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Merchant Transmission Redux

Financial transmission rights and regulated returns have not induced needed construction. Presenting an alternative model.

Fortnightly Magazine - September 2006

Between 1975 and 1999, transmission investment fell from $5 billion per year (in 2003 dollars) to less than half that amount. It is now on an upward trend, but the 2003 figure (the latest available) is only $4.1 billion. 1 Even if investment increases substantially and stays high, the decline in transmission capacity relative to peak loads will not be reversed quickly. 2 That ratio peaked in 1982, a year when wholesale markets had begun to grow.

By 2004, 75 percent of power generated in the United States went through those markets (this figure does not include some bilateral transactions). 3 Arguments that the system was not “designed” for wholesale transactions are beside the point: They are taking place, providing benefits, and must use the same wires that serve everyone else.

By almost any measure, the nation is running short of transmission, and the existing volume of investment cannot long continue to reliably accommodate retail-load growth and larger wholesale volumes. Factors like environmental opposition also have caused declines and delays in transmission investment, but it seems clear that financial transmission rights (FTRs) and regulated returns have not sufficed to induce the necessary construction.

LMP and the Value of FTRs

Uncertainty about the FTRs granted to new transmission lines is only one reason they provide inadequate incentives. Because their value falls with new investment, awarding FTRs to a line builder almost is self-defeating. In the long debate over locational marginal prices (LMP) and FTRs, this consequence largely went unnoticed. Under LMP, the price difference between two nodes equals the difference in their incremental generation costs. (This difference also is the value of an extra megawatt of transmission service between them.) It was thus expected that LMP would provide incentives to locate new generators efficiently and expand transmission where appropriate.

But no one ever adds just 1 MW of transmission capacity. Scale economies remain so great that an efficiently sized upgrade or new line almost invariably will shrink nodal price differences, possibly even to zero. The closer to equality the investment brings prices, the lower the worth of the FTRs it creates, unless a large volume of new rights emerges elsewhere on the system.

Herein is the difference between merchant generation and merchant transmission. The generator earns an income that reflects the additional (marginal) benefits users receive, because its plant is an incremental investment.

The transmission investor that builds on an efficient scale gains only the small post-construction difference in LMPs. This difference equals the congestion cost saved by the last megawatt of new transmission capacity. The upgrade’s full benefits equal the sum of the savings for every megawatt

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