical and financial transmission contracts, and associated market power issues. This work typically takes the transmission network as given. However, in the medium and long term as demand grows and new generating capacity is added to replace older, less efficient, capacity or to meet growing demand efficiently, investments in transmission capacity are likely to be necessary to minimize the overall costs of wholesale electricity supplies, to
more » ... ntain reliability, to mitigate locational market power, and to improve the performance of competitive wholesale and retail markets. Despite growing problems associated with stimulating transmission investment in many restructured electricity markets, there has been surprisingly little research on the institutions governing transmission investment. Early formulations of the structure for competitive wholesale markets envisioned the creation of independent regulated regional transmission and system operating entities (Transcos, or regulated Transmission Companies) that would be responsible for building, owning and operating transmission facilities and would be subject to economic regulation (Joskow and Schmalensee [1983]). More recent research has explored the attributes of incentive regulatory mechanisms that could be applied to such regulated transmission monopolies (e.g., Celebi, Nasser [1997], Le´autier [2000] , Vogelsang [2001]) to integrate energy price (congestion) signals with transmission investment. The institutional arrangements governing transmission operation and investment in England and Wales reflect this basic institutional approach. The regulated Transco model is necessarily subject to the classical challenges of regulated monopoly, namely how to specify and apply regulatory mechanisms that provide good performance incentives to the regulated firm while minimizing the economic rents that the regulated firm can derive from its superior information. An alternative (or complement) to the regulated Transco model is the merchant investment model. It relies on competition, free entry and decentralized property-rights based institutions, and market-based pricing of transmission service to govern transmission investment (Hogan [1992] , Bushnell and Stoft [1996,1997], Chao and Peck [1996] ). In return for investment in additional transmission capacity, merchant investors receive property rights that allow them to collect congestion revenues equal to the difference in nodal energy prices associated with the incremental point-topoint transmission capacity their investments create. The value of these rights to receive congestion revenues represents the revenues merchant investors receive to cover the capital and operating costs of these investments and provides the financial incentives that guide 'market based' transmission investment. Previous theoretical research has demonstrated that under a fairly stringent set of assumptions, all profitable investments are efficient (efficient investments, on the other hand, are not all profitable, due 234 PAUL JOSKOW AND JEAN TIROLE r Blackwell Publishing Ltd. 2005.
doi:10.3386/w9534 fatcat:g4sz7xjdabcr5aldqsaikrql4m