Economic incentives for capacity reductions on interconnectors in the day-ahead market

TL;DR

This paper investigates how transmission system operators in a zonal power market may have incentives to reduce interconnector capacity to maximize domestic welfare, potentially leading to welfare gains for the country but losses for the overall system.

Contribution

It provides an analytical framework explaining incentives for capacity reductions and demonstrates their prevalence through numerical experiments in the Northern-European power system.

Findings

In 97% of tested hours, incentives for capacity reductions were observed.

Capacity reductions can lead to significant welfare gains for Denmark.

The European '70%-rule' can mitigate these incentives and their welfare effects.

Abstract

We consider a zonal international power market and investigate potential economic incentives for short-term reductions of transmission capacities on existing interconnectors by the responsible transmission system operators (TSOs). We show that if a TSO aims to maximize domestic total welfare, it often has an incentive to reduce the capacity on the interconnectors to neighboring countries. In contrast with the (limited) literature on this subject, which focuses on incentives through the avoidance of future balancing costs, we show that incentives can exist even if one ignores balancing and focuses solely on welfare gains in the day-ahead market itself. Our analysis consists of two parts. In the first part, we develop an analytical framework that explains why these incentives exist. In particular, we distinguish two mechanisms: one based on price differences with neighboring countries and one based on the domestic electricity price. In the second part, we perform numerical experiments using a model of the Northern-European power system, focusing on the Danish TSO. In 97% of the historical hours tested, we indeed observe economic incentives for capacity reductions, leading to significant welfare gains for Denmark and welfare losses for the system as a whole. We show that the potential for welfare gains greatly depends on the ability of the TSO to adapt interconnector capacities to short-term market conditions. Finally, we explore the extent to which the recently introduced European "70%-rule" can mitigate the incentives for capacity reductions and their welfare effects.