OverviewElectricity transmission pricing and transmission grid expansion have received increasing regulatory and analytical attention in recent years. Since electricity transmission is a very special service with unusual characteristics, such as loop flows, the approaches have been largely tailor-made and not simply taken from the general economic literature or from the more specific but still general incentive regulation literature. An exception has been Vogelsang (2001), who postulated transmission cost and demand functions with fairly general properties and then adapted known regulatory adjustment processes to the electricity transmission problem. A concern with this approach has been that the properties of transmission cost and demand functions are little known but are suspected to differ from conventional functional forms. The assumed cost and demand properties in Vogelsang (2001) may actually not hold for transmission companies (Transcos). Loop-flows imply that certain investments in transmission upgrades cause negative network effects on other transmission links, so that capacity is multidimensional. Total network capacity might even decrease due to the addition of new capacity in certain transmission links. The transmission capacity cost function can be discontinuous. There are two disparate approaches to transmission investment: one employs the theory based on long-run financial rights (LTFTR) to transmission (merchant approach), while the other is based on the incentive-regulation hypothesis (regulatory approach). An independent system operator (ISO) handles the actual dispatch and operational pricing. The transmission firm is regulated through benchmark or price regulation to provide long-term investment incentives while avoiding congestion. In this paper we consider the elements that could combine the merchant and regulatory approaches in a setting with price-taking electricity generators and loads. MethodsBased on LTFTRs, merchant mechanisms are easiest to understand for incrementally small expansions in meshed networks under an ISO environment. The price-cap method seeks to regulate a monopoly Transco. The regulatory goal in this paper is an extension of Vogelsang (2001) for meshed projects. Transmission output is redefined in terms of incremental LTFTRs (or total LTFTRs, if a long period is assumed) so as to be able to apply the Vogelsang's incentive mechanism to a meshed network. For lumpy and large transmission projects a fixed part of the tariff plays the role of a complementary charge. The variable part of the tariff is based on nodal prices; pricing for the different cost components of transmission is such that they do not conflict with each other (fixed costs are allocated so that the variable charges are able to reflect nodal prices); variations in fixed charges over time partially counteract the variability of nodal prices giving some price insurance to the market participants. * Contact author: División de Economía, CIDE, Carret. México-Toluca 3655, Lomas de Santa Fé, C.P. 01210,...

We propose a merchant mechanism to expand electricity transmission based on long-term financial transmission rights (FTRs). Due to network loop flows, a change in network capacity might imply negative externalities on existing transmission property rights. The system operator thus needs a protocol for awarding incremental FTRs that maximize investors' preferences, and preserves certain currently unallocated FTRs (or proxy awards) so as to maintain revenue adequacy. In this paper we define a proxy award as the best use of the current network along the same direction as the incremental awards. We then develop a bi-level programming model for allocation of long-term FTRs according to this rule and apply it to different network topologies. We find that simultaneous feasibility for a transmission expansion project crucially depends on the investor-preference and the proxy -preference parameters. Likewise, for a given amount of pre-existing FTRs the larger the current capacity the greater the need to reserve some FTRs for possible negative externalities generated by the expansion changes.

This paper examines the Hogan-Rosellón-Vogelsang (2007) (HRV) incentive mechanism for transmission expansion, and tests it for different network topologies. This new mechanism is based upon redefining transmission output in terms of point-to-point transactions or financial transmission rights (FTRs) and applies Vogelsang's (2001) incentive-regulation logic that proposes rebalancing the variable and fixed parts of a two-part tariff to promote efficient, long-term expansion. We analyze three main topics: first, the behavior of cost functions for distinct network topologies; second, the HRV regulatory approach (incorporated into an MPEC Problem and tested for a three-node network), and third an application to a simplified network. The results suggest that the mechanism is generally suited as an incentive tool for network extensions.

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