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Regulatory Uncertainty and Inefficiency for the Development of Merchant Lines in Europe

April 2010

EU Energy Law and Policy Issues

Article written with avec Adrien de Hauteclocque, Florence School  of Regulation and published in Delvaux, B. Hunt, M., Talus, K. (eds), EU Energ y Law and Policy Issues, E RLF collection.

The development of the cross-border electricity transmission network is insufficient in Europe. Until now, restructuring has not succeeded in building a regulatory framework able to incentivize the required increase in interconnection capacity through regulated investment. Regulated investment faces the national bias of regulators and the conflict of interests of some integrated companies. In theory, unbundled, independent and well regulated transmissions service operators (TSOs) which coordinate with each other such that network users feel they face a single TSO over the interconnected network is the best way to organize the power transmission grid. For the moment, such organization has not been implemented in Europe and interconnection capacity continues to limit cross-border exchanges which remain the main potential source of competition between European incumbents in the new oligopolistic environment.

Until recently, merchant transmission investment, i.e an investment in cross-border interconnection exempted from the rules on third party access (thereafter TPA) and/or the use of the congestion rent, has been considered a relatively minor issue in the electricity industry and its regulation has mainly been left to national regulatory authorities. Yet, merchant transmission investment is now back on the European regulatory agenda following the granting of exemptions for instance in electricity to the inter-connector BritNed between Great Britain and the Netherlands, the inter-connector Estlink between the Baltic and Nordic electricity markets and the two East West Cables between North Wales and the Republic of Ireland. The small number of exemptions granted so far in Europe does not display a clear picture on the intended role of merchant transmission investment within the strategy of the European Union for the development of interconnection. This issue is highly topical as the third legislative package concerning common rules for the internal market in energy (thereafter Third Package), published the 14th of August 2009, has as one of its core objectives to unlock transmission investment in the crossborder transmission network. It is thus high time to analyse the emerging regulatory choices of the European Union on this issue as well as their consequences on welfare and the creation of competitive markets.

In the case of merchant transmission investment, private investors are invited to construct electricity transmission lines in return for the rights to the revenue created by the spot price differential across the line. These market prices should therefore signal the need for a new investment and provide the revenue to finance it. In the European Union, the merchant transmission investment mechanism is thought to be a complementary solution for the development of interconnection, reserved to the potentially most risky investment. This is Art 7(1) of the Regulation 1228/2003 on cross-border exchanges which used to set the conditions to obtain the exemption. In the new Regulation 714/2009 of August 20099 repealing Regulation 1228/2003, Art 17(1) replaces word by word the former Art 7(1). These conditions appear rather stringent, at least on paper.

Investing in a transmission line is a long-term commitment with a duration of at least fifteen to twenty years. The transmission owner must know with sufficient certainty the rules which will apply for its remuneration before committing for such a long period of time. Uncertainty of regulation may thus delay or even prevent investment. It is noticeable that a dozen applications have been treated in Europe for gas investments, both pipelines and LNG terminals (but only three in the electricity sector). All the gas exemptions were granted, generally with minor modification, which makes the common regulation of gas exemptions much more predictable. In electricity however, the lack of precedents still contributes to regulatory uncertainty.

Another objective of the legal and regulatory framework must be the quest for efficiency. The economic accuracy of decisions on exemption is indeed fundamental for such a widely regulated activity as it sets the incentives for the investor to align its behaviour with the maximization of social welfare.

This paper thus aims to provide an assessment of both the predictability and the efficiency of the current regulatory framework for merchant transmission investment in Europe. Section II quickly reviews the economic literature on the role of merchant lines within the overall development of cross-border transmission networks. Section III then analyses why the exemption process creates uncertainty for potential investors and discusses the likely changes brought by the Third Package, in particular the creation of the Agency for the Cooperation of Energy Regulators (thereafter ACER). Section IV highlights the general trends which can be derived from recent regulatory decisions. Section V opens up a discussion on the opportunity to let dominant generators participate in the exemption process.      

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