Should European policy-makers wishing to improve the allocation of resources in the electricity sector content themselves with providing market-based incentives? A recent TILEC discussion paper by Gerd Küpper (KU Leuven) and Bert Willems (TILEC) studies the welfare implications of using market mechanisms to allocate transmission capacity in recently liberalized electricity markets. It addresses the issue as to whether access to this essential facility should be traded on a market, or whether the incumbent should instead retain exclusive usage rights. They show that granting exclusive use to the incumbent might be optimal if the capacity of the grid is small and the incumbent can reduce production costs by taking advantage of interregional production-cost differences. This result runs counter to the intuition that arbitrage leads markets to function better. The reason is that when competition is imperfect, arbitrage may reduce productive efficiency. Thus, market mechanisms for the allocation of electricity transmission capacity should be introduced only if sufficient investment in the network is guaranteed or if the market power of the incumbent is curtailed in at least one of the regional markets in which it operates.
Dec 20, 2007
Should access to the electricity grid be traded on a market?
Should European policy-makers wishing to improve the allocation of resources in the electricity sector content themselves with providing market-based incentives? A recent TILEC discussion paper by Gerd Küpper (KU Leuven) and Bert Willems (TILEC) studies the welfare implications of using market mechanisms to allocate transmission capacity in recently liberalized electricity markets. It addresses the issue as to whether access to this essential facility should be traded on a market, or whether the incumbent should instead retain exclusive usage rights. They show that granting exclusive use to the incumbent might be optimal if the capacity of the grid is small and the incumbent can reduce production costs by taking advantage of interregional production-cost differences. This result runs counter to the intuition that arbitrage leads markets to function better. The reason is that when competition is imperfect, arbitrage may reduce productive efficiency. Thus, market mechanisms for the allocation of electricity transmission capacity should be introduced only if sufficient investment in the network is guaranteed or if the market power of the incumbent is curtailed in at least one of the regional markets in which it operates.