The European Commission has just published its strategy to strengthen the European Energy Union.[1] Many issues are addressed, in particular proposals to further the integration of European electricity markets. While the objective is obviously very important for Europe’s citizens, the proposed approach, which relies on numerical goals for construction of new electricity transmission infrastructure between Member States, is difficult to implement. This paper advocates a different approach: the focus should be instead on increasing the coordination of the operations of the existing grids.
1. Inter-country power transfers are essential
Strengthening the common electricity market entails increasing cross border transfers within the European Union. Not only is this a political objective, it is also technically and economically critical.
European countries are gradually diverging when it comes to choosing their electricity policies. For example, while Germany commits to renewable energy by setting the ambitious goal of 80% of electricity production from renewable sources by 2050, France continues to rely on nuclear energy, and the UK appears to be moving towards a balance of nuclear and renewables. It is precisely this difference between national policies that makes cross border transfers valuable.
Consider the France-Germany interface as an example: Germany will eventually produce a significant amount of its electricity from renewable sources. When the sun is shining and the wind blowing, Germany will generate excess electricity at zero marginal cost, and export it to France. On the other hand, on winter nights with no wind, Germany will import electricity from France. With very different power production facilities in each country, being able to transfer proves mutually beneficial.
On the other hand, consider the (hypothetical) case of two countries using exactly the same production technologies. Since at all times the kilowatthours are generated using the same technology on both sides of the border, there is no reason to replace a “nuclear” or “coal” kilowatthour from one country, with a kilowatthour produced with the same technology in another. In this situation, exchanges are not economically profitable and the interconnections serve only to provide security in the event of a failure of generating units or when there is a demand surge in one of the countries.
The above examples illustrate that the economic importance of electric power transfers increases as the types of generation - and thus primary resources available and energy policies - continue to diverge between European Union countries. The Commission is therefore right to attempt to increase cross-border transfers.
An increase in transfers also increases energy policy interdependency between Member States. For example, Great Britain has decided to implement Contracts for Difference to encourage investment in some production technologies, particularly nuclear and renewables. These contracts offer producers additional remuneration equal to a price fixed in advance minus the market price. Producers are thus guaranteed to receive an amount fixed in advance, whatever the market price. If exchanges between Germany and Great Britain increase significantly, German renewable energy produced at zero marginal cost will lower electricity market price in Great Britain. Contracts for Difference will thus become more expensive for British consumers, which will prompt policy makers to limit their number.
Energy policy interdependency is graphically and clearly illustrated on the figure below, reproduced from the work of Karsten Neuhoff and others (discussed later in this post). The study computes electricity wholesale prices for hundreds of points on the European transmission grid. The upper map shows these prices if the wind is not blowing, and the lower map these prices when the wind is blowing. With no wind, prices are around 80 €/MWh across the whole of Europe. With maximum wind on German wind turbines, wholesale prices in Germany fall to around 20 €/MWh. With this cheap electricity exported, prices in France and Spain fall to around 30 €/KWh.
2. Is the 10% interconnection requirement meaningful?
To increase electricity flows between Member States, the Commission proposes a quantitative infrastructure target: transmission capacity between each Member State and its neighbours must be at least 10% of the installed electricity production capacity in the country by 2020, and this figure will probably rise to 15% by 2030. This target has the advantage of being simple and clear.
It is highly likely that new interconnections will be necessary. Historically, electricity transmission lines between countries have been constructed to improve security of supply: if a country experiences a shortfall in electricity production following an accident, it can import energy generated in neighbouring countries. Today the European grid has a relatively high density, but it has not been designed for commercial transfers. The Commission is right in considering that the current infrastructure is not adequately developed and will be even less adapted when power generation facilities become more diverse.
However, there is no economic justification for the 10% objective. The examples discussed previously show that interconnections do not all have the same value. Rather than imposing an across the board criteria of 10%, it would be more effective to focus on high value interconnections. To identify these, the profits from an interconnection should be compared with the cost of its installation and operation.
Engineer-economists from the Massachusetts Institute of Technology[2] have analysed this issue as early as the 1980s. Since interconnections (and transmission lines in general) enable the transfer of kilowatthours between two countries or regions, the economic value of these transfers is the difference in price between the two ends of the line.
Take the example of the recently inaugurated France-Spain interconnection. It cost €800 million and has an effective capacity of 1 400 megawatt (MW). Assuming a 10% discount rate, amortization from construction is €80 million, a cost of around €60 000 per MW per year. Dividing this by the number of hours in the year, interconnection between the two countries comes to around 6.5 € per megawatthour (€/MWh). Therefore, interconnection is economically justified if, and only if, the price difference between the Spanish and the French markets is above an average of 6.5 €/MWh across all the hours in the year.
The greater the capacity of the line and the higher the number of lines between two countries, the more energy is transferred and the more the price difference between the two ends of the line is reduced. As is often the case in economics, the “optimal” interconnection capacity is determined by a marginal criterion: the cost of increasing capacity must be equal to the difference between the prices of energy at the two ends of the line.
Rather than setting a uniform quantitative requirement, it is therefore preferable to focus on high added-value interconnections, namely those linking Member States with sufficiently different energy generating facilities. For example, interconnecting German wind turbines with Scandinavian hydropower reservoirs would increase our ability to store in these reservoirs the surplus wind power produced in Germany, and then release it when there is no wind.
3. Software instead of transmission towers
The Commission emphasises the need to construct new lines. However, constructing new infrastructure, in particular transmission lines, is a longer and more difficult process today to than in the 1970s and 1980s. Ambitious global network expansion plans come up against opposition from local communities who do not wish to see power lines crisscrossing their landscape.[3] In some cases, construction is simply impossible, while in others it is possible only if the lines are underground. The extra cost involved is then significant. For example, the recently inaugurated underground line between France and Spain costs 8 times more than an aerial line.
In many cases, either the interconnections will not be constructed, or their cost will be so high that it will exceed any expected returns. The line will therefore be non-economic or reduced in size.
Rather than focusing on highly uncertain infrastructure development, a more effective policy to increase power exchanges would be to increase the coordination between network operators.
Today, each EU country has its own Transmission System Operator (TSO) which is responsible for “keeping the lights on” within national borders: it controls power flows on the grid in real time and makes decisions on load-shedding if necessary. In France the TSO is Rte, in Belgium Elia, while there are 4 TS0s in Germany.
Each TSO decides which action to take based on its own technical and economic rules for network management, and taking into account other TSOs’ actions. In Europe around fifteen operators make independent decisions, without fully internalizing the impact of these decisions on their neighbours. It is easy to understand that this situation is inefficient. The simplest solution is to integrate grid operation activities within a common framework. This is the Independent System Operator (ISO) or Regional Transmission Operator (RTO). In such a framework, national TSOs would retain their network assets, network access tariffs would be set at state level, but there would be a single network operations centre.
This model has been in place in the United States since the end of the 1960s: after the major blackout in 1965, several north eastern US states decided to create “tight power pools”, which centralise transmission network operations over several states and companies. When the electricity industry was restructured at the end of the 1990s, these “pools” became ISOs and then RTOs, managing the market.
The UK also adopted the ISO model: when the Scotland market was integrated into the England and Wales market in 2005, the Scottish transmission network remained under the ownership of Scottish electricity companies, but its operation was transferred to National Grid, the English TSO.
Several academic studies have evaluated the welfare gains arising from strong coordination of electricity network management. Erin Mansur and Matthew White[4] studied the merger between PJM (an ISO in the US), and its neighbouring ISO. They conclude that commercial transactions increased by 42% following the merger. More recently Karsten Neuhoff[5] and his colleagues simulated the impact of coordination between European TSOs, for various scenarios of renewable penetration. They consider that coordination makes it possible to:
increase international transfers (in MW) by up to 34%,
reduce system costs from 0.8 to 2 billion euros per year (between 1.1 and 3.3% of costs) depending on the penetration of renewables,
reduce average prices in 60 to 70% of the countries studied.
In both of these studies, significant gains are achieved without erecting even one single transmission tower!
The Commission mentions the need for stronger coordination, but does not go so far as to recommend the (eventual) creation of a European ISO. Why being shy when the potential gains for the community are so high?
The answer is that some TSOs do not support the emergence of a European ISO, which would take away some of their responsibilities. Similarly, some countries use the issue of national sovereignty to maintain a national dispatching centre. If there is a power failure and there is a need for load shedding, would a European ISO based in Brussels serve consumers in Belgium first, at the expense of those in France? In fact, the European ISO would carry out load shedding following an established and transparent protocol, and not based on the moods or personal preferences of its employees. Moreover, the creation of the ISO would significantly reduce the likelihood of a power failure by coordinating all available generation and transmission assets.
* * *
The European Commission has correctly identified the important and urgent need to increase transfers between Member States. Rather than announcing objectives with questionable economic effectiveness and uncertain feasibility, a real European goal would be to move ahead with a European ISO project. It is a politically difficult task, but the role of the European institutions is precisely to convince Member States to find compromises that benefit the community as a whole.
[1] http://ec.europa.eu/priorities/energy-union/docs/energyunion_fr.pdf
[2] F. Schweppe, M. Caramanis, R.Tabors and R. Bohn, Spot pricing of electricity, Kluwer Academic Publishers, 1988.
[3] After NIMBY (“Not In My BackYard), citizens now appear to favor BANANA (“Build Absolutely Nothing Anywhere Near Anything”).
[4] “Market organization and efficiency in electricity markets”, http://www.dartmouth.edu/~mansur/papers/mansur_white_pjmaep.pdf, 2012.
[5] «Renewable Electric Energy Integration: Quantifying the Value of Design of Markets for International Transmission Capacity », Energy Economics, 40:760-772, 2013.
