1. Econ 100 1 Winter 2012: Professor Bushnell Principles for Transmission Cost Allocation James Bushnell University of California, Davis December, 2013 1

2. Econ 100 2 Winter 2012: Professor Bushnell Outline What’s so special about transmission? –Cost structure of energy transportation –Externalities Spatial markets –The derived demand for transportation Cost recovery vs. efficient pricing –fixed cost pricing vs. marginal cost (congestion) pricing Investment and cost recovery 2

3. Econ 100 3 Winter 2012: Professor Bushnell Transportation and Spatial Competition The cost and availability of transportation determines the geographic size of a market –Crude oil markets vs. electricity markets Cost structure for transportation in energy is unlike most markets –Marginal costs are very low, capital costs are high –Significant economies of scale;‘Lumpy’ investments Transmission assets are immobile –Captive customers and the hold-up problem Transportation capacity can be limited –Only matters if storage is costly 3

4. Econ 100 4 Winter 2012: Professor Bushnell Transmission Pricing Policy Fights Fight 1: How to charge for use or access to lines with periodic congestion? Fight 2: How to charge for recovery of investment costs of constructing lines. These have often been confused as the same fight. –With the same answer. –But not in New Zealand! 4

5. Econ 100 5 Winter 2012: Professor Bushnell Spatial Markets with Free Transportation 5 South PSPS QSQS 7 MC S = 2 + q s 5 PNPN North QNQN 12 11 MC N = 12 DNDN DSDS

6. Econ 100 6 Winter 2012: Professor Bushnell Spatial Markets with Free Transportation With no congestion and no transport cost, we have one combined market 6 South PSPS QSQS 7 MC S = 2 + q s 5 PNPN North QNQN 12 11 MC N = 12 DNDN DSDS 6 10

7. Econ 100 7 Winter 2012: Professor Bushnell What is the Demand for Transportation? 7 P transport Q transport 5 5 2 3 South to North Transport

8. Econ 100 8 Winter 2012: Professor Bushnell Congestion as Peak-load Pricing 8 P transport Q transport 5 5 Demand for South to North Transport MC of S to N Transport.001 3 2

9. Econ 100 9 Winter 2012: Professor Bushnell Transmission Investment: Why does it have to be so difficult? Efficient congestion prices reflect shadow value of a line –Shouldn’t this be a good signal for value of investment? Yes!, but… –Shadow prices reflect value of a small expansion –Lumpiness (economies of scale) mean that transmission projects are almost never small –Think of a new investment that eliminates all congestion Network externalities make it difficult to define what “expansion” is –Many projects allow an increase some combinations of injections while reducing others 9

10. Econ 100 10 Winter 2012: Professor Bushnell Loop Flow? Power flows in inverse proportion to the impedance (resistance) it faces Example: Nodes 1 & 2 supply only, node 3 demand only 10 3 1 2 Capacity = 6 z 13 z 23

11. Econ 100 11 Winter 2012: Professor Bushnell Loop Flow Power flows in inverse proportion to the impedance (resistance) it faces Example: Nodes 1 & 2 supply only, node 3 demand only 11 3 1 2 Capacity = 1 Capacity = 6 z 13 z 12 z 23

12. Econ 100 12 Winter 2012: Professor Bushnell Feasible Dispatch Sets With 2 “radial” lines can send 6 MW from each source But can’t send 7 from either source 3 rd line “expands” some possibilities but eliminates some others 12 3 6 7 q 1 q 2 z 23 z 13 z 12 z 12 4 3 6

13. Econ 100 13 Winter 2012: Professor Bushnell Feasible Dispatch Sets With 2 “radial” lines can send 6 MW from each source But can’t send 7 from either source 3 rd line “expands” some possibilities but eliminates some others 13 3 6 7 q 1 q 2 z 23 z 13 z 13 z 12 z 12 z 23 4 3 6

14. Econ 100 14 Winter 2012: Professor Bushnell Transmission Investment Market prices can help induce efficient transmission investment –But don’t hold your breath In most cases transmission looks a lot like a natural monopoly –And we can try to apply the principles of natural monopoly pricing to this context 14

15. Econ 100 15 Winter 2012: Professor Bushnell Cost Recovery Principles Classic natural monopoly cost-recovery problem –Marginal cost pricing efficient but doesn’t recover costs Pricing goal should be to minimize deadweight loss –Fixed charges (two-part tariffs)? –Ramsey Pricing? –Is that fair (unfair)? 15

16. Econ 100 16 Winter 2012: Professor Bushnell Average Cost Pricing Creates DWL Q16 $ Q A B Fixed Costs to Recover P A = P B

17. Econ 100 17 Winter 2012: Professor Bushnell Ramsey Pricing reduces DWL Q17 $ Q A B Fixed Costs to Recover PAPA PBPB

18. Econ 100 18 Winter 2012: Professor Bushnell Beneficiaries Pay From Wikipedia From “IntelligentUtility.com” The “beneficiaries pay” theorem adopted by FERC is unaccompanied by a definition of the range of potential transmission benefits or how to calculate them in individual cases. 18 “User pays, or beneficiary pays, is a pricing approach based on the idea that the most efficient allocation of resources occurs when consumers pay the full costs of the goods that they consume.”

19. Econ 100 19 Winter 2012: Professor Bushnell Ramsey Pricing reduces DWL Q19 $ Q A B Fixed Costs to Recover PAPA PBPB

20. Econ 100 20 Winter 2012: Professor Bushnell Transmission Chickens and Eggs For sunk (think unavoidable) transmission costs, this is a monopoly cost allocation issue. But what if generation location decisions cause transmission to be built? –New transmission not unavoidable –Dispersed cost recover creates ability to partially “free-ride” on the network by off loading costs on other users Can create incentives to locate in inefficient places This perspective is one motivation for a “beneficiaries pay” (also “exacerbators”) approach. 20

21. Econ 100 21 Winter 2012: Professor Bushnell Ex-Ante vs. Ex-post Determination of Benefits Very difficult to predict benefits for the next 20 years –Even the process of prediction can drag out proceedings 21

22. Econ 100 22 Winter 2012: Professor Bushnell Difficulties in Measuring Benefits Some benefits hard to quantify –Competitive gains - avoiding market power or restrictive regulations –Reliability gains? –Value of insurance against extreme events (e.g. drought, hurricane, national security, natural disasters) 22

23. Econ 100 23 Winter 2012: Professor Bushnell Difficulties in Measuring Benefits Transmission is extremely long-lived asset –Costs of existing generation may change considerably –New generation difficult to predict How to incorporate impact of transmission investment on new entry? –Demand growth patterns will evolve –No single entity controls these changes - decisions are amongst diverse market actors Some benefits hard to quantify –Competitive gains - avoiding market power or restrictive regulations –Reliability gains? –Value of insurance against extreme events (e.g. drought, hurricane, national security, natural disasters) 23

24. Econ 100 24 Winter 2012: Professor Bushnell Linking Two Symmetric Markets NorthQNQN SouthQSQS Flow = Q N - Q S Line Capacity = k Inverse demand in each market = P(Q) When the line has a very small capacity: Two Monopolies When line has a very large capacity: Duopoly, but no flow on the line How large is “large” and how small is “small”? When line has a “medium” capacity: limited competition

25. Econ 100 25 Winter 2012: Professor Bushnell Ex-Ante vs. Ex-post Determination of Benefits Very difficult to predict benefits for the next 20 years –Even the process of prediction can drag out proceedings Ex-post “tracking” of benefits solves the prediction problem –But it makes the cost allocation endogenous (e.g. driven by) the actions of those using the network –Risks distorting behavior with charges sunk costs 25

26. Econ 100 26 Winter 2012: Professor Bushnell Marginal and Infra-Marginal Allocation One approach to cost recovery would be to claw back proportional surplus from users of the network –In principle this is first degree price discrimination –Close to Ramsey pricing in principle If a firm is infra-marginal they would be ineleastic to the proposed charge (e.g. will not change their behavior) In practice, can a claw-back not change behavior? The trade-offs between precision and blunting endogenous incentives 26

27. Econ 100 27 Winter 2012: Professor Bushnell Summary Transmission exhibits many natural monopoly characteristics Efficient pricing is important but usually insufficient to recover investment costs Average cost pricing can inefficiently discourage usage of the network –What is the elasticity of the beneficiary? Choice of pricing paradigm needs to be reconciled with investment approach –If generation leads transmission – beneficiaries pay –If transmission leads generation – ramsey pricing – How close is that to beneficiaries pay? How practical is it to recover benefits without disrupting behavior? 27