Ad hoc regulation of a merchant interconnector: maximizing the benefits for grid users

This article was previously published in ICER chronicles. It is a collaboration between Ms. Guro Grøtterud, Ms. Lamis Aljounaidi, M. Antoine Dereuddre and M. Adrien Thirion.

How the French and British national regulatory authorities designed a tailor-made framework to enable maximized benefits for grid users from private-funded 1000 MW HVDC interconnector, speeding up necessary investment.

Introduction

In a context where interconnector capacity is lacking, ElecLink Ltd., a firm planning to develop a merchant interconnector between France and Great Britain applied for an exemption before the national regulatory authorities (NRAs) of these two countries, Commission de Régulation de l’Energie (CRE) and Ofgem. Although generally, interconnectors in Europe are regulated, European legislation provides the possibility for merchant investment. CRE decided and Ofgem to investigate whether and under which conditions this merchant investment could contribute positively to the power system and to consumer welfare.

This paper explores the ad hoc solution developed by the NRAs. After examining the benefits of interconnectors, we study whether ElecLink may generate costs for grid users, and if so whether these can be compensated. We will then look at the concrete measures that were taken by the NRAs to maximize net benefits for grid users while taking into account the specificities of the project [DEC]. We will then explain why merchant interconnectors should not become the standard approach for cross-border transmission investment.

What is ElecLink?

ElecLink Ltd is a joint venture between investment fund Star Capital Partners (51%) and Eurotunnel Group (49%). The latter owns and operates a submarine railway tunnel between France and Great Britain. ElecLink’s project is to build, own and operate an electrical interconnector between the transmission grids of the two countries, passing through the existing infrastructure of the tunnel. The HVDC interconnector would have a capacity of 1000 MW, which represents a 50% increase compared to the maximum capacity currently available between the two countries (2000 MW), and it would be commissioned in late 2016.

In France, the regulatory framework for interconnector investment is set by national and European legislation. Currently, all regulated interconnectors are developed by Réseau de transport d’électricité (RTE), the national transmission system operator (TSO). ElecLink’s situation is however different from RTE’s. In particular ElecLink does not receive regulated revenues from grid tariffs. In order to adapt applicable regulation to its particular situation, ElecLink requested an exemption [PC] from parts of the framework normally applicable to interconnectors – possibility which is given by European legislation under certain conditions [REG]. In particular, ElecLink wanted to allocate up to 80% (800 MW) of the interconnection capacity through up-to-twenty-year contracts. ElecLink requested that this exemption be applicable during 25 years.

Which benefits are expected for grid users from interconnectors?

The European energy sector faces and will face several challenges in the coming years, in particular integration of variable renewable energies, the completion of a competitive single market and, potentially, security of supply issues and increased electricity prices. Sufficient grid flexibility would contribute positively to address these challenges.

Currently, the European electricity system is a zonal system where each country is constituted of one price zone. The interconnections between zones are often bottlenecks, i.e. limiting commercial and physical flows between the zones whereas there is less congestion inside the zones. Interconnections are therefore particular points of attention as concerns the flexibility of the European grid. In particular:

Interconnections provide the possibility to optimize the generation pattern and thus to decrease overall generation costs at European level. Interconnections allow for importing electricity from the lower price areas to higher ones, generating overall lower retail prices. Such flows generate social welfare in both the importing and the exporting country in addition to the congestion rent. As concerns France and Great Britain, power prices may differ significantly. In 2013, the spot price was higher in GB than in France 84% of the time, with an average price difference of 20€/ MWh [MRI] during these hours.

Figure 1: Welfare generated by a cross border exchange. Net import (export) curve represents price variation in the importing (exporting) country when the cross border exchange increase. The social welfare is split between net welfare for the importing country, for the exporting one, and congestion rent. Interconnections contribute to integrating variable renewable energies. Generation surplus in one country may be exported instead of being reduced, potentially replacing less green generation in the importing country. Avoiding reducing variable renewables is key in a context of high political ambitions for their development, as their growing part in national final gross consumption increases the difficulty of the challenge.

In addition, interconnections support the security of the European system both on short-term, through balancing energy exchanges and on long-term, as a complement to peak generation facilities available in the zone to cope with high consumption phases. As such, interconnections can avoid excessive investment in peak generation, in particular if demand schemes differ between interconnected countries.

Last, interconnections can be used as a vector to promote competition, by facilitating the entry of new players in national markets. Competition stimulates decreased costs and prices for generation and retail offers in the interest of end consumers.

Historically, the European grid was constituted by national grids that were interconnected for TSOs’ mutual assistance emergency situations. Today, the role of interconnectors has extended from a sole emergency tool for avoiding blackout to an answer to the four abovementioned issues. In this new context, current interconnection capacities prove to be insufficient and massive development is needed. To this aim, several European and national initiatives have been set up, with regulated investment by national TSOs as a general rule.

Can ElecLink play a role in this context?

Would ElecLink substitute regulated projects? Would it generate costs for grid users without compensation? Before considering the regulatory framework to be applied to ElecLink, CRE and Ofgem examined whether the projected interconnector could be useful for grid users, i.e. whether the overall impact for grid users would be negative or positive. Indeed, ElecLink should only be encouraged to realize its project if the impact was positive.

The NRAs first examined the impact of the Eleclink project on the feasibility of planned regulated investments. 2013 figures (see above) seemed to indicate that further interconnection capacity was necessary between France and Great Britain. However, RTE had, together with British counterparts, two new regulated interconnector projects between the two countries. These consisted of submarine DC cables totaling 2000-2400 MW interconnection capacity [PCI]. If ElecLink were to substitute one of these projects, it would result in reduced regulated revenues. Such reduction would potentially be reflected in increased grid tariff paid by grid users and in particular consumers – without any additional social welfare being created, compared to a situation without ElecLink. This possibility was however ruled out, as according to RTE, ElecLink’s project does not change the validity of the regulated projects [PC]. ElecLink will add to, and not substitute, RTE’s projects.

Figure 2: Existing and planned interconnectors between France and Great Britain, with capacity and (planned) commissioning date Second, the NRAs looked at the costs that the new investment might generated for grid users. Indeed, the connection of any asset to the transmission grid may generate congestions. These are solved by grid reinforcement or by other actions such as redispatching of generation. The costs occurred are covered by the TSO [ACCESS] and ultimately by the grid users, in particular the consumers. In addition, even if no regulated projects are substituted by a merchant project, the additional project will cause interconnection capacity prices to decrease. The resulting loss of regulated congestion rent is ultimately suffered by grid users, and therefore constitutes a negative externality.

Negative externalities might reach considerable amounts (whether the investment is regulated or merchant), and even outweigh the positive externalities such as social welfare and increased security of supply expected from a new interconnector. Unlike the national TSO, which is in charge of the whole grid, a merchant investor has no reason to take such costs into account in its business plan.

Therefore, both positive and negative externalities of ElecLink were examined. Calculations provided by ElecLink were analyzed and compared to figures provided, on CRE and Ofgem’s request, both by the national TSOs (congestion costs) and from London Economics (social surplus), a consultancy firm who, on CRE’s and Ofgem’s request, provided analysis of particular parts of ElecLink’s request. Findings showed negative externalities below 100 M€, whereas the positive externalities exceeded 550 M€. Although it is impossible to perfectly forecast future externalities and although these externalities depend on several external factors, the probability for a positive sum of externalities is overwhelming.

This conclusion led CRE to further consider the framework to be set up for ElecLink, in order to allow the realization of the forecasted positive impact.

Figure 3: Distribution of costs and benefits of an interconnector for grid users.

How to make the investment possible...

ElecLink will own and operate one single asset: the ElecLink interconnector. ElecLink will depend solely on the interconnector’s revenues to pay its operating charges, service its debt and possibly pay taxes and distribute dividends.

Interconnectors derive their revenues from selling cross-border capacities. The revenues are thus closely related to the price differential between the markets they connect. Yet, capacities on European interconnectors are only sold for periods, not exceeding year ahead. Income from such products is particularly sensitive to variations of the price differential, and would thus depend on:

• The evolution of electricity demand in France and Great Britain and other relevant markets over the next 25 years

• The evolution of the generation mix and production costs

• The evolution of interconnection capacity between relevant markets over the same period

Forecasts for these elements vary considerably, depending on, amongst others, the development of renewable energy, energy efficiency measures, the future of nuclear production, the cost of energy products (gas, coal, fuel, etc.) and the success of other interconnector projects. Revenues from short term products are thus “uncertain and stochastic” as qualified by London Economics.

However, before deciding to provide debt financing, creditors test the ability of the projects to pay them back under extreme hypotheses. One such hypothesis is that uncertain revenues are not realized. Therefore, creditors request to “have a significant portion of project revenues covered by long-term contracts”. As a result, ElecLink requested the possibility to enter multi-year capacity contracts for up to 80% of its capacity.

The need for project finance and, subsequently, multi-year contracts, was confirmed by London Economics. Therefore, the the NRAs considered necessary for the project to be realized that capacities could be allocated through up to twenty-year long capacity contracts.

...while protecting the interests of consumers...

On regulated interconnectors in Europe, capacities are not allocated for more than a year ahead. Therefore, before allowing ElecLink to allocate up to twenty-year long capacity contracts, it was necessary to examine the impact of this exemption from harmonized European rules may have on the electricity market and thus, ultimately, on consumers. Indeed, although interconnectors generally contribute to enhanced competition, capacities locked in for a very long period could have the opposite effect. Diminished competition is expected to increase market power and thus retail prices.

Therefore, CRE and Ofgem considered that ElecLink should not be allowed to sell more multi- year capacities than what is necessary for the bankability of the project. ElecLink requested to sell up to 80% of the capacity, i.e. 800 MW, as multi-year capacities. However, the project’s need was to secure a certain level of revenues. The NRAs therefore decided to complete ElecLink’s suggested limit by setting a maximum amount (which is kept confidential) for income from multi- year capacities ).

Figure 4: Maximum capacity volume allocated through multi-year capacity contracts, depending on resulting price.

Moreover, if one market player holds a too large amount of allocated multi-year capacities, it could impact competition negatively, in particular if the concerned market player is already in a dominant position in the importing market. Basing on a competition study provided by London Economics, CRE decided to apply the following rules to multi-year capacities:

• Maximum 20% of the interconnector capacity, i.e. 200 MW, may be allocated to a market player with more than 40% market share in the importing market;

• Maximum 40% of the interconnector capacity, i.e. 400 MW, may be allocated to any market player in any direction.

Finally, smaller players must be able to be eligible at least for smaller and/or shorter capacity products.

...and maximizing social welfare

Efficient use of the interconnector

Best practices to efficiently manage the existing and future cross-border infrastructures are currently developed and implemented at European level. Although an exemption has been granted to ElecLink , the major part of these best practices, shall also apply. Indeed, the abovementioned benefits generated by an interconnection highly depend on the operator’s capacity management and the market players’ capacity use.

One of these best practices is Market Coupling, which was implemented between France and Great Britain in February 2014. Market Coupling consists in fully optimizing the use of the interconnection: optimal flow is calculated based on information from the electricity exchanges (bids and offers) and TSOs (available interconnection capacity). This contributes to avoid situations where the highest price zone exports to the lowest price zone, or where the interconnection capacities are not fully used although the prices in the two connected countries differ. Such situations resulted in 2013 in a loss of welfare of 20 M€ [MRI] and illustrate how capacity management influences interconnector benefits for the grid users. ElecLink must to implement this pan-European optimization tool, otherwise the benefits expected from its interconnector would be undermined.

Moreover, ElecLink must implement measures to avoid capacity withholding to guarantee availability of all unused capacity to the market at all times. Together with the Market Coupling, such measures guarantee efficient use of the ElecLink interconnector and prevent any possibility to affect market prices.

Making all capacity available at all times implies in particular that ElecLink has to apply Use-It-Or- Sell-It (UIOSI) and netting. UIOSI means that when a capacity holder does not want to use its long-term rights, the capacity is made available to the market at the day-ahead timeframe, while netting means that when calculating day-ahead capacities in one direction, nominated capacities in the opposite direction are taken into account to maximize available day-ahead capacity.

Thus, ElecLink must respect current best practices. However, these may change over time to adapt to new challenges of the European market. It is therefore key for the regulator to be able to intervene on ElecLink’s capacity management rules during the whole exemption period (25 years). If not, there would be a risk of inefficiency, distortions, and thus a brake to move forward. To cope with this issue, a two-step approach has been chosen:

• An overall frame including high level principles has been defined by the NRAs, this applies for 25 years;

• Capacity management rules to be redrafted when necessary. These are submitted to regulatory approval and shall be adapted to evolutions of the overall market design while respecting the high level principles. This allows the NRAs to control that the rules adapt correctly to new challenges.

Sharing the profits with grid users

According to European legislation, revenues resulting from interconnection capacity allocation are to be invested in increased interconnection capacity or availability of existing capacities. ElecLink requested an exemption from this, allowing it to keep all the revenues from its activities.

Fundamentally, ElecLink’s revenues will come from congestion rents derived from electricity price spreads between two market zones. London Economics’ analysis suggests that revenues may be higher than predicted by ElecLink, and exceed the total costs of the project, including depreciation and cost of capital. Moreover, the downside risks to the project are not such as to justify that ElecLink keeps all the revenues in all circumstances.

Excess profits may be considered as a form of economic rent. Generally, such economic rent is considered to be tamed by market competition when possible or, when impossible, by regulation [TIPR].

Although it is necessary that ElecLink receive revenues from congestion rents, excess profits should be used as foreseen by European legislation. Therefore, the NRAs designed a profit sharing mechanism that works as follows: profits exceeding a certain threshold are distributed, in equal shares, to national TSOs in France and GB and will be used in line with European legislation, i.e. reinvested in interconnection capacities in the interest of grid users. The sharing threshold (which is kept confidential) is consistent with a reasonable internal rate of return, taken into account all the risks taken on by ElecLink.

Moreover, once the sharing threshold reached, ElecLink may keep part of the excess profits. Indeed, if none of the exceeding profits were given to ElecLink, it would probably stop its activity once the sharing threshold was reached. In order to incentivize ElecLink to maintain an optimal interconnector capacity and limit the risk of compromising operation of the interconnector, the NRAs decided that ElecLink would keep 50% of the revenues exceeding the sharing threshold.

Figure 5: Sharing mechanism designed by CRE and Ofgem

The limits of merchant investment

As we have seen, merchant lines, as a private initiative, may be useful to complement regulated transmission operators’ investments and to play a part in speeding up the completion of European integrated markets. Currently, several incentives are developed on European and national level in order to increase regulated investment. Could these be replaced by merchant investment as the standard approach for transmission investments?

Optimal interconnection capacity depend on whose point of view is considered : society or a merchant investor.

• From the society’s point of view, optimal interconnection capacity is reached when additional capacity would fail to generate enough social welfare to recover the costs of the project.

• From a merchant investor’s point of view, optimal interconnection capacity is reached when additional capacity would fail to generate enough congestion rent from price spreads to recover the costs of the project.

At first, adding interconnector capacities increases total congestion rents. However, increased interconnection capacity tends to decrease the price differential between the concerned electricity markets. This means that above a certain capacity, total congestion rents begin to be adversely affected by increased interconnection capacity.

Figure 6: Eventually, total congestion rent decreases with increased interconnection capacity

Merchant investment will not allow for reaching optimal interconnection capacity, as the investor only takes into account the congestion rent, but none of the positive externalities (welfare in importing and exporting countries):

Figure 7: Net social welfare: congestion rent + exporter welfare + importer welfare - interconnector costs Net congestion rent: congestion rent - interconnector costs

This means that under a pure merchant line scheme, there is an inherent incentive to undersize the interconnection capacity in order to maximize profits, leading to suboptimal capacity and potential adverse effects for the electricity market.

As a consequence, although merchant lines may be useful as a complement to regulated investments this should not become the standard approach for transmission investments.

Conclusion

Although interconnection investment is generally regulated in Europe, the example of the ElecLink interconnector shows that merchant investment may contribute positively to interconnection capacities in the interest of consumers. This is particularly the case where regulated investment is not (yet) sufficient: in ElecLink’s case, the merchant interconnector adds to regulated investment and thus accelerates the necessary interconnection capacity increase.

However, this tool is to be handled with care. First, merchant investment does not allow for reaching the societal optimum of interconnector capacity. Second, the potentially important negative externalities of a merchant project need to be taken into account by the regulator before allowing the project to go on. Eventually, an ad hoc regulatory framework needs to be developed. While allowing bankability of the project, such a framework needs to take into account the specificities of the project and of the two interconnected markets. In this aim, a solid cooperation between concerned regulators and detailed exchanges with the merchant investor are key to success.