Cost Allocation for Merchant Transmission by Richard Benjamin1 Economist Round Table Group

Abstract Cost allocation for transmission expansion is a continuing problem, especially in the case where a new line crosses state boundaries, because payments for transmission investment and its use are made at the state level, but the economic impacts from these investments extend beyond state boundaries. The paper advances a solution to this problem by means of a two-part approach to transmission financing. The approach features a variable component, (i.e. an FTR, adjusted for lumpiness) and a fixed component, determined by the increase in import capability that the new line enables.

I would like to thank Ross Baldick and workshop participants at the 2010 IAEE North American Conference for helpful comments on this version of the paper. Any remaining mistakes are my own.

Introduction

Cost allocation for transmission expansion is a particularly thorny problem, especially in the case where a new line crosses state boundaries. As Sauma and Oren (2007) note, sometimes there are misalignments between costs and benefits associated with investments in transmission, because payments for transmission investment and its use are made at the state level, but the economic impacts from these investments extend beyond state boundaries. As a consequence, transmission expansions that maximize social welfare may not produce Pareto superior outcomes, resulting in justifiable local opposition. It appeared that Hogans (1992) introduction of financial transmission rights (FTRs) solved this problem in restructured electricity markets. A point-to-point FTR gives its holder the right to collect congestion rents equal to the difference in locational marginal prices (LMPs) at the sink and the source locations (nodes). Bushnell and Stoft (1997) suggest awarding (or punishing, in the case of detrimental grid expansions) developers with the incremental FTRs associated with their new lines. Merchant transmission development has been slow moving in the United States, however. As many note (see, e.g. Joskow and Tirole (2005) and Barmack et al. (2003)), lumpiness of transmission additions narrows, or even eliminates, the difference in LMPs between the nodes connected by the transmission addition, causing the value of incremental FTRs allocated to a project fall below the redispatch-cost savings attributable to the line, which several economists have argued to be the projects social benefit,2 and frustrating FTR allocation as a means of financing new transmission. As a result of the difficulties merchant transmission has faced in the United States, the Federal Energy Regulatory Commission (FERC) has backed away from its endorsement of the former in its unsuccessful rulemaking on Standard Market Design,

See, e.g. Joskow and Tirole (2005), Barmack et al. (2003), and Leautier (2000).

and instead advanced incentive ratemaking to encourage new transmission development in Order No. 679.3 With the marginalization of merchant transmission, however, the problem of cost allocation for new transmission lines remains. In recognition of this problem, on March 23, 2010, Chairman Jon Wellinghoff indicated FERC would consider initiating a rulemaking on transmission cost allocation.4 The paper advances a two-part approach to financing transmission expansions, whose roots are found in Loeb and Magats (1979) scheme, in which the regulator subsidizes the firm according to the total surplus it generates. Gans and King (2000) apply a variant of this methodology, the incremental surplus subsidy (ISS) scheme, developed by Sappington and Sibley (1988). However, the ISS scheme is ill-suited to transmission investment, as this paper argues. The paper thus contributes to the literature by extracting the strengths of Gans and Kings proposed methodology while pruning the weaknesses. In so doing, it derives a plausible scheme for allocating costs for new transmission projects in the United States. Sections II and III present background information regarding the papers proposed approach and the approach itself, respectively. Section IV briefly considers the methods consistency with transmission pricing principles presented in the literature. Section V concludes.

II. Background A logical point of departure for a study on transmission funding mechanisms is a review of the desirable properties of such mechanisms. In their seminal paper, Prez-Arriaga et al. (1995) note that remunerating transmission owners with the merchandizing surplus (the difference between revenue collected from consumers and that paid to generators) will recover

Final Rule, Docket No. RM-06-4-000, Promoting Transmission Investment Through Pricing Reform, 113 FERC 61,182. 4 Testimony of Chairman Jon Wellinghoff, Federal Energy Regulatory Commission Before the Energy and Environment Subcommittee Of the Committee on Energy and Commerce United States House of Representatives Oversight Hearing for the Federal Energy Regulatory Commission, March 23, 2010

only a fraction (approximately 25%) of required network revenue.5 Nonetheless, Prez-Arriaga et al. argue that a regulatory approach to transmission should implement nodal pricing to encourage transmission expansion, because nodal prices transmit optimal price signals. But because the merchandizing surplus is in general insufficient to remunerate transmission investment, they maintain that a complementary charge is needed to fully finance investment, which should: distort short-term price signals as little as possible, in order to preserve efficiency of the market; 2. distort long-term decision making as little as possible, providing network users the initiative to propose network reinforcements (promote long-term efficiency); and 3. use historical network performance as a baseline for measuring network operation and maintenance activities (be both objective and simple to implement and understand).6
1.

Vogelsang (1999) considers a two-part tariff as well. He argues that the complementary charge (or, fixed fee) should satisfy at least two requirements. They should: (1) be fair (subsidy-free); and (2) not depend on usage (for then they would be variable fees). He argues that fairness implies that the complementary charge should depend on the transmission capacity cost caused by the customer and/or the customers net benefit. Next, the Stanford Energy Modelling Forum (Green 1997) recommends the following principles to assess the performance of transmission pricing mechanisms: 1. 2. 3. 4. 5. 6. Promote efficient daily operation of the bulk power market. Signal locational advantages for investment in generation and load. Signal the need for investment in the transmission system. Compensate the owners of existing transmission assets. Simplicity/transparency. Political feasibility.

Green argues that an LMP system accomplishes the first task, while recognizing that lumpiness of transmission investments, fragmentation of grid ownership and the accompanying externality
5

Chile, in its pioneering electricity statutes, recognized the need for a charge to complement marginal cost pricing for transmission (See Rudnick et al. (1995), referencing Electricity Service Law Decrees, Chile, 1982, 1985, and 1990). The Chilean system, however, did not price congestion (Rudnick et al. 1995, p. 1127.) 6 Of the aforementioned principles, long-term efficiency naturally receives the most play in the literature (short-run efficiency already being covered by efficient locational prices).

issues complicates, and perverse incentives for FTR-holders to sustain congestion complicate the satisfaction of Principles 2 and 3. Principle 4 is based on the simple tenet of no regulatory appropriation. Principle 5 is based on the argument that transmission prices must be understandable in order to send clear price signals. Finally, it is necessary that a transmission pricing scheme satisfy principle six in order to make it coalition proof.7 Vogelsang (1999) adds regulatory Principle 7:
7.

Encourage innovative pricing by market participants.

Vogelsang recommends that the regulatory mechanism accommodate both simple and sophisticated transmission tariffs. Along with advocating efficiency and simplicity, Rubio and Prez-Arriaga (2000) add regulatory Principle 8: 8. Objectivity Rubio-Odriz and Prez-Arriaga believe that a good regulatory mechanism should be based on sound economic and engineering principles. They suggest implementing a two-part tariff for transmission whose complementary charge would be based on the economic benefit that each network facility causes to each agent (the benefit factor method). They maintain that consumers benefit is the reduction in total electricity charges based on spot prices, while producer benefit is their increment in net revenues. And, as they mention in n.7, they take only positive benefits into account, not losses accruing to generators from competition. Of course, it is unrealistic to expect consensus with respect to these principles. For example, Vogelsang (1999) agrees that the regulatory mechanism for transmission has to be based on transparent data. But he notes that the level of complexity of actual tariffs depends on the trade off between efficiency and complexity that market participants and regulators are willing to make and that participants in the transmission market are largely sophisticated firms.
7

As argued by Rubio and Prez-Arriaga (2000) and Vogelsang (1999), political feasibility need not imply that generators be protected from increased competition. Vogelsang adds that eliminating cross-subsidies is no great crime, either.

He therefore questions the necessity of simplicity of a regulatory mechanism for transmission. Likewise, many works ignore the importance of political constraints. While many acknowledge lumpiness of transmission projects,8 in most cases they do so in the context of the feasibility of using FTRs to finance (merchant) transmission investment (e.g. Joskow and Tirole (2005), Gans and King (2000), Hogan (2003, 2011)). However, political constraints form important barriers to siting new transmission projects and should not be overlooked. For example, Green (1997) cites the case in England and Wales, where increases in transmission charges attributable to a new project were capped, so that the changes had to be phased in over four years. Morrison (2005) notes that the most significant reason low-cost states oppose centralized markets is the concern that liberalization will hurt consumers in these regions. He also notes that regulators in low-cost states cannot legally support a policy that will lower electricity prices in a neighboring state if it does so at the expense of consumers in their own state. Barmack et al. (2003) add that losers from transmission investment can be expected to expend up to the amount of the rents they stand to lose to block transmission investment. Finally, Vogelsang (1999, 2006), Rubio and Prez-Arriaga (2000), and Hayden and Michaels (2006) (the latter implicitly) argue that political constraints imply that no interest group involved is made noticeably worse off. Hayden and Michaels acknowledge political constraints by proposing to cap any nodal price that increases due to the new line at its old level. Vogelsang (1999) and Rubio and Prez-Arriaga qualify their arguments by allowing for increased competition among affected generators to reduce generator profits.9 Sappington and Sibley (1988) proposed the ISS scheme as a method for providing regulated monopolies with the incentive to operate and price efficiently (i.e. minimize production cost and charge a price equal to marginal cost, respectively). Under the ISS scheme, the regulator
8

See, e.g. Joskow and Tirole (2005), Gans and King (2000), Barmack et al. (2003), Hayden and Michaels (2006), Hogan (2003, 2011) 9 At a more fundamental level, Reta et al. (2005) reject the principles-based approach entirely. They argue that there is no satisfactory methodology for allocating transmission costs in any power system because all existing approached have their associated advantages and disadvantages that depend on the their own characteristics, the characteristics of the power system, and the price structure of the market

grants the monopolist the increment in total surplus that its activities (e.g., price charged and investment undertaken) generate in each period, subtracting from this sum accounting profits, lagged one period. The authors apply the scheme to the firms investment spending by noting that under ISS, the firm is reimbursed with a lag of one period for any investment expenditures it makes, while reaping the social benefits of its investment for one period as well. Gans and King (2000) apply the ISS scheme to the problem of electricity transmission regulation in Australia, arguing that the existence of market power (on behalf of the transmission provided) and the lumpy nature of transmission investment imply that rewarding transmission owners with FTRs based on nodal prices will send suboptimal signals for transmission investment. Consistent with Leautier (2000), Joskow and Tirole (2002, 2005), Barmack et al. (2003), Hayden and Michaels (2006), and Hogan (2011) inter alia, Gans and King approximate the social value of a new transmission line by the dispatch cost reduction the line enables.10 Applying the ISS scheme to transmission investment, they propose that the regulator allow the investor to retain the social surplus created by any transmission augmentation during the first year of the projects life. Gans and King note measurement of the increment of social surplus generated by the investment requires the calculation of the measurement of the counterfactual: what would social surplus have been without the investment. The authors propose that this counterfactual be approximated by calculating what the system marginal prices would have been for the same demand and generator bids if the transmission network were configured without the investment.11 Presuming the investor to incur the projects capital costs that same year, Gans and Kings scheme then has the regulator reimbursing the investor for the projects entire capital cost after a lag of one year. Gans and King conclude that the ISS scheme will provide builders with
10 11

New transmission lines may also increase system reliability and reduce generator market power. They continue that the difference between the price with and without the investment multiplied by quantity demanded approximates the social value generated by the new investment during the year,

the incentive for optimal investment timing, because under the scheme the investor will delay investment up until the point where the marginal gain and marginal cost of waiting equate. Arguably, the least practical and most problematic element of the ISS scheme as applied to transmission or other large projects is paying the developer total construction cost in a single period. For example, the Midwest Independent System Operators (Midwest ISO) planned interstate transmission projects (Starter Multi-Value Projects, or Starter MVPs) have a total estimated cost of $4.68 billion. MISO customers will pay the cost of these projects in rates over a 40-year period. Anderson et al. (2011) estimate that customers across MISO will pay approximately one-tenth of a cent per kilowatt hour for these projects over this period (or about $0.77 per month for the average Michigan residential user). Paying off the $4.68 billion in one year would result in a politically unacceptable one-year rate shock. Given the long life of transmission projects, lumping a 40-year payoff into a single year is clearly problematic. A second weakness of Gans and Kings methodology is that it assumes a fixed project size (i.e., the authors assume that the optimal investment size is that which will eliminate congestion). While this may be the case, it need not be. A more systematic approach will account for the proposition that one size does not necessarily fit all. However, as mentioned previously, the ISS scheme aligns social and private incentives and thus elicits optimal transmission investment timing. Therefore, this paper does not argue that we should abandon the ISS schemes application to merchant transmission expansion. Rather, this paper thus seeks to tweak the ISS scheme to make it a better fit for funding merchant transmission expansion.

III.

Proposed Approach This paper proposes to compensate merchant transmission projects according to the

reduction in congestion costs (RICC) they enable. In doing so the paper presents a mechanism that (practically, as explained below) equates social and private incentives for transmission expansion, thus attaining efficient transmission investment. We propose a two-part tariff, whose

variable and complementary components sum to the projects incremental social benefit. As with other mechanisms, a complementary component is necessitated because the variable part of the tariff will not necessarily recover total redispatch cost savings. The mechanism proceeds as follows: Like Gans and King (2000) and Hayden and Michaels (2006), we propose to approximate redispatch cost savings attributable by implementing two runs of the regional transmission organizations (RTO) dispatch mechanism: one reflecting the transmission system with the line in place, and the other assuming it had not been built.12 Having conducted the two runs, the RTO would then calculate RICC attributable to the line.13 The RTO would then award the transmission developer the total RICC, as calculated, demonstrated below for a two-node network. The RTO awards the transmission developer through use of a two-part tariff. The first component is based on the merchandizing surplus, as with FTRs. The second component, based on pre-existing RTO collection of transmission revenues, is equal to the total RICC minus the amount of revenue collected under the variable component. Let us now calculate RICC in a simple two-node example. We assume that the two nodes are unconnected prior to the transmission expansion, as shown below:

Node i: Price = pi1 Load = Dispatch = Qj Figure 1: The two-node model

Node j: Price = pj1 Load = Dispatch = Qj

12

Of course, how often the system operator should calculate the counterfactual is an open question, whose answer will necessarily be arbitrary. One would desire that the answer to this question be based on an analysis of the cost and benefit of increasing frequency of calculations, but such is beyond the scope of the present work. In line with someone, who noted that congestion costs can vary substantially on an hourly basis, we suspect that the counterfactual should be derived either hourly or half-hourly, with any further refinement probably not worth the additional cost. 13 If the RTO performs the counterfactual calculation less often then the actual dispatch, then it would compute average reduction in congestion costs for the relevant period.

Without loss of generality, let us assume that marginal cost of generation is linear in supply at each node, so that:
. c i = y + gqi , c j = z + hq j , 0 < y < z <

h>

( z y ) + gQi
Qj

(1) The restrictions are necessary to ensure that node i generation is lower-cost than node j generation throughout the relevant range of output, simplifying the analysis. These assumptions allow us to denote node j as the load pocket, and node i as the generation pocket.14 Now let us assume that a transmission line of capacity K is built between nodes i and j. In our illustrative example, the run assuming the line had not been built yields nodal prices of
p j1 and pi1 . The LMP mechanism run with the line in place then yields prices pj and pi., in

both cases referring to nodes j and i, respectively. We may thus show the RICC associated with this line graphically below15:

14

Alternatively, we might arrive at the unlikely case where transmission expansion reverses the nodal price difference. In any case, we do not wish to analyze the latter case. 15 Note that this is the standard congestion cost example, as found in Joskow and Tirole (2005), at p. 240.

Price d pj 1 a pj b
Net supply of generator i to node j : p = pi1 + gq

pi f pi 1 e K

c
Net demand at node j = Cost savings from backing down generator j: p = pj1 - hq

Quantity

Figure 2: Redispatch-cost savings from line ij.

The ISS scheme, Hayden and Michaels RICC approach, Joskow and Tirole (2005) and this paper all suggest rewarding the developer with the trapezoid dace, that is, the redispatch savings attributable to a new line of capacity K. .16 After calculating the surplus, the next step is to remunerate the transmission developer. Gans and King suggest that the difference between the price with and without the investment multiplied by the quantity demanded approximates the social value generated by the project. Therefore, they recommend charging consumers the without- price and paying generators the with-price to raise the relevant funds.17 Referring to Figure 2, this would imply charging node j consumers the price pj1 while paying node i producers the price pi.
16

Gans and King argue that the calculation of this counterfactual is straightforward. The authors note that the electricity spot market organized under the Australian National Electricity Market (NEM) employs a dispatch procedure utilizing line loss and constraint information as well as generator bids in calculating its generation dispatch (i.e., the supply schedule which forms the least-cost solution to supplying electricity demand at every node in the system). They posit that it would be a relatively simple matter to also calculate what the system marginal prices would have been for the same demand and generator bids for the pre-existing transmission network. Hayden and Michaels also note that this counterfactual is an exercise in system simulations. While Rubio-Odriz and Prez-Arriaga (2000) also argue for benefit calculation based on this counterfactual, they argue that this exercise is computationally expensive. 17 It is not quite clear to which nodes their mechanism applies. However, since they suggest that this amount approximates the incremental surplus generated by the line, the most apt reading is charge node j consumers pj1 (without price) and pay node i producers pi (with price). Since they remain silent on the other parties, one assumes they do not recommend any additional adjustment.

Following Gans and King, we obtain the first two steps of the methodology for computing the variable component.
1. 2.

Credit the transmission developer with the standard FTR revenue, K p j pi . Credit the transmission developer with additional revenue K p j1 p j .

The amount of revenue available for payment of conventional FTRs in this example is
K p j pi . As noted previously, however, this amount falls short of the social value of the

line. To correct for this shortcoming, we transfer the area K p ji p j from load-pocket consumers to the transmission developer. However, it remains to determine the price to charge node j producers and node i consumers. This warrants a closer examination of political factors. First, and most obviously, the not-in-my-backyard effect (NIMBY) serves as an impediment to undesirable projects such as unsightly transmission lines. As Brennan (2006) notes, exurban population growth and the corresponding increase in property values have increased resistance to new transmission lines in the last 20 years or so. While Hirst (2000) attributes some of this increase to a decline in a sense of community in Americans, he and Brennan agree that land use concerns are legitimate.18 Next, as previously noted, the lumpy nature of transmission implies that new transmission projects will result in price changes. In our simple example, prices at both ends of a radial line will change.19 As Barmack et al. (2003) note, these price changes have important distributional impacts. In general, transmission investment produces rent transfers from load pocket generators and generation pocket consumers to load pocket consumers and generation pocket generators, as seen by the price changes at nodes i and j in our example. Therefore, our mechanism will extract consumer surplus from load-pocket (node j) consumers and profits from generation-pocket (node i) generators in order to fund the new line.
18

While we further consideration of NIMBY is beyond the scope of this article, we would be remiss to ignore it in a section regarding political concerns. 19 More generally, loop flow will result in price changes at several different nodes in a network a point we will address in future work.

When a transmission project falls entirely within a single states jurisdiction, the relevant state agency can legitimately weight the benefits and losses of the various groups involved when making transmission siting decisions. However, interstate lines have no such fallback. As Morrison (2005) observes, regulators in low-cost states have a statutory obligation to guard the interests of their consumers. They cannot legally support a policy that will lower electricity prices in other states if doing so disadvantages their states consumers. To blunt this opposition, therefore, we suggest charging generation-pocket consumers the before price pi1. As exposited above, though, increased competition among affected generators is a positive development, which argues against compensating load pocket generators for their losses. Therefore, we suggest remunerating load-pocket generators with the post-line price, pj.20,21 Combined with our previous energy market recommendations, this yields the energy market settlements shown in Table 1 below:
Entity Generation at i Load at i Generation at j Load at j Transmission Owner Energy Market Settlement

pi ( Qi + K )
pi 1 (Qi ) pj Qj K
p j1 Q j

N/A

Table 1: Energy Market Settlements Under the Proposed Mechanism

20

While one might object to the presence of two different prices at a single node, one must remember that RTOs do not settle load at a nodal basis, anyway. Much to the chagrin of economists, load does not see real-time, nodal prices. Rather, RTOs settle load on an average zonal basis. Therefore, whether or not the RTO settles load at pj or pj1, the cost of serving node j load is simply thrown into the pot and averaged in with the rest of the load in node js zone. In essence, then, there are virtually always two different energy prices at every node in the network. To our knowledge, the existence of these multiple prices has not led to any arbitrage opportunities in restructured electricity market. 21 To demonstrate arbitrage opportunities present in poorly structured energy markets, let us consider the old zonal pricing regime of the California ISO, generators were accused of playing the dec game, in which generators in generation-constrained resources submitted relatively high prices in the day-ahead market, and a low bid in the real-time market. In the day-ahead market, the resource would be paid a high price based on its bid. In real-time, when congestion existed, the generator would buy back, or the California ISO would dec the generator, in order to relieve congestion. Given a high sale price and paying a lower buy-back price allowed the generator to pocket the difference without actually producing any electricity! (see, e.g. Alaywan et al. (2004)).

Charging generation pocket consumers the pre-line price, pi1 , for the power they consume results in a deficit equal to ( pi pi1 ) Qi , equal to area (2) in Figure 3 below. The major source

of funding for this collection is the excess payments collected from load-pocket consumers over revenue paid to load-pocket producers, equal to the energy produced and consumed at node j times the difference in prices paid by consumers and to producers at this node, i.e. p j1 p j Q j

, or area (1).

Price pj 1 (1) pj

pi (2) pi 1

Qj-K

Qi

Quantity

Figure 3: Energy Market Adjustments

We may now further our description of the calculation of the variable component of the tariff and the associated transfers as follows: Credit the transmission developer with the standard FTR revenue, K p j pi .

1.

2. 3.

Credit the transmission developer with additional revenue K p j1 p j .

Collect the value p j1 p j Q j from energy produced and consumed in the load pocket by charging consumers the pre-line price and paying generators the post-line price. 4. Transfer this value to node i generators as a credit toward the deficit created by paying generation- pocket generators more revenue than is charged to generation-pocket consumers. A final, common-sense adjustment is dictated by political considerations as well. In order to ensure that load-pocket consumers benefits from the transmission line amount to more than any reliability improvements associated with the addition, they must pay less for energy. Therefore, instead of paying the price pj1 per unit of electricity consumed, load pocket consumers
ith should instead pay a fraction, , w 0 < <1, of the pre-line price.22 Making this change

yields steps 2a. and 3a. to our mechanism: 2a. Credit the transmission developer with additional revenue K p j1 p j . 3a. Collect the value p j1 p j Q j from energy produced and consumed in the load pocket.

Admittedly, the mechanism no longer equates private and social benefit from the transmission line, thus no longer yielding the optimal outcome. However, the wedge between social and private benefit is quite small, equalling

(1 ) 2 ( z + hQ j ) 2 ,
2h

(2)

Which, upon quick inspection of Figure 2, slices off only a small triangle in the upper left hand corner of producer benefit, so the amount of distortion is minimal. Further, the distortion is very cost-effective, yielding a net benefit of
NB = h(1 ) pi1 K + Q j

(3)

While one might argue it appropriate settle node i generation at the pre-line price, and then provide an uplift to those node i generators bidding in above pi1, it would seem inadvisable

22

The value of this fraction should be determined by the weight one places on consumer versus producer benefit, as we will detail in our discussion of the complementary component. Doing so represents an improvement over Hayden and Michaels (2006) ad hoc suggestion that the sponsors gross RICC revenue be capped at 95 percent of the total costs to ratepayers under traditional rolled-in pricing.

for at least two reasons.23 The first is gaming. If only those generators who bid high receive a higher price for their electricity, then all generators will have the incentive to raise their bids, and not only those who are likely to be marginal. This leads to the well-appreciated problem of payas-bid electricity auctions yielding inefficient dispatch.24 The second is political considerations. Node i producers will be much more likely to lobby their state regulatory agency for siting of the new line if all of their generation stands to profit from it. This funding method leaves incentives for generation location intact, by paying generation at each node the LMP. It provides a practically optimal signal for transmission developers, as they receive almost the entire social value of their investment, and will therefore wish to develop projects whose social benefit is positive, only (and will turn down only those projects whose net social benefit is minimal). A possible criticism with respect to incentives is that it does not send true signals for loads. However, this method does nothing to alter the price signals to load under the current RTO practice of charging load the zonal price. These transfers will not, in general, fully-fund the transmission expansion. In order to allocate the full social benefit created from the project to the transmission developer, then, the ISO would have to generate additional revenue through a complementary charge. Since the variable charge extracts rent from downstream consumers, the complementary charge would apply to the conjugate party benefiting from the expansion, that is, node i generators. Roughly speaking, the complementary charge should be equal to the difference between the total payment to the developer (as argued above, the social surplus created by the project) and the amount of revenue collected from the variable charge, as based on LMP differences, above. Vogelsang (1999) argues that under this approach, one cannot determine the complementary charge ex ante because fluctuating spot prices necessitate an adjustable complementary charge as well. While accepting the argument, we reject the conclusion, however, because in our view this

23

24

The RTO could pay an uplift to generation bidding in above pi1. See, e.g. Cramton and Stoft (2007) and Holmberg (2009)

(i) does not jibe with the existing methodology for collecting transmission fees in United States RTOs, and (ii) introduces unnecessary complexity into the mechanism. With respect to the first point, in the United States, RTOs routinely allot grid usage according to physical transmission rights (PTRs). An RTO generally allocates the load serving entities (LSEs) in its service area firm PTRs for network load. This ensures that the LSE has sufficient transmission capacity available to meet its load obligations. The RTO charges the LSE for these rights, and then reimburses them with FTRs (based on the principle that the LSEs were the ones who built the grid, so they should be reimbursed for their investments). The RTO will award non-firm transmission rights for subordinate transactions, such as power marketers moving power. Such rights are non-firm in the sense that the RTO may choose to preclude the associated transactions through transmission loading relief (TLR) procedures.25 With procedures for charging customers for transmission service currently in effect, it is only logical to adapt the mechanism to them. RTOs calculate charges for transmission service based on the revenue requirements of their participating transmission owners (TOs).26 Therefore, we argue that the RTO incorporate the complementary charge into these pre-existing RTO transmission charges. With respect to the second point, it is not necessary that the complementary charge be correct (in the sense that, combined with the variable charge, it compensates the transmission developer the desired amount) every period. Rather, it need only be correct in expectation. Therefore we recommend calculating the complementary charge as follows: 1. Through system simulations, calculate the average shortfall between RICC and the variable component.
25

See, PJM Open Access Transmission Tariff, Section II: Point-to-Point Transmission Service for a detailed description of PJMs methods for allocating firm- and non-firm Point-to Point Transmission rights, and Schedule 7: Long-Term Firm and Short-Term Firm Point-To-Point Transmission Service, and Schedule 8: Non-Firm Point-To-Point Transmission Service for prices for these services (available at http://www.pjm.com/documents/~/media/documents/agreements/tariff.ashx). 26 For example, PJMs transmission charges include a monthly demand charge (based on the customers daily network service peak load contribution) and charges for firm- and non-firm point-to-point transmission service.

Attach a relative social welfare weight on consumer surplus vs. firm profit to calculate the values of the variable and complementary components. 3. Adjust the RTOs demand and point-to-point transmission charges so as to create a surplus in revenue collected (above the revenue requirement of the relevant TOs) equal to the average difference, calculated in step 1.
2.

The first step is straightforward. In order for the mechanism to work reasonably well, the complementary charge should be set to provide the transmission developer with the RICC, on average, and the RTO has no better way to estimate this average other than simulations. The second step involves calculation of

, which determines how much better off load-pocket

consumers will be as a result of the transmission line. To calculate , we must weigh consumers surplus against generator profits. As for the third step, in light of Greens fourth principle, the complementary charge will be an adder on top of the pre-existing TOs combined revenue requirement. Therefore, the RTO must determine the change in the demand and point-to-point transmission charges necessary to cover the existing revenue requirements and provide the revenue calculated in step 1.27 For sake of expositional simplicity, we will ignore the demand charge and the difference between firm-and non-firm transmission reservations while demonstrating the calculation of the complementary charge. We will also ignore variability of demand, treating all values as averages. For sake of generality, we also relax the assumption that Qi =Q j . Total revenue collected in the energy market is then:
TR = pi1Qi + p j1Q j

(4)

While total energy cost is:

In the event that the fixed charge does not fully cover the amount owed to the transmission line, a supplemental, or true-up charge would apply to all transmission line users at the end of the relevant period (e.g. monthly or yearly).

27

TC = pi ( Qi + K ) + p j Q j K

(5) Taking total energy market revenues minus total cost yields the amount collected by the variable component:

VC = pi1Qi + p j1Q j pi ( Qi + K ) + p j Q j K

= ( z y ) K + 2 K hQ j gQi (1 ) Q j z hQ j ( g + h ) K 2
(6) We note that the variable component is strictly decreasing in the slope of the cost function for node i generation, as well as the quantity of load served at that node. The two terms combine to play a huge role in determining the amount of compensation paid to node i consumers and their influence could expunge the mechanisms merits.28 With that qualification in place we continue by calculating the value of the complementary charge. As argued above, on average the complementary charge will equal the amount paid to the transmission developer minus the variable charge. The amount paid to the developer is given by
K 0

)]

p j 1 hq pi 1 + gq dq

q (p j 1 ) 0

p j1 hq dq

= p j 1 pi 1
(7) Where q (p j1 ) =

( g + h ) K 2 (1 ) 2 ( z hQ j ) )K
2 2h

p j1 (1 ) h

Finally, taking the difference between these two quantities yields the amount to be collected by the complementary charge.

28

More specifically, when hQj=gQi, the only difference between this mechanism and traditional merchant transmission is the revenue correction (1 ) p j . A situation such as this might call for relaxation of the constraint that node i consumers be held harmless from the price effects of the transmission line.

CC = p j 1 pi 1 K

( g + h ) K 2 (1 ) 2 ( z hQ j ) VC
2 2h

( g + h) K 2 =
2

2hQ j z ( 3 ) h 2 Q j 2 (1 ) z 2 (8) K hQ j gQi + (1 ) 2h

In our simple example, we had no existing transmission owners to keep whole with respect to the new line. In general, though, this will be a concern. This problem is easily solved, however. Let the load-pockets pre-existing average level of imports be equal to A and let the
A new line bring a change in average imports equal to , where the RTO uses data from the

same counterfactual exercise to compute the latter value. For simplicity, assume that all pre-line transmission rights are priced at pa, and post-line rights are priced at pb. The mechanism (1) calls for the RTO to keep the original transmission owners whole, so that after the lines imposition their revenue is equal to pa A ; and (2) requires the RTO to set the post-line price so that the attendant complementary component combines with the variable component to remunerate the transmission developer. Denote by PRb the amount of revenue to be collected in physical transmission rights after development of the line. The two above conditions require

PRb = pb ( A + A) = (TR VC ) + pa A
(9) This allows us to solve for pb as

pb =
(10)

( TR VC ) + pa A
A + A

Thus, the increase in the charge for physical transmission rights due to the new line is:

pb p a =

( TR VC ) pa A
A + A

(11)

Because the payments to the transmission investor, i.e., the lines net social benefit, will vary with load and generation dispatch, the merchant investor seeking a more stable revenue

stream may issue contracts for differences of differences, as per Baldick (2007). Like Baldick, our method values transmission by its contingency-constrained transport of lower value energy to higher value locations and does not require the RTO to be intimately involved in the allocation and reconfiguration of forward transmission rights.

IV.

Consistency with transmission pricing criteria This section discusses the mechanisms consistency with the criteria suggested for

transmission pricing mechanisms. First, we believe that this mechanism has minimal impact on price signals for generation and load. The mechanism has no impact on the prices that generators see. It does involve some alteration in settlements for load, because it attempts to keep generation-pocket load whole with respect to the imposition of the new line and alters the payments load at the downstream end make. However, because load almost universally does not see nodal prices anyway, due mainly to political constraints, settlement alteration will have minimal impact on the price that downstream load sees. By rewarding merchant transmission with virtually all of the net social benefit due to the project, the methodology should distort long-term transmission decisions only minimally. It should also have minimal impact on decisions for new residential load, as previously argued. Commercial and industrial rates are determined separately from residential rates, so the methodology need not have any impact there. The bigger long-term issue is the amount of time the methodology may be deemed as being relevant. Over longer time periods, the pre-line transmission network will no longer resemble a reasonable baseline against which to judge the impact of the transmission addition. It is likely then, that it would be necessary to infer the lines contribution to net social benefit in later years based on its contribution in the years immediately following the line addition. Admittedly the method is not simple. It involves multiple runs of dispatch mechanisms based on actual and hypothetical network conditions. We see this, along with changing network

configuration over time, as being the methods main drawback. The methodologys political appeal tends to counteract these drawbacks. As discussed above, keeping electricity prices low at the upstream end of the line can help blunt line opposition. Finally, we quickly examine promotion of efficient daily operation of the bulk power market, signals for locational advantages for investment in generation, and compensation for owners of existing transmission assets. The method imposes no new distortions on generation decisions, because it uses pre-existing mechanisms ( PTR revenue) for charging for transmission service. Neither does it have any obvious impact on nodal prices paid to generators. It will not affect dispatch, either, as it alters loads nodal prices only retroactively. Because it affects neither dispatch nor generator prices, it maintains locational advantages for generation, as well as preserving low prices for upstream load. As it preserves FTR revenues for existing transmission, and is consistent with preserving PTR revenues for owners of existing transmission assets, it compensates the owners of existing transmission assets as well as the extant FTR system does.

IV.

Conclusion This paper presents a hybrid methodology to financing transmission expansion, which we

see as being a significant step forward in the search for a practicable cost-allocation method for new projects. By adjusting for lumpiness, the methodology measures the transmission expansions net social benefit, equal to the redispatch-cost savings it enables. The second component of the method, the usage-based fixed charge, where usage is determined according to standard load-flow analysis. One calculates this component as that portion of the PTR charge attributable to flow over the new line. One great advantage of the methodology is that it is equally applicable to rate-based, as well as merchant transmission expansions. For rate-based additions, the fixed component is trued up to equal the lines revenue requirement. For merchant transmission expansions, equal to the net social benefit the line confers.

We find that this methodology fairs well with respect to a number of criteria advanced for a transmission financing mechanism. We argue that it performs well with respect to the beneficiaries pay principle, providing accurate signals for transmission expansion, promoting efficient operation of the bulk power market, being politically feasible, and preserving price signals. The methodology is, admittedly, complex, but it is certainly not impenetrable. Another acknowledged weakness is that it applies comparative statics to an inherently dynamic problem, but that is a weakness shared by any comparative static analysis. We judge this weakness to be tempered by the observation that project remuneration far into the future can be determined based on knowledge gained in early years of the projects life. This papers methodology for financing transmission expansions imputes transmission with a value based solely upon the ability of transmission to transport low-cost power from one region to another. But transmission has always played a role in improving system reliability. We see the study of this attribute as a promising area for future research. Along the lines of Blumsack et al. (2006), one can decompose a change in network topology into a congestion effect and a reliability effect. Adding line limits in the model would allow one to use Blumsack et al.s methodology to examine the congestion effect of a new line. The standard technique for valuing reliability improvements associated with a new line is measure the change in a reliability metric (e.g., the N-k criterion, loss of load probability, loss of energy expectation) attributable to the new line, then value that change using value of lost load (VOLL). However, we suggest a more direct approach. Remunerating a new line through a VOLL estimation is both speculative and potentially politically contentious, especially in regions that have already seen large rate increases in restructured electricity markets. Instead, one could simply credit a new line with the additional revenue brought about by the lines reliability improvement, as suggested by Benjamin (2007). Further work along these lines, as well as simulations using a larger network model, would yield important insights into the promise of the methodology our paper exposits.

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