Lecture Notes in Energy 7

Juan Rosellón
Tarjei Kristiansen Editors

Financial
Transmission
Rights
Analysis, Experiences and Prospects
Lecture Notes in Energy 7

For further volumes:

http://www.springer.com/series/8874
.
Juan Rosellón • Tarjei Kristiansen
Editors

Financial Transmission
Rights
Analysis, Experiences and Prospects
Editors
Juan Rosellón Tarjei Kristiansen
Centro de Investigación y Docencia Åsegårdsvegen 65
Económicas (CIDE) and German 6017 Ålesund
Institute for Economic Research Norway
División de Economı́a
Mexico, Mexico

German Institute for Economic

Research (DIW Berlin)
Berlin
Germany

ISSN 2195-1284 ISSN 2195-1292 (electronic)

ISBN 978-1-4471-4786-2 ISBN 978-1-4471-4787-9 (eBook)
DOI 10.1007/978-1-4471-4787-9
Springer London Heidelberg New York Dordrecht
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Preface

Efficient operation and optimal expansion of the transmission network system are
some of the most complex and challenging issues that we are faced with in
operational market and regulatory policy design for liberalised electricity markets.
Financial transmission rights (FTRs) – the theme of this book – represent an
interesting and welcome addition to the “box of tools” of market-based, regulatory
instruments and mechanisms for effective network operation and regulation.
The actual, real-world situation in most liberalised electricity markets is
characterised with insufficient investment in the transmission network, resulting
in binding capacity constraints, network congestion, and welfare losses to society,
compared to an optimal expansion path. Inadequate operational rules for the
handling of such constraints have added to the failure of the regulatory system to
effectively cope with network issues of a long-term as well as a short-term nature.
The ambition of the editors of the book – Juan Rosellón and Tarjei Kristiansen –
has been to produce a book that can be “an accessible source to researchers and
professionals working with financial transmission rights (FTRs) and electricity
market regulation”. I think that they have admirably succeeded in their objective
and task. The collection of chapters presents an up-to-date survey and stocktaking
of FTRs as a regulatory policy instrument, with a well-balanced blend of theoretical
and practical contributions. The editors should also be credited for not overstating
the case for FTRs in electricity market and network regulation, pointing to some of
their weaknesses and limitations, e.g. in relation to optimal transmission invest-
ment, and emphasising the need for coordinating the use of FTRs with other
regulatory instruments to achieve stated policy objectives.
A fundamental question in electricity market design is to what extent market
transactions and price formation in electricity markets should be separated from
considerations of transmission constraints and network congestion issues. I think
there are strong arguments for adopting a two-step procedure: first, establishing
prices in efficiently functioning electricity markets and, then, solving the network
problems that this market allocation may create, rather than in one simultaneous
operation. In particular, if transmission network and transmission system operation

v
vi Preface

issues are allowed unduly to set the agenda for market operations, we may end up
with an imperfectly functioning market system as a totality.
In such a perspective, FTRs may be considered as a bridging or “intermediary”
instrument between the market and network parts of the system. The primary role of
FTRs, as I see it, at least at this stage of development of market design, is to
function as a transmission congestion risk hedging instrument, comparable to the
role that financial derivatives play as hedging instruments on the market side. To
further develop and introduce FTRs in this capacity should be a regulatory policy
priority. Further research and refinement seem to be needed before FTRs can be
introduced effectively as an instrument for transmission network investment, for
mitigating market power, and for dealing with other regulatory issues and
challenges arising in a liberalised electricity market system. The book also gives
well-founded guidance and direction for such research and refinement.

Einar Hope is Professor Emeritus at the Norwegian School of Economics (NHH)

and Past President of the International Association for Energy Economics (IAEE).
“The essays in this book cover the latest thinking on alternative mechanisms to
manage efficiently scarce transmission capacity, to set prices for using transmission
networks to recover their capital and operating costs, and to provide good incentives
for transmission network operation and investment. Anyone interested in frontier
thinking and practice on these issues will benefit from reading the essays in this book.”
Paul L. Joskow, President, Alfred P. Sloan Foundation (New York, NY) and Elizabeth
and James Killian Professor of Economics, Emeritus, MIT (Cambridge, MA).
“This book from leading experts in the field finally provides a comprehensive overview
of theory and practice of financial transmission rights (FTRs). FTRs are a central
element of successful power market design. They allow generation and load to address
the financial risk of congestion in the transmission network and thus manage the
impacts of increasing deployment of wind and solar power. Read this book to learn
how the FTRs can be part of long-term energy contracting, and thus facilitate
investment in generation and transmission capacity.”
Karsten Neuhoff, Head of Department Climate Policy, DIW Berlin
“Juan Rosellón, a leading researcher with experience as regulator, and Tarjei
Kristiansen, a business person with strong academic records, are the ideal combina-
tion of academic background, hands-on experience, and visionary thinking to assem-
ble – jointly with well-known co-authors – this volume that allows the reader to assess
issues about financial transmission rights, and to weigh potential future applications
but also the limits thereof.”
Christian von Hirschhausen, Chair of Infrastructure Policy, Berlin University of
Technology

vii
.
Acknowledgment

Juan Rosellón acknowledges that his work during the elaboration of this book was
carried out using support of the European Union, through a Marie Curie Incoming
International Fellowship, and of Conacyt (p. 131175).

ix
.
Contents

1 Financial Transmission Rights: Point-to Point Formulations . . . . . . 1

William W. Hogan
2 Transmission Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Ignacio J. Pérez-Arriaga, Luis Olmos, and Michel Rivier
3 Point to Point and Flow-Based Financial Transmission Rights:
Revenue Adequacy and Performance Incentives . . . . . . . . . . . . . . . . 77
Shmuel S. Oren
4 A Joint Energy and Transmission Rights Auction on a Network
with Nonlinear Constraints: Design, Pricing and Revenue
Adequacy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
Richard P. O’Neill, Udi Helman, Benjamin F. Hobbs,
Michael H. Rothkopf, and William R. Stewart
5 Generator Ownership of Financial Transmission Rights
and Market Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
Manho Joung, Ross Baldick, and Tarjei Kristiansen
6 A Merchant Mechanism for Electricity Transmission
Expansion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
Tarjei Kristiansen and Juan Rosellón
7 Mechanisms for the Optimal Expansion of Electricity
Transmission Networks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
Juan Rosellón
8 Long Term Financial Transportation Rights: An Experiment . . . . . . 211
Bastian Henze, Charles N. Noussair, and Bert Willems
9 FTR Properties: Advantages and Disadvantages . . . . . . . . . . . . . . . . 227
Richard Benjamin

xi
xii Contents

10 FTRs and Revenue Adequacy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253

Guillermo Bautista Alderete
11 Trading FTRs: Real Life Challenges . . . . . . . . . . . . . . . . . . . . . . . . . 271
Jose Arce
12 Participation and Efficiency in the New York Financial
Transmission Rights Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
Seabron Adamson and Geoffrey Parker
13 Experience with FTRs and Related Concepts in Australia
and New Zealand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305
E. Grant Read and Peter R. Jackson
14 Transmission Rights in the European Market Coupling System:
An Analysis of Current Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
Gauthier de Maere d’Aertrycke and Yves Smeers
15 Incentives for Transmission Investment in the PJM Electricity
Market: FTRs or Regulation (or Both?) . . . . . . . . . . . . . . . . . . . . . . 377
Juan Rosellón, Zdeňka Myslı́ková, and Eric Zenón
Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
Bios

Chapter 1

William Hogan

William W. Hogan is Raymond Plank Professor of Global Energy Policy at

Harvard University’s Kennedy School of Government and Research Director of
the Harvard Electricity Policy Group.

Chapter 2

Ignacio J. Pérez-Arriaga

Professor Pérez-Arriaga teaches at Comillas University, MIT and the Florence

School of Regulation.

Luis Olmos

Dr. Olmos is a senior researcher at the Institute for Research in Technology of

Universidad Pontificia Comillas.

xiii
xiv Bios

Michel Rivier

Professor Rivier teaches at the Engineering School and is a senior researcher at the
Institute for Research in Technology, both at Universidad Pontificia Comillas,
Madrid.

Chapter 3

Shmuel Oren

Shmuel S. Oren is the Earl J. Isaac Professor in the Science and Analysis of
Decision Making in the Department of Industrial Engineering and Operations
Research at the University of California at Berkeley. He is also Co-Chair of the
Management of Technology Program of the College of Engineering and Haas
School of Business at Berkeley.

Chapter 4

Udi Helman

Dr. Helman has a Ph.D. in energy economics from the Johns Hopkins University
and worked at the U.S. Federal Energy Regulatory Commission and the California
Independent System Operator before his current position directing economic anal-
ysis for BrightSource Energy, a leading developer of solar thermal power projects.

Ben Hobbs

Dr. Hobbs has a Ph.D. in environmental systems engineering from Cornell Uni-
versity, directs the Environment, Energy, Sustainability & Health Institute at Johns
Hopkins University, and chairs the CAISO Market Surveillance Committee.
Bios xv

Richard O’Neill

Richard O’Neill is the Chief Economic Advisor at the Federal Energy Regulatory
Commission and has a doctorate in Operation Research from the University of
Maryland.

Michael H. Rothkopf

Passed away

Michael H. Rothkopf was an applied mathematical modeler who studied and

wrote about auctions and bidding since 1965. Most recently he was Smeal Chaired
Professor of Supply Chain and Information Systems at Penn State’s Smeal College
of Business.

William R. Stewart, Jr

William Stewart is the David L. Peebles Professor of Business at the Mason

School of Business.

Chapter 5

Manho Joung

Mahno Joung holds a Ph.D. in Electrical Engineering from the University of Texas
at Austin (2009).

Ross Baldick

Ross Baldick is Professor at the Department of Electrical and Computer Engineer-

ing at The University of Texas at Austin.
xvi Bios

Chapter 8

Bastian Henze

Bastian Henze works as an advisor on regulatory affairs for a German Transmis-

sion System Operator and holds a Master Degree in Economics from Tilburg
University (2008).

C.N. Noussair

Professor Noussair teaches experimental economics at Tilburg University and

holds a Ph.D. from the California Institute of Technology (1993).

Bert Willems

Bert Willems teaches industrial organization and regulation at Tilburg University

and holds a Master degree in Engineering (1998) and a Ph.D. in economics (2004)
from KU Leuven.

Chapter 9

Richard Benjamin

Dr. Benjamin is a member of the Round Table Group of Experts and has a Ph.D. in
Economics from the University of Illinois.

Chapter 10

Guillermo Bautista

Dr. Guillermo Bautista Alderete is the Manager of Market Validation and Quality
Analysis in the California ISO and serves as an Editor for IEEE.
Bios xvii

Chapter 11

José Arce

Jose Arce runs Maple Analytics, a proprietary trading operation, and has a Ph.D. in
Electrical Engineering from the National University of San Juan, Argentina (2001).

Chapter 12

Seabron Adamson

Seabron Adamson is an energy analyst and economist and a research affiliate and
adjunct lecturer at the Tulane Energy Institute. He holds a M.S. degree from M.I.T
and Georgia Tech, and a M.A. in economics from Boston University.

Geoffrey Parker

Dr. Parker is Professor of Management Science at Tulane University and serves as

Director of the Tulane Energy Institute. Parker received a B.S. degree from
Princeton University and a M.S. and Ph.D. degrees from MIT.

Chapter 13

E Grant Read

E. Grant Read is a consultant on electricity market issues in the Asia-Pacific

region, and Adjunct Professor with the University of Canterbury, in Christchurch,
New Zealand. He has a B.Sc. (Hons) in Mathematics (1975), and a Ph.D. in
Operations Research (1979), both from the University of Canterbury.

Peter R. Jackson

Peter Jackson has a B.Sc. (Hons) in Economics (1992) and a M.Com in Manage-
ment Science (1994). He is currently studying towards a Ph.D. in Management
Science at the University of Canterbury.
xviii Bios

Chapter 14

Gauthier de Maere d’Aertrycke

Gauthier de Maere d’Aertrycke has been working at the Center of Operations

Research and Econometrics under the supervision of Prof. Yves Smeers. His work
is focused on quantitative energy economics.

Yves Smeers

Professor Smeers works on computational models of electricity and gas markets

and on investment models in these sectors. He holds Master Degrees in engineering
and economics from the universities of Liège and Louvain (Belgium) and M.S. and
Ph.D. degrees in Industrial Administration from Carnegie Mellon.

Chapter 15

Zdenka Myslı́ková

Zdenka Myslı́ková holds a Master’s degree in Economics from Center for

Research and Teaching in Economics in Mexico City (CIDE) (2009), and worked
for the Mexican Energy Regulatory Commission.

Eric Zenón

Eric Zenón works at the Centro de Investigación en Energı́a (CIE) in Mexico, and
has a master degree in Engineering and Ph.D. in Engineering (Energy) from the
National Autonomous University of Mexico (2011).
Bios xix

Editors

Juan Rosellón

Juan Rosellón is tenured Professor at the Department of Economics of the Centro

de Investigación y Docencia Económicas (CIDE) and German Institute for Eco-
nomic Research (DIW Berlin). He has been Visiting Professor at the Technische
Universität Berlin (2010–2011), the Technische Universität Dresden (2007–2010),
and the Kennedy School of Government of Harvard University (2002–2005). He
was awarded in 2012 with a Marie-Curie Fellowship from the European Union, in
2009 with the 4th Reimut Jochimsen Prize by the Deutsche Bundesbank, in 2008
with a Georg Forster Fellowship by the Humboldt Foundation, in 2003 with a
Repsol-YPF-Harvard-Kennedy-School Fellowship, and in 2002 with a Senior-
Fellow Fulbright Fellowship. Professor Rosellón has published extensively on
incentive mechanisms to regulate restructured electricity and natural gas markets,
including price-cap methodologies to promote infrastructure investment and
addressing strategic behavior by participants with market power. He is member
of the Editorial Board of Economics of Energy & Environmental Policy, and is also
the Editor of CIDE’s SSCI Journal Economı́a Mexicana, Nueva Época. He was
Chief Economist of the Mexican Energy Regulatory Commission, CRE
(1995–1997), and faculty member of the Program on Privatization, Regulatory
Reform and Corporate Governance at Harvard University (1997–2000), and at
Princeton University (2001). In 1994, he received the National Award in Econom-
ics from Mexican president Ernesto Zedillo. Professor Rosellón holds Ph.D. and M.
A. degrees (Economics) from Rice University, as well as M.Sc (Mathematics), B.Sc
(Mathematics) and B.A (Economics) degrees from the National Autonomous
University of Mexico (UNAM), where he received Gabino Barreda Medal, the
most important student honor granted by UNAM. Contact details: Mexico: División
de Economı́a, Carretera México-Toluca 3655, México D.F., 01210, Mexico, juan.
[email protected]; Germany: German Institute for Economic Research
(DIW Berlin), Mohrenstrasse 58, 10117 Berlin, Germany, [email protected].

Tarjei Kristiansen

Dr. Tarjei Kristiansen was a Vice President with JP Morgan in London and
responsible for German and Nordic power market analysis. Dr. Kristiansen has
also worked for the trading company RBS Sempra Commodities, the utility
Statkraft and KEMA Consulting in its markets and regulation team. Dr.
Kristiansen holds an M.Sc in Physics from the University of Oslo and a Ph.D.
in Electrical Power Engineering from the Norwegian University of Science and
Technology. He completed the Fellows Program at the Mossavar-Rahmani
Center for Business and Government at the John F. Kennedy School of
xx Bios

Government, Harvard University. His Ph.D. focused on risk management

associated with transmission congestion including financial transmission rights.
He frequently publishes papers on European electricity markets, modeling and
financial transmission rights in the US. When he is not analysing and modelling
electricity markets, he spends time jogging or reading finance. He can be reached
at [email protected].
Abbreviations

AC Alternating Current
ACER Agency for the Cooperation of Energy Regulators
AEMC Australian Electricity Market Commission
AEMO Australian Electricity Market Operator
AMP Automated Mitigation Procedure
ANP Adjusted Nodal Price
AP Average Participations
ARR Auction Revenue Rights
ATC Available Transfer/Transmission Capacity
BC Binding Constraints
CAISO California Independent System Operator
CFD Contracts for Differences
CPF Constraint Participation Factor
CPNode Node Available for Trading
CRA Cambridge Research Associates
CRR Congestion Revenue Right
CRR Constraint Rental Right
CSC Constraint Support Contracts
CSP Constraint Shadow Price
CVaR Conditional Value at Risk
CWE Central West Europe
DA Day Ahead
DC Direct Current
DEC Contract Settles as the Difference in LMPs
Between RT and DA
DOE Department of Energy
E East
ECU Experimental Currency Units
ENTSO-E European Network of Transmission System Operators
ERCOT Electric Reliability Council of Texas
EU European Union

xxi
xxii Abbreviations

FB Flow Based
FERC Federal Energy Regulatory Commission
FGR Flowgate Right
FNP Full Nodal Pricing
FTR Financial Transmission Right
GB Gigabyte
GDSK Generation and Demand Shift Key
GSK Generation Shift Key
GWAP Generation Weighted Average Price
HEPG Harvard Electricity Policy Group
HVDC High Voltage Direct Current
IDMA Implicit Dispatch Matching Allocation
INC Contracts that Settles as the Difference in LMPs Between DA
and RT
IOU Investor Owned Utility
IRSR Inter- Regional Settlements Residue
ISO Independent System Operator
ISONE Independent System Operator North England
ISS Incremental Surplus Subsidy
JETRA Joint Energy and Transmission Rights Auction
LF Loss Factor
LHS Left Hand Side
LI Long Island
LMP Locational Marginal Price/Pricing
LRA Locational Rental Allocation
LRAC Long Run Average Total Cost of Generation
LSE Load Serving Entities
LT-FTR/LTFTR Long-Term Financial Transmission Right
LWAP Load Weighted Average Price
MC Market Coupling
MCE Ministerial Council on Energy
MISO Midwest Independent System Operator
MNSP Market Network Service Providers
MS Market Splitting
MW Megawatt
MWh Megawatt per Hour
NEM Australian National Electricity Market
NEMDE Australian National Electricity Market Clearing Engine
NEMMCO National Electricity Market Management Company
NGC National Grid Company
NR Net Revenue
NSW New South Wales
NW North West
NY New York City
NYISO New York Independent System Operator
Abbreviations xxiii

NZEA New Zealand Electricity Authority

OASIS Open Access Same-Time Information System
OPF Optimal Power Flow
OTC Operating Transfer Capability
OTC Over the Counter
P Price
PBR Performance Based Regulation
PJM Pennsylvania-New Jersey-Maryland
PL Profit and Loss
PoI Point of Injection
PoW Point of Withdrawal
PRHSC Protected RHS Capacity
PRR Participant Rental Right
PTDF Power Transfer Distribution Factor
PTP Point-to-Point
PTR Physical Transmission Right
PX Power Exchange
Q Quantity
QLD Queensland
RHS Right Hand Side
RPI Rate of Inflation
RT Real Time
RTO Regional Transmission Operator
SA South Australia
SFT Simultaneous Feasibility Test
SP Shadow Price
SRA Settlement Residue Auction
SW South West
TAS Tasmania
TC Transfer Capacity/Total Cost
TCC Transmission Congestion Contract
TLC Trilateral Market Coupling
TO Transmission Owner
TRANSCO Transmission Company
TSO Transmission System Operator
TSR/TSA Thunderstorm Alerts
UIOSI Use It Or Sell It
UoS Use of the System
USA United States of America
VaR Value at Risk
VB Virtual Bidding
VIC Victoria
VIU Vertically Integrated Utility
VTR Variable Transmission Revenue
ZPTDF Zonal Power Transfer Distribution Factor
.
Introduction

The aim of this book is to be an accessible source to researchers and professionals

working with financial transmission rights (FTRs) and electricity market regulation.
It contains contributions from leading experts within the field (both practitioners
and academics) that provide overviews, both on theoretical and practical aspects,
with detailed discussions. Many of the contributions summarize the current state of
knowledge in a specific area related to FTRs and provide insightful comments that
seek to be accessible to the target audience (typically final-year undergraduates and
postgraduate students studying the economics of energy as well as practitioners in
industry and government). FTRs are a relatively new concept and have mainly been
implemented during the last decade. To our knowledge, there have not been many
academic books published on this subject. We therefore seek to improve the
understanding of such financial transmission contracts. We hope that when the
readers have completed this book, they will have a more comprehensive under-
standing of FTRs and possibly integrate this knowledge into their daily work or
study.
The allocation of scarce electricity transmission capacity presents a major
market design challenge. The electric power system is subject to generation and
transmission technology constraints that make it difficult to define tradable property
rights for physical transmission. This difficulty has led economists to instead create
markets for transmission property rights, which are settled against the congestion
price component of locational marginal prices (LMPs) (Hogan 1992). These
markets have been increasingly adopted in the United States and several other
countries. FTRs were first introduced in northeastern US power markets in the late
1990s. The motivation for the introduction was primarily the management of
transmission price risk. However, other motives included the provision of revenue
sufficiency for contracts for differences, the redistribution of the congestion reve-
nue that the system operator collects, as well as the provision of price signals for
transmission and generation investors.
More precisely, an FTR is a financial contract to hedge source-to-sink (point-to-
point) congestion and entitles its holder the right – or obligation – to collect a
payment when congestion arises in the energy market. The basic definition of an

xxv
xxvi Introduction

FTR consists of: (1) a source and a sink node that identify the point-to-point
direction of the contract, (2) a megawatt (MW) award that is constant for the
duration of the contract, (3) a settlement period, and (4) a life term which identifies
the period of time over which the contract is valid. Nowadays, most FTR markets
offer an obligation type, for which the holder has either the right to collect a
payment when congestion occurs in the energy market or the obligation to pay
when the congestion in the energy market is in the opposite direction of the FTR
definition. The payment or charge is computed as the price differential between the
sink and source nodes times its MW award. An FTR option, in contrast, provides
only the upside benefit to its holder since there is no charge to the holder when
congestion is in the opposite direction of the FTR (Lyons et al. 2000).
Since FTRs are only financial contracts, the payments or charges are indepen-
dent of the actual use of the transmission system by their holders. This separation
provides efficiency by not interfering with the optimal operation of the system. The
allocation mechanisms are usually auction processes run by an ISO (Independent
System Operator). Regardless of the means to issue FTRs, an ISO needs to limit the
overall amount of FTRs that can be feasibly issued. A simultaneous feasibility test
is the underlying process to determine the appropriate amount of FTR awards.
When FTRs are modeled in an allocation process, such as auctions, the source and
the sink used to define every FTR represent bilateral trades for which injections and
withdrawals of power determine the power flow contributions in the transmission
system. Thus, any set of FTRs that can be issued has to be a feasible power flow, in
which no transmission constraints are violated. The transmission system used in the
issuing processes represents as close as possible the transmission system and
configuration that will be used later in the energy market. Since the allocation
process is usually driven by an optimization engine, the optimal solution (or set of
feasible FTRs) is determined by considering simultaneously all FTRs. Therefore,
the optimal set of FTRs is necessarily simultaneously feasible as FTRs will provide
counterflows to each other. By using a simultaneous feasibility test to determine the
optimal set of FTRs to be awarded, revenue adequacy can be ensured. Revenue
adequacy is then the condition in which sufficient money from the forward energy
market is collected to cover all FTR payments over a given period of time.
These and other more detailed concepts on FTRs will be addressed in this book.
The areas covered comprise a wide range of topics related to FTRs. The first part of
the book deals with the formal presentation of key theoretical aspects on a variety of
issues such as FTRs and their different modalities, different mathematical FTR
formulations, transmission pricing and network congestion, flowgate rights (FGRs),
forward and spot auction markets, market power issues in FTR markets, FTR-based
merchant mechanisms for transmission expansion, combined merchant-regulatory
mechanisms, FTRs in an experimental-economics framework, and even an alterna-
tive view on advantages and disadvantages of FTRs. The second part of the book
deals with more practical issues such as revenue adequacy in markets using LMPs;
real-world aspects in allocating, trading, and bidding of FTRs; financial hedging
and risk management strategies; as well as insightful surveys on the most recent
status in countries implementing (or discussing the introduction of) FTRs.
Introduction xxvii

International geographical areas covered include diverse markets in North America,

Europe, and Oceania.
More specifically, in Chap. 1, William Hogan makes a comprehensive presenta-
tion of FTRs. With a standard market design centered on a bid-based, security-
constrained, economic dispatch with locational prices, the natural approach is to
define FTRs that offer payments based on prices in the actual dispatch. Different
models have been proposed for point-to-point and flowgate rights, obligations, and
options. Hogan presents a consistent framework that provides a comparison of
alternative rights. The comparison addresses issues of modeling approximations,
revenue adequacy, auction formulation, and computational requirements.
In Chap. 2, Perez-Arriaga et al. analyze transmission pricing, which is a basis for
derivation of FTRs. They argue that the transmission grid significantly affects
investment and operation decisions and that network effects result in different
nodal prices. However, the application of efficient short-term marginal prices
results in prices that are unable to fully recover the regulated cost of the grid,
which is necessary to ensure the viability of the regulated transmission service.
Therefore, additional, complementary, transmission charges must be applied. Com-
plementary charges should match the shortfall of the grid cost while not interfering
with efficient short-term energy prices and provide efficient long-term locational
signals. Thus, transmission charges must be calculated according to transmission
investor responsibilities, which involve being independent of the commercial
transactions taking place. The complementary charges must be then calculated
once and for all in advance of construction.
Oren analyzes in Chap. 3 a specific issue on the introduction of FTRs to
electricity markets with LMPs, namely, the mechanics and fundamental
relationships between point-to-point FTRs and flow-gate rights (FGRs). Then he
investigates the issue of revenue adequacy in FTR/FGR markets and the possibility
of short positions by transmission owners of FGRs. Such positions allow their
holders to capture some of the FTR auction revenues in exchange for assuming
liability for the corresponding FTR market revenue shortfall, which can be avoided
through improvements in line ratings.
Hobbs et al. present in Chap. 4 another specialized topic: an auction model that
implements a sequence of forward and spot auction markets operated by an ISO or a
regional transmission organization (RTO) for energy and several types of FTRs,
simultaneously. The model includes point-to-point rights as well as options and
obligations and FGRs. This nonlinear model has several applications, including
forward auctions for FTRs conducted on an alternating current (AC) load flow
model. The extension to real power markets includes reactive power (which would
also require an AC model) and the modification of auctions for FTRs on a DC
(direct current) load flow model to incorporate nonlinear losses for the purpose of
loss hedging.
In Chap. 5, Joung et al. study the effects of market power on FTRs. They
specifically investigate how generators’ ownership of FTRs may influence the
effects of the transmission lines on competition. They show that introducing
FTRs in an appropriate manner may reduce the physical capacity needed for the
xxviii Introduction

full benefits of competition. Among the competitive effects of ownership of FTRs,

the focus is on the effects on two possible pure strategy equilibria: the uncon-
strained Cournot equilibrium and the passive/aggressive equilibrium.
Kristiansen and Rosellón propose in Chap. 6 a merchant mechanism to expand
electricity transmission based on long-term FTRs. Due to network loop flows, a
change in network capacity might imply negative externalities on existing FTRs.
The ISO thus needs a protocol for awarding incremental FTRs that maximize
investors’ preferences and preserve certain currently unallocated FTRs (or proxy
awards) so as to maintain revenue adequacy. Kristiansen and Rosellón define a
proxy award as the best use of the current network along the same direction as the
incremental awards. They then develop a bi-level programming model for alloca-
tion of long-term FTRs (LTFTRs) according to this rule and apply it to different
network topologies. They 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 preexisting FTRs, the
larger the current capacity the greater the need to reserve some FTRs for possible
negative externalities generated by the expansion changes.
In Chap. 7, Rosellón presents a combined FTR-based merchant-regulatory
mechanism to incentivize transmission expansion. There are two main disparate
(non-Bayesian) analytical approaches to transmission investment: one employs the
theory based on LTFTR to transmission (merchant approach) while the other is
based on the incentive-regulation hypothesis (performance-based-regulation (PBR)
approach). Practical approaches to transmission expansion have then to a large
extent been designed according to particular criteria as opposed to being based on
general economic theory or on the more specific regulatory economics literature.
Rosellón reviews recently developed approaches for PBR and merchant
mechanisms. Furthermore, he provides insights so as to build a comprehensive
approach that combines both mechanisms in a setting of price-taking electricity
generators and loads.
Henze et al. analyze in Chap. 8 FTRs within an experimental-economics frame-
work. They describe the results of an experiment that considers the behavioral
properties of LTFTRs, with a focus on market efficiency. The setting is one in
which network users can act strategically because they have market power and are
better informed than the network operator about future demand growth. They
measure spot and LTFTR prices, capacity, and welfare and compare them to a
simulated benchmark. They find that, overall, LTFTRs perform well, though they
exhibit considerable heterogeneity.
Benjamin discusses in the last chapter of the theory section, Chap. 9, the
advantages and disadvantages of FTRs. According to Benjamin, FTRs are claimed
to serve four main purposes: transmission price hedging, provision of revenue
sufficiency for contracts for differences, distribution of the merchandizing surplus
that an RTO accrues in market operations, and provision of price signals for
transmission and generation developers. Benjamin argues that FTR allocation has
important distributional impacts and related implications for retail rates. The RTO’s
practices have important implications for the hedging characteristics of FTRs. He
Introduction xxix

argues, via counterexample, that, even in theory, FTRs may not serve as a perfect
hedge against congestion charges. Next, he examines the hedging properties of
FTRs more carefully, commenting on the effectiveness of FTRs as a tool in hedging
profits. Finally, Benjamin looks at the effectiveness of FTRs in hedging congestion
costs in practice.
The practical part of the book starts with Chap. 10, where Bautista Alderete
discusses revenue adequacy, that is, the condition in which the congestion funds
available from the forward energy market are sufficient to cover all FTR payments.
Revenue adequacy is one of the metrics closely studied by market operators and is
an indication of the overall performance of the FTR process. Attaining revenue
adequacy is a challenge due to the inherent changing nature of the variables
impacting both the release of FTRs and the funds collected in the energy market
(namely, outages and derates of transmission elements). He then covers several
practical issues of revenue adequacy in markets using LMPs and FTRs to hedge
congestion.
In Chap. 11, Arce, an expert trader of FTRs, carries out a big picture description
of the challenges existing in real-life operation of FTRs. The FTR business has
evolved substantially in the last 10 years, with more markets to trade and more
sophisticated FTR operations. Furthermore, the low correlation between FTRs and
other financial products has made FTRs very appealing not only to financial
institutions but also to a diverse set of investors. However, there are still challenges
to be addressed before realizing the full value of FTRs as a financial product.
Accordingly, this chapter describes some of them, from the perspective of a
proprietary trading operation, covering three main aspects: building an FTR port-
folio and executing its trade, managing risk and the role played by the FTR desk, as
well as a potential evolution of the FTR business.
In Chap. 12, Adamson and Parker review the history of the New York Indepen-
dent System Operator (NYISO)’s implementation of FTR auctions. They explore
the evolution of participation in the NYISO FTR auction market over the period
2000–2010 by types of firms including utilities, generators/marketers, investment
banks, and specialist funds. Furthermore, they summarize previous analyses of the
NYISO FTR market efficiency, finding that the market was relatively inefficient at
inception, but quickly reduced the spreads between forward and spot prices.
Read and Jackson discuss in Chap. 13 the implementation of FTRs in Oceanian
markets. They discuss the way in which the New Zealand proposal is designed to
deal with locational price differentials resulting from losses and ancillary service
requirements. In the Australian market, approximate congestion rental rights are
available between zones, although they are less firm than the underlying transmis-
sion capacity. In both cases, Read and Jackson discuss extensions to the FTR
concept that have been proposed to deal with the remaining volatility in price
differentials.
Aertrycke and Smeers analyze in Chap. 14 the introduction of FTRs in Europe.
The short-term European electricity market is a zonal system organized along two
different paradigms. “Market splitting” is the rule in the Nordic market (Denmark,
Finland, Norway, and Sweden), while “market coupling” is becoming the reference
xxx Introduction

in the rest of the continental market. The nodal-price model is officially not on the
agenda in Europe even when it is mentioned from time to time. Aertrycke and
Smeers analyze proposals for FTRs in Europe with reference to market coupling
and for the transfer capacity and flow-based models. They conclude that the
organization of both the transfer capacity and flow-based models makes it unlikely
that the firmness of FTRs can be guaranteed in Europe without artificially
restricting the possibilities of the grid.
The book ends with Chap. 15, where Rosellón et al. present an application of a
mechanism (also discussed in Chap. 7) that provides incentives to promote trans-
mission network expansion in Pennsylvania, New Jersey, and Maryland (PJM). The
applied mechanism combines the merchant and regulatory approaches to attract
investment into transmission grids. It is based on rebalancing a two-part tariff in the
framework of a wholesale electricity market with locational pricing. The expansion
of the network is carried out through the sale of FTRs for the congested lines. Under
Laspeyres weights, they show that prices are able to converge to the marginal cost
of generation, the congestion rent decreases, and the total social welfare increases.
The mechanism is shown to adjust prices effectively given either nonpeak or peak
demand.
We really hope that the wide spectrum of issues addressed, the various depth
analyses, practical experiences, and techniques in this book make FTR-related
concepts accessible to all those academically interested as well as practically
working with such financial instruments. We would like to deeply thank all of
those who contributed a chapter in this book as well as the Springer publishing
team.

References

Hogan W (1992) Contract networks for electric power transmission. J Regul Econ 4:211–242
Lyons K, Fraser H, Parmesano H (2000) An introduction to financial transmission rights. Electr J
13(10):31–37
Chapter 1
Financial Transmission Rights: Point-to Point
Formulations

William W. Hogan

1.1 Introduction

Transmission rights stand at the center of market design in a restructured electricity

industry. Beginning with the intuition that electricity markets require some rights to
use the transmission system, simple models of transmission rights soon founder
after confronting the limited capacity and complex interactions of a transmission
grid. The industry searched for many years without success looking for a workable
system of physical rights that would support decentralized decisions controlling use
of the grid.
The physical interpretation of transmission rights was the principal complaint
that buried the Federal Energy Regulatory Commission’s (FERC) original Capacity
Reservation Tariff (FERC1996). Any attempt to match a large number of scheduled
transactions to a set of transmission rights creates a burden that threatens the
flexibility of trade needed to support a market or the flexibility of operations needed
to maintain reliability. And in a design built on the centerpiece of a coordinated spot
market (FERC 2002a), physical transmission rights or any associated scheduling
priority would create perverse incentives and conflicts with priorities defined by the
bids used in a security-constrained economic dispatch. The idea that a simple
physical right can be made to work soon mutates into a complex system of rules
intended to force market participants to act against market incentives. In the end,
the right becomes not so physical and not much of a right. The idea dies hard, but
the physical rights model deserves a decent burial.
If physical rights will not work, then something different is needed to achieve the
same objective in providing a compatible definition of transmission rights for a
competitive electricity market. As electricity market design developed, the focus

W.W. Hogan (*)

Mossavar-Rahmani Center for Business and Government, John F. Kennedy School
of Government, Harvard University, Cambridge, MA 02138, USA
e-mail: [email protected]

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 1

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9_1,
# Springer-Verlag London 2013
2 W.W. Hogan

turned from so-called physical transmission rights to a redefinition of transmission

rights as financial instruments defined with a close connection to both the transmis-
sion grid and a spot market organized through a bid-based, security-constrained,
economic dispatch (Hogan 1992). The financial approach separates actual use of the
grid from ownership of the transmission rights and provides many simplifications
that avoid the principal obstacles encountered in the search for physical rights.
A coordinated spot market with locational prices complemented by financial
transmission rights is a hallmark of market design that works.
There are many possible definitions of financial transmission rights, each with its
advantages and disadvantages. Further, the basic building blocks of financial
transmission rights could support a secondary market with a wide variety of other
trading instruments, just as a forward contract can be decomposed into a variety of
elements with different risk properties.
The basic building blocks under different definitions have different properties.
The purpose here is to organize a common analysis covering different types of
point-to-point financial transmission rights and compare them in regards to four
critical aspects of the transmission rights model. The common notation is an
eclectic synthesis designed to bridge the electrical engineering and economic
market formulations.1
The four aspects of the design cover modeling approximations, revenue
adequacy, auction formulation, and computational requirements. These do not
include important related subjects such as investment incentives. However, an
understanding of at least these four aspects of the formulations would be important
in choosing among the types of rights to include in a market design. The same
would be true of a decision to include all types of rights, where the market
participants could ask for any combination (O’Neill et al. 2002).
Approximation refers to the simplifications inherent in the transmission rights
model in comparison to the complexity of the real transmission system. To illustrate
the point, the simplification that there are no loop flows makes the contract-path
transmission model workable in theory. But the simplification deviates from the
reality and the contract-path model became recognized as inefficient and unwork-
able in practice. The different transmission right definitions depend to different
degrees on approximations of the reality of the network. The discussion here begins
with a simplified but explicit characterization of an alternating current load flow to
then specialize it in the market context for an examination of different transmission
rights.
Revenue adequacy refers to a financial counterpart of physical “available trans-
mission capacity.” A financial transmission right as defined here is a contract for a
financial payment that depends on the outcome of the spot market. By definition,
the system is revenue adequate whenever the net revenue collected by the system
operator for any period of the spot market is at least equal to the payment

1
This paper is an abridged version of the working paper, Hogan (2002). The working paper
includes an elaboration of flowgate financial transmission rights and hybrid models.
1 Financial Transmission Rights: Point-to Point Formulations 3

obligations under the transmission rights. The analogous physical problem would
be to define the available capacity for transmission usage rights such that the
transmission schedules could be guaranteed to flow in any given period. A common
requirement of both is to maintain the capability of the grid, but the complex
interactions make it impossible to guarantee that physical rights could flow no
matter what the dispatch conditions. By contrast, we examine here conditions that
do ensure revenue adequacy for the financial transmission rights.
A natural approach to allocating some or all transmission rights is through an
auction. The auction design also extends to regular and continuing coordinated
auctions that could be employed to reconfigure the pattern of transmission rights,
supplemented by secondary market trading. The auction formulation interacts with
the conditions for revenue adequacy, with different implications for different
definitions of financial transmission rights.
The computational requirements for execution of a transmission rights auction
differ for the different models. The inherent scale of the security-constrained
economic dispatch model takes the discussion into a realm where the ability to
solve the problem cannot be taken for granted. In some cases, the auction model is
no more complicated than a conventional security-constrained economic dispatch,
and commercial software could be and has been adapted successfully for this
purpose. In other cases, the ability to solve the formal model is not assured, and
new approaches or various restrictions might be required. Hence, proposals for
more ambitious financial transmission right formulations have been offered with
the caveat that the expanded service beyond point-to-point rights should be offered
“as soon as it is technically feasible” (FERC 2002b).2
The purpose here is to identify some of the issues raised in the evaluation of
technical feasibility. The comparison of transmission rights models involves
tradeoffs. Some versions may be impossible to implement. At a minimum, ease
of both implementation and use for alternative transmission rights models should
not be taken for granted.

1.2 Transmission Line Load Flow Model

Every alternating current (AC) electrical network has both real and reactive power
flows. The sinusoidal pattern of instantaneous power flow produces a complex
power representation with real and imaginary parts that correspond to real and
reactive power. The real power flows are measured in Mega-Watts (MWs), and the
reactive power flows are measured in Mega-Volt-Amperes-Reactive (MVARs).
The VAR is the product of voltage and current, which is the same unit as the
watt; the notational difference is maintained to distinguish between real and
reactive power. Real power is defined as the average value of the instantaneous

2
Similar qualifications appear in discussions of an introduction of options or flowgate rights in
PJM, New York, New England, the Midwest, and so on.
4 W.W. Hogan

power and is the “active” or “useful” power. Reactive power is the peak value of the
power that “travels back and forth” over the line and has average value of zero and
is “capable of no useful work . . . [and] represents a ‘nonactive,’ or ‘reactive,’ power
(Elgerd 1982).”3 The combination of real and reactive power flow is the apparent
power in Mega-Volt-Amperes (MVA), which is a measure of the magnitude of the
total power flow.
The basic model characterizing electricity markets and financial transmission
rights (FTR) centers on the description of a network of lines and buses operating in
an electrical steady-state. A critical element is the representation of a transmission
line. There is a developed literature on this subject. The choices here do not exhaust
all that is relevant, but illustrate the basic issues in the treatment of AC networks for
purposes of modeling economic dispatch, locational pricing and the related defini-
tion of financial transmission rights. In particular, although the focus is on real power
flow, the model includes non-linear features of real and reactive power and control
devices to illustrate the implications of various simplifications and approximations
often suggested for economic dispatch, pricing and definition of financial transmis-
sion rights. Further extensions to include other elements of flexible AC transmission
systems (FACTS) could be added, with the associated non-linear characterizations
of even the effects on real power flows (Ge and Chung 1999).
A generic transmission line as represented here is illustrated in Fig. 1.1. The data
include the resistance (r), reactance (x), and line charging capacitance (2Bcap).
Variable controls include a transformer with winding tap ratio (t) and a phase shift
angle (α). The voltage magnitude at bus i is Vi and the voltage angle is δi. The flow of
real and reactive power bus from i towards j is the complex variable Zij. Assuming a
steady-state flow can be achieved, the conditions relate the flow of complex power on
a line to the control parameters including the voltage magnitudes and angles. Due to
losses, the flow out of one bus is not the same as the flow into the other. With these
sign conventions, positive flow away from a bus adds to net load at the bus.
The sign conventions support an interpretation of an increase in net load as
typically adding to economic benefit and associated with a positive price. Corre-
spondingly, an increase in generation reduces net load and typically adds to cost.4
The flow of power in an AC electric network can be described by a system of
equations known as the AC load flow model.5

3
For an excellent summary of the basics for those other than electrical engineers, see Elgerd
(1982), pp. 19–32.
4
Atypical negative prices are allowed, and in the presence of system congestion may not be so
atypical.
5
In anticipation of later simplifications, the notation here follows the development of the “DC”
Load Flow model in Schweppe et al. (1988), Appendices A and D. The DC Load flow refers to the
real power half of the nonlinear AC load flow model. Under the maintained assumptions, there is a
weak link between the reactive power and real power halves of the full problem. And the real
power flow equations have the same general form as the direct current flow equations in a purely
resistive network; hence the name “DC Load Flow.” Similar linear approximations are available
for reactive power flow, but the approximation is poor in a heavily loaded system. Hence, if in
addition to real power flow, voltage constraints and the associated reactive power are important,
then we require the full AC model and spot pricing theory as in Caramanis (1982).
1 Financial Transmission Rights: Point-to Point Formulations 5

Fig. 1.1 Generic Zij Zji

transmission line rk xk
representation Vi Vj
di δj
1:tk e jak
1:
Bcapk Bcapk

Let:
nB ¼ Number of buses,
nL ¼ Number of transmission lines, with each line having per unit resistance rk,
reactance xk, and shunt capacitance Bcapij for the Π—equivalent representation
of line k,6
y~P ¼ d P  g P ¼ n B1 vector of net real power bus loads, i.e. demand minus


generation, ytP ¼ yPs ; y~tP where yPs is at the swing bus,

y~Q¼ dQ  gQ ¼ nB1 vector of reactive power bus loads, i.e. demand minus
 
generation, ytQ ¼ yQs ; y~tQ where yQs is at the swing bus,
δ ¼ nB Vector of voltage angles relative to the swing bus, where by definition
δs ¼ 0,
V ¼ nB Vector of voltage magnitudes, where by assumption the voltage at the
swing bus, Vs, is exogenous,
tk ¼ ideal transformer tap ratio on line k,
αk ¼ ideal transformer phase angle shift on line k,
A ¼ the oriented line-node incidence matrix, the network incidence matrix with
elements of 0, 1, 1 corresponding to the network interconnections. If link k
originates at bus i and terminates at bus j, then aki ¼ 1 ¼akj.

6
For a development of the Π—equivalent representation of a transmission line, see Bergen (1986),
Chap. 4. Here we follow Wood and Wollenberg (1984) in representing Bcap as one-half the total
line capacitance in the Π—equivalent representation; (Wood and Wollenberg 1984), p.75. A. See
also Skilling (1951), pp. 126–133.
6 W.W. Hogan

Define7
Gk ¼ rk/(rk2 þ xk2),
Ωk ¼ xk/(rk2 þ xk2),
zPijk ¼ real power (MWs) flowing out of bus i towards bus j along line k, and
zQijk ¼ reactive power (MVARs) flowing out of bus i towards bus j along line k.
Then the complex power flow Zij includes the real and reactive components8:

zPijk ¼ Gk ½Vi2  ðVi Vj =tk Þ cosðδi  δj þ αk Þ þ Ωk ðVi Vj =tk Þ sinðδi  δj þ αk Þ;

zPjik ¼ Gk ½ðVj =tk Þ2  ðVj Vi =tk Þ cosðδj  δi  αk Þ þ Ωk ðVj Vi =tk Þ sinðδj  δi  αk Þ:
(1.1)

and

zQijk ¼ Ωk ½Vi2  ðVi Vj =tk Þ cosðδi  δj þ αk Þ  Gk ðVi Vj =tk Þ sinðδi  δj þ αk Þ

 Vi2 Bcapk ;

2
zQjik ¼ Ωk ½ Vj =tk  ðVj Vi =tk Þ cosðδj  δi  αk Þ
 Gk ðVj Vi =ak Þ sinðδj  δi  αk Þ  Vj2 Bcapk :

Real losses on line k are given by

lPk ¼ zPijk þ zPjik :

Hence, in terms of the angles and voltages we have

h
2

i
lPk ðδ; V; t; αÞ ¼ Gk Vi2 þ Vj =tk  2 Vi Vj =tk cos δi  δj þ αk :

Similarly, reactive power losses are

lQk ¼ zQijk þ zQjik ;

7
Here the notation follows Schweppe et al. (1988). The purpose is to connect to the discussion of
the economics of spot markets and the definition of FTRs. However, the electrical engineering
literature follows different notational conventions. For example, Wood and Wollenberg (1984)
and others use a different sign convention for Ω. Also note that here Vi is the magnitude of the
complex voltage at bus i, not the complex voltage itself as in the appendix. Finally, we use y to
denote the net loads at the buses. This should not be confused with the complex admittance matrix,
often denoted as Y, which is composed of the elements of G and Ω. See the appendix for further
discussion.
8
For details, see the appendix.
1 Financial Transmission Rights: Point-to Point Formulations 7

or
h
2

i
lQk ðδ; V; t; αÞ ¼ Ωk Vi2 þ Vj =tk  2 Vi Vj =tk cos δi  δj þ αk
 
 Vi2 þ Vj2 Bcapk :

Given these flows on the lines, conservation of power at each bus requires that
the net power loads balance the summation of the flows in and out of each bus.
Under our sign conventions and summing over every link connected to bus i, we
have
X X
dPi þ zPijk ¼ gPi  zPjik ; and
kði; jÞ kðj; iÞ
X X
dQi þ zQijk ¼ gQi  zQjik :
kði; jÞ kðj; iÞ

Here the summation includes each directed line that terminates at i (k(j,i)) or
originates at i (k(i,j)) Hence, the net loads satisfy:
X X
yPi  dPi  gPi ¼  zPjik  zPijk ; and
kðj;iÞ kði;jÞ
X X
yQi  dQi  gQi ¼  zQjik  zQijk :
kðj;iÞ kði;jÞ

Recognizing that the individual flows can be expressed in terms of the several
variables, we obtain the relation between net loads, bus angles, voltage magnitudes,
transformer ratios, and phase angle changes:
   
y~P y~P ðδ; V; t; αÞ ~ V; t; αÞ:
¼ ¼ Yðδ;
y~Q y~Q ðδ; V; t; αÞ

Assuming that there is convergence to a non-singular solution for the steady-

state load flow, this system can be inverted to obtain the relation between the bus
angles, voltage magnitudes and the net power loads given the transformer ratios and
phase angle changes9:

9
The convention here is that gradients are row vectors. Hence, with
   
f1 ðu; vÞ @f1 ðu; vÞ=@u @f1 ðu; vÞ=@v
f ðu; vÞ ¼ ; rf ¼ :
f2 ðu; vÞ @f2 ðu; vÞ=@u @f2 ðu; vÞ=@v
8 W.W. Hogan

  " #
δ yP ; y~Q ; t; αÞ
J δ ð~
¼ yP ; y~Q ; t; αÞ; and
¼ Jð~
V yP ; y~Q ; t; αÞ
J V ð~

  " #1
rJ δP r J δQ r yPδ r yPV 1
rJ ¼ ¼ ¼ rY~ :
r J VP r J VQ r yQδ r yQV

This formulation treats all buses, other than the swing bus, as load buses, with
given real and reactive power loads. These are sometimes referred to as PQ
buses.10 In practice, many generator buses are operated as PV buses, where y~P
and V are given and the required reactive power is determined in order to
maintain the voltage (Bergen 1986). There are 4(nB1) variables (i.e., y~P , y~Q ,
δ, V) and 2(nB1) independent node balance equations. Hence, half of the
variables must be specified and then the solution obtained for the remainder.
The corresponding change on the representation of the equations for different
treatment of the buses is straightforward. For example, in the DC-Load model
discussed below, all buses are treated as PV where the first step is to fix y~P and V
to solve for δ and implicitly y~Q .
The power flow entering a line differs from the power leaving the line by the
amount of the losses on the line. Typically, but not always, real power losses
will be a small fraction of the total flow and it is common to speak of the power
flow on the line. In the DC-Load case discussed below, losses are ignored and
the real power flow is defined as the same at the source and destination. In the
case of an AC line, we could select either or both ends of the line as metered
and focus on the flow at that location for purposes of defining transmission
constraints.
We can use these relations to define the link between the power flows on the lines
and the net loads at the buses:

" # " # " #

zP ðδ; V; t; αÞ yP ; y~Q ; t; αÞ; t; αÞ
zP ðJð~ K~P ð~
yP ; y~Q ; t; αÞ
z¼ ¼ ¼ ~ yP ; y~Q ; t; αÞ;
¼ Kð~
zQ ðδ; V; t; αÞ yP ; y~Q ; t; αÞ; t; αÞ
zQ ðJð~ K~Q ð~
yP ; y~Q ; t; αÞ

and " #   " 1

#

 rK~P rzP rJ rzP rY~
rK~y y~P ; y~Q ; t; α ¼ ¼ ¼ 1 :
rK~Q rzQ rJ rzQ rY~
(1.2)

10
The swing bus is a δV bus for which the angle and the voltage are exogenous.
1 Financial Transmission Rights: Point-to Point Formulations 9

Summing over all lines gives total losses as:

2P 3
  lPk ðδ; V; t; αÞ " # " #
LP 6 k 7 yP ; y~Q ; t; αÞ; t; αÞ
lP ðJð~ yP ; y~Q ; t; αÞ
LP ð~
¼ 4P 5¼ ¼ ;
LQ lQk ðδ; V; t; αÞ yP ; y~Q ; t; αÞ; t; αÞ
lQ ðJð~ yP ; y~Q ; t; αÞ
LQ ð~
k

and
1
rL ¼ rlrJ ¼ rlrY~ :
Finally, conservation of power determines the required generation at the swing
bus, gPs and gQs, as:
yP ; y~Q ; t; αÞ þ ιt y~P ; and
gPs ¼ yPs ¼ LP ð~
yP ; y~Q ; t; αÞ þ ιt y~Q :
gQs ¼ yQs ¼ LQ ð~

where ι is a unity column vector, ιt ¼ ð 1 1    1 Þ. Equivalently,

yP ; y~Q ; t; αÞ þ ιt yP ¼ 0; and
LP ð~
yP ; y~Q ; t; αÞ þ ιt yQ ¼ 0:
LQ ð~

These relationships summarize Kirchoff’s Laws that define the AC load flow
model in terms convenient for our subsequent characterization of the optimal
dispatch problem. Given the configuration of the network consisting of the buses,
lines, transformer settings, resistances and reactances, the load flow equations
define the relationships among (1) the net inputs at each bus, (2) the voltage
magnitudes and angles, and (3) the flows on the individual lines.

1.3 Optimal Power Flow

The optimal power flow or economic dispatch problem is to choose the net loads,
typically by controlling the dispatch of power plants, in order to achieve maximum
net benefits within the limits of the transmission grid. Under its economic interpre-
tation, the solution of the power flow problem produces locational prices in the usual
way. For our present purposes we define abstract benefit and cost functions. The
model developed here includes three simplifications. First, strictly for notational
convenience, we assume that all transmission constraints are defined in terms of the
effects of net loads at buses. In reality, transmission constraints may treat loads and
generation differently. Incorporating different buses for generation and load
connected by a zero impedance line would accommodate different effects of load
and generation. This would allow for different prices for load and generation by
treating them as at different locations.
The second simplification is to focus on the real power part of the problem, even
in the AC case. Here we anticipate a market in which we have FTRs for real power
10 W.W. Hogan

but none are required or available for reactive power and there is no reactive power
market. This is not a trivial simplification. It would be appropriate as a model under
the assumption that there are no direct costs of producing reactive power and the
dispatch of reactive power sources is fully under the control of the system operator.
Finally, we abstract from explicit consideration of generation operating reserves.11
With these assumptions, we formulate the economic dispatch problem and then
extend it to the case of security-constrained economic dispatch.

1.3.1 Economic Dispatch

We first specialize the notation to represent the transmission constraints, and then
the simplified aggregate benefit function.
The constraints for the economic dispatch problem derive from the characteri-
zation of the power flow in transmission lines. Under the simplifying assumptions,
we treat the real and reactive power elements differently. Henceforth, we drop the
subscript and treat the variable y ¼ yP ¼ dP  gP as the real power bus loads,
including for the swing bus (yt ¼ ðys ; y~t Þ). We further subsume all other parameters
above in the generic control vector u, with its own constraints as in:
0 1
yQ
u ¼ @ t A;
α
u 2 U:

In addition to these control variables, we recognize that system operators may

change to topology of the network as summarized in A. For simplicity, we limit
attention to differentiable elements of u. However, in the applications discussed
below, the incidence matrix could change. The principal impact of changes in A is
to introduce discrete choices with complications for the optimization problem but
not for the main results for FTRs.
With this notational adjustment, we restate the transmission flows as the function
~ uÞ and the losses as Lðy; uÞ . We assume that the flows are constrained.
Kðy;
In addition, we incorporate the constraint limits as part of the function and append
any other constraints on the real power flows. For example, a constraint on MVA of
apparent power flow at a metered end of the line would be:

z2Pijk þ z2Qijk  bMVA MAXk  0: (1.3)

11
Cadwalader et al. (1998) provides an outline of transmission rights and revenue adequacy in the
context of explicit reserve markets. The analysis is limited to point-to-point obligations, as
discussed below, but could be extended to include other types of financial transmission rights.
1 Financial Transmission Rights: Point-to Point Formulations 11

~ uÞ. All joint constraints on real

We treat this as simply another element of Kðy;
power flows and the various control parameters, including interface and other
~ uÞ. The separate limits on the control variables
operating limits, appear under Kðy;
appear in the set U. Hence, the summary of the constraints is:

Lðy; uÞ þ ιt y ¼ 0;
~ uÞ  0;
Kðy;
u 2 U:

The objective function for the net loads derives from the benefits of load less the
costs of generation. Anticipating a bid-based economic dispatch from a coordinated
spot market, we formulate the benefit function for net loads as:

BðyÞ ¼ Max BenefitsðdÞ  CostsðgÞ

d2D;g2G

s:t:
d  g ¼ y:

Under the usual convexity assumptions, the constraint multipliers for this opti-
mization problem define a sub-gradient for this optimal value problem. For sim-
plicity in the discussion here, we treat the sub-gradient as unique so that B is
differentiable with gradient rB . This gives the right intuition for the resulting
prices, with the locational prices of net loads at pt ¼ rB. The more general case
would require little more than recognizing that market-clearing prices might not be
unique, as for example at a step in a supply function.
Then the economic dispatch problem is:12

Max BðyÞ
y;u2U

s:t:
Lðy; uÞ þ ιt y ¼ 0;
~ uÞ  0:
Kðy; (1.4)

In general, this can be a complicated non-linear and typically non-convex

problem. In most cases, but not all, the economic dispatch problem is well-behaved
in the sense that there is a solution with a corresponding set of Lagrange multipliers
and no duality gap. The problem may still be hard to solve, but that is the challenge
for software implementation.

12
This is similar to the formulation in Caramanis et al. (1982); the principal difference is in
imposing the thermal limit not just on the real power flow, but on the total MVA flow to account
for the total thermal impact. The constraints could also include generator capability tradeoffs. See
Feinstein et al. (1988), pp. 22–26, for a discussion of the generator capability curve tradeoffs
between real and reactive power.
12 W.W. Hogan

Cases where there may be no solution present a real challenge to electrical

systems, as when there is no convergence to a stable load flow, or for markets, when
there may be no price incentives that can support a feasible equilibrium solution.
Both pathological circumstances would present difficulties for electricity markets
that go beyond the discussion of FTR formulations. Hence, while not claiming that
all such economic dispatch problems are well-behaved, we will restrict attention to
the case when (1.4) is well-behaved.
There are many conditions that could be imposed to guarantee that the economic
dispatch problem in (1.4) meets this condition. For our purposes, it is simple to
restrict attention to problems that satisfy the optimality conditions13:

There existsðy ; u ; λ; ηÞ; such that

Lðy ; u Þ þ ιt y ¼ 0;
~  ; u Þ  0; ηt Kðy
Kðy ~  ; u Þ ¼ 0;
η  0; u 2 U;

~ uÞ :
ðy ; u Þ 2 arg max BðyÞ  λðLðy; uÞ þ ιt yÞ  ηt Kðy;
y;u2U

Hence, there is no duality gap (Bertsekas 1995). The Lagrange multipliers

provide the “shadow prices” for the constraints. The solution for the economic
dispatch problem is also a solution for the corresponding dual function for this
economic dispatch problem:


~ uÞ :
Max BðyÞ  λðLðy; uÞ þ ιt yÞ  ηt Kðy;
y;u2U

Assuming differentiability, the first order conditions for an optimum ðy ; u Þ

include:


rBðy Þ  λ rLy ðy ; u Þ þ ιt  ηt rK~y ðy ; u Þ ¼ 0:

Hence, we have the locational prices as

pt ¼ rBðy Þ ¼ λιt þ λrLy ðy ; u Þ þ ηt rK~y ðy ; u Þ:

The locational prices have the usual interpretation

as the price of power at
the swing bus (pG ¼ λ), the marginal cost of losses pL ¼ λrLy ðy ; u Þ and the

13
As an historical note, apparently the early work on optimality conditions by Kuhn and Tucker
was motivated by an inquiry into the theory of electrical networks. Kuhn (2002), p. 132.
1 Financial Transmission Rights: Point-to Point Formulations 13


marginal cost of congestion pC ¼ ηt rK~y ðy ; u Þ .14 These locational prices
play an important role in a coordinated spot market and in the definition of
FTRs.

1.3.2 Security-Constrained Economic Dispatch

The optimal power flow formulation in (1.4) ignores the standard procedure of
imposing security constraints to protect against contingent events. Although the
formulation could be interpreted as including security constraints, it is helpful here
to be explicit about the separate security constraints in anticipation of the later
discussion of FTR formulations and auctions that include the many contingency
limits.
The basic idea of security-constrained dispatch is to identify a set of possible
contingencies, such as loss of a line or major facility, and to limit the normal
dispatch so that the system would still remain within security limits if the contin-
gency occurs. The modeled loss of the facility leaves the remaining elements in
place, suggesting the name of n1 contingency analysis.15
Hence, a single line may have a normal limit of 100 MW and an emergency
limit of 115 MW.16 The actual flow on the line at a particular moment might be
only 90 MW, and the corresponding dispatch might appear to be unconstrained.
However, this dispatch may actually be constrained because of the need to
protect against a contingency. For example, the binding contingency might be
the loss of some other line. In the event of the contingency, the flows for the
current pattern of generation and load would redistribute instantly to cause
115 MW to flow on the line in question, hitting the emergency limit. No more
power could be dispatched than for the 90 MW flow without potentially
violating this emergency limit. The net loads that produced the 90 MW flow,
therefore, would be constrained by the dispatch rules in anticipation of the
contingency. It would be the contingency constraint and not the 90 MW flow
that would set the limit. The corresponding prices would reflect these contin-
gency constraints (Boucher et al 1998).
Depending on conditions, any one of many possible contingencies could
determine the current limits on the transmission system. During any given
hour, therefore, the actual flow may be, and often is, limited by the impacts
that would occur in the event that the contingency came to pass. Hence, the

14
The dispatch and prices are not changed by the arbitrary designation of the swing bus. However,
the choice of the reference bus for pricing, which need not be the same as the swing bus, does
affect the decomposition of the prices.
15
A simultaneous loss of multiple facilities would be defined as a single contingency.
16
Expressing the limits in terms of MW and real power is shorthand for ease of explanation. Line
limits in AC models appear in terms of MVA for real and reactive power.
14 W.W. Hogan

contingencies do not just limit the system when they occur; they are anticipated
and can limit the system all the time. In other words, analysis of the power flows
during contingencies is not just an exception to the rule; it is the rule. The
binding constraints on transmission generally are on the level of flows or voltage
in post-contingency conditions, and flows in the actual dispatch are limited to
ensure that the system could sustain a contingency.
For instance, suppose that the contingency ω is the loss of a line. For sake of
simplicity in the illustration, assume that the only adjustment in the case of the
contingency is to change the net load at the swing bus to rebalance the system. Then
there would be a different network, different flows, and different losses, leading to a
new set of power flow constraints described as:


Lω yωs ; y~; u þ yωs þ ιt y~ ¼ 0;
ω

K~ yω ; y~; u  0;
s
u 2 U: (1.5)

The values of the constraint limits could be different in different contingencies,

including changes in monitored elements. Extension of this model to allow other
changes in dispatch or control parameters present no problem in principle, but
would add to the complexity of the notation. The set of constraints and balancing
equations would be different for each contingency.
If we treat normal operations as the contingency ω ¼ 0, then the combined set of
constraints on the dispatch would be:


Lω yωs ; y~; u þ yωs þ ιt y~ ¼ 0; ω ¼ 0; 1; 2;    ; N;
ω

K~ yω ; y~; u  0; ω ¼ 0; 1; 2;    ; N;
s
u 2 U:

The security-constrained economic dispatch imposes all these constraints on

the net loads in advance of the realization of any of the contingencies. However,
since the swing bus net load is different in every contingency, we subsume the
load balance impacts for ω > 0 in the definition of the constraints, and keep
explicit only the loss balance
in normal
 conditions. Then with the appropriate
change in notation with ( yt ¼ y0s ; y~t ), we arrive at a compact representation of
the constraints as:
1 Financial Transmission Rights: Point-to Point Formulations 15

Lðy; uÞ þ ιt y ¼ 0;
0 0
 1
K~ y0s ; y~; u
B 1
C
B K~ y1 ; y~; u C
B C
B s
C
B .. C
B . C
K ðy; uÞ  B
B ~ω
ω 
C  0;
C
B K ys ; y~; u C
B C
B .. C
B C
@ . A
N
N 
K~ ys ; y~; u
u 2 U:

With this notational convention, we can then restate the security-constrained

economic dispatch problem as:

Max BðyÞ
y;u2U

s:t:
Lðy; uÞ þ ιt y ¼ 0;
K ðy; uÞ  0: (1.6)
However, we now recognize that the single loss balance equation that affects the
benefit function is appended by many contingency constraints that limit normal
operations. If there are thousands of monitored elements for possible overloads of
lines, transformers, or voltage constraints, and there are hundreds of contingencies
that enter the protection set, the total number of constraints in K would be on the
order of hundreds of thousands. This large scale is inherent in the problem, and a
challenge for FTR models.
It is a remarkable fact that system operators solve just such contingency-
constrained economic dispatch problems on a regular basis. Below we summarize
a basic outline of a solution procedure to capture the elements relevant to the FTR
formulations. This method exploits a relaxation strategy and the feature that as we
get closer to the actual dispatch, the pattern if loads are better known and the list of
plausible contingencies and monitored elements reduces accordingly. Anticipating
the discussion of FTRs, however, the larger potential set of constraints would be
relevant.
Under the assumed optimality conditions, the corresponding prices obtained
from the solution appear as:

pt ¼ rBðy Þ ¼ λιt þ λrLy ðy ; u Þ þ ηt rKy ðy ; u Þ:

Hence, the congestion cost could arise from any of the (many) contingency
constraints.
16 W.W. Hogan

1.3.3 Market Equilibrium

The security-constrained economic dispatch problem has the familiar close connec-
tion to the competitive partial equilibrium model where market participants act as
profit maximizing or welfare maximizing price takers.
Assume that each market participant has an associated benefit function for
electricity defined as Bi ðyi Þ, which is concave and continuously differentiable.17
In FERC terminology, the market participants are the transmission service
customers. The customers’ benefit functions can arise from a mixture of load or
demand benefits and generation or supply costs. In this framework, the producing
sector is the electricity transmission provider, with customers injecting power into
the grid at some points and drawing power out of the grid at other points. The
system operator receives and delivers power, coordinates a spot market, and
provides transmission service across locations.
The competitive market equilibrium applied here is based on the conventional
partial equilibrium framework that stands behind the typical supply and demand
curve analysis.18 The market consists of the supply and demand of electric energy
and transmission service plus an aggregate or numeraire “good” that represents the
rest of the economy. Each customer is assumed to have an initial endowment w ~i of
the numeraire good. In addition, each customer has an ownership
P share s i in the
profits “π” of the electricity transmission provider, with si ¼ 1.
i
An assumption of the competitive model is that all customers are price takers.
Hence, given market prices, p, customers choose the level of consumption of the
aggregate good, ci, and electric energy including the use of the transmission system

17
A sufficient condition for these to obtain would be that the demand and supply functions at each
node are continuous, additively separable and aggregate into a downward sloping net demand
curve. The benefit function would be the area under the demand curves minus the area under the
supply curves in the usual consumer plus producer surplus interpretation at equilibrium. To avoid
notational complexity, the assumption here is that each participant has a continuously differentiable
concave benefit function defined across the net loads at every location. Concavity is important for
the analysis below of the equivalence of economic dispatch and market equilibrium, if there is a
market equilibrium. This would eliminate from this competitive market analysis the related unit
commitment problem which includes non-convex start-up conditions. As is well known, in the
presence of non-concave benefit functions there may be no competitive market equilibrium.
Differentiability can be relaxed, with no more than the possibility of multiple equilibrium prices.
Restricting the benefit function to definition at a subset of the locations would be more realistic, but
different only in the need to account for the corresponding variable definitions. It would not affect
the results presented here. In practice, as is often assumed, the benefits functions may be separable
across locations.
18
The partial equilibrium assumptions are that electricity is a small part of the overall economy
with consequent small wealth effects, and prices of other goods and services are approximately
unaffected by changes in the electricity market. See Mas-Colell et al. (1995), pp. 311–343.
Importantly, we adopt here a relaxed set of assumptions that do not include convexity of the set
of feasible net loads.
1 Financial Transmission Rights: Point-to Point Formulations 17

according to the individual optimization problem maximizing benefits subject to an

income constraint:

Max Bi ðyi Þ þ ci
yi ;ci

s:t:
t
~i þ si π:
p yi þ ci  w (1.7)

In this simple partial equilibrium model of the economy, there is only one
producing entity, which is the system operator providing transmission service.
Under the competitive market assumption, the producer is constrained to operate
as a price taker who chooses inputs and outputsP (yi) that are feasible and that
maximize profits. The profits amount to π ¼ pt yi . Hence, the transmission
i
system operator’s problem is seen as:

Max pt y
y;u2U
yi

s:t:
X
y¼ yi ;
i
Lðy; uÞ þ ι y ¼ 0; t

K ðy; uÞ  0: (1.8)

Of course, the transmission service provider is a monopoly and would not be

expected to follow the competitive assumption in the absence of regulatory over-
sight. However, the conventional competitive market definition provides the
standard for the service that should be required of the system operator.19
Given the initial endowment of goods w ~i, and the ownership shares si, a competi-
tive market equilibrium is defined as a vector of prices, p, profits, π, controls, u, and a
set of net loads, yi , for all i that simultaneously solve (1.7) and (1.8).
A competitive equilibrium P will havePa number of important properties that we
can exploit. First, note that ci ¼ w~i , which is implied and necessary for
i i
feasibility. Furthermore, every customer’s income constraint is binding and the
derivative of each benefit function will equal the common market prices, p ¼ rBti.
Hence, the equilibrium price at each location is equal to the market clearing

19
It is the standard formulation to include both the consumption (1.7) and production (1.8) sectors
as part of the definition of competitive market equilibrium. Failure to follow this well established
convention leads to confusion when the term “market equilibrium” is applied excluding the
producing sector in (1.8), as in Wu et al. (1996), pp. 5–24. For a further discussion of equivalence
results, see Boucher and Smeers (2001), pp. 821–838.
18 W.W. Hogan

marginal benefit of net load and the marginal cost of generation and redispatch to
meet incremental load.
Finally, a
motivation for the connection with economic dispatch is that a market
equilibrium yi ; u must also be a solution to the economic dispatch problem
P
with BðyÞ ¼ Bi ðyi Þ. If not, there would be a set of feasible net loads y1i with
P
1  Pi
 
Bi yi > Bi yi . Therefore, by concavity of B we would have:
i i

!
X
 X
 X

1


pt y1i  yi ¼ rBi y1i  yi  Bi yi  Bi yi >0:
i i i


But this would violate the optimality of yi ; u . Hence, a market equilibrium
is also a solution to the economic dispatch problem.
Therefore, under the optimality conditions assumed, the market equilibrium
would satisfy the same local first-order necessary conditions as an optimal solution
to the economic dispatch. In particular, for a market equilibrium we have the
pricing condition that:

pt ¼ rBðy Þ ¼ λιt þ λrLy ðy ; u Þ þ ηt rKy ðy ; u Þ:

Another way to look at this problem is to interpret the equilibrium as satisfying

the “no arbitrage” condition. At equilibrium, there are no feasible trades of electric
loads in (1.8) that would be profitable at the prices p. Hence, let y1 be any other
feasible set of net loads, such that there is a u1 with:


L y1 ; u1 þ ιt y1 ¼ 0;


K y1 ; u1  0;
u1 2 U:

Then by (1.8), we have,


pt y  y1  0: (1.9)

This no arbitrage condition will be important as part of the analysis of

revenue adequacy in the FTR formulations. Importantly, the condition allows
for the controls to change from u . This implies a great degree of flexibility in
changing the dispatch while maintaining the no-arbitrage condition for a market
equilibrium.
1 Financial Transmission Rights: Point-to Point Formulations 19

1.3.4 Linear Approximation of Constraints

The full AC security-constrained economic dispatch problem is a large optimiza-

tion problem with very many constraints. Solution procedures for solving this
problem often rely on local linearizations of at least the constraints and exploit
the condition that in any particular dispatch only relatively few (tens to hundreds) of
the many potential constraints might be binding.
One motivation for the linearization follows from the first order conditions for an
optimum. Suppose we have a solution to the economic dispatch problem at ðy ; u Þ.
The usual Taylor approximation gives:

y  y
Lðy; uÞ Lðy ; u Þ þ rLðy ; u Þ ;
u  u
y  y
K ðy; uÞ K ðy ; u Þ þ rK ðy ; u Þ :
u  u

Then if we have a solution that satisfies the first order conditions for the security-
constrained economic dispatch problem (1.6), this would also satisfy the first order
conditions for the linearized constraints as in:

Max BðyÞ
y;u2U

s:t:
y  y
Lðy ; u Þ þ rLðy ; u Þ þ ιt y ¼ 0;
u  u
y  y
K ðy ; u Þ þ rK ðy ; u Þ  0:
u  u

If the functions are well behaved, then finding a solution to this approximate
problem might also provide a good estimate of the solution to the full problem.
Although the functions are not so well behaved as to be everywhere convex,
practical computational approaches for solving this problem search for a solution
that satisfies the first order conditions. It is not fail safe, and when it fails other
approaches would be necessary. However, given a starting point close to the
optimum, and some judicious choices, this approximation can work well. Since
the actual dispatch involves reoptimization starting with a good solution from the
immediate previous period, as well as feedback from metering actual flows and a
fair bit of operator judgment, this linearization of the model can be a reasonable
approximation. However, as discussed below, the linearization changes with the
dispatch.
The local linear approximation suggests an outline for solving this large problem
through a familiar relaxation approach by ignoring non-binding constraints
(Geoffrion 1970).
20 W.W. Hogan

Relaxation Solution Procedure

Step 1: Select an initial candidate solution ðy0 ; u0 Þ, ignore most (or all) of the
constraints in the economic dispatch using only the small subset K 0 ðy; uÞ,
and set the iteration count to m ¼ 0.
Step 2: Construct the relaxed master problem as:

Max BðyÞ
y;u2U

s:t:
y  ym
Lðym ; um Þ þ rLðym ; um Þ þ ιt y ¼ 0;
u  um
y  ym
K m ðym ; um Þ þ rK m ðym ; um Þ  0:
u  um

Let a solution be ðymþ1 ; umþ1 Þ and update m ¼ m þ 1.

Step 3: Check to see if the candidate solution ðym ; um Þ violates any of the
constraints in (1.6). If so, create a new K m ðy; uÞ including some or all
of these constraints and repeat Step 2. Else done.
The central idea here is that the master problem is much smaller than the full
problem and relatively easy to solve. With judicious choices of the initial solution
and constraint set, the method works well in practice with relatively few iterations
required. In the case that the objective function is represented by a piecewise
linearization (as would be true naturally with step-wise representation of supply
and demand), the master problem is a linear program for which there are efficient
algorithms. Furthermore, in the case of this dispatch problem, evaluation of
constraints in Step 3 requires only that a standard load flow be solved for each
contingency. Although not trivial, this is well-understood albeit non-linear
problem.
One difficulty with this computational approach is the need to calculate rK m
ðy ; u Þ. This gradient is the set of “shift factors” summarizing the marginal
m m 20

impact on constraints from changes in the loads and controls. Although it is

possible to solve the load flow problem exploiting the sparsity of the network
arising from the few links connected to each bus, this sparsity depends on
explicit representation of the angles and voltage magnitudes. By contrast, the
inverse presentation in K ðy; uÞ is dense. In a sufficiently meshed network, every
net load affects every constraint. Hence, virtually every element of rK m ðym ; um Þ
could be non-zero. Part of the art of implementation of this computational
outline is in the details of exploiting sparse representations to evaluate load

20
For more detail on the construction of the gradients, see Weber (1997).
1 Financial Transmission Rights: Point-to Point Formulations 21

flows, and minimizing the need to calculate or represent rK m ðym ; um Þ. Such

commercial dispatch software is well developed and in regular use.21
Further note that in general rK ðym1 ; um1 Þ 6¼ rK ðym2 ; um2 Þ, and this may require
frequent updates of the linearization. Finally, in general we have:

ym1 ym 2
K ðym1 ; um1 Þ  rK ðym1 ; um1 Þ 6¼ K ðym2 ; um2 Þ  rK ðym2 ; um2 Þ :
um 1 um2

Hence, the “right hand side” of the linearized constraint can be different for each
candidate solution. These differences can be quite large, especially for interface
constraints in DC-Load approximations.22
This presents no difficulty in principle for the dispatch problem. However, these
complications are relevant in the discussion of the DC-Load model and in the
adaptation of the security-constrained economic dispatch formulation for FTR
auctions.

1.3.5 DC-Load Approximations

A common simplification of the load flow model for real power is known as the
DC-Load approximation (Schweppe et al. 1988). In terms of the present discussion,
the DC-Load model adds further restrictive assumptions that allow us to ignore both
real power losses and reactive power loads in determining the real power flows,
further specializing the linearization of the constraints.
The key assumptions include:
• There is sufficient reactive power net load at each bus to maintain per unit
voltages equal to 1.0 (Vi 1:0);
• All phase angle settings are at zero angle change and a fixed tap ratio for
transformers (t ¼ 1:0; α ¼ 0)23;
• The voltage angle differences across lines are small.
These assumptions imply a choice of controls (u ¼ u0) that yield full decoupling
between real and reactive power flow and no transmission losses. The real power
flow in (1.1) reduces to:

21
For example, firms providing such software include ALSTOM ESCA Corporation, Nexant, Inc.,
Open Access Technology International, Inc.
22
For examples, see Hogan (2000).
23
For simplicity, we can assume that the ideal transformers with a fixed tap ratio have been
incorporated in a per unit normalization, which results in a simplified Π—equivalent representation
of a transmission line. See the appendix for further details
22 W.W. Hogan

zPijk ¼ Gk ½1  cosðδi  δj Þ þ Ωk sinðδi  δj Þ;

zPjik ¼ Gk ½1  cosðδj  δi Þ þ Ωk sinðδj  δi Þ:

Under the small angle difference assumption, we have:


cos δi  δj 1;


sin δi  δj δi  δj :

Hence, the real power flow approximation becomes:



zPk ¼ zPijk ¼ Ωk δi  δj ¼ zPjik ¼ Ωk δj  δi :

This linearity produces a substantial simplification. Let:

Ω ¼ the diagonal matrix of line transfer factors,
z ¼ the vector of line flows (zPk ) in the DC-Load approximation.
Then, with our sign conventions we have:

y ¼ At z;
z ¼ Ω Aδ:

Furthermore, the inversion that eliminates the angles as in (1.2) reduces to

another linear equation for the DC-Load formulation with


H ¼ rKy 0; u0 :


This is the matrix of shift factors. Under the DC-Load assumptions, H ¼ 0 H~ ,
 t 1
where H~ ¼ ΩA~ A~ ΩA~ ~ 24 Although A
with the swing bus dropped in defining A.
is sparse, the matrix of shift factors is dense, meaning that nearly every net load
affects nearly every line. Calculating an element of row of H, meaning the shift
factors for a particular line in a particular contingency, is about the same amount of
work as finding a DC-Load flow for that contingency.
For a given contingency the matrix that links the angles and the net loads, as in

y ¼ At Ω Aδ;

is quite sparse, with the only non-zero elements being for the nodes that are directly
connected. Furthermore, solving for the angles given the vector of net injections, y,
involves no more than finding a particular solution for a set of linear equations. In
general, this is much less work than solving for the full matrix inverse, and in
advanced optimization algorithms this is done quickly and cheaply using sparse

24
Also the transfer admittance matrix as described in Schweppe et al. (1988), p. 316.
1 Financial Transmission Rights: Point-to Point Formulations 23

matrix techniques. Once the vector of angles is known for a given set of net loads, it
is an easy matter to complete the one matrix multiplication to obtain the complete
load flow in z for each contingency. The import of all this is the simplicity of
evaluating a particular load flow as compared to calculating the full transfer
admittance matrix in H.
Note that calculating a particular row of H is about the same order of difficulty as
evaluating the load flow for that particular contingency. Let εi be the elementary
row vector with all zeros but a 1 in the ith position. We can obtain any row of H, say
hi, as the solution to a set of sparse linear equations. By construction:
 t 1
hi ¼ εi H~ ¼ εi ΩA~ A~ ΩA~ :

Hence, we have the sparse system:

 t 
hi A~ ΩA~ ¼ εi ΩA:
~ (1.10)

In other words, calculating a complete load flow for all the lines is about as much
work as calculating the shift factors for one line. Both require solution of a sparse
set of linear equations of the dimension equal to the number of nodes. There are
specialized sparse matrix techniques for this computation as a part of commercial
dispatch software.
With these approximations, the constraints could be restated as:

ιt y ¼ 0;


K 0; u0 þ Hy  0:

Letting b ¼ K ð0; u0 Þ, the familiar DC-Load restatement of the security-

constrained economic dispatch becomes:

Max BðyÞ
y

s:t:
ι y ¼ 0;
t

Hy  b: (1.11)

It is an easy matter to extend the definition of H to include other linear

constraints on y, including interface constraints expressed as limits on aggregations
of flows on lines.
As above, the matrix H for the full security-constrained problem is very large
and dense, and successful solution of the security-constrained economic dispatch
exploits approaches such as the relaxation algorithm outlined above that avoid
unnecessary computation of the elements of H and include only the binding
24 W.W. Hogan

constraints. Furthermore, the DC-Load model is convex and the relaxation algo-
rithm will assure convergence to a global solution.
As discussed below, many models for transmission rights exploit the specialized
structure of (1.11) to simplify the problem and guarantee various equivalence
conditions between and among different FTRs. In this context, it is important to
remember that (1.11) is only a simplified approximation and that key elements of
these assumptions are violated by regular operating conditions in the system. The
different approximations have different effects on the alternative FTR models and
the associated auction problems.
Here we consider the implications of various modifications of these assum-
ptions. Suppose that the phase shifting transformers are set to shift the angles. If
we hold the angle shifts fixed, then the approximation under the other DC-Load
assumptions becomes:


zPk ¼ Ωk δi  δj þ Ωk αk :

In principle, this changes the inversion in (1.2) to eliminate the bus angles such
that even under zero net loads there would be real power flow on all the lines in
order to maintain balance at every node. This preserves linearity and a constant H,
but changes the residual limits for the constraints. Hence, we would have b ¼ bðαÞ,
meaning that the limits on the power flow equations would be changing to reflect
the phase angle settings. In principle, a phase shift on one line could affect the
residual limit on every line.
If the ideal transformer tap ratio (t) were to change from 1.0, there would be a
modified Ω ^ to reflect the changing impedance.25 In addition, the inversion depends
on the topology of the network as summarized in A. This may change from one
dispatch to another. In each case, the inversion to eliminate the voltage angles
and the associated linearization of the constraints actually depends on the values of
(t; α; A). To the extent that these are treated as variables in the economic dispatch,
their constraints in U create additional non-linearities. For instance, if a phase-
shifting transformer is controlling flow but reaches a limit on the ability to control a
line, the representation of the phase angle regulator changes. Although the details
depend on the particular case, if there is any possibility of actual changing the
topology or settings of phase-shifting transformers, even for the simpl-
ified real power only DC-Load approximation we have H ðu0 Þ ¼ rKy ð0; u0 Þ and
bðu0 Þ ¼ Kð0; u0 Þ. In other words, the linear approximation is not the same across
the dispatches.
Therefore, the security-constrained, economic dispatch of the DC-Load approx-
imation could be written as:

25
For example, see Oliveira et al. (1999), pp. 111–118.
1 Financial Transmission Rights: Point-to Point Formulations 25

Max BðyÞ
y

s:t:
ιt y ¼ 0;



H u0 y  b u0 : (1.12)

When this problem is solved at any given hour, for fixed u0 the resulting model
takes on the form of the DC-Load approximation. Both constraint limits and shift
factors adjust regularly. Hence, it is important below to be explicit about the fact
that the linearizations, and therefore, the model itself, changes from dispatch to
dispatch, especially for any changes in topology A.
Finally, in addition to these changes, other slight modifications of the DC-Load
model retain most of the computational simplicity but make the approximation
further sensitive to the non-linear properties of the system. For example, consider
incorporating line losses:



lPk ðδ; 1; 1; 0Þ ¼ Gk 2  2 cos δi  δj :

Using the approximation that for small angle differences,

2

 δi  δj
cos δi  δj 1 ;
2

the approximate line losses are:



2
lPk ðδ; 1; 1; 0Þ ¼ Gk 2  2 cos δi  δj Gk δi  δj rk z2Pk :

Here we have used the condition that rk << xk .26

Define R as the diagonal matrix of line resistances, j Aj as the matrix of the
absolute values of the incidence matrix, and z2 as the vector of squares of the
individual line flows. Then we could include losses in the economic dispatch
problem that is almost like the DC-Load model27:

26
This approximation applies to high voltage systems, but is less usable on lower voltage circuits.
27
This approach is from Transpower in New Zealand.
26 W.W. Hogan

Max BðyÞ
y; z; δ
s:t:
y ¼ A z  12j Ajt Rz2 ;
t

z ¼ Ω Aδ;
δs ¼ 0;
z  b:

Note that this computational form of the problem does not need a separate
overall balance equation, as this is accounted for in the individual node equations.
Hence, we have net loads (generation) balancing losses as in:

ιt ðg  d Þ ¼ ιt ðd  gÞ ¼ ιt y ¼ ιt At z þ 12 ιt j Ajt Rz2 ¼ ιt Rz2 :

This is no longer a linear problem, but the addition of the few quadratic terms in
the node balance equations is easier to deal with than a full AC model. However,
this simplified formulation would capture some of the interaction between losses
and congestion, with the additional power flows needed to account for losses adding
to losses and congestion. The inverse linearization of the solution in terms of the net
loads would now differ further from the pure DC-Load approximation.28

1.4 Point-to-Point Financial Transmission Rights

Financial transmission rights are defined in terms of payments related to market

prices. Although many years were spent in the search for well-defined and workable
physical transmission rights, the complexity of the grid and rapidly changing
conditions of the real market outcomes made it impossible to design physical rights
that could be used to determine the use of the transmission system.29 By contrast,
financial transmission rights specify payments that are connected to the market
outcomes but do not control use of the system. Rather, the actual dispatch or spot
market produces a set of market-clearing prices, and these prices in turn define the
payments under the FTRs.
The system operator accepts schedules and coordinates the spot market as a
bid-based, security-constrained, economic dispatch. The resulting locational prices
apply to purchases and sales through the spot market, or the difference in the
locational prices defines the price for transmission usage for bilateral schedules.

28
A version of this DC-Load-Flow implementation with losses appears in a GAMS model
available at www.whogan.com.
29
For further details, see Harvey et al. (1997).
1 Financial Transmission Rights: Point-to Point Formulations 27

The need for transmission rights to hedge the locational price differences leads to
the interest in FTRs.30

1.4.1 PTP Obligations

The definition of point-to-point (PTP) forward obligations as FTRs follows closely

the notion of bilateral transmission schedules. A generic definition includes both
balanced and unbalanced rights. Given a vector of inputs and outputs by location,
the kth PTP forward obligation is defined by:
0 1
0
B gi C
B C
PTPkf ¼ B 0 C:
@ dj A
0

With a corresponding vector of market clearing prices, this FTR is a contract to

receive
0 1
0
B gi C
B C
pt PTPkf ¼ pt B 0 C ¼ pj dj  pi gi :
@ dj A
0

Although any such vector could be allowed, it is clear that any such FTR could
be restated as a mix of balanced and unbalanced rights:
0 1 0 1
0 0
B dj C B gi  dj C
B C B C
PTPkf ¼ B 0 CB 0 C:
@ dj A @ 0 A
0 0

Motivated by the discussion of options below, it is convenient to define two

types of forward obligations, balanced (τ fk ) and unbalanced (gfk ), such as

30
For further discussion of market structure, see Chandley and Hogan (2002).
28 W.W. Hogan

0 1 0 1
0 0
B x C B 0 C
B C
τ fk ¼ B 0 C; g fk ¼ B g C
@ 0 A:
@ x A
0 0

We can think of the balanced PTP-FTRs providing for the same input and output
at different locations. More generally, all that is required of a balanced PTP-FTR is
that the inputs and outputs sum to zero, ιt τ fk ¼ 0. The unbalanced FTRs can be
thought of as forward energy sales at any location and would be a contribution
towards losses to balance the system. The notation suggests that individuals could
hold either or both types of PTP-FTR forward obligations, and there is no need that
the locations be the same.
The intended role of the PTP-FTR is to provide a hedge against variable
transmission costs. If a market participant has a balanced FTR between two
locations and schedules a corresponding bilateral transaction with
the same
 inputs
and outputs (x), then the charge for using the system would be pj  pi x, which is
exactly the payment that would be received under the FTR. Hence, the balanced
FTR provides a perfect hedge of the variable transmission charge for the bilateral
transaction.
The holder of an unbalanced forward obligation FTR has an obligation to make
the payment equal to the value of the energy at the relevant location. If the holder
also sells an equal amount of energy at the same location in the actual dispatch, the
payment received for the energy is pi g, equal to the payment required under the
FTR. Hence, we can think of the unbalanced FTR as a forward sale of energy.
Although in principle there would be no difficulty in allowing negative unbalanced
PTP-FTRs, equivalent to forward purchases of energy, it is convenient to interpret
unbalanced PTP-FTR obligations as forward sales of energy.
In this case of obligations, the PTP-FTRs are easily decomposable. For example,
an FTR from bus 1 to bus 2 can be decomposed into two PTP-FTR obligations from 1
to a Hub and the Hub to 2. The total payment is ðp2  pHUB Þ þ ðpHUB  p1 Þ ¼
ðp2  p1 Þ. This provides support for trading at market hubs and the associated trading
flexibility. Periodic FTR auctions provide other opportunities to obtain other
reconfigurations of the pattern of FTRs
An attraction of the FTR is that the spot market can operate to set the actual use
of the transmission system and the FTRs operate in parallel through the settlements
system to administer financial hedges. Importantly, the system of payments will be
consistent as long as the set of PTP-FTRs satisfies a simultaneous feasibility
condition.
1 Financial Transmission Rights: Point-to Point Formulations 29

1.4.1.1 Revenue Adequacy

Suppose that we have a set of balanced (τ fk ; k ¼ 1; . . . ; N) and unbalanced (gfk ;

k ¼ 1; . . . ; N ) PTP-FTRs obligations for any possible locations. Consider the
constraints from the security-constrained dispatch in (1.6) or equivalently in
(1.8). We say that the set of FTRs is simultaneously feasible if there is a u 2 U
such that:
X X
y¼ τ fk  g fk ;
k k
Lðy; uÞ þ ιt y ¼ 0;
Kðy; uÞ  0: (1.13)

Assume the set of PTP-FTR forward obligations is simultaneously feasible. If

we have a market equilibrium (p; y ; u ) in the spot market, then from (1.9) it
follows immediately that we meet the revenue adequacy condition,
! !
X X X X
t  
py p t
τ fk  g fk ¼p t
y  τ fk þ g fk ¼ pt ðy  yÞ  0:
k k k k

In other words, at the market equilibrium prices the net payments collected
by the system operator through the actual dispatch (pt y ) would be greater than
or equal to the payments required under the PTP-FTR forward obligations
P f P f
pt τ k  g k . This revenue adequacy condition is general enough to
k k
accommodate a great deal of flexibility.
Note that the simultaneous feasibility condition does not require that the set of
PTP-FTRs be feasible at the current set of controls (u ) associated with the market
equilibrium. All that is required is that the system operator could choose a set of
controls that would make the PTP-FTRs feasible. There could be a very different set
of actual operating conditions, including changes in the configuration of the grid,
but as long as the controls and configuration could be set to make the PTP-FTRs
feasible, the simultaneous feasibility condition holds and revenue adequacy
follows. This is true even though actual physical delivery to match the FTRs
would be impossible at the current settings of the grid controls at u . This is an
important simplification compared to physical rights and a primary attraction of
using financial rights.
The intuition of revenue adequacy is clear. If the dispatch of PTP-FTRs were
more valuable than the market equilibrium, in violation of the revenue ade-
quacy condition, the system operator could have selected this dispatch outcome.
Since we have by assumption a market equilibrium that differs from the PTP-
FTRs, and the PTP-FTRs are simultaneously feasible, the market equilibrium
30 W.W. Hogan

from (1.8) must be at least as valuable as the payment obligation under the
PTP-FTRs.31

1.4.1.2 PTP-FTR Auction

Allocation rules for FTRs follow different procedures. For example, in PJM
Load Serving Entities (LSE) are required to purchase network service and meet
installed capacity requirements. As part of this process, LSEs acquire FTRs.
Grandfathering rules under existing contracts might be another source of alloca-
tion, and so on.
A natural way to allocate PTP-FTR forward obligations would be to conduct an
auction. Suppose that we represent bids for balanced forward-obligations by (t fk ; τ fk)
and for unbalanced forward obligations by (ρ fk ; g fk ). Here the first element is the
scalar amount of the FTR and the second element is the vector pattern of inputs and
outputs. For simplicity, we subsume any upper bounds on
 the awards are part of
the concave and differentiable bid function βk t fk ; ρ fk . With these notational
conventions, a formulation of the PTP-FTR forward obligation auction would be:
X  
Max βk tkf ; ρkf
y;u2U;t fk 0;ρ fk 0 k
s:t:
X X
y¼ t fk τ fk  ρ fk g fk ;
k k
Lðy; uÞ þ ιt y ¼ 0;
K ðy; uÞ  0: (1.14)

A solution of this problem would determine the award of FTRs and the
_
associated market clearing prices for the awards. The locational price p would be
of the same form as in the market equilibrium model, with

_t _ _ _t
p ¼ λ ιt þ λ rLy ðy ; u Þ þ η rKy ðy ; u Þ:

However, the prices here would be based on the expected value of the hedge over
the many dispatches to which it applies. The corresponding market clearing prices

31
The definition of FTRs could be extended to include the sharing rule for allocation of any
difference between the collections and payments. This is formalized in the market equilibrium
model as si. In practice, the FTR implementations for existing system redistribute any excess
collection to reduce access charges or some similar purpose. Although this is a more important
issue for defining incentives for system expansion, it does not affect the analysis here.
1 Financial Transmission Rights: Point-to Point Formulations 31

for the auction awards would be the difference in the locational prices for the
balanced obligations and the locational price for loss contributions. Hence,
   
_
@βk t fk ; ρ fk _t _
@βk t fk ; ρ fk _t
pt f ¼ ¼ p τ fk ; pg f ¼  ¼ p g fk :
k
@t fk k
@ρfk

By construction, the FTRs would be simultaneously feasible. In addition to an

initial sale to allocate FTRs for the existing grid, this same format accommodates
offers to sell existing FTRs. By this means, regular auctions of this form also
provide opportunities to reconfigure the pattern of FTRs.
It is obvious that the PTP-FTR auction problem in (1.14) is essentially of the
same form as the security-constrained economic dispatch problem in (1.6) or the
market equilibrium problem in (1.8), with the addition of a set of simple linear
constraints on the net loads as dictated by the bids. Furthermore, the addition of the
linear constraints on the awards could be included in the master problem of the
relaxation solution procedure described above, allowing for a direct adaptation of
familiar optimal dispatch software to solve the auction problem. This is the essence
of the AC-formulation of the PTP-FTR obligation auction conducted by the New
York Independent System Operator (NYISO), where the computational feasibility
of the solution procedure has been verified in practice.32
In the case of a dispatch that prices losses and includes losses in the PTP-FTRs,
the consistent model anticipates that market participants will take on the forward
commitment to meet the financial requirements for losses. Various approximations
might be considered where this is a requirement is modified.33 In the early
implementations, the focus of PTP-FTRs was on congestion costs.

1.4.1.3 PTP-FTR for Congestion

The initial PJM implementation employed a DC-Load dispatch model similar to

(1.12).34 The dispatch and the resulting market prices do not explicitly treat
marginal losses. Hence, the prices differ across locations only due to the effects
of congestion. The PTP-FTRs are defined for payments on congestion cost, and in
this case are the full hedge for the difference in locational prices. Under this system,
the payments for losses are treated as part of an uplift charge, and not covered by the
FTRs. Since the congestion costs define the only locational price differences

32
For results of New York auctions, see: http://www.nyiso.com/markets/tcc_auctions/
2001_2002_winter.html.
33
For a further discussion see Harvey and Hogan (2002).
34
In PJM, financial transmission rights are called fixed transmission rights (FTR).
http://www.pjm.com/energy/ftr/ftrauc.html.
32 W.W. Hogan

charged or hedged, revenue adequacy follows from the simultaneous feasibility

condition for the PTP-FTRs.
The implementation in New York differs in its treatment of losses. Losses are
included in the dispatch model and the associated market prices. However, the PTP-
FTRs are defined as balanced rights only and provide for payment of congestion
costs but not the cost of losses. The auction for FTRs uses an AC formulation as in
(1.14). Market participants obtain balanced FTRs and the NYISO includes
provisions for losses in the auction, in order to obtain a feasible solution in the
auction. However, the NYISO does not assume financial responsibility for loss
hedges. In New York, the FTRs provide a hedge only for congestion costs.35 This
New York type implementation leads to a different version of the revenue adequacy
condition.
P
Let the allocation of balanced FTRs in the auction be τ f ¼ t fk τ fk . Choose
k

an arbitrary unbalanced vector of loss contributions g f such that τ f ; g f is
simultaneously feasible. Let there be a market equilibrium ðp; y ; u Þ from
the actual dispatch. The prices decompose into the price of generation ( pG ¼ λ),
the marginal contribution to losses (ptL ¼ λrLy ðy ; u Þ), and the cost of congestion
ðptC ¼ ηt rKy ðy ; u Þ). By the simultaneous feasibility of the PTP-FTRs, we have



pt y  pt τ f  g f ¼ ptC τ f þ pG ιt þ ptL τ f  pt g f :

Define the loss rentals on the FTRs as the difference between the payment for
losses at the marginal cost and the average cost of the losses. Hence,


πL  ptL τ f  pt g f ¼ pG ιt þ ptL τ f  pt g f :

If we have these loss rentals as non-negative, π L  0 , then the simultaneous

feasibility test coupled with this condition is enough to ensure that the total net
payments from the dispatch are at least as large as the congestion payments under
the PTP-FTRs, as in:

pt y  ptC τ f : (1.15)

Since g f is arbitrary but feasible, we could have chosen g f to maximize the loss
rentals for the FTRs given the prices for this hour. In other words, if we have
sufficiently inexpensive locations at which to deem the unbalanced FTR loss
contribution, the loss rentals would be non-negative and along with the

35
In New York, financial transmission rights are called Transmission Congestion Contracts
(TCC).
1 Financial Transmission Rights: Point-to Point Formulations 33

simultaneous feasibility condition would be sufficient to ensure revenue adequacy

in the sense of (1.15) for congestion hedges only.36
In the case of New York, the loss prices and loss rentals may be small, and the
typical situation would be that losses would be costly with the maximum loss
rentals implied for the FTRs being positive. Under typical conditions, therefore,
simultaneous feasibility would guarantee revenue adequacy for the congestion
payments under the FTRs.

1.4.2 PTP Options

A PTP-FTR obligation is a financial contract for the payment of the locational price
difference. When matched with a corresponding delivery of power, the charge for
transmission usage just balances the FTR payment, and there is a perfect hedge.
This is true whether or not the price difference is positive or negative. If the price
difference is negative, the schedule provides valuable counterflow for which the
provider is paid, and the payment from the spot market dispatch just balances
the obligation under the FTR. There is a perfect match either way.
A natural complement to the PTP-FTR obligation would be a PTP-FTR option
that did not require payment when the price difference was
negative.  Hence for the
balanced PTP-FTR option τok the payment would be max 0; pt τok . This financial
contract might be more attractive as a tool for hedging purposes, and it is typically
the first suggestion from market participants because of the perception that there is a
closer analogy to the presumed option not to schedule under a physical right. The
option might also be more valuable for speculators who want to trade rights but
don’t plan to match the FTR with a schedule.
Unlike obligations, PTP-FTRs are not decomposable in the sense of to and from
a hub. The difficulty is inherent in the option. For example, an FTR option from
bus 1 to bus 2 cannot be decomposed into two PTP-FTR options from 1 to a
Hub and the Hub to 2. The total payment under the two options would be max
ð0; p2  pHUB Þ þ maxð0; pHUB  p1 Þ 6¼ maxð0; p2  p1 Þ. Hence, reconfiguration of
options would require coordination in a formal auction.
Whatever the merits of the PTP-FTR option, it presents complications that do
not arise in the case of obligations. The difficulty flows from the simple fact that the
dispatch formulation (1.6) does not include options; in the real dispatch everything
is an obligation. Hence the auction model for options does not follow directly from
the formulation for economic dispatch. Further, the associated settlement rules for
options do not follow immediately from the analysis for obligations.

36
It is a conjecture, but not proven, that this “optimized” FTR-loss rental is always non-negative,
and that simultaneous feasibility alone is sufficient for revenue adequacy in this congestion-only
case.
34 W.W. Hogan

The analytical problem for options is similar to the problem for physical rights.
Without knowing all the other flows on the system, it is not possible in general to
know if any particular transaction will be feasible. Hence, to guarantee feasibility it
is necessary to consider all possible combinations of the exercise of options. For
example, if too few of the other options are exercised, there may be insufficient
counterflow to support a particular transaction; or if all the options are exercised,
some other constraint might be limiting. This ambiguity does not arise with
obligations, which by definition are always exercised.

1.4.2.1 Revenue Adequacy for Options

As with PTP-FTR obligations, simultaneous feasibility of the exercised options is a

necessary condition to guarantee revenue adequacy.37 To demonstrate that simulta-
neous feasibility is also sufficient requires an expansion of the definition and test for
simultaneous feasibility. Once we know which options are exercised, we can treat
them like obligations for settlement purposes, so if the exercised rights are simulta-
neously feasible, we will have revenue adequacy. But the test of feasibility of all
possible combinations of exercise of options requires an expansion of the model.
Here we consider only the possibility of balanced PTP-FTR options, combined
with both balanced and unbalanced forward obligations. As above, we have a set
of balanced (τ fk ; k ¼ 1; . . . ; N) and unbalanced ( g fk ; k ¼ 1; . . . ; N ) PTP-FTR
obligations for any possible locations. In addition, define the balanced options as
(τ0k ; k ¼ 1; . . . ; N). Let xk be the fraction of each option exercised. Since different
exercise patterns produce different losses, we need some flexibility in the total loss
provision. As with contingency constraints, we impose this balancing adjustment at
the swing bus. For the moment, assume the unbalanced obligations are large enough
to ensure that this adjustment is non-negative. Then for feasibility we require by
analogy to (1.13) that there is a u 2 U and a scalar balancing adjustment at the
swing bus with ε0s  0 such that:
X X X 1
y¼ τ fk þ xk τok  g fk þ ε0s ;
k k k 0
Lðy; uÞ þ ιt y ¼ 0;
K ðy; uÞ  0:

Since this must be true for an arbitrary exercise of options and applies to all
constraints collectively, it must be true for each contingency and constraint

37
The FTRs may be revenue adequate under some dispatch cases without simultaneous feasibility,
but not under all dispatch cases. For instance, if the FTRs follow the same pattern as the dispatch,
but imply even more of the valuable flows than is feasible, the FTRs would not be revenue
adequate.
1 Financial Transmission Rights: Point-to Point Formulations 35

combination. A formulation that allowed for a different u 2 U for each exercise of

the options would be the weakest condition. A somewhat simpler test that provides
a sufficient condition for simultaneous feasibility is to require that any exercise of
the options be feasible for the same u 2 U.38
Consider first the constraints in K ðy; uÞ. The constraints do not depend on the
value of y at the swing bus that is merely a balancing adjustment. Hence, the
constraints would be satisfied if there is a u 2 U such that
P f Max
P o P Max Kiω ðy; uÞ ¼ Max P P o P
Max Kiω ðy; uÞ  0:
τ þ xk τ 
f
g ; i;ω i;ω f
τ þ xk τ 
f
g ;
y¼
k k k
y¼
k k k (1.16)
k k k k k k
0xk 1 0 xk 1

Recall from (1.5) that there is a loss function for each contingency, and many
constraints. Here we represent these loss functions and constraints explicitly to
make clear the nature of the constraints induced by the options. Hence, define a new
function wωi , meaning constraint i in contingency ω:


wωi τ f ; tok ; g f ; u ¼ Max Kiω ðy; uÞ
Es ;y
0xk 1

s:t:
X 1
y ¼ τf þ xk tok τok  g f þ εs ;
k 0
Lω ðy; uÞ þ ιt y ¼ 0: (1.17)

The notation tok refers to the vector of award levels of the options. Here εs is the
load adjustment at the swing bus to achieve balanced loads in the contingency. This
notation allows and anticipates a different solution y for every constraint and
contingency combination. Apparently the condition that the constraint Kiω is
satisfied for all possible exercise of options is equivalent to:


wωi τ f ; tok ; g f ; u  0:

This wωi is an optimal-value function, the result itself of an optimization problem

(Shimuzu et al. 1997). However, it is a well-defined function that would allow
restatement of the auction problem in terms of the variables defining the auction
awards.
For the contingency we define:

38
These two definitions would be the same if there is a saddle point for the function f ðy; uÞ ¼ Max
i;ω
Kiω ðy; uÞ: However, the usual convexity arguments would not apply to guarantee a saddle point as it
seems unlikely that f would be concave in y, Ponstein (1965), pp. 181–188. In any event, the
former computational problem appears more difficult.
36 W.W. Hogan

0
 1
wω1 τ f ; tok ; g f ; u
B ω
f o  C

 B w2 τ ; tk ; g f ; u C
B C
wω τ f ; tok ; g f ; u  B .. C:
B . C
@ A


wωn τ f ; tok ; g f ; u

Hence, the sufficient condition in (1.16) for simultaneous feasibility of PTP-

FTRs with options requires:

0  1
w0 τ f ; tok ; g f ; u
B 1
f o  f  C
B w τ ; tk ; g ; u C
B C
B .. C

f o  BB . C
C
w τ ; tk ; g ; u  B ω
f o
f  C  0:
B w τ ; tk ; g f ; u C
B C
B .. C
B C
@ . A

f o 
w τ ; tk ; g f ; u
m

Finally, to treat losses and ensure that ε0s  0 , define the worst case for the
contribution of losses and the unbalanced obligations:


L0O τ f ; tok ; g f ; u ¼ Max L0 ðy; uÞ
y
0xk 1

s:t:
X
y ¼ τf þ xk tok τok  g f ;
k
L0 ðy; uÞ þ ιt y ¼ 0:

If we have enough loss obligations to meet this maximized exercise of FTR

losses, then we have enough total forward unbalanced obligations to meet or exceed
the exercised FTR losses and ensure that we meet the assumption above that ε0s  0.
Therefore, we set the simultaneous feasibility condition with PTP-FTR obligations
and options as:


L0O τ f ; tok ; g f ; u  ιt g f ¼ 0;


w τ f ; tok ; g f ; u  0;
u 2 U:

Consider a market equilibrium ðp; y ; u Þ. Let τo be the corresponding

aggregate 
of exercised options from the simultaneously feasible combination, τ f ; tok ; g f ; u :
1 Financial Transmission Rights: Point-to Point Formulations 37


In other words, τo is the aggregate of all the options with pt τ ok  0. Then let εs be the
difference in the net load at the swing bus required to achieve balance of the FTR in
the pre-contingency case ω ¼ 0, i.e.,

 1 
y ¼ τ f þ τo  g f þ ε ;
0 s
L0 ðy; uÞ þ ιt y ¼ 0:

By construction it must be that εs  0. Further, let

1 
g f  ¼ g f  ε :
0 s

Then since g f  differs from g f only for the swing bus, which is allowed to adjust
freely for each contingency in the definition of w, we have a u 2 U with


w τ f ; tok ; g f  ; u  0:

Therefore, the exercise of the options must be feasible. Hence, we have a

balanced load that satisfies every constraint, or

y ¼ τ f þ τo  g f  ;
Lðy; uÞ þ ιt y ¼ 0;
K ðy; uÞ  0;
u 2 U:

Following (1.9) we must have:

pt ðy  yÞ  0:


The payments under the PTP-FTRs equal pt τ f þ τo  g f ¼ pt y  ps εs . By
construction, εs  0. Hence, if the swing bus price ps  0, the net revenue from the
dispatch will be adequate to pay out the obligations and exercise of options for
the PTP-FTRs. Typically, εs should be small so that even with a negative price at the
swing bus, any revenue inadequacy would be bounded by the small value of the
difference in losses.

1.4.2.2 PTP-FTR Auction with Options

With this background, the natural extension of the auction for PTP-FTRs in (1.14)
becomes:
38 W.W. Hogan

X  
Max βk tkf ; t ok ; ρ fk
u2U;t fk 0;t ok 0; ρ fk 0 k
s:t:
!
X X X (1.18)
L0O t fk τ fk ; tok ; ρ fk g fk ; u  ιt ρ fk g fk ¼ 0;
k k k
!
X X
w t fk τ fk ; t ok ; ρ fk g fk ; u  0:
k k

This is a well-defined model and the objective function is well-behaved.39 The

major change from the AC auction model with obligations only is that the conven-
tional constraint functions K have been replaced with the more complicated con-
straint functions w. Evaluating any element of the function K requires solving an
AC load flow problem, one for each contingency. Evaluating any element of
w requires solution of an AC optimal power flow problem, one for each contingency
and constraint combination. This is a significant increase in computational burden.
In a relaxation and sequential approximation approach for solving the AC
auction model with obligations only, the corresponding model from (1.14) is:
X  
Max βk t fk ; ρ fk
y;u2U;0t fk ;0ρ fk k
s:t:
X X
y¼ t fk τ fk  ρ fk g fk ;
k k
Lðy; uÞ þ ι y ¼ 0; t

K ðy; uÞ  0:

A computational approach to this problem would exploit the close similarity

with security-constrained optimal dispatch problem. The sequential approximation
approach begins with a simplified version of the problem that ignores many of the
constraints and is solved via a sequential linearization. Then a candidate solution


ðy^; u^Þ ¼ ^t f  ^g f ; u^ is tested for feasibility by solving a load flow to evaluate Kiω
ðy^; u^Þ. If the constraint is violated, determine the gradient of the function and impose
the new constraint:

y  y^
Kiω ðy^; u^Þ þ rKiω ðy^; u^Þt  0:
u  u^

39
This is a parametric satisfaction problem in the terminology of Shimuzu et al. (1997), p. 285.
1 Financial Transmission Rights: Point-to Point Formulations 39

This linearized constraint would be appended to the auction model, and there
would be further iteration until a solution is found that optimizes the bid function
and satisfies all the constraints. Typically we are limited to search algorithms that
find solutions to the first-order Karush-Kuhn-Tucker (KKT) conditions and, there-
fore, to a guarantee only of local optimal solutions.
Applying this same idea to the AC auction with options would require a method
for (1) evaluating w and (2) finding a linear approximation whenever the constraint
is violated.
Consider first the question of evaluating a constraint. For each contingency
constraint, a good guess as to the solution of the unconstrained optimal power
flow in (1.17) would be to use the DC-Load approximation above to determine the
value for x, the pattern of the exercise of the option. For each option, if Hiω τok > 0 set
the corresponding kth element x to 1, otherwise set the element to zero. Let the
result be the vector x~ωi that achieves this value for the ith constraint in contingency ω.
This is the same solution for x that would be obtained in the DC-Load case.
P
^ f ; u^ , the change in the constraint as
Then compute rK ωi x~ω ^t f þ x~ωik tok τok  g
i
k
we change the exercise of the options. If the solution satisfies the condition that the
elements of this gradient vector have positive signs when and only when the
corresponding elements of x~ωi are at the upper bound, then we can show that x~ωi
satisfies the first-order conditions for achieving the maximum for the optimal value
function. If so, then we would expect that this is the optimal solution for wωi , at least
for a well-behaved network. If the first order condition is satisfied at a local
optimum that is not a global optimum, then an ordinary local search algorithm
may not be able to find a global solution.
In practice, we accept approximate solutions of the first-order conditions as
optimal solutions. If the problem is well-behaved, then the simple solution based
on the DC-Load model should define the worst-case exercise of options for each
constraint without the necessity to conduct a further search. (Note that this is not the
same thing as saying that the DC-Load estimate of K is acceptable. We use the DC-
Load guess for the solution x, but use a full AC load flow to evaluate the constraint).
If the first order condition is not satisfied, then this should be a good starting
point for a search to find an acceptable solution to maximize Kiω ðy; uÞ. This case
would require iterative solution of an optimal power flow problem for the applica-
ble contingency. This is easier than finding the full security-constrained solution for
the auction model.
In any event, let the end result of evaluating the optimal value function wωi be x^ωi ,
P f f P
with corresponding solution ðy^; u^Þ where wωi ^tk τ k ; ^t ok ; ^ρ fk gk f ; u^ ¼ Kiω
k k
ðy^; u^Þ. This gives us an evaluation of the constraint. If the value is greater than zero,
the constraint is violated.
Recognize that there will be different value of x^ωi , the implied exercise of the
options, for each constraint i and contingency ω. This is not an obstacle in principle
because in using the optimal-value function we are interested only in the value of the
40 W.W. Hogan

violated constraint and its linear approximation relative to the option awards, not to
the exercised awards. Hence we need only use the exercised awards temporarily, at
each constraint, to evaluate the function and calculate the linear approximation.40
In the case of a violated constraint, the optimal-value function is not in general
differentiable or even convex. However, it does have a generalized gradient @ o w
that serves a similar purpose (Clarke 1990).41 In the present application the
generalized gradient of the optimal value function wωi has a simple form that limits
the domain where it is nondifferentiable to those points where some of the elements
of the options awards are zero. These are important points, since not all options will
have positive awards. Hence, the lack of a regular gradient is relevant.
The following vector will always be an element of the generalized gradient:
2 3t
r K ω ðy^; u^Þt

y i ω 

 6 t 7

^ f ; u^ t  6 Max 0; ry Ki ðy^; u^tÞτk
o
ϕωi ^τ f ; ^t ok ; g 7 2 @ o wω ^τ f ; ^t o ; g^ f ; u^ :
4 ry Kiω ðy^; u^Þ 5 i k

ru Kiω ðy^; u^Þt

(1.19)

To see this, note that the special nature of the problem in (1.17), where the swing
bus net load is determined freely to meet the condition, could be restated as:


wωi τf ; tok ; g f ; u ¼ Max K~iω ðy~; uÞ
εs ;y
0xk 1

s:t:

ys X 1
¼ τf þ xk tok τok  g f þ εs :
y~ k 0

40
Note: in the early stages of the computation, we might accept both the DC-Load solution and the
associated DC-Load shift factors as the estimates of the linearized constraint. However, when
close to the solution, the assumption that the DC-Load model is inadequate means that we need an
exact evaluation of both the function and the linearized representation of any violated constraint.
41
Here we follow the applications Shimuzu et al. (1997), p. 28. A generalized gradient of a
function f(x) at the point x is defined as @ o f ðxÞ in terms of the generalized directional derivative as
the set of vectors

@ o f ðxÞ ¼ fγ 2 Rn j f o ðx : sÞ  γ t s; 8s 2 Rn g;
where
f ðx þ τsÞ  f ðxÞ
f o ðx : sÞ ¼ lim sup :
x!x
τ
τ#0
1 Financial Transmission Rights: Point-to Point Formulations 41

In other words, ys does not enter the objective function and the resulting
gradients depend only on the objective function derivatives. At most points, w is
differentiable. But at points where it is not differentiable, the generalized gradient
exists and equals the convex hull of the limit points of the gradients, including
(1.19), (Shimuzu et al. 1997).

Whenω the option  award is zero, any element in the interval ½Max
0; ry Ki ðy^; u^Þτok ; þ1Þ would also give rise to a generalized gradient. Thus the


^ f ; u^ is an extreme point of the generalized gradient. It should
vector ϕωi ^τ f ; ^t ok ; g
give an adequate linear representation of the constraint function in the range of
interest over the non-negative allocations.
For a violated constraint, therefore, the idea is to introduce the linearized
constraint:
0 P 1
t f τ f  ^t f
B k k k C


B to  t^o C
wωi ^τ f ; ^tko ; g ^ f ; u^ B
^ f ; u^ þ φωi ^τ f ; ^tko ; g B Pk f f k f
C
C  0:
B ρk g k  ^g C
@ A
k
u  u^

This would then serve as a constraint in the sequential approximation of the

nonlinear AC auction problem in the corresponding way that the constraint would
enter in the case of obligations only. For the linear approximation, the usual first
order KKT conditions would generalize to finding zero as an element of the
generalized gradient.
As a technical point, this application would depend on a slightly stronger set of
assumptions to guarantee that w is Lipschitz near the solution. These conditions
would apply for a slightly modified version of the problem where for a sufficiently
large value of the penalty M we redefine the value function as:

 X
wωi τ f ; tok ; g f ; u ¼ Max Kiω ðy; uÞ  M mk
εs ;y;0xk ;0mk ; k
xk mk 1

s:t:
X 1
y ¼ τf þ xk tok τok  g f þ εs ;
k 0
Lω ðy; uÞ þ ιt y ¼ 0:


This allows the function to be finite for all τ f ; tok ; g f ; u and locally Lipschitz
everywhere (Shimuzu et al. 1997). The generalized gradient at a non-differentiable
point would be bounded by M, but the same lower extreme point should define the
appropriate local linearization to use in the large optimization problem. The
sequential linear approximations would use these function evaluations and
42 W.W. Hogan

selections from the generalized gradient to search for the optimal solution that
satisfied the generalized Karush-Kuhn-Tucker conditions for the master problem.
Relaxation Solution Procedure with PTP-FTR Options

0
Step 1: Select an initial candidate solution ^τ f ; ^t ok ; g^ f ; u^ , ignore most (or all)
of the constraints in the economic dispatch using only the small subset


^ f ; u^ 0 , and set the iteration count to m ¼ 0.
wωi ^τ f ; ^τ ok ; g
Step 2: Construct the relaxed master problem as:
X  
Max βk t fk ; t ok ; ρ fk
u2U;t fk 0;t ok 0;ρ fk 0 k
s:t:
!
X X X
L0O t fk τ fk ; t ok ; ρ fk g fk ; u  ιt ρ fk g fk ¼ 0;
k k k
0 P 1
t fk τ fk  ^t f
m

B k C
B C


 B t ok  ^t ok m C
wi ^τ ; ^t k ; g ; u^ þ ϕi ^τ ; ^t k ; g ; u^ B
^ ^ C  0:
ω f o f m ω f o f mt
BP f f C
ρ g  g^ f
m
B C
@ k k k A
u  u^m


^ f ; u^ mþ1 and update m ¼ m þ 1.
Let a solution be ^τ f ; ^t ok ; g

m
Step 3: Check to see if the candidate solution ^τ f ; ^t ok ; ^g f ; u^ violates any of


the constraints. If so, create a new wωi ^τ f ; ^t ok ; g^ f ; u^ including some or
m

all of these constraints and repeat Step 2. Else done.

Success with this proposed relaxation procedure for solving the auction problem
with PTP-FTR options depends on the expectation that relatively few of the (very)
many contingency constraints will be binding. This is a well-established condition
in the dispatch model and the associated PTP-FTR obligation-only auction model
that is of the same form as the dispatch. By contrast, if the introduction of options
produces many more bids and many more binding constraints, then the scale of the
problem may overwhelm current computational capabilities.
A concern with the potential number of binding constraints applies as well to the
case of a DC-Load model for PTP-FTR obligations and options. However, the DC-
Load formulation would have the computational advantage that evaluation of the
constraints and the associated generalized gradient would be a relatively simple
calculation that reduces to calculating the associated shift factors in Hðu0 Þ and
evaluating the positive elements to construct the generalized gradient. In the DC-
Load formulation ignoring losses, we would have:
1 Financial Transmission Rights: Point-to Point Formulations 43

!

 X
wDC ωi τ ;
f
tok ; u ¼ Max Hiω ðuÞ τ þ
f
xk tok τok  bðuÞ;
0xk 1 k
X

¼ Hiω ðuÞτ f þ tok max 0; Hiω ðuÞτok  bðuÞ:
k

Combining all the constraints and contingencies, we have


wDC τ f ; tok ; u  0:

The corresponding auction model with bids for balanced forward-obligations by

(tfk ; τfk ) and balanced forward-option by (tok ; τok ) would be
X  
Max βk t fk ; tok
u2U;t fk 0;tok 0 k
s:t: (1.20)
!
X
wD C t fk τ fk ; tok ; u  0:
k

Even in the DC-Load case, therefore, this computation is not trivial. For
obligations we need to evaluate only the load flow for each contingency given τf ,
the aggregate of the obligations. Following the discussion of (1.10), this amounts to
solving a system of linear equations for each contingency but evaluates all
constraints in that contingency at once. But in order to evaluate the constraint in
(1.20), we need to calculate the shift factors for every constraint in the contingency,
each of which involves a similar system of linear equations. In other words, in the
relaxation algorithm the need to calculate shift factors expands from the violated
constraints only to every constraint when options are included.
Although this does require more computation, the evaluation of the constraints is
separable and efficient means should be available to do the many evaluations, at
least in the DC-Load case. Furthermore, not every constraint needs to be included in
the relaxed master problem. As long as the number of binding constraints is small,
meaning hundreds and not hundreds of thousands, this auction model might accom-
modate PTP-FTR options and obligations and be computationally feasible.
By construction of the constraints, exercise of the options along with the
obligations would be simultaneously feasible under the condition that the system
operator could select the set of controls needed to satisfy the constraints for the
obligations and exercised options. Hence, the revenue collected in the final spot
market dispatch would always be sufficient to pay the amounts required by the
various PTP-FTR contracts.
44 W.W. Hogan

Fig. 1.2 Transmission line Ik Im

and transformer r x
Vk Vm

1:tkme jakm
Ycap Ycap
2 2

1.5 Conclusion

So-called physical transmission rights present so many complications for a

restructured electricity market that some other approach is required to provide
property rights for the grid. Under a standard market design built on a bid-based,
security-constrained, economic dispatch with locational prices, the natural
approach is to define financial transmission rights that offer payments based on
prices in the actual dispatch. Different models have been proposed for point-to-
point, including obligations and options. With consistent definitions, the rights can
be shown to be simultaneously feasible and revenue adequate in various AC
formulations or approximations. The conditions for simultaneous feasibility also
define the form of auctions that would award or reconfigure the rights. In the case of
point-to-point obligations, the practical feasibility of the approach has been
demonstrated with adaptations of commercial dispatch software. In the case of
point-to-point options, the computational strategies are more demanding but have
been implemented in a limited way.

Appendix: Generic Transmission Line Representation

The generic transmission line analysis employs complex variables. To avoid

confusion here, the indexes for the two terminals of the line are k and m. For a
development of the model transmission line and transformer model, see Grainger
and Stevenson (1994). By choice of parameters, this generic transmission line
representation allows for a Π -equivalent representation of a line with no trans-
former, an ideal transformer, or a combination of both.
Here we follow Weber (1997)’s notation and conventions. This is useful in that
Weber also provides an extensive detail on the characterization of the Jacobian of
the power flow equations to provide further insight into the implications of the AC
power flow model, including calculation of the derivatives with respect to the
transformer parameters. As shown in Fig. 1.2 let Vk represent the complex voltage
with magnitude jVk j and angle θk. The data include the line resistance (r), reactance
(x). The transformer includes turns ratio (tkm) and angle change (αkm ). The line
charging capacitance is the complex Ycap.
1 Financial Transmission Rights: Point-to Point Formulations 45

The line admittance (y) is the inverse of the line impedance (z) formed from the
resistance and reactance.

1 1 1 ðr þ jxÞ 1 r  jx r  jx
y¼ ¼ ¼ ¼ ¼ ¼ g þ jb:
z r þ jx r þ jx ðr þ jxÞ r þ jx r  jx r 2 þ x2

With P as the real power and Q as the reactive power, the general rules for
complex power (S) have:

S ¼ P þ jQ ¼ VI  ¼ zII  ¼ zj I j2 ¼ ðP  jQÞ ¼ ðV  I Þ :

The line capacitance is represented here as:

Ycap
¼ 0 þ jBcap :
2

Following Weber, for the generic representation in Fig. 1.2, complex current (Ik)
from k towards m satisfies:

Ycap ejαkm
I k ¼ Vk y þ  Vm y:
2 tkm

Therefore, the complex power flow from k to m is:


Ycap ejαkm 
Sk ¼Vk Ik ¼Vk Vk yþ Vk Vm y
2 tkm
Ycap  jVk jjVm jejðθk θm þαkm Þ 
¼ jVk j2 yþ  y ;
2 tkm


 jVk jjVm j
¼ jVk j2 gj bþBcap  ðcosðθk θm þαkm Þþjsinðθk θm þαkm ÞÞðgjbÞ;
tkm
jVk jjVm j
¼ jVk j2 g ðgcosðθk θm þαkm Þþbsinðθk θm þαkm ÞÞ
tkm
jVk jjVm j  

þj  gsinðθk θm þαkm Þbcosðθk θm þαkm Þ jVk j2 bþBcap :
tkm

The complex current (Im ) from m towards k is

ejαkm 1 Ycap
Im ¼ Vk y þ Vm 2 y þ :
tkm tkm 2
46 W.W. Hogan

Hence,

ejαkm  1 Ycap
Sm ¼Vm Vk y þVm Vm 2 yþ ;
tkm tkm 2
jVm jjVk jejðθm θk αkm Þ g b
¼ ðgjbÞþ jVm j2 2 j 2 þBcap ;
tkm tkm tkm
g jVm jjVk j
¼ jVm j2 2  ðgcosðθm θk αkm Þþbsinðθm θk αkm ÞÞ
tkm tkm
j Vm j j Vk j b
þj  ðgsinðθm θk αkm Þbcosðθm θk αkm ÞÞ jVm j2 2 þBcap :
tkm tkm

If the system is normal and the angle change is fixed, then the angle change can
be included in the line admittance. Similarly for normal systems, if the transformer
tap setting is fixed, the turns ratio can be included in the per unit normalization of
the voltages, which would produce appropriately modified values of y but with the
elimination of the separate transformer parameters (t, α ).42 Ignoring the line
capacitance, this simplified representation would be


Sk ¼ jVk j2 g^  jVk jjVm j g^ cosðθk  θm Þ þ b^ sinðθk  θm Þ

 
þ j jVk jjVm j g^ sinðθk  θm Þ  b^ cosðθk  θm Þ  jVk j2 b^ :

and


Sm ¼ jVm j2 g^  jVm jjVk j g^ cosðθm  θk Þ þ b^ sinðθm  θk Þ

 
þ j jVm jjVk j g^ sinðθm  θk Þ  b^ cosðθm  θk Þ  jVm j2 b^ :

This is a familiar simplification often seen in the electrical engineering literature.

However, if the system is not normal, tap ratios are variable, or phase angle
adjustments are variable, it will be necessary to use the more general representation
as shown above.
The notation translation to the discussion in the main text has:
Gk ¼ g; Ωk ¼ b; δi ¼ θk ; Zij ¼ Sk ; αk ¼ αkm ; tk ¼ tkm :

42
Normal is a term of art, not necessarily intended to mean “usual.” A system is normal if for each
parallel path the product of ideal transformer gain magnitudes is equal and the sum of ideal
transformer phase shifts is the same. See Bergen and Vittal (2000), pp. 154–175.
1 Financial Transmission Rights: Point-to Point Formulations 47

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Chapter 2
Transmission Pricing

Ignacio J. Pérez-Arriaga, Luis Olmos, and Michel Rivier

2.1 Introduction

The transmission grid has a major impact on the operation and investment decisions
in electric power systems. This impact is more noticeable when the electricity sector
is organized around a wholesale market, where the transmission network becomes
the meeting point of producers and consumers. The relevance of transmission is
presently increasing with the growing penetration of intermittent renewable energy
sources, frequently distant from the main load centres and significantly adding to the
variability of flow patterns.
This chapter examines the economic impact of the transmission network on its
users. This impact is twofold. On the one hand the network modifies the bulk prices of
electrical energy, due to the presence of network losses and congestions. On the other
hand, the costs of investment and operation of the transmission network have to be
allocated to its users, according to some reasonable criterion. In principle both impacts
should have a locational component. Injections or withdrawals of power in the grid
affect losses and constraints differently depending on the node where they occur.
Besides, the responsibility of network users in the reinforcements to the network
generally depends on the location of these generators and loads. Thus, the allocation
of the cost of the grid to its users should be guided by the location of the latter.
The chapter starts by discussing in Sect. 2.2 the effect of the transmission grid on
system operation costs: how network constraints modify the economic dispatch of
generation plants, and the costs of transmission losses. Section 2.3 presents the
concept of nodal prices (locational marginal prices) and how to compute them.

I.J. Pérez-Arriaga (*)

Comillas Pontifical University, Alberto aguilera 23, 28015 Madrid, Spain
Massachusetts Institute of Technology, 77 Massachusetts Avenue, Cambridge, MA 02139, USA
e-mail: [email protected]; [email protected]
L. Olmos • M. Rivier
Comillas Pontifical University, Alberto aguilera 23, 28015 Madrid, Spain

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 49

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9_2,
# Springer-Verlag London 2013
50 I.J. Pérez-Arriaga et al.

The main properties of nodal prices are explained in Sect. 2.4. Section 2.5 describes
how the impact of the transmission network on electricity energy prices is accounted
for in practice in different power systems. Finally, Sect. 2.6 examines the allocation
of the transmission network costs among the network users in the form of regulated
network tariffs Sect. 2.7 concludes.

2.2 The Effect of Transmission on System Operation Costs

The unavoidable physical limitations of transmission networks when connecting

producers to consumers have three main undesirable effects on the operation of the
system. First, part of the energy transmitted over the lines and other grid facilities
is transformed in heat and, therefore, never reaches the consumption centres.
The difference between the amount of power injected at one end of a line and that
withdrawn at the other end is called the loss of power in the line, or line loss. Second,
the transmission grid imposes constraints due to a variety of technical reasons on any
given set of power transactions that the network users want to make happen. Third,
problems affecting the integrity and well functioning of the grid may result in the
interruption of power supply to certain (or all) loads or the deterioration of the quality
of electricity supplied. Thus, the quality of the electricity supply service may be
affected by the grid.
Therefore the transmission grid may affect both the operation costs and the set of
power injections and withdrawals that are allowed to take place. Conversely, the
specific location of generators and loads in the grid is the driving factor behind the
need for network expansion, which tries to improve the reliability of electricity
supply and to reduce the operation costs derived from losses and network constraints.
The locational differentiation of energy prices and network charges sends locational
signals to prospective network users to be located so that these adverse effects are
minimized.
Understanding the origin of network related operation costs, as well as the main
drivers behind these costs and their impact on the system economic dispatch is of
essence. Next, each of the three main effects of the grid on the system operation and
its costs is discussed separately.

2.2.1 Network Losses

Most of the energy losses in electric power grids are due to the resistance of conductors
to the circulation of electric current flows. These are known as ohmic losses. Other
losses are due to the corona effect whereby electrical discharges take place in the air
surrounding high voltage line conductors. Losses also occur within network devices
like transformers, reactors, capacitors. Due to existing losses, consumers receive
less energy than generators produce.
Transmission network losses result in additional system costs. More energy has to
be produced than is consumed, because part is lost while being transported. These costs
2 Transmission Pricing 51

correspond to additional production costs, i.e. they are not network costs per se, though
they are a consequence of the need to transport power over the transmission grid. The
cost of losses is affected by transmission expansion and operation decisions. It is
therefore advisable to set efficiency incentives encouraging the System Operator and
network users to reduce these costs.
Ohmic losses in a line are nearly proportional to the square of the power flow over
the line (more precisely, they are proportional to the square of the current in the
wires). This means that the increase in losses per unit increase in the system load
(marginal increase in losses) is approximately twice as large as the average amount
of losses per unit of load (total amount of losses/total system load). Consequently, the
marginal cost of transmission losses (transmission losses cost increase/increase in
system load) exceeds their average cost (total cost of losses/total system load).
The increase in transmission losses in the system due to a marginal increase in the
load at a certain node depends on the location of this node in the grid, since the
resulting changes in line flows depend on the latter as well. Therefore, transmission
losses create geographic differences in the marginal cost of supplying electric energy.
This implies that the marginal cost of meeting a marginal increase in demand can only
be correctly assessed if the exact node where demand is increased is specified. Other
factors contributing to these differences are described in the next subsection.
Due to transmission losses, some power plants may take precedence in the merit
order of the economic dispatch over other plants whose production costs are lower.
The merit order of power plants in the dispatch must be affected by the loss factor
corresponding to each plant according to its location in the grid.1

2.2.2 Network Constraints

Networks restrict in many ways the power transactions that can take place in the
system. Most typically, transactions cannot result in a current intensity (roughly
proportional to the power flow, for a given voltage level) over any line that exceeds
the maximum one that can be handled by this line. The underlying reason to limit the
current intensity over a transmission line may be thermal – and therefore dependent
upon the physical characteristics of the facility – or related to the conditions of system
operation as a whole, like the provisions to guarantee an appropriate system dynamic
response to disturbances or to avoid stability related problems that usually increase
with the length of lines. Another typical grid constraint is the need to keep voltages
within certain limits at all nodes, which may call for having some generation unit
connected near the node experiencing problems. The maximum allowable short-
circuit power may also limit grid configuration. Generally speaking, the chief effect
of grid constraints is to condition system operation, leading to deviations from the most

1
The loss factor at a certain node represents the increase in transmission losses in the system
resulting from a unit increase in the power injected at this node. Loss factors depend on the existing
system operation conditions.
52 I.J. Pérez-Arriaga et al.

efficient one from an economic point of view. Most common constraints in distribution
grids are related to voltage limits and maximum line capacities.
Just as in the case of network losses, the mere existence of the transmission
network adds to system costs by requiring the dispatch of more costly generation
units to surmount the physical limitations imposed by the grid. This does not imply
that network design or development is flawed, since network investments required to
ensure the total absence of constraints in the system would probably not be economi-
cally justified. Some network constraints may therefore be justified from an economic
point of view (provided that they do not systematically prevent the coverage of
demand).
The cost of grid constraints, like that of losses, corresponds to additional generation
costs that are associated with the characteristics of the network. Therefore, these costs
are not part of the cost of the network itself. Operation and expansion decisions
may affect the cost of grid constraints, which advises sending economic signals
encouraging parties in the system to reduce this cost.
Both losses and grid constraints result in changes in the economic dispatch.
The merit order of generation units depends not only on their production costs but
also on their location in the grid and their impact on losses and grid constraints.
The marginal cost of supplying load depends on the location in the grid of the former
and therefore, may vary from one node to another. Additional costs associated with
losses and constraints must be assigned to network users.
As explained below, nodal prices applied to the electric energy sold or purchased
are economic signals that efficiently internalize all the short-term effects of the
network on electricity supply costs. Due to their relevance, next Sects. 2.3 and 2.4
are devoted to discussing nodal prices and their properties.

2.2.3 Quality of Service

Transmission networks have also an impact on the quality of the electricity supply
service. In countries where the electricity system is well developed, generation outages
or lack of total generation capacity are hardly ever responsible for electricity supply
interruptions. In a small percentage of cases, the origin of interruptions lies in joint
generation and transmission security failures (although the consequences of such
events are usually very severe, since they affect large areas in the system). Supply
disruptions are in fact practically always due to local distribution grid failures.
Distribution business regulation should strike a balance between the cost of developing
the grid and the resulting enhancement of end consumer quality of service. The effect
of the transmission grid on the quality of service is not so notorious and will not be
discussed further in this section.
2 Transmission Pricing 53

2.3 Nodal Prices: Definition and Computation

Losses and grid constraints result in differences in the local marginal value of energy
among transmission nodes.2 Locational energy prices affect the short and long term
efficiency of the functioning of the system by driving market agent decisions on how
much power to produce or consume at each time, as well as where to site the new
generation or load they plan to install, which may in turn affect the development of the
transmission network.
Short-term locational energy prices also vary over time. Separate prices are
computed for each hour in day-ahead markets and in some power systems they are
also computed as close as several minutes ahead of real time. Signals sent through
these prices are needed to achieve maximum system efficiency. They aim to ensure
that the generators with the lowest variable costs are the ones dispatched and demand
can respond to the actual costs of supplying energy at each location. Besides, these
signals also drive the expansion of the system, since expectations about future values
of energy prices at the different locations affect market agents’ long-term decisions on
the siting of new generation and demand facilities.

2.3.1 Concept of Nodal Prices

Nodal pricing represents the most sophisticated and efficient expression of locational
energy prices. The marginal cost of electricity in a system corresponds to the extra cost
incurred to serve a differential increase in the system load. It can be demonstrated that
pricing the electricity produced or consumed in each node at the local marginal cost
leads generators and loads in the system to make efficient operation decisions.
As a result of the existence of the grid, the marginal cost of electricity varies from
one node to another. The nodal electricity price, also called locational marginal
electricity price, in each node k is the short term cost of supplying most economically
a marginal increase in demand in this node while complying with grid constraints.
Nodal energy prices can be computed both for active and reactive power, as discussed
in (Schweppe et al. 1988). However, nodal prices of reactive power have not been used
in any real life system.3
When taking into account the actual features of electricity systems, which obvi-
ously must include the transmission network, any computed marginal system costs
must be node specific. The uniform marginal system cost considered in several
electricity markets results from disregarding the effect of the transmission network
on the generation economic dispatch. Both short and long term marginal costs can be

2
Nodal prices are also called locational marginal prices. In the pioneering work on this subject, see
(Schweppe et al. 1988), the most general term “spot prices” is used.
3
In some systems, like UK, energy and capacity payments associated to the production of reactive
power have been paid to agents located in specific areas of the system where voltage problems may
occur. However, no systematic nodal or zonal reactive power pricing scheme has been applied.
54 I.J. Pérez-Arriaga et al.

computed at system level and for each node. Long term marginal costs consider the
option to marginally increase transmission or generation capacity to meet an increment
of the load at a certain node.

2.3.2 Computation of Nodal Prices

Nodal prices can be readily obtained as by-products of the models widely available
to compute the economic dispatch in the short-term taking into account the trans-
mission grid. Models used may be as complex as needed. Using a very simple
model, we aim to illustrate the process of computation of nodal energy prices within
a centralized economic dispatch where network effects are considered.
In model (2.1) of the system economic dispatch, we make use of linear equations
representing the flow of power over the grid according to Kirchhoff laws4 (DC
model). For the sake of simplicity, ohmic losses in each line have been represented
as a function of the flow over this line and assigned to the extreme nodes of the line,
thus being equivalent to an extra demand in each of the two nodes (half of the losses
would be assigned to each node). For other representations of line losses, see, for
instance, (Rivier et al. 1990). Besides, in order to make the formulation simpler, the
only grid constraints considered are maximum line capacities.
X
max i
fBi ðdi Þ  Ci ðgi Þg

s:t:
X  
di  gi þ m
tim  fim  Li;m ðfim ; Rim Þ ¼ 0 8i pi

yi  ym
tim ¼ fim 8i; m xim
xim

fim  fim 8i; m mim (2.1)

yref ¼ 0

gi  gi 8i bi

di  di 8i ai

4
Kirchhoff laws are two. First one states that at each node, power injections must equal power
withdrawals. Second one states that, when flowing among two nodes, power is split among the
different parallel paths between these nodes in inverse proportion to the electrical distances along
these paths.
2 Transmission Pricing 55

In the formulation in (2.1), i is an index representing the set of nodes; m is an alias

of i; Bi ðdi Þ is either the benefit obtained by agents at node i from the power di they
consume or the offer by agents at node for the power di they consume. Then, Bi ðdi Þ is
equal to the cost of electricity for consumers plus the consumer surplus; Ci ðgi Þ is the
either the cost incurred by agents at node i when producing gi units of power or the bid
by agents at node i to produce gi units of power; tim is a binary variable whose value is
1 when nodes i and m are connected through a line and is 0 otherwise; fim is the flow
over the line between nodes i and m in the direction from i to m; Li;m ðfim ; Ri;m Þ is the
fraction (half) of transmission losses in the line between nodes i and m that has been
assigned to node i and has therefore been represented as an extra load in this node:
losses over a line depend on the flow and resistance of the line; yi is the phase angle at
node i; xim is the reactance of the line between nodes i and m; fim is the maximum flow
allowed over the line from i to m in the relevant direction; yref is the reference phase
angle; g1 is the maximum power production in node i and d1 is the maximum demand
for power in the same node. Apart from that, pi, xim, mim, bi and ai are the dual variables
of the corresponding constraints, which are obtained, together with the primal
variables, when solving the optimization problem.
The nodal price at node k, rk , is, in this simple case, the dual variable of the kth
nodal balance equation, pk .5

rk ¼ pk (2.2)

The system economic dispatch can be modeled using an alternative formulation,

see (2.3). In model (2.3), ohmic losses in the transmission grid are easily represented.
X
max i
fBi ðdi Þ  Ci ðgi Þg

s:t:
X
i
ðdi  gi Þ þ Lðd; gÞ ¼ 0 g
X  
i
PTDFi;l  ðgi  di Þ ¼ fl 8l xl

fl  fl 8l ml (2.3)

gi  gl 8i bi

di  dl 8i ai

5
Strictly speaking, the nodal price expression will be rk ¼ pk þ ak, although ak will be non-zero
only at those nodes where all the demand is fully unserved.
56 I.J. Pérez-Arriaga et al.

Most symbols in model (2.3) have already been used in this section. New ones are
described next. Lðd; gÞ represents transmission losses in the system expressed as a
function of power injections and withdrawals; PTDFi;l , is the Power Transfer Distri-
bution Factor of the flow over linel with respect to the power injection at nodei, i.e. it is
the sensitivity of the flow over this line with respect to the power injected at this node;
fl is the flow over line l and fl represents the maximum amount of power allowed over
linelin the direction in which the flow actually goes in the scenario considered. Finally,
when used as an index, l refers to the set of lines in the system.
Nodal energy prices can be computed from the solution of the economic dispatch
in (2.3) as a linear combination of several of the dual variables of constraints in this
problem.

dL X
rk ¼ g þ  k ¼ g þ g   ðml  PTDFk;l Þ (2.4)
ddk l

dL
where dd k
is the loss factor corresponding to node k; and k is a variable representing
the difference between the energy system price and the nodal price at each node.
Then, generally speaking, this variable should be different from zero for all nodes but
that taken as a reference for computing the system price. It reflects the impact of the
grid on the value of energy at each node and depends on the reference node chosen.
The formulation of the optimization problem in (2.3) should depend on the
identity of the node chosen as a reference nodes. The derivative of the systems
losses with respect to demand at node k and PTDFs depend on the choice of
reference node. The amount of power being dispatched at each node; the overall
value of accepted bids; and nodal prices are not affected by the choice of the
reference node but dual variable g is. Therefore, (2.4) should instead read as in (2.5).
X
rk ¼ gs þ k;s ¼ gs þ gs  LFk;s  ðml  PTDFk;l;s Þ ¼ rs  ð1 þ LFk;s Þ
X l
 l
ðml  PTDFk;l;s Þ ð2:5Þ

2.4 Main Properties of Nodal prices

Nodal electricity prices consider the impact of the transmission network on the
short term marginal value of energy both from a technical and an economic point of
view. The level of these prices depends, at any time and node of the network, on
system operation conditions including the following: set of available generation and
transmission facilities and their technical features (capacities, line impedances);
load level at each node; and variable costs of generators. Amongst nodal electricity
prices main properties, there are their ability to send efficient short term signals; the
efficient allocation among parties of the cost of losses and network constraints; their
2 Transmission Pricing 57

ability to recover only part of the cost of the grid; and the option to decompose them
into a system (or energy) a loss and a congestion part. The remainder of this
subsection discusses these properties in detail.

2.4.1 Property 1: Efficient Short-Term Energy Prices

It can be easily demonstrated that nodal prices are optimal short term economic
signals that internalise all the grid effects in a single value – the price to buy or sell
energy in €/$/£ per kWh – separately computed for each node. In other words, when
the energy produced or consumed at a certain node i is priced at the corresponding
nodal price pi , market agents located at this node are encouraged to behave most
efficiently in order to maximize the social benefit of the system. The proof of this
statement can be found in (Schweppe et al. 1988).
Consumers decisions will only be optimal if they exhibit some elasticity to the price
of energy (the larger the amount of power purchased, the smaller value they place on,
or the price they are willing to pay for, an extra unit of power). However, most
consumers do not decide how much power to purchase at any given moment in time
based on the price they will have to pay for it. Hence, the amount of power retrieved by
consumers at the majority of nodes can be considered to be an input to the dispatch
problem where prices are determined. Unless the dispatcher has access to the true
utility function of consumers ( Bi for consumer at node i ), nodal prices will not
maximize social welfare in the short term.
Besides, achieving an optimal operation of the system requires bids from
generators corresponding to their true production cost function (we have worked
under the hypothesis that the cost function Ci ðgi Þ used in the dispatch and the agent
problems is the same). However, generators may bid strategically deviating from
their true cost function since, in reality, some degree of market power always exists.

2.4.2 Property 2: Efficient Allocation of Network Losses

Associated Costs and Redispatch Costs due to Network
Constraints

Nodal prices result in those network users located in areas where the power they
produce or consume cause significant losses or network congestion facing less
favorable prices (higher for consumers, lower for producers) than those network
users that, due to their location in the grid, contribute to reducing network losses or
alleviate congestion in the grid. Therefore, besides producing optimal short-term
signals, nodal prices are locational signals encouraging agents to install new load or
generation in places where the resulting ohmic losses and network congestion are
as small as possible.
Note however that, while nodal prices send economic signals in the direction of
reducing losses and congestion costs, they are not assigning to agents the social cost
58 I.J. Pérez-Arriaga et al.

of losses and network congestion. This is remarkably clear for losses, since, due to
the fact that losses increase with the square of power flows, nodal price differences
due to losses result in larger net revenues for the system than the cost of system
losses.

2.4.3 Property 3: Contribution to the Recovery of Network

Investment and Maintenance Costs

The application of nodal prices to the power injected and withdrawn in each node
gives rise to a net revenue NRt at each time t, whose expression is provided in (2.6).
The overall net revenue for the whole system over a certain period of time, normally
a year, is widely known as the Variable Transmission Revenues (VTR) of the
system, whose mathematical expression is provided in (2.7):
X
NRt ¼ n
ðpn;t  dn;t  pn;t  gn;t Þ (2.6)
X
VTR ¼ t
NRt (2.7)

where n represents the set of nodes in the system and t the time.
As shown in (Olmos 2006), VTR can also be computed line by line according to
(2.8). Each line l between nodes in and out, where power flows from node in to node
out, can be considered an arbitrageur buying energy Pl;in;t injected in the line at node
in and time t and selling energy Pl;out;t retrieved from the line at node out and the
same time. Given that the amounts of power injected into and withdrawn from line l
differ by the amount of ohmic losses in this line, and nodal prices at time t at both
line nodes pin,t and pout,t also differ, the commercial exploitation of line l will result
in a net revenue at time t represented in (2.8) by NRl;t .6
X X X
VTR ¼ l;t
NRl;t ¼ t l
ðpout;t  Pl;out;t  pin;t  Pl;in;t Þ (2.8)

Variable Transmission Revenues computed according to (2.7) and (2.8) are the
same. These revenues are associated with differences among nodal prices and powers
injected into and withdrawn from the grid due to transmission losses and congestion.
Network revenues associated with congestion are also known as congestion rents.

6
Exceptionally, “network revenues” may be negative when line losses are very large due to
corona discharge. Note that network revenue is the profit that the transmission network would earn
if energy were purchased from generators at their nodal price and sold to consumers at theirs.
However, the transmission network should not be allowed to conduct free market transactions, but
must rather be treated like a regulated monopoly with pre-established remuneration. Exceptions,
namely merchant lines, may be justified for individual lines under special circumstances.
2 Transmission Pricing 59

VTR critically depend on the level of development of the grid. Overdeveloped grids
will result in small losses and congestion, thus leading to small differences among
nodal prices. These, in turn, will result in small VTR. On the other hand, underdevel-
oped grids will result in large differences among nodal prices probably leading to large
VTR (although losses will probably be large as well).
Pérez-Arriaga et al. (1995) demonstrate that, under ideal conditions affecting the
planning of the grid, VTR in an optimally developed network would amount to exactly
100 % of the network investment costs. Ideal conditions affecting the development of
the network to be met for network variable revenues to amount to 100 % of the network
costs are investigated in Rubio and Pérez-Arriaga (2000), and mainly include the
following:
• Static and dynamic network expansion plans are the same and planning errors do
not occur.
• Investments in transmission are continuous.
• Economies of scale do not exist in the transmission activity.
• Reliability constraints considered in system development planning are also
considered in system operation.
In real life systems, VTR fall short of total transmission costs. The former only
manage to recover about 20 % of the costs of the grid, according to estimates in
Pérez-Arriaga et al. 1995. Main reasons for revenues from the application of nodal
prices being so low are briefly discussed next.
First, economies of scale and the discrete nature of network investments result in
an overdevelopment of networks in practice (see Dismukes et al. 1998). In effect,
building lines with a large capacity is generally preferable over building a larger
number of small lines even when the former are not going to be fully used during
the first years of their economic life. As we have just explained, overinvesting in the
development of the grid results in small nodal price differences and a small VTR.
Second, certain reliability constraints and a wide range of scenarios shall be
considered when planning the expansion of the grid, This is due to the fact that there
is a high level of uncertainty about the operation conditions that may occur in the
system throughout the economic life of investments being decided. However, some of
these restrictions and all these scenarios but one will not be considered when comput-
ing the operation of the system. Due to the fact that the set of constraints considered
when computing the expansion of the system tends to be larger than that considered for
operation planning, long term nodal prices computed assuming grid investments are
continuous would also differ substantially from short term nodal prices. Specifically,
differences among long term nodal prices, and therefore also revenues from their
application (which should amount to the exact cost of the grid assuming continuous
investments), would be much larger than those computed for short term prices.
Therefore, even if (short term) nodal prices are applied, revenues from their
application will not suffice to recover the cost of the grid. Additional transmission
charges will need to be levied on network users to complete the recovery of this
cost. This is discussed in Sect. 2.6.
60 I.J. Pérez-Arriaga et al.

Given that Financial Transmission Rights entitle owners to receive the difference
between the energy prices at the nodes that these rights refer to, the aggregate value for
market agents of all the simultaneously feasible transmission rights (defined as
obligations) that can be issued in the system would equal the expected overall net
revenues from the application of energy prices. Due to the fact that, as just mentioned,
these revenues tend to be much smaller than the total cost of an optimally developed
transmission grid, it is highly unlikely that the financing of investments in the
transmission grid through the issuance of FTRs would result in an appropriate devel-
opment of the grid. Most of the required reinforcements could not be financed through
this scheme.
Authorities must bear in mind that revenues of transmission companies or the
System Operator should generally not depend on revenues resulting from the appli-
cation of nodal prices. Otherwise, they will have a perverse incentive not to invest in
the further development and maintenance of the grid so as to increase nodal price
differences and therefore their revenues. Revenues of transmission service providers
should generally be regulated (not dependent on nodal price revenues), though VTR
should probably be devoted to finance part of the payments to these companies.

2.4.4 Property 4: Decomposition of Nodal Prices in Their Energy,

Losses and Congestion Components

As already pointed out when discussing the computation of nodal prices in Sect. 2.3.2,
the nodal energy price in each node can be decomposed into three components: one
associated with the marginal cost of producing electricity in the system; another one
associated with the effect that increasing the demand in this node has on ohmic losses
and the marginal cost of electricity; and a third one related to the effect of marginally
increasing the demand in the node on transmission constraints and the cost of these
constraints. The decomposition of nodal electricity prices is investigated by Rivier and
Pérez-Arriaga (1993), where the mathematical expression of the nodal price in node k
provided in (2.9) is derived.
X
rk ¼ gs þ Zk;s ¼ gs þ gs  LFk;s þ j
mj  NCj;ks (2.9)

where, gs can be deemed the cost of producing electricity in the system, which is
common to all nodes whose prices are to be computed; and Zk;s is the part that can be
deemed specific to each node k, which comprises the cost of losses caused by an
increase in the node Pdemand, gs  LFk;s , and the cost of restrictions affected by this
demand increase, j mj  NCj;ks . LFk;s is the loss factor of node k; mj is the cost of
each restriction j; and NCj;ks is the impact of an increase in demand in node k on the
system variable constrained in restriction j. LFk;s and NCj;ks are therefore sensitivity
factors measuring changes of losses and any constrained parameter of the system,
respectively, for an increase in demand at node k.
2 Transmission Pricing 61

However, defining a one-to-one relationship between each nodal price r and its
energy, losses and constraint components is not possible. As highlighted in (2.9),
components of the price at a node k must be defined taking as a reference the nodal
price at another node s, which we shall call reference node from now on. Thus, the
energy component of price rk , gs , corresponds to the nodal price at node s; the losses
component is defined in terms of LFk;s , which is the loss factor at node k taking
as a reference node s, meaning the increase in the ohmic losses in the system resulting
from an increase in power injected in node s to supply a marginal increase in electri-
city demand in node k; finally, the constraint component of price rk is defined
in terms of the impact NCj;ks on the system variable constrained by grid constrain j
of an increase in power injected in node s to supply a marginal increase in electricity
demand in node k. Changing node s taken as a reference for the computation of nodal
price rk would result in a change of the value of its energy, losses and constraint
components, while the nodal price itself would not change.
The reference node s may be chosen to be the one(-s) where the marginal
generator(-s) in the system economic dispatch is(are) connected. Then, the energy
component of the nodal price at node k would refer to the cost of producing electricity
with the most efficient generation unit(-s) available, while the losses and constraint
components would correspond to the cost for the system of transporting electricity
produced by the marginal generator(-s) in the dispatch to node k. This, in any case,
must be deemed an arbitrary decomposition of nodal price rk , since the system
marginal generator may change depending on the set of active constraints and existing
losses, and therefore the production cost of this generator cannot be deemed indepen-
dent of constraints and losses in the system. Therefore, decomposing nodal prices into
its energy, losses and constraint components may have practical applications but one
should be aware of the limitations of such a composition.
An interesting corollary of the decomposition of nodal prices just discussed is
the existing relationship between the prices in any two nodes k1 and k2 in the
system, which is provided in (2.10).
X
rk1 ¼ rk2  ð1 þ LFk1;k2 Þ þ j
mj  NCj;k1;k2 (2.10)

Equation (2.10) results from deriving the expression of nodal price rk1 according to
(2.9) when taking node k2 as the reference one. Rivier and Pérez-Arriaga (1993),
discuss other less-relevant properties of nodal prices. Other algorithms have been
proposed more recently to overcome the dependence of the decomposition of prices on
the reference bus chosen (see Cheng and Overbye 2006). This and other research
works try to get around this challenge by imposing constraints on the decomposition
problem that determine the identity of the reference bus.
62 I.J. Pérez-Arriaga et al.

2.4.5 Dependence of the Sensitivity of Line Flows with Respect to

Nodal Power Injections on the Choice of Reference Node

Factor PTDFk;l refers to the sensitivity with respect to the power injection in node k
of a specific type of constrained variable: the flow over line l .7 Sensitivity factors
of line flows are commonly used in regulatory approaches normally related to the
allocation of the costs of transmission lines. Factor PTDFk;l;s is commonly claimed to
represent the marginal use of line l by agents located in node k.
As already mentioned, the value of PTDFs depends on the reference node
considered when computing them. Then, the sensitivity of the flow in line l with
respect to the power injection in node k must be denoted PTDFk;l;s , thus refering
to the specific node s where an increase in the power withdrawn balances the afore-
mentioned increase in the power injected in node k (neglecting losses, the extra
power withdrawn in node s must be the same as that injected in node k8).
Given the role that PTDFs have in the allocation of the cost of transmission lines
according to some of the methods proposed for this (namely the so-called Marginal
Participations method), discussing the effect of the selection of the reference node on
the value of these factors is relevant. If losses are neglected and line flows are assumed
to be a linear function of power injections and withdrawals, applying the superposition
principle it can be easily proved that the PTDFs of line l with respect to the power
injected at node k computed using reference nodes s1 and s2 are related by the
expression in (2.11).

PTDFk;l;s2 ¼ PTDFk;l;s1 þ PTDFs1;l;s2 (2.11)

Note that PTDFs1;l;s2 does not depend on the reference node chosen. This involves
that changing the slack node results in a uniform increase (either positive or negative)
of the sensitivities of the flow in each line with respect to the power injected in all nodes
of the system. Therefore, absolute differences among the sensitivities of the flow in a
line with respect to power injections in different nodes of the system do not depend on
the reference node used to compute these sensitivities.

7
Power Transfer Distribution Factors are normally defined as the sensitivities of flows with respect to
power injections, while sensitivity factors of constrained variables in general, NC, are normally
defined with respect to power withdrawals. Therefore, changing the sign of factors NC corresponding
to line flows is necessary to compute PTDFs. Besides, it must be noted that PTDFs are defined by some
authors as the sensitivity of line flows with respect to point to point transactions rather than power
injections. Thus, for example, authors in Galiana et al. (2003) compute the sensitivity of line flows
with respect to equivalent bilateral power exchanges (whereby each demand is assigned a fraction of
each generation and each generator is assigned a fraction of each demand in a uniform manner) to
allocate the cost of these lines to their users.
8
If losses are considered, the amount of power withdrawn in the reference node should not be 1 MW
(a unit increase) but an amount slightly larger or smaller depending on the effect on transmission
losses in the system of the considered power transaction between node k and reference node s.
2 Transmission Pricing 63

Then, if part of the cost of transmission lines is allocated to agents according to the
sensitivities of the flows in the former with respect to power injections by the latter,
differences among the transmission charges to be paid by different agents would not
depend on the reference node chosen to compute line flow sensitivities. However, this
does not mean that charges computed using any reference node make engineering and
economic sense. As explained in Olmos and Pérez-Arriaga (2009), only those cost
allocation methods whose underlying principles are sound can be deemed to produce
sound transmission charges.
If transmission losses are taken into account, the choice of the reference node has
a small, albeit nonzero, influence on differences among the sensitivities of a line
flow with respect to power injections in different nodes, as shown in (2.12) and
(2.13), which have been derived from the discussion on the subject in Rivier and
Pérez-Arriaga (1993):

ð1 þ LFk;s2 Þ ¼ ð1 þ LFk;s1 Þ  ð1 þ LFs1;s2 Þ (2.12)

PTDFk;l;s2 ¼ PTDFk;l;s1 þ PTDFs1;l;s2  ð1 þ LFk;s1 Þ (2.13)

Differences among line flow sensitivities with respect to different injection nodes
are dependent on the choice of the reference node because the change in the sensitivity
factor for a certain injection node resulting from a change of the reference node is a
function of the loss factor of this injection node. However, differences among loss
factors computed for different injection nodes are likely to be very small. Hence,
generally speaking, differences among line flow sensitivity factors can be deemed
slack node independent.

2.5 Main Locational Energy Pricing Schemes:

Alternatives to Nodal Pricing

The management and pricing of the effect that the transmission network has on the
energy dispatch is one of the areas where the power system academic community has
been more prolific recently (see Chao and Peck 1996; Stoft 1998; Ruff 1999; Chao and
Peck 2000; Tabors and Caramanis 2000; Boucher and Smeers 2001; ETSO 2001;
Henney 2002; Hogan 2002; O’Neill et al. 2002; ETSO 2004; ETSO/EuroPEX 2004 as
a sample of relevant works on the subject). The choice of the transmission pricing
scheme to be applied should condition the definition of Financial Transmission Rights,
as we shall explain below for each of the main types of schemes. Any transmission
pricing scheme to be implemented must comply with sound engineering and
economic principles but it must also be politically acceptable. This section describes
and critically analyses the most relevant options for the pricing of the effects of
transmission on power system dispatch. We discuss only market based methods, i.e.
those which aim to maximize the economic value of energy and transmission capacity
bids accepted.
64 I.J. Pérez-Arriaga et al.

Pricing schemes can be classified according to different criteria. Probably the two
most relevant ones are (1) the type of interface involved in these schemes between
energy and transmission pricing and (2) the level of locational differentiation (granu-
larity) in final energy prices that result from them. According to the first criterion,
pricing schemes can be classified into implicit schemes, where energy prices computed
include the effect of the transmission grid on the economic value of energy, and
explicit ones, where the effect of the network on the value of energy at each location
is priced separately from energy itself. According to the second criterion, one may
distinguish among nodal pricing, where a separate energy price is computed for each
transmission node; zonal pricing, whereby the system is divided into pricing areas and
a separate price is computed for each of them; and single pricing, where a single energy
price is applied at all nodes in the system.
We shall here review main pricing alternatives according to the location differ-
entiation in final energy prices they create. Within each main option corresponding
to a level of disaggregation of prices, a distinction may be made between implicit
and explicit schemes if appropriate.

2.5.1 Nodal Differentiation of Energy Prices

By far, the most relevant scheme within this category is nodal energy pricing (also
called Locational Marginal Pricing), which produces a separate price for the energy
consumed and generated at each transmission grid node. Energy prices computed
through nodal pricing implicitly include the effect of grid losses and transmission
congestions, internalising both effects in a single value (€/$/£ per kWh) that varies at
each system node. Therefore, nodal pricing is an implicit transmission pricing scheme
that produces perfectly efficient signals for decisions concerning the (short-term)
economic operation of generation and demand, since nodal prices correctly convey
the economic impact of losses and constraints at the different producer and consumer
locations.
When focusing on the effect of grid congestion on the dispatch, nodal pricing may
be seen as the outcome of a joint competitive auction of energy and physical rights to
use the transmission capacity. O’Neill et al. (2002), provide an example of imple-
mentation of a contingency constrained auction for both energy and transmission
rights where the authors consider both options and obligations. Auctions proposed in
O’Neill et al. (2002), are different from other designs of implicit auctions in the sense
that authors propose using them both in the short and the long term.
The academic community has come up with several designs to run implicit auctions
in a decentralized manner. Thus, Aguado et al. (2004), decomposes the original
problem into several simpler ones. The optimal outcome at regional level is found
through an iterative process. The concept, properties and way to compute nodal energy
prices have already been extensively discussed in the preceding sections within this
chapter.
Instead of integrating the effect of transmission on the energy dispatch, one may
think of separately pricing the effects that network congestion or losses should have on
2 Transmission Pricing 65

the final price of energy. However, if we are not able to define areas of uniform energy
prices, which result from the application of a zonal, instead of a nodal, pricing scheme,
separating the allocation of energy and capacity is not possible (or feasible from a
practical point of view). When zonal prices cannot be defined, any power transaction
significantly affects the flow through the congested lines and has to participate in the
transmission capacity allocation process. Then, the unconstrained energy dispatch
taking place after the allocation of transmission capacity (where limits to power flows
imposed by the network are not considered) has to replicate exactly the outcome of the
capacity allocation process (either the capacity auction or the outcome of the bilateral
trading process taking place among agents to buy and sell transmission capacity
rights).
However, the effect of transmission losses on efficient energy prices can effectively
be computed separately from the energy system price (the so called lambda in nodal
pricing nomenclature) through the application of loss factors. Therefore, there is no
need to forgo the short-term loss signals that contribute to the economically efficient
system operation. The losses attributable to each player, either computed as a marginal
or average value, can be applied in the form of corrective factors to determine the
prices to be paid or earned by this player or, rather preferably, the net amount of energy
produced or consumed by the former. This should lead players to internalise the losses
they are responsible for in their offers.
When energy prices differ by node, Financial Transmission Rights can be used to
hedge against possible financial losses from the volatility in the differences among
prices at two or more nodes (ETSO 2006). FTRs hedging a certain power transaction
may be issued by any party. However, leaving their issuance in the hands of the TSO
responsible for transmission among the nodes in the transaction would ensure revenue
adequacy (Hogan 1992). According to this criterion, the issuing party should in this
case be the corresponding national or State TSO for local transactions and the regional
TSO for cross-border transactions.
Examples of nodal pricing can be found in electricity markets in Chile, Argentina,
New Zealand and several Regional Transmission Organizations (RTOs) in the USA,
such as the PJM system (Pennsylvania, New Jersey, Maryland), the Electric Reliability
Council of Texas (ERCOT) system, or the California system. Loss factors are used for
instance in the Irish Single Electricity Market.
Revenues from the application of nodal prices correspond to the economic value
produced by the transmission grid by transporting power from nodes where it has a
lower value (price) to those where its value is higher. Then, these revenues should be
devoted to pay the regulated revenues to be earned by grid owner(-s).

2.5.2 Zonal Differentiation of Prices

Zonal price differentiation schemes involve applying the same final energy price
within each of a set of areas while allowing price differences to take place among
these areas. Normally, under zonal price schemes, a single market price is applied to all
agents in the system unless significant network congestion occurs restricting the
66 I.J. Pérez-Arriaga et al.

energy flows among pre-defined areas. In the latter case, prices differ among areas but
the same price is applied to all nodes within any of these areas. Therefore, zonal price
differences are normally caused by grid congestion, though a system of zonal loss
factors is applied in some systems.
Energy price differences among electrical zones can result from the application of
both implicit and explicit schemes. Zonal type implicit pricing schemes are normally
referred to as zonal pricing or market splitting. Explicit mechanisms normally take
the form of a coordinated auction of the capacity of the corridors linking price zones.
Zonal pricing normally involves the computation of a single, centralized, energy
dispatch in the whole national or regional system where network effects within each
uniform price area are neglected. It is therefore a simplification of nodal pricing.
Market splitting, which can be considered a particular case of zonal pricing, involves
the consideration of only one offer curve and one demand curve for the whole system
in a first step. If the resulting pattern of flows causes significant congestion on the
corridors linking the predefined areas, separate offer and demand curves are consid-
ered for each price area and, according to these curves, power is transacted among
areas so that existing congestion is solved. This implementation of market splitting
agrees with that of many others in the academic literature and the industry (see ETSO
1999; Newbery et al. 2003). Market splitting is applied within the Nordel region and in
Italy. Zonal pricing has been also used in California.
Alternatively, the network capacity of likely-to-be-congested corridors linking
uniform price areas may be explicitly allocated prior to running an only-energy market
within each area. Market agents must acquire the right to use the inter-area transmis-
sion capacity they need to carry out the commercial transactions they want to get
involved in, i.e. physical transmission rights over this capacity. Agents may buy this
capacity (the right to use it) in a centralized explicit auction where the right to use the
transmission network is allocated to those agents who value it most. Alternatively,
agents may negotiate bilaterally the acquisition of those rights previously issued by the
corresponding TSO.
Chao and Peck were the first ones to propose the utilization of rights over the
capacity of likely-to-be-congested flow-gates (corridors) (see Chao and Peck 1996),
where authors demonstrate that, under ideal conditions, this system would converge
towards efficient energy prices. Similarly, Oren and Ross 2002, propose in an auction
for flow-gate rights prior to the energy dispatch. Authors propose a system whereby
SOs responsible for the energy dispatch in the different control areas would coordinate
to manage the flow on the congested lines that is the responsibility of transactions
taking place within different areas. There are other works on the use of flow-gate rights
in combination with unconstrained energy markets (see Tabors and Caramanis 2000,
for an example).
Once transmission capacity rights have been assigned in one way or the other, the
energy auction takes place. Only those transactions that have acquired capacity rights
to access the congested transmission they use can participate in the energy market.
Auctioning transmission capacity at regional level requires some centralized coordi-
nation (see ETSO 2001). If flow patterns due to the different transactions were not
considered jointly they might result in unexpected violations of network constraints
2 Transmission Pricing 67

unless significant security margins were applied. But employing security margins
would most likely result in an underutilization of the transmission grid.
In those systems where explicit auctions are used, local authorities are in charge of
the dispatch of energy within their corresponding areas. Thus, areas or countries enjoy
a high level of independence. For this reason, capacity auctions have been widely
applied in real life power systems. Up till recently, this was the method used to manage
congestion on the borders between Austria and the Czech Republic, Belgium and
the Netherlands, Denmark and Germany or France and the United Kingdom, among
others (see Consentec/Frontier 2004).
The implementation of both zonal pricing schemes and mechanisms for the explicit
allocation of transmission capacity on congested corridors implies the definition of
internally well-meshed areas which can be considered as super nodes for congestion
management purposes. Nodal energy prices computed within any of these predefined
areas should be very similar if losses are ignored and serious congestion is limited to
the interconnections between areas. Then, these areas can be regarded as “Single Price
Areas” (SPAs) as far as congestion management is concerned (Christie and
Wangensteen 1998; Stoft 1998; Chao and Peck 2000).
Balanced transactions within a SPA should not significantly affect the flow over
inter-area links. In other words, any bilateral transaction within a SPA should not
create loop flows outside this area which may significantly contribute to congestions
inter Single Price Areas. The definition of Single Price Areas, whenever applicable, is
not a trivial matter without practical consequences, see (Boucher and Smeers 2001). In
zonal pricing schemes it will affect the validity of the energy dispatch and energy
prices computed. What is more, as explained when discussing nodal pricing schemes,
if we were not able to define SPAs, separating the allocation of energy and capacity,
and therefore applying explicit capacity pricing mechanisms, would not be possible.
Borders among Single Price Areas may probably not coincide with political ones.
Thus, assuming SPAs that are the same as existing control areas or countries may result
in an inefficient dispatch or, even worse, in one that is far from being feasible. Thus, the
plans to implement an implicit auction among Power Exchanges in Europe should be
reconsidered carefully (see ETSO/EuroPEX 2004).
Financial Transmission Rights to be defined in this case should refer to two or more
of the pricing zones whose definition has just been discussed, as price differences to
hedge within each of these zones would be zero.
Revenues from the application of pricing schemes with zonal differentiation should
be devoted to the coverage of network allowed regulated revenues, as with nodal
prices, since they are just a simplified version of the nodal pricing scheme.

2.5.3 Single Pricing

In densely meshed transmission grids with no systematic or structural congestions,

applying pricing mechanisms introducing nodal or zonal energy price differentiation is
often regarded to be an unnecessary sophistication. Then, a single energy price is
computed for the whole system. Once the outcome of the only energy market is known,
68 I.J. Pérez-Arriaga et al.

one can check whether the pattern of commercial transactions violates any network
constraint. Only when a constraint is violated does the System Operator need to re-
dispatch some generation. Several implementations of re-dispatch are possible.
According to some of them, the cost of the re-dispatch carried out to solve any
violation of the network constraints should be minimum (see Rau 2000; Tao and
Gross 2002). In these cases, market-based mechanisms must be used to modify the
pattern of generation in the system. In other words, changes to the dispatch must be
based on the bids sent by market agents indicating how much they ask for in order to
change their market positions. Other re-dispatch algorithms aim to minimize the
number and size of the adjustments to the original dispatch (see Galiana and Ilic
1998; Alomoush and Shahidehpour 2000). Fang and David 1999, describe other
possible schemes.
Alomoush and Shahidehpour (2000) and Biskas and Bakirtzis (2002), are aimed at
re-dispatching generation and load in the context of regional markets. These
algorithms must achieve coordination among the different zones. Thus, Biskas and
Bakirtzis (2002), decomposes the original problem using Lagrangian relaxation
techniques. The coordination variables are the prices of the power exchanges between
zones.
Counter-trading is a specific implementation of the method of re-dispatch. In
counter-trading, the System Operator nominates pairs of generators that modify their
outputs to create a power flow that goes in the opposite direction to the one causing
network congestion in the unconstrained energy dispatch. Obviously, one could
generalize and say that re-dispatch is nothing but counter-trade, since any increase in
the output of a generator has to be matched by a corresponding and identical (except
for losses) reduction in the output of another generator.
Typically, the extra cost of re-dispatch or counter-trade is socialized to all
consumers thus leading to uniform energy prices in the whole system (single pricing).
In this case, any economic signals resulting from the management of congestion,
which could have been used to emulate nodal or zonal pricing, are lost. Conceptually
speaking, assigning the cost of re-dispatch to those market agents that “create” the
network constraint is possible. Economic signals would thus not be completely lost.
This is a technically complex task, nevertheless Rivier and Pérez-Arriaga (1993), and
others. Tao and Gross (2002), allocate the cost of re-dispatch taking into account the
participations of agents (injections and withdrawals considered separately) in the flow
over the congested lines. In order to do this, they express the flow over the congested
lines as a function of power injections and withdrawals. Similarly, Baran et al. (2000),
determines the participation of each transaction in the flow over congested lines.
Afterwards, the total cost of re-dispatch is allocated among congested lines taking
into account both the marginal cost of the restriction on the flow through each
congested line and the incremental cost of the re-dispatch necessary to avoid violating
this restriction.
Experience with counter-trade in California shows that those schemes based on
re-dispatch may be subject to gaming by market agents who artificially create
congestion in the grid in order to be paid afterwards to remove it. In any case, nodal
pricing or implicit auctions seem to be superior to congestion management
2 Transmission Pricing 69

mechanisms based on re-dispatch. Singh et al. (1998), compare nodal pricing to a

mechanism based on decentralized bilateral trade among market agents, followed by
the minimum cost re-dispatch necessary to solve infeasibilities. They conclude that
price signals resulting from nodal pricing are more efficient, unless the cost of re-
dispatch is efficiently allocated to the agents responsible for congestion in the grid.
However, as we have explained before, efficiently allocating the cost of re-dispatch is
not an easy task nor is there an indisputable way to do it.
However, nodal and zonal pricing schemes may also result in extra incentives to
exercise market power when, due to the reduction in the size of the relevant market
under these schemes in the presence of congestion, market agents gain power to
unilaterally affect the energy price in any of the pricing zones the system is divided
into. Auctioning Financial transmission Rights may aggravate this problem when
market agents enjoying market power in an importing area are allowed to buy
transmission rights into this area, see Olmos and Neuhoff 2006.
Applying a single energy pricing scheme does not result in net revenues (congestion
rents) to be devoted to partially covering the cost of regulated transmission grid lines.
On the other hand, as already mentioned, if redispatching generation and or load is
necessary, a net cost will be incurred. Many national power systems apply single
energy pricing schemes internally (within their borders). These include almost all
European countries and Colombia.
Obviously, implementing single pricing within a system would render FTRs
useless at local level, since there would not be energy price differences to hedge.
Market agents would only need to be hedged against potential differences among
single energy prices applied in different local (national, State) systems. For the most
part, this is the case within the Internal Electricity Market of the European Union.

2.6 Completing the Recovery of the Network Cost:

Computation of the Complementary Transmission Charges

2.6.1 Fundamentals

Electric power transmission is nearly regarded a natural monopoly. Therefore, trans-

mission should be a regulated business. Both under traditional cost of service regula-
tion and under incentive regulation, the allowed annual revenues of the regulated
transmission company, which are set by the regulator, must be paid by transmission
network users. We discuss here how network related economic signals should be
designed to achieve the recovery of the allowed transmission revenues while promot-
ing efficiency in the short-term (encouraging agents to make optimal operation
decisions) and in the long-term (driving agents’ decisions on the location of new
generators and loads).
As already shown, energy prices applied may have different levels of spatial
differentiation due to the existence of losses and constraints in the grid. Energy price
differences among nodes give raise to location-related economic signals to network
70 I.J. Pérez-Arriaga et al.

users and result in some partial recovery of the total allowed revenues of the regulated
transmission company. As already explained, revenues from the application of nodal
prices comprise those obtained well ahead of real time through the sale of Financial
(or Physical) Transmission Rights over the capacity of likely to be congested corridors,
or hedging differences in prices among different nodes, and those obtained in the day-
ahead and real time markets through the application of these prices to power injections
and withdrawals. However, as Rubio and Pérez-Arriaga (2000), show, the net revenue
resulting from the application of nodal prices amounts only to a small fraction of the
total regulated cost of the grid. Revenues resulting from the application of alternative
energy pricing schemes are expected to be lower. The fraction of regulated transmis-
sion revenues recovered from the application of energy prices is normally referred to as
Variable Transmission Revenues (VNR).
Therefore, completing the recovery of the cost of the grid requires applying
additional charges, normally called complementary charges, that relate to the fraction
of the grid cost not recovered through energy prices. Complementary charges should
also send economic signals to agents encouraging them to reduce the cost of expansion
of the grid. Therefore, these charges should encourage agents to install new generation
or load in those locations where reinforcements needed for the grid to cope with the
resulting incremental flows are least costly.
Additionally, complementary charges should be compatible with the application of
efficient short-term economic signals. Complementary charges refer to all transmis-
sion business costs associated with network infrastructure including investment costs
(asset depreciation as well as a return on net fixed assets), operation and maintenance
costs, and other administrative and corporate costs. On the other hand, line losses and
generation costs due to grid constraints, System Operator costs and those costs related
to the provision of Ancillary Services should be levied on system users through other
charges. Then, complementary charges are related to the allocation of long term costs
not to be affected by short-term decisions by agents (the cost of lines already existing
is not conditioned by how much power each generator or load is transacting at
each time). As a consequence of this, complementary charges should interfere as
little as possible with short-term economic signals, so as not to compromise the
efficiency of system operation.
Transmission charges can be divided into Connection charges and Use of the
System (UoS) charges. Connection charges are employed to allocate the cost of
transmission facilities directly connecting a network user, or group of users, to the
rest of the grid. UoS charges are related to the costs of the rest of transmission facilities.
Economic principles advocate allocating the cost of each transmission line according
to the responsibility of grid users on the construction of that line. Applying this
principle is easy when it is about allocating the cost of connection facilities: those
responsible for their construction are the users connecting through them to the rest of
the system. On the other hand, determining the responsibility of generators and loads in
the construction of the bulk of the transmission grid is much more difficult, especially
when the grid is meshed. The remainder of this section is devoted to the discussion of
the design of UoS charges. Both the allocation method employed to determine which
2 Transmission Pricing 71

fraction of the grid should be paid by each agent and the design of transmission charges
are discussed next.

2.6.2 Allocation of the Cost of the Main Grid to Its Users

Determining those generators and loads that were responsible for the construction of
some lines has proven to be a very difficult task. Then, it is most sensible to use some
proxy of cost causality, such as the level of network utilization of each line by each
agent, as the basic criterion for the allocation of the cost of this line. This involves
assuming that the responsibility of each agent in the construction of a line is propor-
tional to the amount of use of the line by the agent.
However, the cost of those expensive lines that only benefit a subset of network
users, in non-well-meshed networks, should be allocated according to the responsibil-
ity of network users in the construction of the former. The fraction of the cost of each
line that each network user is responsible for can be computed based on the a priori
estimation of the benefits produced by this line for this user.
Unfortunately, computing the electrical utilization of lines by agents is not a simple
task either, since there is no indisputable method to do it. Several methods to determine
the use of the network by agents have been proposed and applied, with results that vary
significantly from one another. It is important to keep in mind that the final objective is
not computing the use of the network by each agent, but determining the responsibility
of this agent in the construction of the line.
Transmission tariffs in most countries do not contain any locational signal. They
disregard the need to allocate efficiently line costs (see for instance ETSO 2008;
Lusztig et al. 2006). Regulators have settled for simple transmission charges that
socialize the cost of the network to its users. However, in our view, as time passes and
all kinds of new generation compete to enter into the system, sending clear locational
signals – including transmission tariffs – will become more relevant.

2.6.2.1 Computing the Responsibility of Agents in Network Costs

Whenever computing the benefits that network users obtain from transmission lines is
not possible, the responsibility of these users in network costs should be determined
taking as a reference the best estimate possible of their use of the grid. Olmos and
Pérez-Arriaga (2007) point out that methods to be used to compute the use of the grid
by generators and loads shall be in agreement with the underlying technical and
economic principles of the functioning of power systems. Even when there is no
indisputable method to compute the utilization of lines by agents, some proposed in the
literature, like the method of Average Participations (AP) described first in Bialek
(1996) and Kirschen et al. (1997), or the Aumann-Shapley method, whose application
for the computation of transmission tariffs is analyzed in Junqueira et al. (2007),
seem to be sensible options.
72 I.J. Pérez-Arriaga et al.

Most usage based network cost allocation methods providing sensible results (like
AP or Aumann-Shapley) aim at determining the “average” use of the grid by each
generator or load as if the latter had always been in place. However, the responsibility
of agents in network reinforcements is directly related to the incremental flows
produced by the decisions of these agents to install new generators or loads in specific
places. Hence, usage based cost allocation factors produced by methods like AP or
Aummann-Shapley should be modified to take account of the different possible
patterns of change of the flows in the system caused the installation of each generator
or load and the time when this generators or load and the lines in the system were built.
The application of these principles to the process of computation of transmission
charges is discussed in detail in Olmos and Pérez-Arriaga (2009).
Olmos and Pérez-Arriaga (2009) point out, the loading rate of each transmission
line and the desired split of total transmission costs between generation and load in the
system should also condition the level of transmission tariffs (complementary charges)
paid by each network user. The fraction of the total cost of a line to be allocated to
agents according to their responsibility in the construction of the line should probably
be limited to the ratio of the loading rate of the line to that of other similar lines in the
system. The remainder of the cost of this line should probably be socialized, since
current users of the grid cannot be deemed responsible for the construction of the
fraction of the capacity of a line that is expected not to be used until long time in the
future (for lines that are underutilized in the present).
As already mentioned, the split of total transmission charges between generation
and load should probably take place according to the total benefits that generation on
the one hand, and load, on the other, will obtain from the grid. However, given that
estimating these benefits may turn out to be very difficult in most cases, a 50/50 split of
costs between the two groups may be adopted unless system authorities have sound
arguments to set a lower limit to the overall fraction of costs to be paid by generators
(operation decisions by generators may be more sensitive to the level of transmission
charges than those by loads).

2.6.3 Designing UoS Charges

Designing transmission charges involves not only developing the methodology for
computing the responsibility of agents in the cost of the transmission grid, but also
providing adequate answers to many implementation issues. We now focus on the
most relevant aspects of the implementation of locational transmission grid charges
that are not directly related to the cost allocation algorithm applied. These include
computing the number of operation scenarios to be considered; defining the structure
of charges and their updating procedure; and deciding the way to deal with
grandfathering issues arising in the process of implementation of these charges.
As Olmos and Pérez-Arriaga (2009) point out, tariffs should be published based on
the expected future operation of the system over a set of scenarios that are representa-
tive of the different set of situations that may exist in the future once the considered
generator or load has entered into operation. The relative weight given to each scenario
2 Transmission Pricing 73

in the computation of the allocation of the cost of a line should be in accordance with
the reasons justifying the construction of this line. The total cost of the line should be
apportioned into two parts: one representative of the weight that the reduction of
transmission losses had on the decision to build the line and another one representative
of the weight of the decrease in congestion costs. Then, the relative weight given to
each scenario in the process of allocation of the cost of the fraction of the line deemed
to be built to reduce losses should be proportional to the system losses in this scenario.
The relative weight given to each scenario in the process of allocation of the cost of the
fraction of the line attributable to the reduction of congestion costs should be propor-
tional to the level of congestion costs in this scenario, which, as a proxy, can be
deemed proportional to the load level.
As aforementioned, operation decisions by network users, which are short-term
decisions, should not be conditioned by the level of the transmission charge paid by
these agents to recover the total network costs, which should be a long term signal.
Short-term locational signals can be sent via nodal energy prices (locational marginal
prices, LMP in the US terminology). If transmission tariffs are applied in the form of
energy charges (€/MWh), i.e. a charge that depends on the amount of energy produced
or consumed by the corresponding agent, network users will internalize these charges
in their energy bids to the Power Exchange or in their bilateral contracts, therefore
causing a distortion in the original market behaviour of these agents and the outcome
of the wholesale market. It is then concluded that the transmission charge should have
the format of a capacity charge (€/MW. year) or of just an annual charge (€/year). The
first option runs into the problem of applying the same charge to all generation units
with the same maximum capacity, which may have quite differing operation profiles.
(the same occurs with demands that have widely different utilization factors and the
same contracted capacity). The transmission charge should therefore be an annual
charge (€/year) or a capacity charge computed separately for each type of generator or
demand in each type of area in the system (see Olmos and Pérez-Arriaga 2009).
Olmos and Pérez-Arriaga also argue that the transmission tariff to be applied to
each generator or load must be computed once and for all before its installation,
since the level of this tariff should be based on the expected incremental contribu-
tion of this generator or load to the use of the grid (this is the driver of transmission
investments). This means that the transmission charge to be paid by a network user
should not be modified after its installation. Otherwise, the locational signal sent
through this charge would be severely weakened.
Lastly, the process of implementation of new tariffs must be thought carefully.
In order to avoid making big changes to the level of tariffs paid by already existing
network users when introducing a new tariff scheme, the application of charges
computed according to the new scheme could be limited to new network users.
Alternatively, charges paid by already existing users could gradually evolve from
the old tariff regime to the new one. In any case, the difference between the total cost of
the grid and revenues from the application of tariffs should be socialized (preferably to
demand).
74 I.J. Pérez-Arriaga et al.

2.7 Conclusions

Chapter 2 has analysed the effect that the grid should have on prices paid and earned by
network users. Prices set should send both efficient short term signals driving operation
decisions and long term ones driving the development of the system. Additionally,
prices should provide an adequate remuneration of the transmission service
guaranteeing its economic viability. Therefore, prices applied should be able to
recover 100% of the regulated cost of the grid. No single set of prices seems to be
able to meet all the aforementioned requirements, nor the sale of FTRs aimed at
hedging the corresponding energy price differences. Thus, at least two set of transmis-
sion related prices must be applied.
Energy prices are aimed at driving operation decisions. Nodal prices, also called
locational marginal prices, are deemed to be optimal energy prices because, assuming
perfect information and competition, they encourage market agents to make socially
optimal short-term decisions. Nodal prices internalize the effect of network losses and
congestion on operation costs. However, in many real life systems, differences among
nodal prices are small. Then, applying a single energy price (Single Pricing) or a
price common to all the nodes within each of a set areas (zonal pricing) is considered to
be preferable.
Net revenues resulting from the application of locationally differentiated energy
prices, or from the sale of FTRs corresponding to commercial power transactions
taking place, fall short of those needed to recover the whole cost of the grid. Then,
additional charges, normally called transmission charges, or complementary charges,
must be applied to complete the recovery of the grid cost. Complementary charges
applied should allocate the cost of lines to those network users responsible for their
construction. The electrical usage of lines by agents may be used as a proxy to network
cost causality. However, it is the incremental usage made of new lines by new agents
what determines the network reinforcements to be made. Therefore, network usage
factors produced by most network cost allocation methods are useless, while average
network usage factors produced by other methods like Average Participations or the
Aumann-Shapley method must be modified to reflect the incremental nature of flows
driving the development of the grid. Last but not least, in order for transmission
charges not to interfere with the short term decisions by network users (to be driven
by energy prices), they should be computed, once and for all, before the corresponding
generators or loads are installed, and should take into account the expected increase in
network flows that may result from the installation of the latter over all the set of
possible operation situations that may occur along the economic life of these
generators or loads. Besides, network tariffs should be applied as a fixed annual charge
or a capacity charge computed separately for each type of generator or demand in each
area in the system.
2 Transmission Pricing 75

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Chapter 3
Point to Point and Flow-Based Financial
Transmission Rights: Revenue Adequacy
and Performance Incentives

Shmuel S. Oren

3.1 Introduction

The prevalent market mechanism for defining transmission rights in North American
restructured electricity markets is through financial instruments that enable energy
traders to hedge congestion risk. The underlying quantities for such instruments are
either Locational Marginal Prices (LMP) or shadow prices on transmission flowgates
which are determined as part of an Optimal Power Flow (OPF) calculation. There are
three prevalent forms of financial transmission rights whose settlements are based on
the above underlying quantities:
FTR Obligations – These are LMP SWAPS defined over specific time intervals and
between specific nodes, whose holder is entitled to receive, or obligated to pay, the
nodal price difference between designated locations per MW denomination.
FTR Options – These are one sided LMP SWAPS defined over specific time intervals
and between specific nodes, whose holder is entitled to receive the nodal price
difference between designated locations per MW denomination if that difference is
positive (but can walk away if it is negative.)
FGR – These are directional rights defined over specific time intervals and specific
links, entitling their holder to the shadow price on the links capacity constraint in
the designated direction per MW denomination.
Alternative forms of entitlements to the transmission infrastructure which have
been used in the past or are still used in parts of the world include contract path rights
which are based on a fictional “commercial path” between designated locations,
or physical capacity rights between designated locations or on specific network
interfaces. One major shortcoming of such physical rights is that they require coordi-
nation between the dispatch and transmission rights ownership. Furthermore, when the

S.S. Oren (*)

Department of IEOR, University of California at Berkeley, Berkeley, USA
e-mail: [email protected]

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 77

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9_3,
# Springer-Verlag London 2013
78 S.S. Oren

rights definition is not consistent with the physical flows induced by specific point to
point energy transactions (as is the case for contract path), then the available transmis-
sion capacity between points (ATC) varies depending on overall dispatch patterns,
making it difficult to issue entitlements that extend over long time periods. By contrast,
financial rights have the advantage of enabling complete decoupling between the
actual dispatch and the settlement of congestion charges. The system operator can
dispatch generation resources in the most efficient way with no regard to how
transmission rights ownership, and impose congestion charges based on actual use
of the network. The congestion revenues are then distributed to the rights holders so
that a network user whose transmission rights holdings match its network use breaks
even. Any discrepancies between use and financial rights holdings will result in
financial shortfalls or surpluses but will not impact dispatch efficiency. Furthermore,
insuring that the amounts of FTRs and FGRs issued conform with physical feasibility
enables the issuance of long term rights with minimal financial risk to the underwriters.
FTRs defining point to point financial transmission rights have been first introduced
within a general framework of contract networks by Hogan (1992) and have been
widely adopted in the US as an integral part of the nodal market designs implemented
by the various independent system operators. Flow based transmission rights (financial
or physical) have been first introduced in a seminal paper by Chao and Peck (1996).
The potential use of FGRs, which are financial flow based rights, as substitutes or
complements to FTRs has been discussed by Chao and Peck (1996), Chao et al. (2000),
Ruff (2001), O’Neill et al. (2002) (and in numerous follow-up papers). However,
FGRs, are rarely used in today’s markets since energy traders prefer FTRs that are
more suitable for hedging point to point congestion risk. Specifically, a bilateral energy
transaction of X MW from node A to another node B in the network is exposed to
congestion risk between the two location and is liable for a congestion charge that
equals to the difference of LMPs between the two node. That charge is equivalent to
the net cost resulting from selling the power at node A and buying it back at node B at
the respective nodal prices. A trader can offset such a congestion charge by holding an
FTR from node A to B for X MW which entitles him to the nodal price difference
between node B and node A time X. Hence the FTR payoff exactly equals the
congestion charge. Conceptually, however, FTRs and FGRs are equivalent due to a
fundamental relationship between nodal price differences and flowgate shadow prices
which is explained in the next section (see Chao et al. 2000). To understand the
relationship between FTRs, FGRs and how they relate to optimal dispatch and
locational marginal pricing we begin with a brief tutorial explaining these basic
concepts in the following section.

3.2 A Primer to LMPs, FTRs and FGRs

The objective of Optimal Power Flow (OPF) is to find the output levels for a set of
generation resources that are distributed over a transmission network (and are already
running and synchronized), so as to minimize total cost of serving specified loads (or
maximize social welfare if loads are characterized by price sensitive loads), while
accounting for losses and without violating transmission flow constraints. In general
3 Point to Point and Flow-Based Financial Transmission Rights: Revenue. . . 79

Fig. 3.1 PTDF matrix for

five node example

flows on transmission links are determined by Kirchhoff laws for Alternating Current
(AC) and they must satisfy thermal and voltage limits. For the purpose of this
exposition, however, we will ignore losses and assume a Direct Current (DC) approxi-
mation of Kirchhoff’s laws in which case flows are only constrained by thermal limits
specified for each transmission line.
Under such simplifications the flow pattern in a network can be characterized in
terms of a matrix of Power Transfer Distribution Factors (PTDF) whose ij element
specifies the incremental flow induced on each transmission link j by injecting one
incremental MW at node i and withdrawing it at some designated reference node. The
transmission links are specified as directional so negative flow indicate flow in the
opposite direction. In the following, for clarity, we will denote the transmission links
by pairs of indices representing the adjacent from/to nodes so that hk represents the
directional link from node h to node k. The PTDF matrix can be easily computed
through simulation or directly from the electrical properties (susceptances) of the
transmission lines. As an illustrative example Fig. 3.1 gives the PTDFmatrix
corresponding to the 5 node network shown, with node 1 as reference node. This
example due to Fernando Alvarado (2000, personal communication) portrays a
stylized representation of the PJM system.
According to the PTDF matrix in Fig. 3.1, PTDF45;2 ¼ 0:15, indicating that
injecting 1 MW at node 2 and withdrawing it at the reference node 1 results in
0.15 MW flow on the line connecting nodes 4 and 5 in the direction from 5 to 4
(opposite to the designated 45 direction). The PTDF matrix can be used to deter-
mine the impact of injections and withdrawals at any pair of nodes on any
transmission line using superposition. For instance, the flow on the line 1–4
resulting from injecting 1 MW at node 2 and withdrawing it at node 5 is given by
PTDF14;2  PTDF14;5 ¼ 0:18  0:09 ¼ 0:09 . This calculation is invariant to the
choice of reference node since, the PDTF matrix for any reference node i can be
obtained from the given matrix by subtracting the column corresponding to the
reference node in the given PTDF matrix from each of the columns.
80 S.S. Oren

As indicated above the underlying quantities for financial transmission rights are
locational marginal prices (LMPs) or line shadow prices (SP). These quantities are
meaningful in the context of optimal power flow or optimal dispatch. A well-known
property of optimal dispatch is that if no transmission constraint is binding, then the
marginal cost of serving one incremental unit of energy at any node is identical and
there is at least one marginal generation unit that can be moved to produce such an
incremental unit at that cost. A less obvious result is that if one transmission line is
congested and the system is dispatched optimally, then supplying an incremental unit
of energy at any node without violating the binding constraint can be achieved by
adjusting the output of up to two generation units, so called, marginal generators which
can be moved up or down. This principle can be generalized in the sense that when the
OPF results in m binding constraints then supplying an incremental unit of energy at a
specific node without violating the constraints may require change in output levels of
up to m þ 1 marginal generators. Solving an OPF problem determines the output
levels of all operating generators and identifies the marginal units which implicitly
determines the LMPs and transmission line shadow prices. Following are intuitive
definitions of these two concepts.
Locational Marginal Price (LMP): The least cost of providing an incremental unit of
energy at a node under optimal dispatch, without violating the binding transmission
constraints.
Line Shadow Price (SP): The maximum dispatch cost savings, under optimal dis-
patch that can be achieved due to an incremental unit increase in the lines’ flow
capacity constraint without violating any of the binding transmission constraints.
Given the set of marginal generators corresponding to an OPF solution and the
PTDF matrix we can calculate the LMPs and Shadow prices according to the above
definitions. Clearly only lines operating at the limit have positive shadow prices and
LMPs at nodes with generators that are free to move up or down will equal that
generator’s marginal cost. However, at nodes with no generation or with generators
operating at their capacity limits (up or down), the LMP can be positive or negative. To
illustrate the LMP calculation consider the example in Fig. 3.1 and assume that the line
connecting nodes 4 and 5 is operating at its limit in the 5–4 direction under optimal
dispatch where the two marginal generation units are at node 1 with marginal cost of
$15/MWh and at node 4 with a marginal cost of $30/MWh. To determine the LMP at
node 2 we must calculate the incremental outputs Q1 ; Q4 of the marginal units at
nodes 1 and 4 so as to deliver 1 MWh to node 2 without increasing the flow on the
congested line. From the PTDF matrix in Fig. 3.1 we can determine that 1 MW injected
at node 1 and withdrawn at node 2 will increase flow on line 4–5 by 0.15 MW.
Likewise injecting 1 MW at node 4 and withdrawing it at node 2 will increase flow
on line 4–5 by 0.37 þ 0.15 ¼ 0.22 MW. Thus the quantities Q1 ; Q4 must satisfy
the system of equations:




0:15 0:22 Q1 0
¼ ) Q1 ¼ 0:59 Q4 ¼ 0:41
1 1 Q4 1
3 Point to Point and Flow-Based Financial Transmission Rights: Revenue. . . 81

Hence the cost of supplying a marginal 1 MW at node 2 which is the LMP at

node 2 is given by:

LMP2 ¼ 15  Q1 þ 30  Q4 ¼ 15  0:59 þ 30  0:41 ¼ $21:15=MWh

A similar calculation can be performed to determine the shadow price on the line
connecting nodes 4 and 5 in the congested direction 4–5. Now the objective is to
perturb the outputs of the marginal units by incremental amounts Q1 ; Q4 so as to
increase the flow on the congested line 5–4 while maintaining the energy balance.
The resulting quantities can be determined by solving the system of equations:




0:15 0:22 Q1 1
¼ ) Q1 ¼ 2:7 Q4 ¼ 2:7
1 1 Q4 0

Which tell us that the increased capacity enables us to increase output from the
cheap marginal unit at node 1 by 2.7 MW while reducing the output of the expansive
marginal unit at node 4 by the same amount. Thus, the incremental change in dispatch
cost due to a unit increase in capacity of the congested line (flowgate) which is the
flowgate shadow price is given by:

SP54 ¼ 15  Q1  30  Q4 ¼ ð15  30Þ  2:7 ¼ $40:5=MW=h

It should be noted that shadow prices are direction specific and have non zero
values only if the line flow is at capacity. So in the above example SP45 ¼ 0, since
the line flow capacity constraint in the direction 4–5 is not binding.
Clearly there is a close relationship between LMPs and flowgate shadow prices
both of which are calculated from the same data. In general it can be shown that for
any pair of nodes i,j the following fundamental relationship holds.
X
LMPj  LMPi ¼ SPhk  ðPTDFhk;j  PTDFhk;i Þ (3.1)
all flowgates hk

As explained earlier a 1 MW point to point FTR obligation is a forward contract

entitling (or obligating) its holder to receive or pay the stream of LMP differences
between two specific nodes over a designated time period. Likewise a 1 MW FGR is a
forward contract entitling its holder to receive the stream of shadow prices on a specific
flowgate over a designated time period. Hence, the above fundamental relationship can
be extended to relate point to point FTR obligations and FGRs implying that a point to
point FTR obligation may be viewed as a portfolio of FGRs weighted by the
corresponding PTDF differences. This relationship, however, becomes more compli-
cated with respect to point to point FTR options. A simplistic approximation,
suggested by O’Neill et al. (2002), is to calculate the payoff (or price) of a point to
point FTR option as the partial summation of the weighted FGR payoffs (or prices)
over flowgates for which the PTDF difference in the above formula is positive. Since
82 S.S. Oren

shadow prices and hence FGR payoffs are nonnegative such an approximation ensure
a nonnegative payoff for the point to point FTR option. Such a calculation, however,
overcompensates point to point FTR options in cases where the payoff is positive but
reduced by the presence of “couterflow” branches. Unfortunately, the decomposition
of point to point FTR options into FGRs enabled by the above approximation is
essential for a joint auction that offers the different instruments simultaneously.

3.3 Managing Congestion Risk

In LMP based markets, energy transactions in the Day Ahead market are exposed to
congestion rents that are determined as the LMP difference between the injection and
withdrawal nodes. A trader buying energy at one location to be delivered at another
location, incurs such congestion rents as the difference between the selling price of
energy at the source and the buying price at the delivery point when the transactions are
cleared through the ISO market. Alternatively, if the delivery is scheduled as a firm
bilateral transaction then it is subject to a congestion charge imposed by the ISO that
equals to the LMP difference between the injection and withdrawal locations. In either
case a trader can hedge its exposure to the congestion charges by acquiring financial
transmission rights.
In view of the fundamental relationship between point to point FTRs and FGRs
explained above, a trader could achieve the same protection against congestion
charges provided by a point to point FTR obligation by buying the equivalent portfolio
of FGRs. To illustrate this equivalence consider the three node network in Fig. 3.2
with identical susceptances for all three lines and flow limits as indicated on the
respective lines.
Injecting 1 MW at node 1 and withdrawing it at node 3 produces (2/3)MW flow on
the line 1–3 and (1/3)MW flow on the lines 1–2 and 2–3. Suppose that G1 has a
bilateral contract with L3 to deliver 150 MW and wishes to hedge the contract against
congestion charges. This can be done by procuring 150 MW FTR obligation from node
1 to 3. In real time the congestion rent charged to the bilateral transaction is the nodal
price difference between the two nodes times the 150 MW transacted. That amounts is
also the settlement payment for the 150 MW FTR from node 1 to 3. Thus the FTR
settlement exactly offsets the congestion charge. Alternatively, the bilateral transac-
tion can be hedged against congestion by procuring a portfolio of FGRs as follows:
100 MW FGR on line 1–3, 50 MW FGR on line 1–2 and 50 MW FGR on line 2–3.
Each FGR is paid in real time the corresponding shadow price per MW.
Assume that only the line 2–3 is congested then the shadow price on the other two
lines is zero and the settlement payment for the above FGR portfolio is 50  SP23
but from the fundamental relationship between nodal prices and shadow prices on
transmission lines we know that LMP3  LMP1 ¼ 13 SP23 . Hence the settlement
payment for the FGR portfolio is 50  3  ðLMP3  LMP1 Þ which is identical to the
settlement for the FTR from node 1 to 3 both of which equal the congestion charge for
the bilateral transaction.
3 Point to Point and Flow-Based Financial Transmission Rights: Revenue. . . 83

Fig. 3.2 Three node example G1

1
≤3 G3
00
2 /3

≤100
3

20
1/3 ≤2
G2 L3
2 1/3

The difference between using FTRs or FGRs in hedging congestion risk arises
when considering changes in the network topology which will produce changes in the
PTDFs such changes may result from contingencies or deliberate control actions
switching lines in or out. Whether FTRs or FGRs are used to define property rights
and hedging mechanisms has also implication regarding the extend to which the
physical capacity of the network can be fully subscribed and the ability of market
participants to fully hedged their energy transactions. Since the payoff of a point to
point FTR obligation is based on the actual LMP difference which is also used in
computing the congestion rents, a 1 MW FTR obligation between two nodes provides a
perfect hedge against the congestion charges imposed on a 1 MW energy transaction
between the same nodes. Such a hedge provides insurance against congestion risk
resulting from changes in dispatch patterns and LMPs as well as changes in the
network topology, including line capacity ratings and the PTDFs.
The availability of perfect hedging instruments does not imply, however that all
transactions that can be accommodated in real time by the physical system can be
hedged while assuring that the real time congestion revenues suffice to pay off the
settlements to all outstanding FTRs (i.e., revenue adequacy). As discussed below, the
conditions that will guarantee revenue adequacy result in unsubscribed flowgate
capacity which in turn can lead to congestion revenue surplus. Such surplus indicates
that some energy transactions could not be fully hedged. When FGRs portfolios are
used to hedge congestion risk associated with energy transactions, it is the responsi-
bility of the FGRs holder to assemble a portfolio that synthesizes the LMP differences
that are used to compute congestion charges, such a portfolio protects the holder
against fluctuations in shadow prices on the flowgates and against changes in the
flowgate capacity ratings but does not provide insurance against variation in the
PTDFs. So it is the responsibility of the insured to track such variations to ensure
that the FGR portfolio produces sufficient settlement revenue to cover the congestion
charges that are based on the LMP differences.
On the other hand, FGR allocations are based on the full flowgate capacity as
opposed to FTR allocation that only subscribes the flowgate capacity corresponding to
the allocated FTRs. Thus, the entire wire capacity can be subscribed through FGRs and
as long as flowgate capacities are not reduced, the congestion revenues (which can be
assigned to flowgates based on the real time PTDFs), will match the FGR settlements
84 S.S. Oren

(i.e., revenue adequacy is automatically guaranteed). Another consideration is the

need for centralized coordination in issuing and secondary trading of the various forms
of financial transmission rights. As will be discussed below, Assuring revenue
adequacy for point to point FTRs requires central coordination since available trans-
mission capacity between any two nodes depends on the entire constellation of other
point to point FTRs issued.
Consequently, the issue of point to point FTRs is always done by a central authority
such as an ISO and any secondary trading takes place through centrally coordinated
reconfiguration auctions. By contrast, since FGRs are only tied to specific flowgate
capacities, they can be issued by multiple entities owning specific flowgate assets or
producing counterflow and can be traded independently in secondary markets. This
issue has come up, for instance, in the European Union where congestion revenues on
international interconnect flowgates are collected by the interconnected countries
which are also vested with the right to issue long term contracts for the use of
such facilities.
Arguments in favor and against employing FGRs in practice as hedges against
congestion risk can be found in Chao et al. (2000) and Ruff (2001). In our subsequent
discussion we will not duel any further on this debate and only exploit the conceptual
interpretation of FTRs as an FGR portfolio.

3.4 Revenue Adequacy and Simultaneous Feasibility

Hogan (1992) has shown that if the outstanding FTRs satisfy a “simultaneous feasibil-
ity test” (SFT) and the network topology is fixed then the FTR market is “revenue
adequate”. Revenue adequacy means that congestion revenues and merchandising
surplus (i.e., the difference between the buying cost and the sales revenues for energy
traded through the pool) collected by the system operator from bilateral transactions
and local sales and purchases at the LMPs, will cover the FTR settlements. The SFT
requires that if all the FTRs were exercised simultaneously as physical bilateral
transactions then the transmission flow constraints would not be violated.
In FTR auctions bidders submit bids for specific FTRs and the ISO selects winning
bids by treating FTR bids as proposed schedules using a security constrained OPF that
maximizes the FTR auction bid value. These constraints are also imposed if any
portion of the FTRs is being allocated based on historical use or other allocation
criteria. As mention above, the hypothetical dispatch (referred to as the FTR point)
corresponding to simultaneous bilateral schedules replicating all outstanding FTRs
must meet all security and flow constraints i.e. the grid must be able to support all the
bilateral transactions covered by the FTRs. The auction produces a set of winning bids
and uniform clearing prices for each pair of nodes that equal to the LMP differences of
the auction OPF.
Clearly, the FTR point characterizing the mix of awarded FTRs, may differ from
real time dispatch. However, but if the topology hasn’t changed the FTR point
represents a feasible but not necessarily optimal dispatch. Hence, if the nomogram is
convex, then the congestion revenues will be sufficient to cover the FTR settlements.
3 Point to Point and Flow-Based Financial Transmission Rights: Revenue. . . 85

G1 FTR 2 → 3 (nomogram faces correspond

1
£30 G3 MW flowgate capacities)
0
Changing capacity

£100
B
320 X
3
300
1 of line 2 to 3
A Z
0
£22
G2 L3 2→3 Y
2
C
2 G1+ 1 G2 £ 300 1®3
3 3 100 D
1 G1+ 2 G2 £ 220 1®2
3 3 FTR 1 ® 3
E
–100 £ 1 (G1– G2) £ 100
3
20 300 400 MW
• Two sided FTRs must stay within the outer nomogram
• One sided FTRs (options) must stay within the inner nomogram
because we cannot rely on counterflows to alleviate congestion.

Fig. 3.3 Feasibility region of FTR options and obligations and the effect of flowgate capacity rating

This follows from a theoretical argument based on duality of linear programs, showing
that minimum cost dispatch is equivalent to maximizing congestion revenues.
Figure 3.3 below illustrates the nomogram representing feasible dispatch for the
three node DC system introduced earlier with identical susceptances for all lines but
different flow limits as shown. The vertical axis of the graph represents injection at
node 2 and withdrawal at node 3 while the horizontal axis represent injection at node 1
and withdrawal at node 3. The feasible region given the flow constraints is
characterized by a convex polyhedron defined by the system of linear inequality
constraints implied by Kirchhoff’s law and the flow limits on the lines. The same
constraints also characterize the feasible set of FTRs from node 1 to node 3 and from
node 2 to node 3 that will meet the SFT described above. The facets of the polyhedron
correspond to the flow capacity constraints and adjusting these capacities is
represented by a parallel shift of these facets as shown for line 2–3.
We note that the system can accommodate up to 400 MW transaction from node 1
to 3 if there is a 100 MW transaction from node 2 to node 3 which produces
counterflow on the congested link from node 1 to node 2. In the absence of such
counterflow, the system can only accommodate a 300 MW transaction from node 1 to
node 3. In the context of the SFT, reliance on conterflow translates to reliance on an
FTR obligation with a negative real time settlement which will supplement the
congestion revenues to produce sufficient income for FTR payoffs.
FTRs with an expected negative real time settlement have negative value and those
who are willing to assume such an obligation would expect to be paid upfront and will
submit negative bids (i.e. offers) in the FTR auction to undertake the obligation. If the
holder of such an FTR obligation from node 2 to node 3 actually executes the
corresponding transaction in real time, by injecting power at node 2 and taking it out
at node 3, it produces counterflow for which it will collect negative real time
congestion charges (i.e., counterflow payments) that will exactly offset the negative
settlement of the FTR obligation from node 2 to node 3. In such a case, the auction
income from taking on an FTR obligation with negative payoff is a net gain to the FTR
holder which can be used, to subsidize a forward contract at a price below marginal
86 S.S. Oren

production cost if executing the transaction produces couterflow that will offset the
negative FTR settlement.
However, undertaking such an FTR obligation entails exposure to performance risk
in case that the FTR holder cannot execute the transaction due to a generator outage,
for instance. To avoid such exposure, market participant would prefer (assuming all
else being equal) FTR options that protects them from potential liability that comes
with an FTR obligation. Issuing FTR options rather than obligations implies, however,
that the ISO cannot rely in the SFT on counterflows and cannot rely on the supplemen-
tal revenue produced by FTR obligations with negative settlemet. Hence, the feasible
region for FTR options in the case depicted by Fig. 3.3 is the chopped off light portion
of the nomogram. While FTR options are attractive from a risk management perspec-
tive their use is limited since they severely limit the simultaneously feasible FTRs that
can be issued and they turn out to be expensive as compared to the two sided FTR
obligations. One of the important uses of FTR options is to convert historical
entitlements to physical transmission rights held by MUNIs, for instance, (which are
inherently options) to financial transmission rights.
To illustrate how FTRs can facilitate efficient forward energy trading, lets assume
that the marginal cost of G1 is $30/MWh the marginal cost of G2 is $45/MWh and of
G3 is $100/MWh. The load at L3 is 500 MW and the capacities of all three generators
exceeds 500 MW. The optimal dispatch for this case is at point D of the nomogram in
Fig. 3.3, which corresponds to supplying the load at L3 with 400 MW from G1 and
100 MW from G2. The corresponding LMPs at nodes 1,2,3 are $30/MWh, $45/MWh
and $40/MWh respectively. Both, line 1–3 and line 1–2 are operating at the flow limit
with corresponding shadow prices of $5/MW/h and $20/MW/h, respectively. If the
optimal dispatch and LMPs are forecasted correctly, the FTR auction will clear with
100 MW FTR obligations from node 1 to 3 awarded at $10/MW/h and 400 MW FTR
obligation from 2 to 3 awarded at $5/MW/h (i.e. the bidder gets paid for assuming
the obligation).
Both G1 and G2 can enter into forward contracts to deliver energy to L3 at
$40/MWh which for G1 would result in a gain of $10/MWh and for G2 in a loss of
$5/MWh. G1 can then hedge its exposure to real time congestion charges by using its
forward contract surplus to buy FTR obligations from node 1 to 3 in an amount
matching the forward energy contract. Likewise, G2 can offset the forward contract
deficit with expected real time counterflow payments or lock in these payments by
taking on FTR obligations from node 2 to 3 so as to match the forward contract
quantity. The system operator collects from G1 congestion rents for 400 MW from
node 1 to 3 in the amount of $10/MWh (based on the LMP difference) and pays to G2
$5/MWh for 100 MW of counterflow totaling $3,500/h. The FTR settlement amount to
$10/MWh times 400 MW for FTRs from node 1 to 3 less the amount collected from the
FTRs from node 2 to 3 of $5/MWh times 100 MW, adding up to $3,500/h. So in this
case the ISO breaks even.
Suppose, however, that the real time LMPs were not forecasted correctly in the FTR
auction and the bids resulted in an FTR point other than point D on the nomogram.
Specifically, assume that the FTR auction awards corresponded to point E on the
nomogram with 300 MW FTRs from node 1 to 3 and no FTRs from node 2 to 3. Then,
3 Point to Point and Flow-Based Financial Transmission Rights: Revenue. . . 87

the FTR settlement amounts to 300  10 ¼ $3,000/h resulting in a congestion reve-

nue surplus of $500/h. In general the real time settlement for any feasible FTR award
combination will be less than or equal to the congestion revenue corresponding to the
optimal dispatch point D.
FGRs can be used in a similar way to the above although achieving proper
hedging places more burden on energy traders. In an FGR auction all the FGRs
corresponding to the lines capacities rating (in both directions) are being allocated.
However, if the dispatch is correctly forecasted in the FGR auction, only the FGRs
on the line from node 1 to 3 and from node 1 to 2 have positive clearing prices
which in our example equal to $5/MW/h and $20/MW/h respectively. The total
auction revenue will be the same as in the corresponding FTR auction totaling
5  300 þ 20  100 ¼ 10  4005  100 ¼ $3,500/h. as in the case of FTRs,
G1 and G2 can hedge their forward energy contracts to deliver energy to L3 at $40/
MWh. In this case G2 would buy (100/3)MW FGRs on line 1–3 (backed by wire
capacity) and sell (100/3)MW FGRs on line 1–2 (backed by counterflow it expects
to produce) at a total gain of (100/3)  (205) ¼ 500/h which exactly offsets its
forward energy contract deficit. G1 could buy (800/3)MW FGRs on line 1–3
(backed by wire capacity) and (400/3)MW FGRs on line 1–2 of which 100 MW
is backed by wire capacity and (100/3)MW is backed by counterflow.
The total FGR cost to G1 is (800/3)  5 þ (400/3)  20 ¼ $4,000/h which
exactly matches its forward energy contract surplus. These FGR procurements match
the expected flows induced by the transactions corresponding to the forward contracts
entered into by G1 and G2 (based on the system PTDFs). In real time G1 pays as before
congestion charges of $10/MWh for 400 MW it delivers to L3 and receives FGR
settlements (based on shadow prices) of (800/3)  5 þ (400/3)  20 ¼ $4,000/h
which exactly offsets the congestion charges. Likewise G2 collects $500 in counterflow
payments from the ISO which cover its net FGR settlement liability resulting from
$5/MW/h income for (100/3)MW FGRs it sold on line 1–3 less its $20/MW/h payout
for its short position on (100/3)MW FGR on line 2–3, totaling $500/h. In the
above setting the ISO always breaks even since the wires capacity is fully sold while
both the congestion rents and the FGR settlements are based on the same flows and
shadow prices.
The revenue surplus we have identified when FTRs are being used results from the
fact that an FTR auction only allocates flowgate capacity corresponding to the FTRs
that are sold leaving the remaining flowgate capacity in the hands of the ISO. Hence
when the real time dispatch differs from the FTR point, unsold flowgate capacity may
become valuable and the congestion revenue corresponding to that unsold capacity
translates into a revenue surplus for the ISO. For instance in Fig. 3.3, if FTRs awarded
in the auction correspond to point E, then the constraint on line 1–3 is not binding and
100 MW of flowgate capacity on line 1–3 remains unsold. Then when the real time
dispatch moves to point D on the nomogram and the shadow price on line 1–3 goes to
$5/MW/h, the congestion rents on that unsold flowgate capacity retained by the ISO
produce a revenue surplus of $500/h.
88 S.S. Oren

3.5 Line Derating and Topology Changes

Flowgate capacity ratings will affect the feasible SFT nomogram as illustrated in
Fig. 3.3 for a three node DC network. Consequently, if in real time operation, a
flowgate rating is decreased from what was assumed in the SFT or if the flowgate
failed due to a contingency, then, the FTR operating point may not be feasible in the
real dispatch topology as shown in Fig. 3.4.
Such line derating may result in revenue shortfall, i.e., the congestion rents that are
based on the real time LMP differences may not suffice to cover the settlements to all
outstanding FTRs. To illustrate such revenue shortfall more explicitly consider a three
node example introduced by Hedman et al. (2011) and shown in Fig. 3.5 . In this
example FTRs are allocated based on an SFT which assumes the depicted topology.
In particular 60 MW FTR obligations from node A to B and 30 MW FTR obligation
from node A to C have been sold through an auction (or allocated by any other means).
The feasible region for the SFT is characterized by the set of linear inequalities:

2 1
 50  AB þ AC  50
3 3
1 2
 100  AB þ AC  100
3 3
1 1
 100  AB  AC  100
3 3
 100  AB þ AC  100
 100  AB  100 (3.2)

This region is illustrated in Fig. 3.6 as the triangle consisting of areas 1, 2, and 4.
The outstanding FTRs represent a point on the boundary of the feasible region
(depicted by the gray square) and hence they satisfy the SFT for this topology.
If the topology doesn’t change then the optimal dispatch coincides with the FTR
allocation and hence the corresponding congestion revenues exactly cover
thepayments to FTR holders. Suppose, however, that in operation one of the lines
between node A and B fails. Such a contingency will shrink the feasible region to area
4 in Fig. 3.5 which is represented by the inequalities:

1 1
25  AB þ AC  25
2 4
1 3
100  AB þ AC  100
2 4
1 1
100  AB  AC  100 (3.3)
2 4

Thus, the outstanding FTRs are no longer simultaneously feasible under the new
topology.
3 Point to Point and Flow-Based Financial Transmission Rights: Revenue. . . 89

FTR 2®3 Nomogram area reduced

by derating line 2 to 3.
B
G1 320 MW
2® 1
· X
1 G3 300 MW · A · Z
·
Y
£100 ·
2® 3

3 165 MW ·C
H 1®3
100 MW ·D
G2 L3 1® 2
2 FTR1®3
E
O ·
20 MW 300 MW 400 MW

If FTRs are awarded based on Pt. B or D. and RT dispatch

is at Pt. H, then congestion revenues will not cover FTR
settlements.

Fig. 3.4 The effect of derating flowgate capacity

Fig. 3.5 Revenue adequacy example

Fig. 3.6 Feasible region for different topologies

The optimal dispatch under the above contingency is represented by the black
square in Fig. 3.6. Tables 3.1, 3.2, and 3.3 below show that the congestion revenues
corresponding to this dispatch fall short of covering the settlement payments to the
90 S.S. Oren

Table 3.1 Optimal dispatch results with all lines in

Node Gen output LMP Gen cost Trans-action MW Cong. rent
A 90 MW $50/MWh $4,500 A–B 60 MW $3,000
B 40 MW $100/MWh $4,000 A–C 30 MW $750
C 0 MW $75/MWh $0 Congestion rent: $3,750
Total generation cost: $8,500

Table 3.2 Optimal dispatch results with one line A–B out
Node Gen output LMP Gen cost Trans-action MW Cong. rent
A 65 MW $50/MWh $3,250 A–B 35 MW $1,750
B 65 MW $100/MWh $6,500 A–C 30 MW $750
C 0 MW $75/MWh $0 Congestion rent: $2,500
Total generation cost: $9,750

Table 3.3 FTR settlements

Source to FTR FTR settlements (one line A–B
sink: quantity: FTR settlements (all lines in) out):
A to B 60 MW $3,000 (LMP gap: $3,000 (LMP gap: $50/MWh)
$50/MWh)
A to C 30 MW $750 (LMP gap: $25/MWh) $750 (LMP gap: $50/MWh)
Total FTR settlements: $3,750 $3,750

FTR holders. In this case the contingency affected the generators’ output and flows
but did not affect the LMPs and hence the FTR payments. Specifically, the
congestion revenues dropped from $3,750 to $2,500 while the FTR settlement
remains $3,750 resulting in a shortfall of $1,250.
Surprisingly, revenue adequacy can be restored and generation cost reduced in
this case by switching off the other line between nodes A and B. The feasible region
corresponding to the topology with both lines between node A and B out is defined
by the constraint:

AB þ AC  100

Since both A to B and A to C transactions must share the line between A and C.
Hence, the feasible region is now represented by the triangle consisting of areas 1, 3
and 4 in Fig. 3.6 whereas the optimal dispatch moved from the black rectangle to the
white rectangle. Furthermore, the gray rectangle representing the outstanding FTRs is
now within the feasible region and can, therefore, be interpreted as a suboptimal
feasible dispatch. Since an optimal dispatch solution also maximizes congestion
rents (by duality theory of linear programming), it follows that the congestion rents
exceed the FTR settlements which equal to the congestion rents corresponding to a
feasible suboptimal dispatch. The above observations are verified numerically by the
results in Tables 3.4 and 3.5. The optimal dispatch results with both lines between node
A and B out are summarized in Table 3.4 and the corresponding FTR settlements are
given in Table 3.5. We note that generation cost dropped to $8,000 which is below the
3 Point to Point and Flow-Based Financial Transmission Rights: Revenue. . . 91

Table 3.4 Optimal dispatch results with two lines A–B out
Node Gen output LMP Gen cost Trans-action MW Cong. rent
A 100 MW $50/MWh $5,000 A–B 70 MW $3,500
B 30 MW $100/MWh $3,000 A–C 30 MW $1,500
C 0 MW $100/MWh $0 Congestion rent: $5,000
Total generation cost: $8,000

Table 3.5 FTR settlements with the two lines A–B out
Source to sink: FTR quantity: FTR settlements (both lines A–B open):
A to B 60 MW $3,000 (LMP gap: $50/MWh)
A to C 30 MW $1,500 (LMP gap: $50/MWh)
Total FTR settlements: $4,500

optimal dispatch with all lines in, while congestion revenues increased to $5,000 which
is sufficient to cover the $4,500 FTR settlement payments.

3.6 Allocating Revenue Shortfalls

When a revenue shortfall occurs, i.e. congestion revenues cannot cover the settlement
payments to FTR holders, the system operators must make up the difference. The
various approaches adopted by system operators in the US for addressing such revenue
shortfalls include:
• Full payment to FTRs based on nodal prices and uplift of the shortfall to sellers
or buyers of energy (full funding approach)
• Prorate settlement to all FTRs to cover shortfall (“haircut” approach)
• Intertemporal smoothing of congestion revenue accounting by carrying over
revenue surpluses and shortfall over an extended time period.
• Prorate settlement to FTRs based on impact of derated flowgates
• Full funding of FTRs and assignment of shortfall to owners of derated flowgates.
The first three alternatives socialize the cost of derated lines to energy sellers or
buyersor to the FTR holders or across time periods. In the extreme case when a derated
line is radial such socialization is vulnerable to gaming. An FTR holder on a derated
but underutilized radial line has the incentive to congest that line though fictitious
transactions in order to capture FTR revenues. The last two alternatives, which we
advocate in this paper, directly assigns shortfalls to users or owners of derated
flowgates. An important motivation for such an approach is to prevent potential
gaming through overscheduling intended to induce congestion that will increase the
payoff on certain FTRs. To illustrate such direct assignment consider the three node
example in Fig. 3.2. In that example 1 MW FTR from node 1 to 3 contains 1/3 MW
flow on line 2–3, whereas 1 MW FTR from node 2 to 3 contains 2/3 MW flow on line
2–3. Thus, if line 2–3 is derated by 50 % the congestion revenue shortfall will be 110
times the shadow price SP23 on line 2–3.
92 S.S. Oren

The aforementioned shortfall can be assigned to the line owner while preserving
full funding of the outstanding FTRs. Alternatively it can be assigned to the FTRs by
reducing their settlement payment in accordance to the proportion of the derated line
flow that they contain. Specifically since the capacity of line 2–3 was reduced by 50 %,
The payment to a 1 MW FTR from node 1 to 3 is reduced by 0:5  ð1=3Þ  SP23 and
the payment to a 1 MW FTR from node 2 to 3 is reduced by 0:5  ð2=3Þ  SP23. The
SFT requires that the number of FTRs from node 1 to 3 times 1/3 plus the number of
FTRs from node 2 to 3 times 2/3 does exceed the thermal limit of line 2–3 which is
220 MW (and it equals to that limit when the shadow priceSP23 is positive.) Hence, the
reductions of FTR settlement payments above adds up exactly to 110  SP23 which is
the revenue shortfall due to the derating of line 2–3.
Consider now the case when more than one line is derated. Suppose that line 2–3 is
derated by 50 % and line 1–3 is derated by 20 %. Direct assignment the of revenue
shortfall will again reduce the settlement payments to each FTR based on its flow share
on each derated line. Thus payments to 1 MW FTR from node 1 to 3 is reduced by
0:5  ð1=3Þ  SP23 þ 0:2  ð2=3Þ  SP13. Likewise payments to 1 MW of FTR from
node 2 to 3 is reduced by 0:5  ð2=3Þ  SP23 þ 0:2  ð1=3Þ  SP13 . An intuitive
analogy to the above approach is to think of FGRs as stocks and of FTRs as mutual
funds which contain the various FGRs in proportions reflecting the corresponding
PTDFs. When a line is derated by 50 % it is equivalent in our analogy to a stock loosing
half its value. In the financial analogy it is natural that when a stock loses part of its
value then the different mutual funds containing that stock will be impacted in
proportion to their holdings of that stock. It would seem unreasonable to suggest that
the loss of a stock would be born equally by all mutual funds offered by a brokerage
house regardless of the holdings of the stock in each fund. Likewise it is natural and fair
to allocate the revenue shortfall due to derating of a line according to the flow impact of
each FTR on the derated line.

3.7 Expanding the FTR Feasible Region via Short FGRs

While derating line capacities reduces the feasible set of FTRs that the network could
support without revenue shortfalls, increasing line capacity ratings will increase the set
of FTRs that can be awarded in the auction as shown in Fig. 3.7 below. Such an
increase could result from a physical change in line capacity due to an upgrade of a line
or improved maintenance. Alternatively, an increase in line capacity used for the
purpose of the SFT can be “virtual” and supported by short positions on FGRs, just as
an increased number of available FTRs between two points can be underwritten by
counterflow commitments. A short position on an FGR amounts to an obligation to
either increase the flowgate capacity or underwrite the settlement cost of the added
FTRs. The holder of a 1 MW short FGR position on a particular line is paid the shadow
price on that line in the SFT power flow calculation and is liable for the shadow price
on that line in real time. The payment received by such a short position holder in the
FTR auction is financed by the revenue from the additional FTRs that can be sold due
to the increase in the SFT feasible nomogram.
3 Point to Point and Flow-Based Financial Transmission Rights: Revenue. . . 93

Nomogram area increased

FTR 2-3
by adding 55 MW of virtual
capacity to line 2 to 3) Expanded Auction Outcome

B
320 MW
G1 2→1 X
1 300 MW
G3 A
≤3 (325, 250)
00
2→3 Y
≤100

3 C
(380, 140)
1→3
55 D
≤200+ 100 MW
G2 L3 1→2
2
E FTR 1-3
O
20 MW 300 MW 400 MW

Fig. 3.7 Expanding FTR feasibility with short FGR positions

The real time settlement paid by the short FGR holder supplements the congestion
revenues and will cover any FTR revenues shortfall resulting from the oversold FTRs.
If the line for which the short FGR position was issued is not congested in real time
then the holder of that position gets to pocket the auction revenue for underwriting that
position. To illustrate, suppose that the auction clearing price on both FTRs depicted
along the axis in Fig. 3.6 (Node 2–3 and node 1–3) is $10/MW/h, then the
corresponding shadow price on line 2–3 is also $10/MW/h. A short position of
55 MW on line 2–3 will earn its underwriter $550/h. Such a short position expands
the feasible region in the SFT as shown in Fig. 3.7 and changes the results of the FTR
auction clearing so that the number of FTRs awarded from node 2 to 3 increase from
140 MW to 250 MW while the number of FTRs awarded from node 1 to node 3 is
reduced from 380 to 325. In this particular case the expansion of the feasible region
did not change the FTR clearing prices only their awarded quantities. Thus the net
gain in FTR auction revenue is 10  (250140) + 10  (325380) ¼ $550/h
which is exactly the amount paid by the auctioneer for the 55 MW short FGRs. In
real time the underwriter of the short FGRs is liable for 55  SP23 which should cover
any revenue shortfall resulting for the incremental FTRs awarded against the short
FGR position. However, if the line 2–3 turns not to be congested SP23 is zero and no
revenue shortfall occurs so that the short FGR underwriter got to pocket the short
position income.
Short FGR positions can be assumed by any entity that wishes to bet against certain
lines being congested. However, such instruments are ideally suited for transmission
owners (TOs) who are in a position to upgrade the line or maintain it so as to increase
its real time rating. Thus, short flowgate positions provide incentives for incremental
improvements and maintenance (e.g. vegetation control) that can enhance real time
transmission capacity. If a line is not binding in real time then the TO retains the
auction income for the short position taken. Similarly, short positions on long term
flowgate rights can finance planned upgrades and investments that will alleviate
congestion on the shorted flowgates while enabling the ISO to issue long term FTRs
against such upgrades.
94 S.S. Oren

Like in every performance based incentive scheme, performance must be measured

and verified against a credible and stable yardstick (e.g. PBR scheme for NGC in
the UK). TOs should get assurances that they will not face a moving target and
improvements they make will not change the nominal line rating used in subsequent
FTR auctions. Furthermore, active participation by TOs in FTR trading must be
regulated to insure correct incentives (e.g. long positions by TOs should not be allowed
since they create incentives to restrict flow).

3.8 Conclusion

Just as point to point FTRs provide a convenient hedge against congestion charge risk
for point to point energy transactions, FGRs are convenient instruments for managing
flowgate capacity risk and reward investment in such capacity. When a revenue
shortfall occurs allocating the losses based on the imbedded FGR content of various
FTRs or directly to the TO of the affected flowgate, eliminates socialization that can
cause inefficiencies and gaming. Conversely FGR short position that expand possible
FTR awards provide a useful means for financing investment and reward performance
that improves flowgate ratings. These positions also allow private parties to underwrite
FTR revenue shortfalls due to flowgate capacity risk. Such activities, however, must be
carefully regulated and monitored to avoid perverse incentives and abuses.

Acknowledgement This chapter is intended as a tutorial and review of previous work. Much of
the text and most of the figures used are adopted from a joint conference paper with Kory Hedman,
published online in the proceeding for the IREP 2010 symposium Oren and Hedman (2010). I also
adopted material, especially the example in Fig. 3.1, that was developed by Fernando Alvarado as
part of a tutorial we jointly presented on financial transmission rights in the year 2000. This work
was supported by the National Science Foundation Grant IIP-0969016 and by the Power Systems
Engineering Research Center.

References

Chao H-P, Peck S (1996) A market mechanism for electric power transmission. J Regul Econ 10(1):25–59
Chao H-P, Peck S, Oren SS, Wilson RB (2000) Flow-based transmission rights and congestion
management. Electr J 13(8):38–58
Hedman KW, Oren SS, O’Neill RP (2011) Optimal transmission switching: economic efficiency
and market implications. J Regul Econ 40:111–140
Hogan WW (1992) Contract networks for electric power transmission. J Regul Econ 4:211–242
O’Neill RP, Helman U, Hobbs BF, Stewart WR, Rothkopf MH (2002) A joint energy and
transmission rights auction: proposal and properties. IEEE Trans Power Syst 1(4):1058–1067
Oren SS, Hedman KW (2010) Revenue adequacy, shortfall allocation and transmission perfor-
mance incentives in FTR/FGR markets. In: Proceedings of the IREP 2010 symposium,
Bouzios, 1–6 Aug 2010
Ruff LE (2001) Flowgates, contingency-constrained dispatch, and transmission rights. Electr J 14(1):34–55
Chapter 4
A Joint Energy and Transmission Rights Auction
on a Network with Nonlinear Constraints:
Design, Pricing and Revenue Adequacy

Richard P. O’Neill, Udi Helman, Benjamin F. Hobbs, Michael H. Rothkopf,

and William R. Stewart

4.1 Introduction

The forward and real-time (spot) auction markets operated by independent system
operators (ISOs) allow for trade in multiple wholesale electricity products,
differentiated by time and location on the transmission network.1 This chapter

1
In the United States, there are two types of independent system operators established under
federal jurisdiction – Regional Transmission Organizations (RTOs) and Independent System
Operators (ISOs). RTOs have additional geographical requirements compared to the original
ISOs, such as encompassing a larger multi-state region, as well as some functional differences,
such as regional transmission planning. However, wholesale market design is not differentiated
between the two types of organizations. Since ISO is a more generic term, we will use this term to
refer to both types of organization in the remainder of the chapter. In the U.S., ISOs and RTOs
include the California ISO, ERCOT (encompassing most of Texas, and not subject to federal
jurisdiction), PJM RTO, the Midwest ISO (MISO), New York ISO, ISO New England, and the
Southwest Power Pool (SPP). For a survey of the designs of some of these markets in the United
States, see O’Neill et al. (2006). Each of the U.S. ISOs and RTOs also has a website with extensive
documentation of market rules and procedures as well as data on market outcomes. We refer to
some of these below.
R.P. O’Neill (*)
Federal Energy Regulatory Commission, Washington, DC 20426, USA
e-mail: [email protected]
U. Helman
BrightSource Energy, Oakland, CA 94612, USA
B.F. Hobbs
Johns Hopkins University, Baltimore, MD 21218, USA
e-mail: [email protected]
M.H. Rothkopf
Pennsylvania State University, University Park, USA
W.R. Stewart
College of William and Mary, Williamsburg, VA 23187, USA
e-mail: [email protected]

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 95

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9_4,
# Springer-Verlag London 2013
96 R.P. O’Neill et al.

presents a general auction model that implements key features of the ISO markets,
including definition of several market products, the rules for joint auctioning of the
products in a sequence of forward and spot markets, the rules for financial settle-
ment of those products, and the requirements to ensure revenue adequacy of the
auctioneer. The model formulation is focused on a joint energy and transmission
rights auction (JETRA; henceforth, the ‘auction model’ or ‘auction’), along with a
non-linear representation of the transmission network constraints. However, the
formulation can be extended, in some cases with modification, to other market
products. Our earlier paper (O’Neill et al. 2002) explored properties of this auction
with linear transmission constraints.
At its inception, this auction model informed deliberations at the U.S. Federal
Energy Regulatory Commission (FERC) in the early 2000s over a possible standard
market design tariff for the wholesale power markets under its jurisdiction. A key
objective at the time was to establish a framework for introducing a more complete
set of financial transmission rights for the ISOs, including both point-to-point rights
and “flowgate” rights, then considered to be mutually exclusive designs (see, e.g.,
Chao et al. 2000; Hogan 2000). Subsequently, political factors made it impossible
for FERC to require implementation of a standardized wholesale market design.2
Nevertheless, individual U.S. ISO market designs have since converged on certain
products and pricing rules represented in our model formulation, such as point-
to-point financial transmission rights and day-ahead and real-time markets with
locational marginal pricing (LMP) of energy incorporating marginal congestion
and loss charges. Other products discussed below have, however, not yet been
introduced, such as forward locational energy sales integrated with the transmission
rights auctions, and flowgate rights.
Despite this progress, the wholesale market design process has not been
completed in the U.S., and there are almost continuous efforts at each ISO to
introduce new products and pricing rules – some standardized across the ISOs,
some not. This process advances market completeness by expanding the set of
products and prices to a fuller range of the services provided by generation,
non-generation,3 and transmission assets, as is required for economic efficiency,
especially under changing market and system conditions (such as integration of
variable renewable generation). As some of these possible new market products,
such as a reactive power product, require representation of non-linear transmission
network constraints, whether for forward sales or real-time settlement purposes, our
model continues to be applicable to the evolution of U.S. ISO market designs as
well as regulatory reforms in other countries. At the same time, our illustrative
extension to new products does not necessarily reflect an endorsement: as the
history of market design in the U.S. has shown, for any specific ISO, the

2
The standard market design tariff was proposed by FERC in 2002, but failed to achieve sufficient
political support in certain regions to be implemented in its original form.
3
“Non-generation resources” is the term adopted by FERC to refer to demand response, storage
and other non-generation resources that may provide market services.
4 A Joint Energy and Transmission Rights Auction on a Network with Nonlinear. . . 97

determination of the products for inclusion should be left to the market participants
based on their needs and preferences as well as the physical characteristics of the
regional power system (as well as being subject to approval by FERC or state
regulators).
In deciding whether or not to adopt a more elaborate market design, such as that
proposed in this chapter, the market operator, stakeholders, and regulators have to
balance several criteria. Two of them are emphasized in this chapter, and motivate
our design: efficiency in the allocation and trading off of various market products
(in our case here, forward energy and transmission rights), given what bidders say
they are willing to pay for them; and revenue adequacy for the market operator.
Others that are relevant include: incentive compatibility (the extent to which an
auction design encourages bidders to reveal their true valuations and costs in their
bids); complexity and cost of implementation relative to anticipated benefits to the
market; transparency; and perceived fairness (definable in several ways).

4.1.1 General Features of the Forward and Spot Market Designs

We refer to forward markets4 as any ISO market that clears prior to the ISO’s physical
dispatch, or real-time, market. As a general matter, offers and bids that clear forward
markets are financially but not physically binding,5 whereas those that clear the real-
time auctions are treated as physical commitments that typically must follow the
system operator’s instructions or be subject to warnings or financial penalties.
In practice, ISOs hold forward markets on a variety of time-frames that reflect
operating requirements and constraints, market needs or simply utility/regulatory
conventions. The basic market sequence is characterized in Table 4.1. The types of
market products shown are not offered uniformly in all ISOs (for example, only one
ISO provides pre-day-ahead forward reserves); we provide further detail on product
definition in the next section, but focus in this section on a general description of the
market sequence and the features reflected in our auction formulation.
The number and timing of forward markets in JETRA is a market design decision
that needs to reflect the conditions that pertain in the market and stakeholder
preferences. The minimal requirement of the ISO is that it run a real-time market;
it is possible to provide all forward products through formal or informal markets
operated by other parties. However, non-ISO operated markets that do not clear using

4
We only consider ISO forward auction markets here, not any off-ISO bilateral power exchanges
that can also operate in forward time-frames and in the same geographical territory. The existence
of ISO auctions does not preclude operation of secondary non-ISO forward markets for transmis-
sion rights or bilateral energy transactions. In the U.S., ISO and non-ISO markets are generally
regulated under a just and reasonable standard originating and under a fraud and abuse standard in
the Federal Power Act.
5
The exception to this rule is sales of forward capacity that create performance obligations in real-
time.
98 R.P. O’Neill et al.

Table 4.1 Characterization of existing forward and spot U.S. ISO markets
Auction Financial settlement
Time-frame periodicity interval Types of market products
Spot markets Real-time Hourly 5–60 min Energy (physical only)
(physical)
Forward Hour-ahead Hourly 1h Energy, operating
markets reserves
(financial) Day-ahead Daily (24 h) 1 h for energy Energy, operating
Daily for ‘make reserves, residual
whole’ capacity
payments
Pre-day- Semi-annually Months, possibly Operating reserves,
ahead or annually differentiated by financial transmission
time of day rights, capacity

a good representation of the network and the full dispatch run a significant risk of
infeasible trades. This has happened in the CalPX in the early days of the California
market and several European exchanges. For revenue adequacy, FTRs require
assumptions about the network configuration, but if non-ISO markets only trade
simple flowgates, then they can avoid the need to make such assumptions. However,
the downside of only selling simple flowgates is that the rights holder is not
guaranteed a perfect hedge for a bilateral power contract between two points. A
distinct advantage of a central forward market operated by the ISO is that it is in the
best position to incorporate network constraints along with the rest of the generation,
load, and net imports. The other advantage is that the ISO can back FTR payments
with congestion revenues, which an independent party cannot.
Pre-day-ahead markets. The pre-day-ahead ISO markets have conventionally
been used to transact products denominated in time-periods of months or multiple
months, such as financial transmission rights and capacity. Some ISOs have used
such markets to procure forward operating reserves. In the auction design we propose
in Sect. 4.3, the mathematical formulation explicitly represents only energy and
financial transmission rights for pre-day-ahead auctions. A key generalization of
the model has been to accommodate the joint auction of products that were previously
advocated as mutually exclusive market designs, intended to support different visions
of how forward market institutions should develop. Specifically, the auction model in
(O’Neill et al. 2002) – and the analogous one presented here for the nonlinear case –
synthesize and extend several prior auction models to allow for the simultaneous
auction of flowgate, or flow-based, transmission rights and point-to-point transmis-
sion rights specified as options or obligations (Chao and Peck 1996; Harvey et al.
1997; Hogan 2000, 2002), in addition to real energy and possibly other products.6

6
The debate over the implementation of alternative transmission rights formulations is recounted
in Hogan (2000, 2002) and O’Neill et al. (2002), among other sources, and will not be repeated
here.
4 A Joint Energy and Transmission Rights Auction on a Network with Nonlinear. . . 99

Pre-day-ahead energy transactions, whether in separate energy-only auctions7 or

in joint auctions with financial transmission rights, have not been introduced
explicitly by any of the U.S. ISOs. However, conceptually, energy commitments
could enter the pre-day-ahead auctions for transmission rights where the energy
may be needed to make up losses on the transmission network, or to supply inertia
or reactive power that are not explicitly modelled to create additional transmis-
sion capacity into transmission constrained areas. An example of the latter is the
“San Francisco nomogram” constraint discussed in (O’Neill et al. 2002). Our
introduction of energy into the forward transmission rights auction is a generaliza-
tion of these applications.
Day-ahead and real-time markets. In day-ahead and real-time auction
markets, products include real energy priced and settled using LMPs, and regula-
tion and operating reserves settled at system-wide or zonal prices. With respect to
day-ahead energy markets, ISOs typically use a two-phase day-ahead market
clearing, in which first both physical8 and financial (or virtual) bids are accepted
and day-ahead prices determined, and second, a reliability unit commitment is
conducted using bids associated with physical generation only and forecast load.
Financial demand and supply bids9 have some unique properties in that they are
not associated with physical energy supply or demand, or physical transmission
capacity. They can be used for financial hedging and are permitted, in part, in
the forward markets to counter market power and to aid in producing better
price convergence (on average) between and among the forward markets and the
real-time market.
Simultaneously, transmission users are charged for marginal transmission costs
(congestion and possibly losses) and congestion revenues are used to settle the
financial transmission rights awarded in the pre-day-ahead auctions. Generally,
these settlements take place using day-ahead market LMPs, unless the ISO only
operates a real-time market, in which case they are settled against real-time LMPs.
Point-to-point transmission rights are settled based on the differences in the LMP
congestion components between their injection and withdrawal points, while if the
ISO offered them, the flowgate rights would be settled using transmission shadow
prices (called flowgate marginal prices in FERC 2002).10 Settlement rules are
defined precisely in the next section.

7
For example, some ISOs have evaluated additional energy auctions prior to the day-ahead
auction, but not integrated with other products.
8
That is, bids backed by physical assets. Selection in the day-ahead auction market does not
require that the seller of the physical asset deliver in real-time; the seller still has the option to not
perform and sell or buy back its position in real-time. The incentive to perform is thus primarily
financial. In contrast, in real-time, failure to perform as instructed may result in administrative
penalties.
9
In this chapter we will use the term ‘bid’ at times to include either a bid or offer.
10
While ISOs do not offer flowgate rights through auctions, there are a number of applications of
flow-based capacity reservations that are used by the ISOs and affect energy prices in real-time.
For example, currently, ISOs exchange flowgate capacity with their neighbors through Joint
Operating Agreements to feasibly and optimally allocate loop flow.
100 R.P. O’Neill et al.

Finally, the real-time markets begin at midnight of the operating day, clear
every 5–10 min, and settle every 5–60 min.11 In these markets, only physical bids
are allowed, subject to performance requirements, and all financial positions are
re-settled. Forward markets close in time to real-time, such as markets held one or
more hours before the operating hour, are more “physical” in nature than financial,
although the ISO has less time to recover from failure to perform than in the
day-ahead market, where it has time to conduct reliability commitments and
procure additional reserves.
In all these markets, various additional rules have been established to prevent
market power and market manipulation by entities that also hold other property
rights (including physical transmission scheduling), and appropriate creditworthi-
ness rules are required for all cleared bids.
The actual timing of the sequence of ISO market clearing for the various market
products is due to a mix of factors, including scheduling conventions inherited from
predecessor utilities, regional system operators (e.g., power pools) and reliability
organizations, market design decisions and computational constraints at the ISOs,
and the interests of the market participants as new market designs were developed.
Unfortunately, the timing of the sequence has tended to differ among ISOs,
including contiguous ones, resulting in “seams” issues, some of which have been
resolved over time through improved coordination (see, e.g., O’Neill et al. 2006).

4.1.2 Auctions with Non-linear Transmission Network

Constraints

To formalize and generalize the design of these forward and real-time markets, the
authors first introduced a multi-settlement, joint energy and transmission rights
auction on a network characterized by an approximate linearized ‘dc’ load flow
model (O’Neill et al. 2002, 2003) (for a derivation of the dc load flow approxima-
tion, see, e.g., Schweppe et al. 1988). In order to simplify auction clearing and
financial settlements, linear network constraints are used in all U.S. ISO markets.
For example, forward auctions for obligation and option point-to-point Financial
Transmission Rights (FTRs) in PJM employ a dc load flow model.12 As noted, some
market operators create additional linear ‘nomogram’ constraints or ‘cuts’, often
proxies for voltage limits, to ensure feasibility of the underlying physical system.
According to our communications with software developers, the more general
linear model in O’Neill et al. (2002) has been a basis of the development of the
recently implemented transmission rights markets for the ISOs in ERCOT (Texas)
and California in the U.S..

11
That is, some ISOs financially settle on a 5–10 min basis, while others settle on the basis of an
hourly integrated price.
12
www.pjm.com/markets/ftr
4 A Joint Energy and Transmission Rights Auction on a Network with Nonlinear. . . 101

But other ISOs have implemented auctions with non-linear transmission

constraints. In the New York ISO, the obligation point-to-point financial transmis-
sion rights are called Transmission Congestion Contracts (TCCs). In contrast to
PJM, the auction is conducted using an approximate AC optimal power flow model
that respects thermal, voltage and stability constraints within the New York control
area.13 There are other market products that would require consideration of non-
linear constraints. The inclusion of reactive power in the auction market would also
require the AC load flow model (FERC 2005; Hogan 1993; Kahn and Baldick 1994;
O’Neill et al. 2008) or a linear or quadratic approximation to the model. Moreover,
proposals for forward hedging of marginal losses through unbalanced point-
to-point transmission rights would require auctions with a dc load flow model and
quadratic losses (Harvey and Hogan 2002). This chapter thus generalizes the linear
auction model in O’Neill et al. (2002) to the case with nonlinear constraints.
Whatever the final set of products, a key goal of the market design is to ensure
the revenue adequacy of the auctions, which means that the ISO collects sufficient
revenues to cover payment obligations. A theoretical result presented here is
that for the auction with nonlinear transmission constraints that define a convex
feasible region, the forward and spot auction sequence can be revenue adequate
(the analogous proof for the linear case is shown by O’Neill et al. 2002). However,
as with any transmission rights auction, additional rules are needed to account for
revenue inadequacy due to changes in system topology. While we show the formal
conditions for revenue adequacy, we do not explore in detail how market
participants are affected financially when there is a shortfall. There are currently
different rules for dealing with shortfalls. For example, in PJM, revenue inadequacy
of FTRs is addressed by prorating the shortfall among the FTR holders. In NYISO,
revenue inadequacy of TCC holders is covered by the transmission owners to
provide incentives for efficient timing of transmission maintenance.

4.1.3 Additional Extensions of the General Auction Model

In each step of the sequence of auctions, our general model framework can be
extended to include additional products,14 pricing rules, settlements, or linkages
with auctions for other wholesale market products. Some of these extensions are
discussed in the subsequent sections, but we summarize several others here.
For example, some ISOs have established forward capacity (MW) auction
markets to satisfy annual or multi-year local area and system-wide planning reserve
margins (or resource adequacy requirements). These forward markets pay a loca-
tional clearing price for capacity, which in some designs is set by an administrative

13
www.nyiso.com
14
Including those, such as generator start-up, that requires mixed integer programming
formulations, as discussed in Sect. 4.4.
102 R.P. O’Neill et al.

demand curve. The network models are also zonal rather than nodal, another
difference with our model formulation as presented here. One linkage between
the capacity auctions and the model of this chapter is that, as a general rule, offers
that clear the capacity auction then have an offer obligation in the ISO day-ahead
markets, making the capacity payment equivalent to the ISO buying a call option
(on behalf of the load-serving entities that have the capacity obligation) on energy
that pays the LMP when exercised. Hence, the model presented here can be viewed
as a framework for final settlement of the energy call option associated with
capacity rights.
Closer to actual operations, the sequential auction market design can be
implemented with additional settlements between day-ahead and real-time energy
markets in order to better accommodate variable energy generation by renewable
sources, such as wind and solar generation, whose production forecast uncertainty
decreases as the real-time market approaches. A sequence of auction markets, for
example, occurring every six hours with rolling horizons, might allow for more
efficient adjustments as the uncertainty decreases.
The remainder of the chapter is organized as follows. Section 4.2 offers a
description of the types of energy and transmission right bids in the auction.
Section 4.3 presents the mathematical statement of the auction model with nonlinear
transmission constraints, and provides more mathematical detail on how transmission
rights are specified for the auction. Section 4.4 discusses the settlement system and
conditions for maintaining revenue adequacy. Section 4.5 provides an example based
on a dc load flow with quadratic losses. Section 4.6 offers conclusions. An appendix
presents the proof of revenue adequacy for a sequence of forward and real-time
market auctions with ‘expanding’ transmission constraints that define a convex
feasible region.

4.2 Auction Products

We now turn to the set of energy and transmission rights products modeled in the
auction design, a subset of those discussed above. The types of electricity products
that can be traded in the auction mechanism proposed in this chapter have been
described by Baldick et al. (2005), Chao and Peck (1996), Chao et al. (2000),
Harvey et al. (1997), and O’Neill et al. (2002, 2003, 2006). This section provides
further qualitative description of these products, while the next section introduces
our model’s notation.
Energy. Several types of bids are typically allowed in energy and transmission
auctions: supply offers, demand bids, financial bids, and transmission bids. Point-
to-point transmission bids represent what a bilateral energy transaction is willing to
pay for marginal congestion charges (and possibly losses) associated with its
transmission schedule. If both the points are inside the ISO, the product is financial.
Physical point-to-point bids are typically used on the boundaries of ISO systems
where there is no fully arbitraged LMP on the “other side” of the boundary, which is
4 A Joint Energy and Transmission Rights Auction on a Network with Nonlinear. . . 103

often called a proxy bus or interface. The model presented here can accommodate
each of these types of bids. For purposes of this discussion, some important aspects
of energy auctions are not considered, such as the inclusion of unit commitment
start-up and no-load costs, restrictions on bids to control the exercise of market
power15 and changes in network topology.16
Currently, energy offers (to sell) and bids (to buy) have only been allowed in the
day-ahead and real-time markets. In a pre-day-ahead ISO auction market for energy
and transmission, as discussed above, energy transactions could be used also
to balance point-to-point transmission rights in a lossy system, or to increase
transmission capacity for forward sale. These one-sided or unbalanced “rights”
(actually, obligations) can be called “nodal revenue rights.”
Simple Transmission Capacity Rights and Portfolio Combinations. As noted
in the flowgate or flow-based rights literature (e.g., Chao and Peck 1996; Chao et al.
2000), there are two types of elementary transmission rights, which we call here the
“simple rent collection right” and the “simple rent payment right.” The simple rights
are defined over single transmission elements, which include lines, transformers,
other transmission elements or collections of transmission elements whose capacity
is limited by exogenous thermal, stability, or contingency considerations. Such
rights are often generically called “flowgate” rights (FERC 2002). For each element,
the direction of the flows covered by the simple rights is defined separately and
arbitrarily, in either a positive or negative direction. The simple rent collection right
on a transmission element confers to the buyer the right to collect the rents that
would occur when that element is congested, for the capacity specified in the right.
Because the flow-based right is directional, the holder of a rent collection right only
collects non-negative rents.
The simple rent payment right obliges the seller to pay any rents on a transmission
element, for the capacity specified in the right. The rent payment right allows a
market participant to create or consume financial capacity on a specific transmission
element. Moreover, if the ISO did not itself allocate rights, but simply facilitated an
auction of buyers and sellers (see Sect. 4.3), then all transmission owners could offer
physical transmission rights. The simple rights can be aggregated into more complex
rights through linear combinations or portfolios, for example, covering several
transmission lines, nomograms, or constructing “point-to-point” rights on the basis
of power flow distribution factors (O’Neill et al. 2002).
The combination of buying a rent collection rights on some transmission element
and selling rent payment rights on other transmission element creates portfolio of

15
Bid restrictions for market power reasons can include a uniform, “safety net” bid cap for all
generators, bid thresholds on generators that trigger market power mitigation, a requirement to bid
approximate marginal costs, and other measures.
16
Network topology changes can be either purposeful, to increase market surplus, or due to
planned outages, such as maintenance, or to unplanned outages. Topology changes to increase
market surplus, called optimal transmission switching, can ironically cause revenue inadequacy in
the point-to-point transmission rights settlements. Corrective switching to stabilize or re-optimize
the system can follow unplanned outages.
104 R.P. O’Neill et al.

flowgate rights. For a set of simple rights that constructs a point-to-point right,
holding this portfolio on each transmission element in the set is analogous in the
linear dc JETRA model to the point-to-point obligation rights with a constant
topology. In general, however, the individual rights and the portfolios are more
likely to offer an imperfect rather than a perfect hedge against congestion charges
associated with an energy transaction. Since an exact match between a particular
point-to-point transaction and a portfolio of the rights would be difficult to create
and maintain (although some authors propose that the ISO provide subsidies to
maintain particular portfolios as complete hedges, for example, Chao et al. 2000).
A transmission right that offers a perfect, or complete, congestion hedge is
defined as one in which the congestion charges associated with real-time market
transactions are equal to the congestion revenues obtained by the rights holder.
An imperfect hedge is one in which the congestion charges are not equal to the
revenues to transmission rights holders. For many holders, then, the flowgate right
will be used to collect rents on heavily congested transmission elements rather than
to hedge any particular power transaction.
Flowgate rights can be made available or withdrawn in the real-time market due
to forced outages, the use of short-term ratings instead of steady-state ratings or
unanticipated changes in weather. For example, changes in ambient temperature
and wind speed can change the transmission line’s carrying capacity.
Point-to-Point Transmission Rights. There are two types of point-to-point
rights, the obligation right and the option right. An obligation right is more
accurately described as a “contract” (Harvey et al. 1997), since it embodies an
obligation to pay congestion revenues, but is now conventionally termed a financial
transmission right. A point-to-point obligation transmission right is defined as the
right to receive a payment or the obligation to pay the congestion charge rents that
result from the physical flows associated with putting power into the system at a
point of injection (POI) and taking power out of the system at a point of withdrawal
(POW) (Harvey et al. 1997). Note that for a point-to-point obligation, flow in
one direction adds an equivalent amount of “counterflow capacity” in the other
direction. This can be generalized to multiple point-to-multiple point rights, which
we will call network rights. These rights may simply aggregate point-to-point rights
or may be “contingent” rights, when they hedge multiple possible POIs and POWs
(discussed in O’Neill et al. 2002). The point-to-point obligation transmission right
is equivalent to the forward transmission congestion contracts (TCCs) described in
Harvey et al. (1997). The network rights were described in FERC’s proposed
capacity reservation tariff (FERC 1996).
The amount that is received (or paid, if negative) by the holder of the obligation
right is the nodal price at the POW minus the nodal price at the POI multiplied by
the quantity specified in the right. (A variant implemented at some ISOs pays only
the difference in the congestion portion of the LMP price and not the loss compo-
nent.) If the injections and withdrawals of power specified in the right are scheduled
in the market in which the right is settled (and then executed in the real-time market,
if different from the settlement market), then the right provides a complete
congestion hedge, i.e., no additional payment for congestion will be necessary.
4 A Joint Energy and Transmission Rights Auction on a Network with Nonlinear. . . 105

The point-to-point option transmission right is defined as the option to put power
into the system at one or more POIs and take power out of the system at one or more
POWs. The option TCCs discussed by Harvey et al. (1997) are similar to these
point-to-point option rights in the linearized dc load flow model (O’Neill et al.
2002). It can be interpreted as the right to collect congestion rents if they exceed
zero, without the obligation to pay that amount if negative. (I.e., they are options
with a strike price of zero.) This option faces considerable computational
challenges in an auction model with nonlinear transmission constraints, in that a
separate load flow has to be calculated for each combination of possible exercised
options (Hogan 2002). However, using a linearized dc load flow approximation
model, the computation can be reduced sufficiently, thus facilitating the implemen-
tation of point-to-point options (alternatively, portfolios of flowgate rights could be
used to approximate a point-to-point option right). In an auction with linear
constraints, the point-to-point option is shown to be equivalent to setting aside
capacity in each transmission constraint for positive increments of flow associated
with the right but ignoring negative flows (“counterflow”) in the opposite direction
(e.g., O’Neill et al. 2002). This allows the auction to be run using a single set of
power flow distribution factors (PTDFs), but no analogous reduction has been
developed for the nonlinear case. Moreover, as we showed previously (O’Neill
et al. 2002), the reduction in the linear case implies that an appropriately defined
bundle of flowgate rights dominates the point-to-point option in the sense that there
exists such a bundle whose cost is the same as the option right but which will pay
off at least as much as an option right and, under some possible outcomes, it will
pay strictly more. Although a point-to-point option has been included in some ISO
markets, it has been excluded in others for various reasons. These include the fact
that such rights would excessively diminish the available rights in locations where
there are physical set-asides to honor prior physical transmission scheduling rights;
a lack of stakeholder interest in such options as a hedging instrument; and to the
software development costs and computational requirements of its implementation.
Point-to-point rights can be balanced or not balanced. A balanced right is one in
which the quantity injected is equal to the quantity withdrawn. An unbalanced right
does not have this requirement, so that an entity can approximate losses (average or
marginal) by specifying a higher quantity injected than withdrawn.
Finally, as with the flowgate right, point-to-point rights can be bought from or
sold into the auction.

4.3 The Auction with Nonlinear Constraints

4.3.1 Mathematical Statement

The types of energy bids and transmission rights described in Sect. 4.2 are
represented in the mathematical statement of the auction model with non-linear
constraints, JETRA-NL, below with more detail in Sect. 4.3.2. For ease of
106 R.P. O’Neill et al.

recognition, the notation used in the model borrows and extends from standard
references, such as Chao and Peck (1996) and Harvey et al. (1997). All variables are
assumed to be real power; however, the framework allows for the inclusion of
reactive power (VARs). Units of the decision variables and right hand sides (RHS)
of the constraints are in megawatts (MW or MWh/hour), while the objective
function coefficients are in $/MWh.
The JETRA-NL model is formally stated below. In brief, the formulation
maximizes the net economic value (4.1) of accepted energy and transmission bids
subject to definition of the net injection at each bus (4.2), inequality constraints
upon injections and flows (4.3, 4.4, and 4.5) (whose capacity can be sold as rights),
load flow constraints (4.6), upper bounds on transmission and energy rights (4.7,
4.8, 4.9, and 4.10), and nonnegativity restrictions.

JETRA-NL: max vðtF; tP; g; x; y; f þ; f  Þ ¼ bF tF þ bP tP þ cþ gþ þ c g (4.1)

AP tP þ Aþ gþ þ A g  y ¼ 0 ðpÞ (4.2)

BN tF þ K 0 ðx; y; f Þ  FN ðmN Þ (4.3)

B þ t F þ f þ  Fþ ðmþ Þ (4.4)

B  tF þ f   F  ðm Þ (4.5)

K 00 ðx; yÞ  f þ þ f  ¼ 0 ð gÞ (4.6)

tF  T F ðy F Þ (4.7)

tP  T P ðy P Þ (4.8)

gþ  Gþ ðrþ Þ (4.9)

g  G  ðr Þ (4.10)

t F ; t P ; gþ ; g ; f þ ; f   0

To avoid unnecessary notation, the bids are shown as having a lower bound
of zero; more generally, quantity bids could have nonzero lower bounds. This
generalization is a simple transformation in the linear parts of models. We assume
a feasible solution exists; for instance, zero for all decision variables will be feasible
if K0 (0,0,0) ¼ 0. The notation is defined as follows:
4 A Joint Energy and Transmission Rights Auction on a Network with Nonlinear. . . 107

4.3.1.1 Index Sets

I is the set of nodes, i ¼ 1, . . ., nI, in the system. F is the set of transmission

(or flowgate) bids to buy or sell rights on individual transmission elements
(e.g., a line, capacitor, transformer, or other transmission equipment) or a set of
transmission elements, and is indexed by k ¼ 1, . . ., nF. P is the set of transmission
bids to buy or sell point-to-point rights, with index k ¼ 1, . . ., nP. Mþ is the set of
bids to sell (inject) energy, indexed by m ¼ 1, . . ., nMþ. M is the set of bids to buy
(withdraw) energy, with index m ¼ 1, . . ., nM . H is the set of transmission
elements in the system on which rights are purchased and sold, and the associated
constraints are (4.4) and (4.5). It uses index h ¼ 1, . . ., nH, where nH defines the
cardinality of H. H0 is the set of additional interaction constraints that result from
analysis of voltage, angle, stability, and contingency constraints, sometimes called
nomogram or cut set constraints. On these constraints, rights can be purchased and
0 0
sold. These constraints are indexed by h ¼ 1, . . ., nH , where nH defines the
cardinality of H0 . The set H0 is associated with the mapping K0 in (4.3).

4.3.1.2 Variables

f ¼ f þ  f  is a vector-valued variable describing flows on the transmission

elements. f þh and f h, h 2 H0 , representing the flow induced by x and y on
transmission element h in the positive and negative direction respectively (defined
arbitrarily).
g ¼ gþ  g is a vector, where gþm, m 2 Mþ represents the quantity of energy
sold by the mth energy bid and g m , m 2 M represents the quantity of energy
purchased by the mth energy bid
t F, ft F k ; k 2 Fg, and t P, ft P k ; k 2 Pg, are vectors where t F k represents the
quantity of rights awarded to (bought by or sold to) the kth bid for flowgate (F)
transmission type rights and t P k represents the quantity of rights awarded to the kth
bid for point-to-point (P) transmission type rights.
x is the set of variables that affect the topology and performance of the network,
e.g., phase shifter settings, dc line settings, reactive power compensation and
contingency set-asides on transmission elements for locational reserves. In today’s
practice, these variables are typically determined either exogenously or as a part of
an iterative procedure, but the auction can accommodate bidding for these settings
in the auction; see, e.g., O’Neill et al. (2002).
y is a vector, {yi, i2I}, where yi > 0 is the amount of real power injected at node
i, and yi < 0 is the amount withdrawn at node i that is induced by the t P, gþ and g
bids.
p, mN, mþ, m, g, y F, y P, rþ, r are vectors of Lagrange multipliers associated
with sets of primal constraints in the auction.
108 R.P. O’Neill et al.

4.3.1.3 Parameters and Functions

bF, fbF k ; k 2 Fg, and bP, fbP k ; k 2 Pg, are vectors. bF k , k 2 F and bP k , k 2 P
represents the $/MWh value that the bidder associates with a transmission bid. Bids
to buy are positive and bids to sell are negative.
Fþ, fFþ h ; h 2 H0 g, F, fF h ; h 2 H0 g, and FN, fFN h ; h 2 H 00 g, are transmission
capacity constraints including thermal, stability or contingency limits associated
with one or more transmission elements (e.g., several transmission elements
grouped as a flowgate). Each individual constraint in the third category of capacity
constraints (condition (4.3)) involve two or more flows simultaneously and so we
refer them to interaction constraints. In practice, they are often called nomogram
constraints.
Bþ, B are matrices, fBþ hk ; h 2 H0 ; k 2 Fg, fB hk ; h 2 H 0 ; k 2 Pg, where
þ
B hk represents the quantity in the positive direction on transmission element
h that is requested in bid k and B hk represents the quantity in the negative
direction on transmission element h that is requested in bid k.
BN is a matrix, fBN hk ; h 2 H00 ; k 2 Fg, where BN hk defines the quantity of the hth
transmission network interaction constraint that the kth bid for a F right requires.
An ‘interaction’ constraint is any constraint that is not simply a lower or upper
bound on some variables (especially flows) or otherwise associated with a single
transmission element. Examples include voltage and stability constraints. The set of
network constraints H00 includes these constraints.
cþ, fcþ m ; m 2 Mg , and c, fc m ; m 2 M g are vectors where cþ m < 0
represents the unit $/MWh value to sell energy bid m and c m > 0 represents the
unit value to buy energy bid m.
Aþ, faþ im ; i 2 I; m 2 Mg, and A, fa im ; i 2 I; m 2 M g, is a matrix where
þ
a im ¼ 1, if there is an injection of energy at node i associated with energy bid m;
aim ¼ 1, if there a withdrawal at node i associated with energy bid m; and zero
otherwise for simple trades. The formulation also permits energy portfolio bids
where the matrix entries are not restricted to 0, 1 or 1.
K0 (x, y, f) is the mapping that defines additional inequality constraints upon flows
resulting from off-line studies of contingencies, stability, voltage and angle
constraints.
K00 (x, y) is the mapping from x and y to flows f. These are the basic load flow
constraints, expressing flows as a function of injections. Consequently, ∂K00 (x,y)/∂y
can be viewed as a matrix of the power transfer distribution factors (PTDFs).

  
The set of optimal bids accepted by the auction is denoted as tF ; tP ; gþ ; gg
and the set of Lagrange multipliers that satisfy the Karush-Kuhn-Tucker (KKT)

    
conditions for the auction is denoted p ; mN ; mþ ; m ; g ; y F ; y P ; rþ ;

r g . If there are no losses, then the congestion rents (i.e., opportunity costs)
resulting from flows are mNFN þ mþFþþmF.
Constraint (4.2) includes the net injections from the energy part of the auction along
with net injections implied by the point(s)-to-point(s) transmission auction; their sum
yields the overall net injections at each node, y. Constraints (4.4 and 4.5) require that
4 A Joint Energy and Transmission Rights Auction on a Network with Nonlinear. . . 109

the flowgate F rights plus flows induced by y and x are subject to the bounds on each
transmission element. Constraints (4.3) further require that the F rights and flows
induced by y and x are subject to the interaction constraints on the system (i.e.,
represent a feasible physical dispatch with respect to those constraints). Constraint
(4.6) calculates the flows induced by x and y. For instance, (4.2) and (4.6) together
could be based on the linearized dc load flow analogues of Kirchhoff’s current and
voltage laws, respectively (as in the example at the end of this chapter). Constraints
(4.7, 4.8, 4.9 and 4.10) enforce the upper bounds on each type of bid.
In general, the underlying physical constraints of a reliable AC system yield a
nonconvex set. Let it be called C. Let C be the set that satisfies (4.2, 4.3, 4.4, 4.5, 4.6,
4.7, 4.8, 4.9 and 4.10). C is often represented by an energy management system
combined with judgment of experienced operators, various approximations and the
results of contingency analyses. The set C includes relationships between power,
reactive power, Kirchhoff’s law, losses, voltage, phase angle regulators, dc lines and
all specified contingencies. These constraints ensure the reliability/feasibility of the
implied dispatch. Here we assume C  C, that is, JETRA-NL is a restriction of the AC
problem. In general, a full AC model would include a doubling of the size of y to
include reactive power. More generally, we could define gþ m 2 Gþ m ; g m 2 G m
could define additional constraints on generators and load such as ramp rate
constraints or total energy limits over a series of hours (e.g., hydro energy
constraints).
Several further generalizations are worth mentioning. First, the model could
allow “all or nothing” or binary bids for rights. This can be accomplished by adding
integer variables and replacing the upper bound constraints such as the following
for gm: If transmission switching was considered, it would also affect K00 (due to
KVL); this complication is not considered in this chapter.

gm  G m z m  0

where zm are 0/1 variables. Lower bounds could be similarly specified as follows:

gm  G m z m  0

where the underlining denotes a lower bound.

Furthermore, the introduction of integer variables allows for unit commitment
(i.e., dynamic optimization) of generation (e.g., Hobbs et al. 2001) and transmission
switching (FERC 2005; O’Neill et al. 2005a), as well as for consideration by
longer-term auction markets of entry by technologies with investment costs, as is
characteristic of generation and transmission projects. Elsewhere, we have shown
that efficient market-clearing prices in auction markets with non-convexities in
technology and production exist using a two-part pricing scheme in which the
integral activity (e.g., start-up) is offered a specific (“non-anonymous” or discrimi-
natory) price while the associated commodity (e.g., energy) is cleared through
a single or uniform market clearing (“anonymous” or non-discriminatory) price
110 R.P. O’Neill et al.

(Elmaghraby et al. 2004; O’Neill et al. 2005b). Most ISOs have adopted such a
two-part pricing regime (often called a revenue sufficiency or bid-cost recovery
guarantee) for generator offers accepted in the day-ahead market and real-time
market. The omission of these binary variables yields suboptimal solutions with
lower market surplus and possibly an infeasible dispatch, but their inclusion
threatens revenue adequacy and may induce changes in the settlement rules.
Finally, to this point, we have assumed that the ISO is defining and selling
transmission rights. An initial allocation of rights can be done through an auction or
by other methods. For example, in most U.S. ISO markets, the ISO first allocates
transmission rights or the rights to a portion of transmission auction revenues. Next,
the ISO conducts the transmission auction as if it owns the transmission rights under
its control, but then returns auction revenues to transmission holders. In this
approach, the capacity held by the ISO, Fþ and F, is the unallocated capacity. If
Fþ ¼ F ¼ 0, the ISO offers no transmission rights and trading takes place among
the rights holders.

4.3.2 Specifying the Bids for Energy and Transmission Rights

Because in some cases our notification diverges from familiar notation from prior
transmission rights models (e.g., Chao and Peck 1996; Harvey et al. 1997), this
section elaborates on the product definitions and characteristics introduced in
Sect. 4.2, reviewing the mathematical formulation of the products as required by
the auction model.
Energy. An simple energy bid (real or financial) to sell is defined by scalars,
Gþ m and cþ m , and the vector aþ m ; cþ m (usually cþ m < 0) is the cost (e.g., in $ per
MWh) for a step m, and Gþ m (e.g., in MWh) is the maximum quantity for sale in
step m ðgþ m  Gþ m Þ. Adding the locational aspect, aþ m is a vector of 0 s and a
single aþ im ¼ 1 defining the injection node i. Symmetrically, an energy bid (real or
financial) to buy is defined by scalars, G m, and c m, and the vector a m; c m specify
the bid value (e.g., in $ per MWh) for step m up to G m, the maximum quantity for
the step ðg m  G m Þ. Adding the locational aspect, a m is a vector of 0 s and a
single a im ¼ 1 defining the withdrawal node i. For example, to define a simple
bid to sell one unit of energy at node 6 in a network, aþ 6m ¼ 1 and aþ im ¼ 0 for
i 6¼ 6. If a 6m ¼ 1, then it would be a bid to buy one unit of energy at node 6.
An individual bid can be part of a step-wise function with each step a separate value
of the index m.
Simple Transmission Capacity Rights and Portfolio Combinations. A bid for
a transmission right of either the flowgate (F) or the point-to-point (P) type is
defined by b and T. What differentiates the bids for F and P rights is that flowgate
rights are directly associated with a transmission element and/or combination of
transmission elements while point-to-point rights are associated with injections and
withdrawals independent of the topology.
4 A Joint Energy and Transmission Rights Auction on a Network with Nonlinear. . . 111

To sell the simple rent payment transmission right, bF k < 0 is the lowest amount
a bidder is willing to accept to sell up to T F k units. A bid, k 2 F, for this right on
transmission element j in the positive direction is defined by inserting Bþ hk ¼ 1
in the flow constraint (4.4) for h ¼ j and 0 for h 6¼ j. Similarly, a bid on transmis-
sion element j in the negative direction is defined by B hk ¼ 1 in flow constraint
(4.5) for h ¼ j and 0 for h 6¼ j.
To buy the simple rent collection transmission right, bF k > 0 is interpreted as the
highest amount a bidder is willing to pay to buy up to T F k units. A bid, k 2 F, for this
right on transmission element j in the positive direction is defined as Bþ hk ¼ 1 for
h ¼ j in (4.4) and 0 for h 6¼ j. Similarly, a bid on transmission element j in the
negative direction is defined by B hk ¼ 1 in (4.5) for h ¼ j and 0 for h 6¼ j.
Those parameters (extending notation introduced by Chao and Peck 1996)
indicate how much capacity on transmission element h is taken up by a unit of
this type of right. In fact, a portfolio of flowgates k is defined by, Bþ hk , B hk , BN hk ,
the proportions of each flowgate in the portfolio.
Point-to-Point Transmission Rights. As noted, the point-to-point transmission
bids, l2P, are defined over one or more POIs and one or more POWs at the nI nodes
in the system (more than one POI or POW defines a so-called network right). In the
auction, the bidder would further have to specify whether the right is desired as an
option or obligation; if options are allowed, this would result in different and more
complicated computations (Hogan 2002). For the buyer of the P right, bP l (usually
bP l > 0) represents the highest amount bidder l is willing to pay to buy up to T P l
units. For sellers of the rights, bP l (usually bP l < 0) is the lowest amount a bidder l is
willing to accept to sell up to T P l units. AP l is a vector of net injection coefficients
defining the net injection at each node i in each l 2 P, with elements aP il. For a POI
(conversely, POW), aP il > 0 (conversely, aP il < 0). Hence, for balanced rights in a
P
lossless transmission system, i aP il ¼ 0.
The portfolio of flowgate rights can be constructed that provides the same
payoffs as a specified set of point-to-point rights if the topology is known and
unchanging. However, if the network topology changes, then, in general, the flow
patterns associated with a given point-to-point right will change. Generally, the
point-to-point rights are independent of the topology, but flowgate rights depend
specifically on the topology.

4.4 Forward and Dispatch Markets: Financial Settlement

and Revenue Adequacy

ISO auction markets operate in a sequence of forward and real-time market

auctions, with products such as transmission rights and generation capacity being
traded pre-day-ahead, while energy and bid-based ancillary services are typically
traded day-ahead and in real-time. As noted above, the exact timing and content of
these product auctions are a matter of market design based on the history and
112 R.P. O’Neill et al.

characteristics of specific ISO markets. This section provides the general mathe-
matical procedure for financial settlement and its link to revenue adequacy, focused
on the two types of transmission rights and energy. A few brief simple examples are
also given.
There are alternative sets of market rules that could be used for selling all or part
of a set of transmission rights and/or forward energy commitments. Here, our
formulation mathematically liquidates all rights in each auction. Carrying the rights
to the next stage could be accomplished by bidding an equal specification to the
current rights with a corresponding large bid value (although this rule could conflict
with market power mitigation rules) or submitting a fixed bid, that is, a bid with an
upper and lower bound equal to current holdings. Holdings are liquidated by simply
not submitting a bid. By convention, in ISO markets, point-to-point transmission
rights are formally settled in the day-ahead market, while financial energy trades
through the ISO auctions can be transacted day-ahead but cashed out at the real-
time physical dispatch prices. We do not require any financial bid to be cashed out
until the real-time market. Energy sales and purchases are settled financially in each
forward market.
The notation, s, is introduced to designate the sequence of energy and transmis-
sion auctions, where s ¼ S, S  1, . . ., 1, 0, and the sth auction is defined as
JETRAs. JETRA0 is the final, real-time dispatch auction. The optimal values for
energy and transmission rights resulting from the sth auction are designated tFs, tPs,
gþs and gs . The optimal dual values will be similarly superscripted.

4.4.1 Multi-settlement System

Table 4.2 summarizes the multi-settlement system for the auction model using a
uniform clearing price rule. The table shows the market design in which transmis-
sion rights contracts and nodal revenue rights contracts are settled finally in the
real-time dispatch market (s ¼ 0). In essence, for each auction s2S, the ISO settles
the rights contracts acquired in auction s þ 1.
Row one of Table 4.2 shows that in each auction, s, transmission and energy
rights contracts from auction s þ 1 are settled (or liquidated) at the auction price
times their contract holdings from the s þ 1 auction (note again that incrementing
by 1 is moving the auction backwards in time). Row two shows the contracts
established in auction s will pay or are paid the auction price times the quantity
of transmission rights and forward energy contracts that clear the market.
The real-time dispatch market, s ¼ 0, settlements shown in rows three and four
follow the same logic as the forward markets with respect to holders of transmission
rights or forward energy contracts, who are paid the auction price times their
holdings from the prior auction iteration, s ¼ 1. Only physical injections and
withdrawals are traded in auction 0, but the forward rights from s ¼ 1 are settled.
Table 4.2 Calculation of settlement payments in auction s for rights allocated in auctions s þ 1 and s using uniform clearing price rule
Point-to-point rights
Flowgate rights (F) (P) Energy supply and demand (g)
       
JETRAs (s  1) (forward market): Payment mN;s BN;sþ1 tF;sþ1 (interaction constraints) ps AP;sþ1 tP;sþ1 ps Aþ;sþ1 gþ;sþ1 ; ps A;sþ1 g;sþ1

to holders of contracts from previous auction mþs Bþ;sþ1 tF;sþ1 (flowgates in + direction)
sþ1 s ;sþ1 F;sþ1
m B t (flowgates in  direction)
       
JETRAs (s  1) (forward market): Payment mN;s BN;s tF;s (interaction constraints) ps AP;s tP;s ps Aþ;s gþ;s ; ps A;s g;s
 
by purchasers of contracts in auction s mþ;s Bþ;s tF;s (flowgates in + direction)
 
ms B;s tF;s (flowgates in  direction)
       
JETRA0 (real-time market): Payment to holders of mN;0 BN;1 tF;1 (interaction constraints) p0 AP;1 tP;1 p0 Aþ;1 gþ;1 ; p0 A;1 g1
 
contracts from previous auction 1 mþ0 Bþ;1 tF;0 (flowgates in + direction)
 
m0 B;1 tF;1 (flowgates in  direction)
      
JETRA0 (real-time market): Payment by mN;0 BN;0 tF;0 (interaction constraints) p0 AP;0 tP;0 p0 Aþ;0 gþ;0 ; p0 A;0 g;0
 
purchasers of physical energy in auction 0 mþ0 Bþ;0 tF;0 (flowgates in + direction)
 
m0 B;0 tF;0 (flowgates in  direction)
4 A Joint Energy and Transmission Rights Auction on a Network with Nonlinear. . .
113
114 R.P. O’Neill et al.

The implicit congestion charge associated with any pair of injections and
withdrawals at different nodes is the difference in the auction LMPs at those two
nodes. For instance, using our notation, if two awards for bids m and m0 result in
g m ¼ g m0 , where g m is an injection at node 1 (a1m ¼ 1) and g m0 is a withdrawal at
node 2 (a2m ¼ 1), then the total congestion charge associated with these two
transactions is p 2 g m  p 1 g m0 ¼ ðp 2  p 1 Þg m .
A property of this settlement system that follows from convexity of the JETRA
model and the optimality of its solution is that the prices in auction s are such that
there remain no arbitrage opportunities among the rights awarded in that auction.
As an example, a pair of energy rights, one involving injection of 1 MW at one node
i and the other involving withdrawal at another node i0 would result in exactly the
same settlement as an equivalent point-to-point right from i0 to i, so that no
profitable arbitrage can be undertaken between those two types of rights. In a
sense, the numerical process of finding an optimal solution can be viewed as
consisting of searching for and taking advantage of all profitable arbitrage among
the bids; if there remained profitable arbitrage opportunities at as solution, then the
solution by definition could not be optimal.
Pre-day-ahead forward energy transactions, or nodal revenue rights, are not yet
offered in ISO auctions. Hence their financial settlement deserves some further
explanation. Settlement would take place, as with other transmission rights, in the
day-ahead market (or in the real-time market if there is no day-ahead market). The
holder of the injection right gets paid the nodal price for the energy it produces but
is obligated to pay the nodal price to the ISO for energy represented in its nodal
energy right, while the holder of the withdrawal right is obligated to pay the nodal
price for the energy it actually consumes but is paid the nodal price for the energy
quantity specified in its forward right. As with the two-sided, point-to-point right,
executing the physical transaction specified in the right results in a net zero financial
position in settlement. There are practical issues to implementing such a forward
energy auction, most notably creditworthiness.

4.4.2 Revenue Adequacy of the Auction Sequence

Revenue adequacy could pertain to each pair of auctions in the sequence. Also,
revenue adequacy could pertain to the entire sequence. If all pairs are revenue
adequate, the full sequence is revenue adequate. A set of sufficient conditions for
revenue adequacy is that the constraint sets are convex and the constraint set does
not contract over the auction sequence. The proof is in the appendix. Even if the
constraint set is not convex, if it is not contracting (i.e., if all feasible solutions in
previous iterations remain feasible in subsequent iterations), then even if the prices
do not result in revenue adequacy, each and every market participant can in theory
be made better off by re-allocating the surplus. This is because the objective
function (total surplus) can only improve if the feasible region is non-contracting.
4 A Joint Energy and Transmission Rights Auction on a Network with Nonlinear. . . 115

This re-allocation may require a deviation from the uniform clearing price
settlement, for example using two-part tariffs or fixed monetary transfers.
Beginning with each auction clearing, a requirement for revenue adequacy is
that the auction result respects the set of transmission constraints. For point-to-point
rights, this is commonly known as “simultaneous feasibility,” meaning that the
power flow induced by the injections and withdrawals associated with the rights
awarded is feasible (Harvey et al. 1997). Here “simultaneous feasibility” applies to
all rights in each auction.
Turning next to the conditions on the auction sequence, we have assumed
heretofore that each auction in the sequence, JETRAs, is conducted with the same
set of transmission constraints. However, an important feature of actual electricity
markets is that in the forward markets for transmission rights, the transmission
constraints modeled may be either more or less restrictive than the set operative in
the real-time market.
The further ahead a forward market is of the physical dispatch auction s ¼ 0, the
greater the uncertainty about the network topology that will apply in the dispatch.
This could justify a conservative transmission constraint set in the further forward
auctions. For forward auctions closer in time to the dispatch, some uncertainty will
be resolved and this will justify increased offerings by relaxing the constraints. For
example, equipment may need to be derated if it is extremely hot, but temperature is
not known until a time closer to the dispatch. The uncertainty can be captured in
auction models through either multi-state or chance-constrained models, but these
models are large and harder to solve and may require different settlement rules.
In general, the recursion of the auction markets is revenue adequate as long as
the transmission capacity constraints form a nested, expanding sequence, a restric-
tion which is stated more formally in the proof in the appendix. If K00 is linear and K0
is convex, the constraint set is convex. For s0 > s, if the constraint set defines a
0 0
feasible region that is convex and non-contracting, that is, Fþ;s  Fþ;s ; F;s 
F;s and FN;s  FN;s , then the auction sequence is revenue adequate. Non-
contracting means that in each auction in the sequence, the transmission constraint
set must be no more restrictive than the prior auction. This is an obvious require-
ment to prevent overselling of flowgate transmission rights.
A expanding constraint set can be thought of as the ISO holding back some of
the rights until it is reasonably sure they will be available. Therefore, it is not
unusual for the auction sequence to start with a conservative estimate of the
availability of the network topology. Some ISOs have adopted simple rules to
accommodate this requirement; for example, the California ISO sells forward
transmission rights to only a small percentage of its transmission capacity
(Bautista-Alderete 2010). Long-term point-to-point transmission rights are usu-
ally made available on conservative basis to account for the long-term uncer-
tainty. Operational experience will be required to determine what quantity of
alternative types of transmission rights can be made available in each forward
market (annual, monthly, weekly, etc.).
116 R.P. O’Neill et al.

As noted above, if the auction sequence is not revenue adequate in actual market
operations, for example due to unplanned transmission outages affecting day-ahead
and real-time market settlements, then each ISO has rules for how revenue
shortfalls to rights holders are allocated.

4.5 Auction Example with Quadratic Losses

This section presents a numerical example of the auction model in a simplified

network based upon a linearized dc load flow with quadratic losses (e.g., Hobbs
et al. 2008; Schweppe et al. 1988). The only transmission elements considered are
lines. Constraint (4.3) is omitted and (4.6) is modified to represent the dc analogues
to Kirchhoff’s Current and Voltage Laws:

Current Law: y þ Dð f þ  f  Þ þ f T L f  þ f þT Lþ f þ  0 (4.11)

Voltage Law: Rð f þ  f  Þ ¼ 0; (4.12)

where the new notation is as follows:

D is a matrix that maps flow variables to the associated current law (enerrgy
balance) constraints. The rows of the vector correspond to buses, and the columns
correspond to lines of the network.
Lþ, L are tensors of rank 3, where the only nonzero elements in Lþ (L) are
lþ ikk ðl ikk Þ, representing the resistance loss coefficients (decrease in imports to bus i)
due to a positive (negative) flow through transmission line k.
R ¼ {rvk} are line reactances used in the voltage law analogues. Each element is
the value of reactance for transmission line k that appears in voltage loop v.
rvk ¼ þRk or Rk if line k occurs in loop v, depending on whether a positive flow
( f þ  f ) is in the same or opposite sense of flow around v. On the other hand,
rvk ¼ 0 if link k does not occur in loop v. Consistent with the dc model, the number
of independent loops v must be equal to K  N þ 1, where K is the number of lines
considered and N is the number of buses.
Note that (4.11) is a relaxation of the Kirchoff’s Current Law (energy balance)
equality constraint that results in a convex feasible region (Chao and Peck 1998).
An example is given below to illustrate (4.11) and (4.12).
An important property, noted in Harvey and Hogan (2002), is that if likk > 0, for
some k, then in general no set of balanced P (point-to-point) rights will be feasible
(revenue adequate) by themselves (except in the degenerate case of tP ¼ 0). This is
because of losses. Revenue adequacy is thus possible only if sufficient energy rights
are also sold (in particular, “rights” that oblige the rights holder to make payments
to the ISO; i.e., rights g whose coefficients in Ag are positive). A combination of
such energy and balanced point-to-point rights g and TF can also be viewed as a set
of imbalanced point-to-point rights.
4 A Joint Energy and Transmission Rights Auction on a Network with Nonlinear. . . 117

Fig. 4.1 Network for three

bus JETRA-NL example

The numerical example takes place on the three node network in Fig. 4.1, in
which the arrows show the direction of flow on lines k ¼ 1, 2, 3 for injections at
buses A and C (with a larger one at A) and a withdrawal at bus B. These directions
also coincide with the positive directions of flows associated with those lines. All
loss factors on all lines equal 0.0001 [MW/MW2], and all lines have a physical flow
limit of 600 MW (only the limit for k ¼ 1 is shown because that is the only one that
binds in the solutions below). All line reactances, Rk ¼ 1. Then for this network,
(4.11) and (4.12) become:
 
KCLA : yA þ ð f þ 1  f  1 Þ þ ð f þ 3  f  3 Þ þ 0:0001 ð f  1 Þ2 þ ð f  3 Þ2  0

 
KCLB : yB  ð f þ 1  f  1 Þ  ð f þ 2  f  2 Þ þ 0:0001 ð f þ 1 Þ þ ð f þ 2 Þ  0
2 2

 
KCLC : yC þ ð f þ 2  f  2 Þ  ð f þ 3  f  3 Þ þ 0:0001 ð f  2 Þ2 þ ð f þ 3 Þ  0
2

KVL : ð f þ 1  f  1 Þ  ð f þ 2  f  2 Þ  ð f þ 3  f  3 Þ ¼ 0

Notice that if the only existing transmission or energy right is, say, a balanced tP
involving an injection of 1,000 MW at A (yA ¼ þ1,000) and a withdrawal of
1,000 MW at B (yB ¼ 1,000), this would be infeasible. There are two reasons
for this. First, such an injection-withdrawal pair would induce more than 600 MW
of flow on line k ¼ 1 (in the lossless case, 667 MW
would flow). Second, because 
of line losses, there is no set of nonnegative flows f þ 1; f  1 ; f þ 2 ; f  2 ; f þ 3 ; f  3
that would simultaneously satisfy all four of the above constraints. Thus, there
would either need to be some additional energy injected to make up for the loss, or
the point-to-point right would need to be imbalanced, with more injected at A than
withdrawn at B. The infeasibility of this right implies that the ISO might be revenue
deficient if it settled that right at nodal prices from an optimal dispatches subject to
the above constraints; this is indeed the case, as we see below
118 R.P. O’Neill et al.

We illustrate a sequence of JETRA-NL with this network. In auction s ¼ 1, due

to ISO caution, only 550 MW of rights are released on each line k rather than the
full 600 MW. As mentioned, this is the current policy of certain ISOs in order to
lessen the likelihood of revenue inadequacy. We assume that in this auction there
are the following bidders for transmission and energy rights:
• Bidder 1 is willing to pay up to $60 per MWh per hour for up to 700 MW of
point-to-point obligation transmission rights from node i ¼ A to i ¼ B;
• Bidder 2 is willing to pay up to $30 per MWh per hour for up to 300 MW of
point-to-point rights from C to B;
• Bidder 3 bids is willing to pay up to $80 per MW per hour for up to 100 MW of
flowgate rights on line k ¼ 1 in the direction from bus A to bus B; and
• Bidder 4 offers to sell up to 100 MW of forward energy rights at node B at a price
of $90/MWh.
The resulting formulation of JETRA-NL is as follows:

JETRA  NL; s ¼ 1 : max 60t P 1 þ 30t P 2 þ 80 tF 3  90g4

t P 1  yA ¼ 0

 t P 1  t P 2 þ g4  y B ¼ 0

t P 2  yC ¼ 0

t F 3 þ ð f þ 1  f  1 Þ  550

 ð f þ 1  f  1 Þ  550

ð f þ 2  f  2 Þ  550

 ð f þ 2  f  2 Þ  550

ð f þ 3  f  3 Þ  550

 ð f þ 3  f  3 Þ  550
 
 yA þ ð f þ 1  f  1 Þ þ ð f þ 3  f  3 Þ þ 0:0001 ð f  1 Þ2 þ ð f  3 Þ2  0

 
 yB  ð f þ 1  f  1 Þ  ð f þ 2  f  2 Þ þ 0:0001 ð f þ 1 Þ þ ð f þ 2 Þ  0
2 2

 
 yC þ ð f þ 2  f  2 Þ  ð f þ 3  f  3 Þ þ 0:0001 ð f  2 Þ2 þ ð f þ 3 Þ  0
2
4 A Joint Energy and Transmission Rights Auction on a Network with Nonlinear. . . 119

Fig. 4.2 Awarded financial transmission and energy rights and LMPs for dispatch round s ¼ 1 of
the JETRA-NL example

ð f þ1  f 1Þ  ð f þ2  f 2Þ  ð f þ3  f 3Þ ¼ 0

t P 1  700

t P 2  300

t F 3  100

g4  100

t P 1 ; t P 2 ; t F 3 ; g4  0

The ISO runs JETRA-NL for this auction, and makes the following awards of
rights:
• 677.6 MW of point-to-point rights to Bidder 1, who pays the ISO $40,655 for
these rights (equal to the nodal price difference between A and C times the
awarded
• 0 MW of point-to-point rights to Bidder 2
• 100 MW of flowgate rights to Bidder 3, who pays $7856 for those rights
(flowgate 1’s shadow price times the award)
• 30.4 MW of energy rights from Bidder 4, who the ISO pays $2,734 (B’s nodal
price times the energy right sold)
Figure 4.2 shows this solution to the auction, along with the nodal and flowgate
prices. The ISO’s net receipts from the auction are $45,776, which is less than the
120 R.P. O’Neill et al.

$45,922 objective function for the auction model.17 This discrepancy arises because
Bidder 3’s upper bound is binding, meaning that she pays less for the rights than
they are worth to her.
We now move to the next (and final) JETRA-NL iteration, s ¼ 0, which is the
physical dispatch. We assume that there are two power plants, neither with capacity
limits. The plant at A offers to sell energy at $20/MWh (variable gA), while C’s
plant offers at $50/MWh (variable gC). There is a 1,000 MW load at B (variable gB).
The ISO makes available the full 600 MW of flow capacity in each line for this
iteration. The resulting JETRA-NL is:

JETRA-NL; s ¼ 0 : max  20gA  50gC

gA  y A ¼ 0

 gB  y B ¼ 0

gC  y C ¼ 0

ð f þ 1  f  1 Þ  600

 ð f þ 1  f  1 Þ  600

ð f þ 2  f  2 Þ  600

 ð f þ 2  f  2 Þ  600

ð f þ 3  f  3 Þ  600

 ð f þ 3  f  3 Þ  600
 
 yA þ ð f þ 1  f  1 Þ þ ð f þ 3  f  3 Þ þ 0:0001 ð f  1 Þ2 þ ð f  3 Þ2  0

 
 yB  ð f þ 1  f  1 Þ  ð f þ 2  f  2 Þ þ 0:0001 ð f þ 1 Þ þ ð f þ 2 Þ  0
2 2

 
 yC þ ð f þ 2  f  2 Þ  ð f þ 3  f  3 Þ þ 0:0001 ð f  2 Þ2 þ ð f þ 3 Þ  0
2

ð f þ1  f 1Þ  ð f þ2  f 2Þ  ð f þ3  f 3Þ ¼ 0

17
Round off errors result in slight discrepancies in results. For instance, $45,922 is the exact
objective function value resulting from the exact decision variable values, while the values of the
decision variables presented here, which are rounded off, yield $45,920 instead.
4 A Joint Energy and Transmission Rights Auction on a Network with Nonlinear. . . 121

Fig. 4.3 Nodal injections and withdrawals and LMPs for dispatch round s ¼ 0 of the JETRA-NL
example

gB ¼ 1000

gA ; gC  0

The resulting dispatch is shown in Fig. 4.3, along with the nodal prices. The ISO
pays a total of $30,652 to the two generators for their energy, while receiving
$86,470 from the load at B. The resulting total surplus gained by the ISO is $55,818.
If congestion portion of this surplus is calculated as the sum of the flowgate shadow
prices times the flows, the congestion surplus is $50,797, while the loss surplus is
the remaining $5020. The loss surplus arises because of the quadratic nature of
losses, which means that marginal losses are roughly double the average loss.
Consumers pay for marginal losses. In this example, the ISO essentially gets to
keep the difference between marginal and average losses. In practice, the U.S. ISOs
are required to refund excess revenues to market participants.
From its surplus, the ISO must pay the holders of financial transmission and
energy rights awarded in the earlier JETRA-NL s ¼ 1. The following awards are
made to financial rights holders:
• Bidder 1, who holds 677.6 MW of point-to-point rights from A to B that were
awarded in s ¼ 1, is paid the nodal price difference ($86.5–$20) times those
rights, or $45,039.
• Bidder 2 owns no rights, and so receives no payment
• Bidder 3 is paid 100 MW times the flowgate shadow price for k ¼ 1, or $8466.
• Bidder 4 has to pay the ISO $2,627 for its 30.4 MW of energy injection rights at
node B.
122 R.P. O’Neill et al.

The net payments to financial rights holders by the ISO is $50,879. Note that
each bidder happens to make money on their financial rights. Bidders 1 and 3 get
paid more in s ¼ 0 for their transmission rights than they paid in s ¼ 1, while
Bidder 4 pays less to settle her energy right in s ¼ 0 than she got paid in s ¼ 1.
Note that since Bidder 4 has no physical asset, her energy right is what is known in
U.S. markets as a virtual energy right, in which energy is bought in one market, and
then the same amount is sold back in the next, arbitraging the difference in prices.
Bidder 4 is what is known as a virtual supplier, since she supplied power in the first
auction s ¼ 1. Because the energy price in s ¼ 1 was greater than s ¼ 0, she makes
money on that energy transaction.
The fact that the financial rights holders made money on their rights has no
implications for revenue neutrality of auction s ¼ 0. In fact, the ISO’s surplus in the
final dispatch round s ¼ 0 of JETRA-NL ($55,818) exceeds its net payments to
owners of financial rights awarded in s ¼ 1 ($50,879, as just noted)., This is
necessarily the case because the dispatch model is convex (the feasible region
defined by the load flow constraints (4.11 and 4.12) plus capacity constraints is
convex, while the objective function is linear), and the transmission flows that
would induced by the financial rights awarded in s ¼ 1 are feasible in the dispatch
model. In particular, note that the s ¼ 1 flows in Fig. 4.2 are feasible if the
transmission limits were the 600 MW values assumed in the s ¼ 0 dispatch
optimization.
As an example of financial rights that would not be revenue adequate, return
again to the simple example mentioned before in which the only transmission or
energy rights held after s ¼ 1 are 1,000 MW of point-to-point rights from A to B.
This set of rights would violate the load flow and capacity constraints of the
network in Fig. 4.1. The settlement in that case, based on s ¼ 0’s nodal prices,
would be ($86.5  $20)  1,000 MW, or $66,500; this would exceed the ISO’s
surplus of $55,818 in s ¼ 0, violating revenue adequacy.

4.6 Conclusion

The nonlinear auction model presented here provides a general framework for
representing and implementing a more complete version of combined energy and
transmission rights auctions that have been proposed and discussed in the United
States. With all types of energy and transmission capacity bids allowed, the auction
framework can be extended to most types of forward hedging. Frequent auctions
increase liquidity by providing additional opportunities to trade while considering
the network constraints that bilateral markets have difficulty factoring in. In
addition, this framework could facilitate the efficient operation of off-ISO forward
bilateral markets, which should benefit from more liquid transmission rights, such
as the rights on commonly congested flowgates or possibly hub-to-hub rights. The
proof of revenue adequacy that we previously provided for the auction with linear
constraints (O’Neill et al. 2002) has been extended to the auction with convex
4 A Joint Energy and Transmission Rights Auction on a Network with Nonlinear. . . 123

constraints. However, the introduction of non-convex constraints invalidates

the proof of revenue adequacy, assuming that a uniform pricing rule is used to
determine the prices of rights and to settle them.
The practical obstacles to implementation of the model are computational
requirements, implementation costs and transactions costs. For these reasons,
while there is now broad consensus on many elements of market design, such as
locational marginal prices for energy and financial transmission rights, market
design proposals have allowed for phased implementation of different types of
transmission rights and different auction products to allow for development of
software and resolution of cost allocation issues.
The nonlinear auction model provides an analytic framework for exploration
of additional market design features. For example, more frequent auctions add
liquidity to the market. Future research to be conducted by the authors within this
framework includes the modeling and pricing of locational reserves, pricing of
reactive power (e.g., FERC 2005), property right awards for transmission
expansion, pricing under optimal topologies, and unit commitment of transmission
elements (e.g., O’Neill et al. 2005a).

Acknowledgments The authors would like to thank R. Baldick, H.-P. Chao, R. Entriken,
W. Hogan, D. Mead, and S. Oren for helpful comments on this and previous descriptions of the
JETRA proposal, as well as editors of this volume and anonymous reviewers of a previous version.

Appendix: Proof of Revenue Adequacy for the Auction Sequence

This appendix provides a set of sufficient conditions and a proof of revenue

adequacy of the auction sequence. This proof extends the revenue adequacy proofs
for transmission in Harvey et al. (1997) and O’Neill et al. (2002), both of which
considered the case of linear transmission constraints, to an auction with both
flowgate or flow-based and point-to-point rights together with nonlinear transmis-
sion constraints that define a convex feasible region. To simplify the presentation,
the auction model is mapped into a more compact and general non-linear program
(NLP) representing an auction in the following way:
As before, the rights bid for and awarded in the s-th auction in a sequence of
auctions determine the distribution of revenues from the subsequent auction, s  1.
Meanwhile, the prices obtained in the s-th auction determine how the rights
awarded in the previous auction s þ 1 are financially settled, as well as how
much winning bidders in auction s pay for the rights they win.
Define gs as the vector of quantities awarded to P- and G-type bids
(encompassing tP, gþ and g in the JETRA-NL model) with upper bound Gs in
the s-th auction in the sequence. Define a general benefit function c(gs) (based on
the bids by those seeking rights) for the bid award level, gs. The vector ys represents
net injections in the s-th auction associated with rights gs. Ks(y) represents the flows
induced by ys as a result of the applicable load flow equations. Define ts as the vector
124 R.P. O’Neill et al.

of F transmission rights (tF in the JETRA-NL model) with upper bound Ts in the
s-th auction. Fs is the vector of bounds in auction s for transmission elements and
network flow constraints. Define p as the vector of dual values for the nodal energy
balance constraint, which can be interpreted as the shadow or clearing prices for
energy. Finally, define m as the vector of dual values associated with transmission
constraints, which can be interpreted as the shadow prices for transmission rights.
Using the resulting model NLP, the sth auction in the auction sequence s þ 1, s,
s  1, . . ., 0, termed NLPs, is:

NLPs : max bs t þ cs ðgÞ

Agy ¼ 0 ðpÞ

Bs t þ K s ðyÞ  Fs ðmÞ

t  Ts ðy Þ

g  Gs ðrÞ

Note that all constraint and objective function parameters can depend on s.
The optimal solution to NLPs is defined as {ys, ts, gs} and the corresponding
optimal dual variables are {ps, ms, y s, rs}. To demonstrate revenue adequacy of the
auction sequence, prices and payments must be defined for the bids for g and t that
are accepted. Duals ps are the market prices for gs, and ms are the market prices for
Fs, and are treated as row vectors in the below. The rights held as a result of the
s þ 1st auction in the sequence are gs þ 1 and ts þ 1. Financial settlements
(payments by the auctioneer) in NLPs for rights to its revenues, analogous to
those defined above for the full auction model, are psAgs þ 1 and msBs þ 1t s þ 1 for
the two types of rights awarded in the previous auction NLPs þ 1, where the
superscript T is the transpose operator Meanwhile, the winning bidders for the
two types of rights awarded by NLPs pay ps TAgs and msTBsts, respectively.
The following theorem concerns the revenue adequacy of this sequence of
auctions, and is a generalization of our earlier results for the linear JETRA
(O’Neill et al. 2002):
Theorem 1 If Bs(g) is concave, Ks(y) is convex, Ks(y)  Ksþ1(y) for all y, and
Fsþ1  Fs, then each auction in the sequence of auctions {S  1, . . ., s, . . ., 1, 0},
is revenue adequate; that is:

psT ðAs gs  Asþ1 gsþ1 Þ þ msT ðBs ts  Bsþ1 tsþ1 Þ  0:

Proof By convexity of Ks,

K s ðysþ1 Þ  K s ðys Þ þ rK s ðys Þðysþ1  ys Þ:

4 A Joint Energy and Transmission Rights Auction on a Network with Nonlinear. . . 125

Rearranging, we obtain,

rK s ðys Þys  rK s ðys Þysþ1 þ K s ðys Þ  K s ðysþ1 Þ:

Premultiplying by the row vector of transmission capacity shadow prices

ms  0,

ms rK s ðys Þys  ms rK s ðys Þysþ1 þ ms K s ðys Þ  ms K s ðysþ1 Þ (4.13)

From the KKTs to NLPs,

ms ðBs ts þ K s ðys ÞÞ ¼ ms Fs (4.14)

Since Ks(y)  Ksþ1(y) and Fs  Fs þ 1 and because (Bsþ1tsþ1, ysþ1) is a feasible

solution to NLPsþ1,

Bsþ1 tsþ1 þ K s ðysþ1 Þ  Fs (4.15)

Multiplying both sides by ms  0,

ms ðBsþ1 tsþ1 þ K s ðysþ1 ÞÞ  ms Fs (4.16)

Combining (4.14) and (4.16) and multiplying both sides by 1 (which requires
reversing the inequality),

 ms ðBsþ1 tsþ1 þ K s ðysþ1 ÞÞ   ms ðBs ts þ K s ðys ÞÞ (4.17)

Adding (4.13) and (4.17), eliminating terms that cancel, and finally rearranging,

ms rK s ðys Þys  ms ðBsþ1 tsþ1 Þ  ms rK s ðys Þysþ1  ms ðBs ts Þ

Substituting ps ¼ msrKs(ys) from the KKT condition for ys for problem NLPs
and rearranging,

ps ðys  ysþ1 Þ þ ms ðBs ts  Bsþ1 tsþ1 Þ  0

Finally, in NLPs, Asgs ¼ ys while in NLPsþ1, Asþ1gsþ1 ¼ ysþ1; substitution of

these constraints establishes the desired result:

ps ðAs gs  Asþ1 gsþ1 Þ þ ms ðBs ts  Bsþ1 tsþ1 Þ  0:

Note that this result does not explicitly depend on the form of the objective
function NLPs. The objective can be linear or nonlinear, as long as it is concave so
that the KKT conditions describe an optimal solution, then the use of the KKT
conditions in the above proof remains valid.
126 R.P. O’Neill et al.

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Chapter 5
Generator Ownership of Financial Transmission
Rights and Market Power

Manho Joung, Ross Baldick, and Tarjei Kristiansen

5.1 Introduction

Game theory is well suited to analyze a situation with strategic interdependence of

multiple decision makers. Electricity markets include both physical and operational
attributes. Likewise, electricity markets are characterized by a relatively small number
of large market players, limited competitiveness and strategic behavior. Cournot
models compete in quantities while Bertrand models compete in prices. Supply
function equilibrium function models assume market players compete both in quantity
and price. These are realistic assumptions for electricity markets where market players
submit a price-quantity schedule. However these models are complex to solve and may
not incorporate all technical attributes of electricity markets. Cournot models are
easily solvable and yield under reasonable conditions a unique Nash equilibrium.
They are also more suitable for short term analysis.
Competition is introduced in most electricity markets around the world. Markets
are also increasingly coupled with interconnectors and thus may exhibit stronger price
convergence. To supply more power to a region a decision maker has three choices:
build power plant assets, reduce local consumption or build transmission assets.
Transmission assets may bring increased competitive benefits to a market. The main
objective of transmission rights is to hedge against locational price differences. But an
FTR is also a transmission property right. Such a right brings the benefits associated

M. Joung
Zigi Solutions, LLC. 9085 Judicial Dr. #2127, San Diego, CA 92122, USA
e-mail: [email protected]
R. Baldick (*)
Department of ECE, The University of Texas at Austin, Austin, TX 78712, USA
e-mail: [email protected]
T. Kristiansen
Åsegårdsvegen 65, N-6017, Ålesund
e-mail: [email protected]

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 129

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9_5,
# Springer-Verlag London 2013
130 M. Joung et al.

with transmission capacity and facilitates efficient use of scarce resources. Property
rights are also a mechanism to reward transmission investments.
Among researchers (Joskow and Tirole 2000; Léautier 2000; Gilbert et al. 2004)
there is consensus about the need to mitigate market power for any FTR auction to be
efficient. Joskow and Tirole (2000) study a radial line network under different market
structures for both generation and FTRs. They demonstrate that FTR market power by
a producer in the importing region (or a consumer in the exporting region) aggravates
their monopoly (monopsony) power, because dominance in the FTR market creates an
incentive to curtail generation (demand) to increase the value of the FTRs. Allocation
of FTRs to a monopoly generator depends on the structure of the market (Joskow and
Tirole 2000). When the FTRs are allocated initially to a single owner that is neither a
generator nor a load, the monopoly generator will want to acquire all FTRs. When all
FTRs initially are distributed to market players without market power, the generator
will buy no FTRs. When the FTRs are auctioned to the highest bidders, the generator
will buy a random number of FTRs. Extending this analysis, Gilbert et al.(2004)
analyze ways of preventing perverse incentives by identifying conditions where
different FTR allocation mechanisms can mitigate generator market power during
transmission congestion. In an arbitraged uniform price auction, generators will buy
FTRs that mitigate their market power, while in a pay-as-bid auction FTRs might
enhance their market power. Specifically, in the radial line case, market power might
be mitigated by not allowing generators to hold FTRs related to their own energy
delivery. In the three-node case, mitigation of market power implies defining FTRs
according to the reference node with the price least influenced by the generation
decision of the generator. In practical implementations of the FTR model, market
power mitigating rules are designed (Rosellón 2003). The Federal Energy Regulatory
Commission (FERC) has included market power mitigation rules in the standard
market design (FERC 2002). FERC indicates that insufficient demand-side response
and transmission constraints are the two main sources for market power. FERC
differentiates between high prices because of scarcity and high prices resulting from
exercising market power. Using a merit-order spot market mechanism FERC proposes
to use a bid cap for generators with market power in a constrained region and a “safety
net” for demand side response. Regulated generators are also subject to a resource
adequacy requirement. Chandley and Hogan (2002) claim that this mechanism is
inefficient because the use of penalties for under-contracting (with respect to the
resource adequacy requirement) would not permit prices to clear the energy and
reserve markets. Moreover, long-term contracting should be voluntary, and based on
financial hedging, not on capacity.
Borenstein et al. (2000) studied the economic benefits of linking markets with a
transmission line. Their work demonstrated that there may be no direct relationship
between the level of competition and the actual physical line utilization. For a
sufficiently large transmission line capacity, a competitive outcome may be achieved
even if the flow is zero. A market outcome similar to two merged markets would be
replicated. Borenstein et al. (2000) applied their duopoly model to the California
electricity market. Willems (2002) conducted a similar study but included the role of
the network operator to enhance the competition level. Leautier (2000) studied
5 Generator Ownership of Financial Transmission Rights and Market Power 131

regulatory contracts for transmission system operators and introduced a contract that
incentivizes the operators to optimally expand the transmission network. Stoft (1999)
studied market power arising from generation shipped to consumers over congested
transmission lines. He included FTRs and the congestion rent distribution. Joskow and
Tirole (2000) conducted a more general study of market power and transmission rights
and suggested possible regulatory mechanisms. Cho (2003) researched the competi-
tive equilibrium in a network with limited transmission capacity and a developed a tool
to identify an efficient equilibrium. He included transmission right markets for specific
electricity market structures. Gilbert et al. (2004) studied the market power effects of
transmission rights. Their initial analysis focused on a simple two-node network and
was extended to meshed networks.
This chapter analyzes the FTR ownership effects on the strategic behavior of
electricity generators in a Cournot framework developed by Joung (2008). We follow
Borenstein et al. (2000) with two identical but geographical distinct markets. Each
market has an identical monopoly supplier and cost function. The model setup is
similar to Borenstein et al. but also includes FTRs. Various FTR models are introduced
and market efficiency is studied under FTR ownership. Joskow and Tirole studied
FTRs in a two node market model and Pritchard and Philpott (2005) considered a
similar model. However the market structure was simplified by assuming that only one
market had consumers while the other only had producers. The market power
structures were limited to monopolistic and oligopolistic competition in one market
while the other market remained competitive. Thus the competitive effects of FTRs
were not considered in the more typical case where producers in both markets are
imperfectly competing. Likewise Cho (2003) analyzed FTRs in a two stage model
where stage 1 included the transmission market with strategic behavior and stage 2 the
energy market with price taking behavior. He demonstrated that inefficient equilibria
may exist. However real world electricity markets differ from the proposed model and
the results are thus not directly applicable. Gilbert et al. (2004) proposed a three stage
model with transmission right allocation, trading and energy market output allocation.
The model is solved backwards starting with the energy market. However the two node
model has limitations since there is competition only among generators located in one
market while the other market is perfectly competitive. Similar to Joskow and Tirole
(2000) this does not consider the case when generators in different markets are
imperfectly competing. Likewise the transmission line is always assumed to be
congested. These limitations influence the results of each stage of the game and
therefore limit the analysis of the energy market.
Game-theoretic studies focused on the competitive effects of FTRs have tried to
consider mixed strategy equilibria. Borenstein et al. (2000) utilized a numerical
method, Gilbert et al. (2004) presented analytic results for mixed strategy equilibria
but the model limitations excluded the competitive effects of FTRs when generators in
different markets are imperfectly competing.
This chapter studies the interactions between two incompletely competitive
markets. In particular, this chapter investigates the competitive effects of FTR owner-
ship of generating firms for their market strategy formulation. A Cournot framework is
applied and the best response curves provide implications for FTR ownership effects in
132 M. Joung et al.

Fig. 5.1 Two market model

an unconstrained Cournot equilibrium. Allocation of outward directional FTRs to

generators could result in a lower needed transmission line capacity than in Borenstein
et al.’s work (2000) to achieve full competition. These FTRs which are directed from
the generator to other markets hedge the generator’s exposure to prices in its own home
market and therefore mitigate its market power. If the generator possesses an FTR
from another market to its own, the FTR causes a negative effect on competition. The
FTR increases exposure to prices in the generator’s home market and increases its
market power. The model is also extended to include the analysis of asymmetric
markets and where one market is competitive.

5.2 Two Market Model

We consider a model of two markets. Demand in each market is assumed to be

characterized by an affine inverse-demand function. In each market there is a single
generating firm. These two markets are linked by a single transmission line whose
capacity is K. The transmission line is operated by a third entity and the electricity
pricing follows the nodal pricing rules (Schweppe et al. 1988). Both generating firms
try to maximize their profits by employing quantity strategies (Cournot competition).
Figure 5.1 conceptually depicts the market model.
To make competitive analysis more tractable, we assume two markets are
identical. That is, demand in each market is assumed to be identical and to be
characterized by the same inverse-demand function denoted by P: <+ ! <+., and
we also assume that both generating firms have an identical cost function
C: <+ ! <+. Asymmetric markets will be discussed as an extension of the sym-
metric market model.
In order for the model to be more concrete, we make the following assumptions:
• The inverse demand P(q) in each market is represented by an affine curve with a
negative slope:

PðqÞ ¼ aq þ b; where a; b 2 <þ ; (5.1)

• Generating firms’ generating costs C(q) are represented by a convex quadratic

function:

a
CðqÞ ¼ q2 þ bq þ c; where a; c 2 <þ ; and b 2 <: (5.2)
2
5 Generator Ownership of Financial Transmission Rights and Market Power 133

Fig. 5.2 FTR directions Right Holder Sourcing Direction

Gen Network

Sinking Direction

5.3 FTR Models

In this chapter, three FTR models are defined: the reference model, the FTR option
model, and the FTR obligation model. The reference model considers the case in
which neither firm has any FTRs.
The FTR option model is the market model with generators’ owning FTR options.
An FTR option is a financial contract for collecting the amount of money determined
by the locational price difference and the share of the right. This option gives the
owner the right to collect a portion of the congestion rents when the price difference
is positive, but does not require payment when the price difference is negative.
The FTR obligation model is the market model with generators’ owning FTR
obligations. An FTR obligation is a similar financial contract to an FTR option, but
it has negative payoff if the nodal prices reverse. That is, if the price difference is
positive, a holder collects the congestion rents of the transmission line, while for the
negative price difference, the holder makes a payment. Obligation-type rights also
have two possible directions.
We define the “direction” of FTRs from the point of view of the generating firm
that holds the transmission rights. We say the “sourcing” direction for FTRs that are in
the direction from the market where the right holding generating firm is located to the
other market. That is, the payoff of sourcing FTRs is defined by the nodal price in the
other market minus the nodal price at the generator. The opposite direction is called
the “sinking” direction. That is, the payoff of sinking FTRs is defined by the nodal
price at the generator minus price in the other market. These two directions are
illustrated in Fig. 5.2.

5.4 Competitive Effects of FTRs

In this section, we derive analytical expressions for the best response of each firm
for different FTR models: the reference model without financial transmission rights
(in Sect. 5.4.1), the FTR option model (in Sect. 5.4.2), and the FTR obligation
model (in Sect. 5.4.3). We also analyze the competitive effects of the corresponding
financial transmission rights for each model using best response analysis.
Following Borenstein et al. (2000), for the best response analysis, we define two
categories of optimal responses: optimal aggressive output and optimal passive output.
First, suppose that firm i is in the situation such that the opponent, firm j, is producing
nothing (more generally, that firm j is producing so little energy that there is transmis-
sion congestion on the line in the direction from market i to market j). In this case, the
best response of firm i is to produce its optimal quantity given that the line is congested
134 M. Joung et al.

from i to j. Under the nodal pricing scheme, this quantity will be the same as the
monopoly output for firm i when the market is isolated but with the demand shifted to
the right by K. This is called the optimal aggressive output for i and denote it with a
superscript þ .
Now, suppose that firm i is in the situation such that the opponent, firm j, is
producing a great amount of electric power (more generally, firm j is producing enough
energy to cause line congestion from market j to market i). In this case, the best
response of firm i is to produce its optimal quantity given that the line is congested in
the direction from market j to market i. Under the nodal pricing scheme, this quantity
will be the monopoly output for firm i when the market is isolated with the demand
shifted to the left by K. This monopoly quantity is called the optimal passive output for
i and will be denoted with a superscript .
Besides the optimal aggressive and passive outputs, one more category of best
response behavior is needed to cover the uncongested case. Since the resulting quantity
is equivalent to the unconstrained Cournot best response output for the merged
markets, this output is called the Cournot best response output and is denoted with a
superscript C.

5.4.1 Reference Model

If the electricity market is perfectly competitive and there is no market power, the
introduction of FTRs into the market has no effect on the prices for energy or the
dispatch of generators. As a reference model, the case is considered such that neither
firm has any rights on the transmission line. The reference case will be denoted with a
superscript r. In this case, the optimal aggressive and passive outputs, and the Cournot
best response output, which are denoted by qr+(K), qr-(K), and qirC(qj) respectively, are
expressed by (5.3), (5.4), and (5.5).1

b þ aK  b
qrþ ðKÞ ¼ ; (5.3)
2a þ a

b  aK  b
qr ðKÞ ¼ ; (5.4)
2a þ a

 a bb
i qj ¼ 
qrC qj þ : (5.5)
2ð a þ aÞ aþa

Here, it can be observed that the function qr+ is increasing in its argument while the
function qr and the function qirC are both decreasing in their argument (Note that qr+

1
There is no case where (5.3) and (5.4) are achieved in an equilibrium in a symmetric model;
however, in an asymmetric model, passive/aggressive equilibria are possible, in which case a pair
of (5.3) and (5.4) will be an equilibrium output pair.
5 Generator Ownership of Financial Transmission Rights and Market Power 135

and qr. are functions of line capacity K, while qirC is a function of production by the
other firm, qj.).
This reference model is equivalent to the symmetric two-firm model of Borenstein
et al. (2000). This section serves to review their results. The line will be congested only
when the difference between the outputs of two firms is greater than 2K, since
otherwise, by transferring a smaller amount of electricity than the line capacity K,
the two markets’ prices would be equalized.
Let us consider the best response of firm i with respect to the other firm j’s
strategy, qj. When firm j is producing any amount up to qrþ ðKÞ  2K , firm i can
maximize its profit by producing the fixed amount qrþ ðKÞ . As firm j’s output
increases above qrþ ðKÞ  2K, however, firm i can maximize its profit and still export
K by producing 2K more than firm j. That is, firm i maximizes its profit by producing
qj þ 2K, accounting for the segment of slope 1 in the best responses shown in
Fig. 5.2. Note that as qj keeps increasing, firm i’s resulting payoff from maintaining
an aggressive response is decreasing. As firm j’s output continues to increase, two
situations can be thought of.
On the one hand, if K is small, then producing the optimal passive output qr ðKÞ
becomes more profitable for firm i before
the value of qi ¼ qj þ 2K reaches the
unconstrained Cournot best response qrC i qj . This is shown by the dashed curve in
Fig. 5.3.
On the other hand, if the line capacity is large enough, say,K 0 as shown in Fig. 1.3

as
the solid curve, then firm i’s best response will change from qj þ 2K to qrC i qj .
However, even in this situation, as qj keeps increasing, producing
 q ðKÞ will
r

eventually be more profitable for firm i than producing qrC i q j : This accounts for
the transition in the best responses to qr ðK 0 Þ and qr ðKÞ; respectively, for high
enough qj.
To summarize, the situations for the two values of line capacity are illustrated in
Fig. 5.3. The solid curve shows the case of relatively large capacity K 0 where firm i’s
optimal response includes some values equal to the Cournot unconstrained best
response. The dashed curve shows the case of relatively small capacity K where the
best response never includes values equal to the Cournot unconstrained best response.
As shown in Fig. 5.3, the best responses of both firms will have different
characteristics according to the transmission line capacity K. Specifically, increase
of physical line capacity implies both increase of the optimal aggressive output
qr+(K) and decrease of the optimal passive output qr(K). Borenstein et al. (2000)
shows that this, in turn, implies an increase in the competition-promoting effects
of the transmission line:
• Decrease in the equilibrium price of the mixed strategy equilibrium, and
• Increase in the range of market demand conditions that result in the pure strategy
Cournot equilibrium.
The results of Borenstein et al. (2000) also shows that if K is very small, then there is
no pure strategy equilibrium, while if K is large enough, the Cournot duopoly
equilibrium will be reached as the unique equilibrium. That is, the equilibrium is
136 M. Joung et al.

qj BR curve with K
BR curve with K’

Unconstrained
qr+ (K) − 2K Cournot
best-response
qr+ (K′) − 2K′ function

qr− (K′) qr − (K) qr+ (K) qr+ (K′) qi

Fig. 5.3 Best response curves for firm i (K < K’)

specified by (5.5), with zero flow along the line but with the line providing the full
competitive benefits of merged markets.

5.4.2 FTR Option Model

An FTR option is a financial contract for collecting the amount of money determined
by the locational price difference and the share of the right. This option gives the
owner the right to collect a portion of the congestion rents when the price difference
is positive, but does not require payment when the price difference is negative. FTR
options have been implemented in PJM first (PJM 2011) and are being introduced in
several other markets in the United States, recently including the Electric Reliability
Council of Texas (ERCOT) “nodal” market in 2010 (ERCOT 2011).
An FTR option has a specified exercise direction and if the nodal price difference
is positive in this direction, then the FTR provides a positive payoff. There is zero
payoff for price differences in the other direction. This means that each firm i has two
possible directions for his FTR option in this two market model; that is, a direction
from market i to j (the sourcing direction) and one from j to i (the sinking direction).
Let iji and jii denote generating firm i’s FTR option share from market i to j and
from market j to i, respectively, such that iji ; iji 2 ½0; 1. That is, iji describes the share
of sourcing FTR, while jii describes the share of sinking FTRs. We use superscript uo
to denote options.
We have:

Lemma 1. Let quoijþ

i , quoij
i , and quoijC
i be the optimal aggressive, passive, and
Cournot responses for firm i holding share iji . Let quojiþ
i , quoji
i , and quojiC
i be the
5 Generator Ownership of Financial Transmission Rights and Market Power 137

optimal aggressive, passive, and Cournot responses for firm i holding share jii .
Then:
    
quoijþ
i K; iji ¼ qrþ 1 þ iji K ; (5.6)

quoij
i ðKÞ ¼ qr ðKÞ; (5.7)



quoijC
i qj ¼ qrC
i qj ; (5.8)

quojiþ
i ðKÞ ¼ qrþ ðKÞ; (5.9)
    
quoji
i K;  ji
i ¼ q r
1 þ  ji
i K ; (5.10)



quojiC
i qj ¼ qrC
i qj : (5.11)

Proof. See Appendix.

Lemma 1 suggests that the ownership of an FTR option is equivalent to expanding
the capacity of the line in one direction. This specific relationship is mainly from the
linearity of demand. When the demand linearity is relaxed, this relationship would
change, but a similar qualitative effect would be expected.
To summarize, an FTR option results in the change of either the optimal aggressive
output (see (5.6)) or optimal passive output (see (5.10)) compared to the reference
model. By possessing aniji FTR option, firm i’s optimal aggressive output increases as
indicated by (5.6), observing that by (5.3), qr+ is increasing in its argument. By
possessing an jii FTR option, firm i’s optimal passive output decreases as indicated
by (5.10), observing that by (5.4), qr is decreasing in its argument. The change of the
best response due to an FTR option is illustrated in Fig. 5.4. Note that, in order to
differentiate two different response curves in Fig. 1.4, there are some line segments
that are illustrated as being close together although they are in fact coincident.
As shown in Fig. 5.4, according to its direction, each FTR option has one of two
different effects: either increase of the optimal aggressive output as shown in Fig. 5.4a
or decrease of the optimal passive output as shown in Fig. 5.4b. This, in turn, affects
the range of conditions for realization of the pure strategy equilibrium. Here, we focus
on the effect on the occurrence of three forms of equilibrium: the unconstrained
Cournot equilibrium, passive/aggressive equilibrium, and mixed strategy equilibrium
Borenstein et al. (2000). We do not consider overlapping equilibria as described in the
work of Borenstein et al. (2000).
Increase of the optimal aggressive output has no effect on achieving the uncon-
strained Cournot equilibrium since the unconstrained Cournot best response region is
the same as that in the reference case and the range of conditions for the unconstrained
Cournot equilibrium will be also the same as shown in Fig. 5.4a. On the other hand,
138 M. Joung et al.

a
reference model
qj
FTR option model
ij
with ηi

Unconstrained
qiuoij + ( K,hiij ) −2K Cournot
best-response
q r + ( K ) − 2K function

q r − ( K ) = qiuoij − ( K ) qr+ (K) qiuoij + ( K,htij ) = q r +((1+hiij )K ) qi

Best Response Curves for Firm i without FTRs and with hiij .
b

reference model
qj
FTR option model
with hi ji

Unconstrained
Cournot
best-response
q r + ( K ) - 2K function

qiuo - ( K,hiji ) q r - ( K ) q r + (K ) = qiuoj + (K ) qi

Best Response Curves for Firm i without FTRs and with hi ji .

Fig. 5.4 Comparison of best response curves. (a) Best response curves for firm i without FTRs
and with iji . (b) Best response curves for firm i without FTRs and with jii

decrease of the optimal passive output reduces the unconstrained Cournot best
response region since the right holder becomes more inclined to the optimal passive
output. That is, the transition of its best response from the unconstrained Cournot
response to the optimal passive output occurs at a smaller value of the other firm’s
output as shown in Fig. 5.4b.
5 Generator Ownership of Financial Transmission Rights and Market Power 139

Consider a case where, without FTRs, the capacity of the transmission line is
enough to achieve the unconstrained Cournot equilibrium. Figure 5.5a illustrates this
case. From the previous argument, if firm i possesses an iji FTR option and/or firm j
possesses an jij FTR option, then the resulting equilibrium will be the same as the
unconstrained Cournot equilibrium in the reference case as shown in Fig. 5.5b.
In contrast, suppose that firm i possesses anjii FTR option. In this case, the resulting
equilibrium may change from the unconstrained Cournot equilibrium to a mixed
strategy equilibrium. This is illustrated in Fig. 5.5c. Figure 5.5c shows that by i
possessing an jii FTR option, the change of best response curve of firm i may result
in a mixed strategy equilibrium instead of the unconstrained Cournot equilibrium that
is achieved without FTRs (Fig. 5.5a). A similar effect can occur if firm j possesses anijj
FTR option.
However, for the range of jii 2 ½0; 1, the introduction of FTR options cannot
create enough asymmetry to yield a passive/aggressive equilibrium.
Lemma 2. Suppose that, without FTRs, the capacity of the transmission line is
enough to achieve the unconstrained Cournot equilibrium. In this case, by firm i’s
possessing an jii FTR option, the resulting equilibrium cannot change to a passive/
aggressive equilibrium.
Proof. Suppose that, with firm i’s possessing an jii FTR option, a passive/aggressive


equilibrium is achieved. Then, the price differencePij qi ; qj , between two markets is
obtained as:
     
Pij quoji
i ; q rþ
j ¼ P q uoji
i þ K  P q rþ
j  K
0  1
2 þ  jii a
¼ @  2AaK < 0 (5.12)
2a þ a

This contradicts the assumption of achieving a passive/aggressive equilibrium since,

with negative price difference, FTR options will not generate any additional payoffs
and, therefore, firm i’s best response will not become the optimal passive output.
Q.E.D.

5.4.3 FTR Obligation Model

An FTR obligation is a similar financial contract to an FTR option, but it has

negative payoff if the nodal prices reverse. That is, if the price difference is positive,
a holder collects the congestion rents of the transmission line, while for the negative
price difference, the holder makes a payment. Obligation-type rights also have two
possible directions. FTR obligations are implemented in several markets in the
Eastern US, including PJM (PJM 2011), New York ISO (New York ISO 2011), and
140 M. Joung et al.

Fig. 5.5 Illustration of the a

effects of FTR options on the
Cournot equilibrium. (a) Best qj Unconstrained Cournot
response curves without best-response functions

FTRs. (b) Best response

curves with FTR option iji Cournot
equilibrium
and jij . (c) Best response
curves with FTR option jii
BRj (qi )

BRi (qj )

qi
Best Response Curves without FTRs.

b
qj Unconstrained Cournot
best-response functions

Cournot
equilibrium

BRj (qi )

BRi (qj )

qi
Best Response Curves with FTR option h iij and h jji .

c
qj Unconstrained Cournot
best-response functions

BRj (qi )

BRi (qj )

qi
ji
Best Response Curves with FTR option h i .
5 Generator Ownership of Financial Transmission Rights and Market Power 141

New England ISO (New England ISO 2011), and are available in California ISO
(California ISO 2011), Midwest ISO (Midwest ISO 2011) and the ERCOT nodal
market (ERCOT 2011).
Let the FTR obligation share of firm i be denoted by gi 2 ½1; 1, where the
sourcing direction is assumed positive. That is, firm i collects or pays gi portion of
the total congestion rents. We use superscript ob to denote FTR obligations.
We have:
Lemma 3.
b þ ð1 þ gi Þak  b
qobþ ðk; gi Þ ¼ ¼ qrþ ðð1 þ gi ÞkÞ; (5.13)
i
2a þ a

b  ð1  gi Þak  b
qob ðk; gi Þ ¼ ¼ qr ðð1  gi ÞkÞ; (5.14)
i
2a þ a

 1 bb

qobC qj ¼  qj þ ¼ qrC
i qj : (5.15)
i
2ð a þ aÞ aþa

Proof. See Appendix.

These results imply that firm i possessing gi FTR obligation has the same effects
on the firms’ strategic behaviors as having two directional transmission lines with
different capacities: capacity ð1 þ gi ÞK MW from market i to j and capacity ð1  gi Þ
K MW from market j to i. The resulting competitive effects are different depending
on the sign of gi .
First, suppose that gi  0. This means that, in terms of its effect on competitive
behavior, the effective line capacity increases by the amount of gi K MW in the i to j
direction, while the effective line capacity decreases by gi K MW in the opposite
direction. This results in an increase of both the optimal aggressive output and the
optimal passive output compared to those in the reference model.2
On the other hand, if gi < 0, the opposite results are obtained; that is, the optimal
aggressive and passive outputs decrease. Figure 5.6 shows these effects of an FTR
obligation.
As shown in Fig. 5.6a, a positive FTR obligation will have positive effect on
achieving the unconstrained Cournot equilibrium by increasing the unconstrained
Cournot best response region. A negative FTR obligation will have a negative effect
on achieving the unconstrained Cournot equilibrium as shown in Fig. 5.6b. Suppose
that, without FTRs, the unconstrained Cournot equilibrium is achieved as illustrated in
Fig. 5.7a. Here, we consider only the effect of firm i’s possession of FTR obligations.
In this case, if firm i possesses a positive FTR obligation then the only possible pure
strategy equilibrium will be the same unconstrained Cournot equilibrium as shown in
Fig. 5.7b.
Now consider a case where, without FTRs, the capacity of the transmission line is
not enough to achieve the unconstrained Cournot equilibrium. Figure 5.7c illustrates

2
Of course, the amount of power transferred over the line remains limited to K.
142 M. Joung et al.

a
qj reference model

FTR obligation model

with gi > 0

Unconstrained
qiob+ (K,gi ) – 2K Cournot
q r+ ( K ) – 2K
best-response
function

qiob – ( K , g i )

q r – (K ) q r +( K ) qiob+ ( K,gi ) qi

Best Response Curves For Firm i without FTR and with g i > 0.
b
qj reference model

FTR obligation model

with gi < 0

Unconstrained
Cournot
q r + ( K ) – 2K
best-response
function
qiob+ (K,gi ) – 2K

qiob – ( K,gi ) q r – ( K ) qiob+ ( K,gi ) q r + ( K ) qi

Best Response Curves For Firm i without FTR and with g i > 0.

Fig. 5.6 Comparison of best response curves. (a) Best response curves for firm i without FTR and
with gi > 0. (b) Best response curves for firm i without FTR and with gi < 0

this case. As shown in the figure, due to the insufficient line capacity, two best response
curves do not intersect at the unconstrained Cournot equilibrium. Without FTRs, only
a mixed equilibrium can occur. By Borenstein et al. (2000), the expected price will be
higher than in the Cournot equilibrium. Figure 5.7d shows that by i and j each
possessing a positive FTR obligation, two best response curves intersects at the
unconstrained Cournot equilibrium due to both firms’ changed Cournot best response
regions. As illustrated in Fig. 5.7d, a positive FTR obligation may result in the
unconstrained Cournot equilibrium when it was impossible without FTRs.
5 Generator Ownership of Financial Transmission Rights and Market Power 143

a
qj Unconstrained Cournot
best -response functions

Cournot
equilibrium

BRj (qi)

BRi(qj)

qi

Best Response Curves without FTR.

b
qj Unconstrained Cournot
best-response functions

Cournot
equilibrium

BRj(qi)

BRi(qj)

qi
Best Response Curves with Positive FTR Obligations.

Fig. 5.7 (continued)

144 M. Joung et al.

c
qj Unconstrained Cournot
best-response functions

BRj(qi)

BRi(qj)

qi
Best Response Curves without FTR.

d
qj Unconstrained Cournot
best-response functions

Cournot
equilibrium

BRj(qji)

BRi(qj)

qi

Best Response Curves with Positive FTR Obligations.

Fig. 5.7 Illustration of the effects of positive FTR obligations on the Cournot equilibrium.
(a) Best response curves without FTR. (b) Best response curves with positive FTR obligations.
(c) Best response curves without FTR. (d) Best response curves with positive FTR obligations

On the other hand, Fig. 5.8 illustrates that negative FTR obligations may result in a
passive/aggressive equilibrium while the unconstrained Cournot equilibrium is
achieved without FTRs. Figure 5.8a illustrates that, due to the sufficient line capacity,
5 Generator Ownership of Financial Transmission Rights and Market Power 145

qj Unconstrained Cournot
best-response functions

Cournot
equilibrium

BRj(qi)

BRi(qj)

qi
Best Response Curves without FTR.

qj Unconstrained Cournot
best-response functions

Passive/aggressive
equilibrium

BRj(qi)

BRi(qj)

qi
Best Response Curves with Negative FTR Obligations.

Fig. 5.8 Illustration of the effects of negative FTR obligations on the Cournot equilibrium.
(a) Best response curves without FTR. (b) Best response curves with negative FTR obligations
146 M. Joung et al.

two best response curves intersect at the unconstrained Cournot equilibrium without
FTRs. Here, we consider only the effect of firm i’s possession of FTR obligations. As
shown in Fig. 5.8b, with i possessing a negative FTR obligation, a passive/aggressive
equilibrium is achieved.

5.5 Model Extensions

In this section, we comment on two model extensions: an asymmetric market and a

competitive market.

5.5.1 Asymmetric Markets

Borenstein et al. (2000) showed that for the reference model, if markets are asymmetric
enough, then even a very thin transmission line can provide a pure strategy equilib-
rium: a passive/aggressive equilibrium. Moreover, they showed that, with a suffi-
ciently large line, the unconstrained Cournot equilibrium is the unique pure-strategy
equilibrium and that this is the same as the case of symmetric markets.
With our other FTR models, under certain conditions, a passive/aggressive equilib-
rium is possible even in the case where, without ownership of FTRs, the unconstrained
Cournot equilibrium is the unique pure-strategy equilibrium. This shows that FTRs
may effectively increase asymmetry of markets that, otherwise, is not enough to yield a
passive/aggressive equilibrium. However, by the same reasoning as for the reference
model, with a sufficiently large line capacity, the unconstrained Cournot equilibrium
will be the unique pure-strategy equilibrium even with FTRs.
Consider a case where, without FTRs, asymmetry of markets is small enough to
achieve the unconstrained Cournot equilibrium. Figure 5.9a illustrates this case.
Suppose that firm i possesses an jii FTR option. In this case, the resulting equilibrium
may change from the unconstrained Cournot equilibrium to a passive/aggressive
strategy equilibrium. This is illustrated in Fig. 5.9b. Figure 5.9b shows that by
i possessing an jii FTR option, asymmetry of markets increases enough to result in a
passive/aggressive equilibrium instead of the unconstrained Cournot equilibrium that
is achieved without FTRs (Fig. 5.9a).

5.5.2 Competitive Market

In the work of Borenstein et al. (2000), the reference model was compared to a variant
in which one of the markets is perfectly competitive. The result was that the effect of a
transmission line on the reference model is greater than the effect on a model where
one of the markets is competitive. This is mainly because the strategic interaction of
two firms in the reference model leads to the Cournot duopoly quantity, while in
the other model with a perfectly competitive market, the best response of a firm
5 Generator Ownership of Financial Transmission Rights and Market Power 147

a
qj Unconstrained Cournot
best-response functions

Cournot
equilibrium

BRj(qi)

BRi(qj)

qi
Best Response Curves without FTRs.
b

qj Unconstrained Cournot
best-response functions

Passive/aggressive
equilibrium

BRj(qi)

BRi(qj)

qi
Best Response Curves with Positive FTR Obligations.

Fig. 5.9 Illustration of the effects of FTR options on the Cournot equilibrium. (a) Best response
curves without FTRs. (b) Best response curves with FTR option jii

confronting the competitive market will be the monopoly quantity, given imports from
the competitive market equal to the line capacity.
Joskow and Tirole (2000) studied a similar model with FTRs. In their model, one
market has a demand and a strategic supplier, while the other market has only
competitive suppliers. Consequently, the direction of line flow is only in the direction
148 M. Joung et al.

to the market with demand and any strategic interaction among firms is not considered.
They have shown using this setup that if only the strategic firm in the demand market
holds FTRs, then these rights will enhance its market power.
Unlike Joskow and Tirole’s model, in FTR models presented in this study, each
market has both supply and demand and both directions of line flow must be
considered. By assuming that one of the markets is competitive, there is no strategic
interplay between firms. To correspond to Joskow and Tirole’s model, we assume
that firm i is the only strategic firm and that firm j is perfectly competitive. We
consider the cases of FTR options and FTR obligations in Sects. 5.5.2.1 and 5.5.2.2.
Since firm j is perfectly competitive, the following equation holds:


C0 qj ¼ cqj þ b ¼ pj ; (5.16)

where pj is the price in market j. The price pj is determined by the supply quantities
as follows:
8
>  aqj þ aK þ b; if qi < qj  2K;
>
<
q þ qj
pj ¼  a i þ b; if qj  2K  qi  qj þ 2K; (5.17)
>
> 2
:
 aqj  aK þ b; if qi > qj þ 2K:

From (5.16) and (5.17), the quantity qj is represented by (5.18):

8
> 1 1
>
> ðb þ aK  bÞ; if qi < ðb  b  ð2c þ aÞK Þ;
>
> cþa cþa
>
>
>
> aqi 2
>
< þ ðb  bÞ;
2c þ a 2c þ a
qj ¼
>
> 1 1
>
> if ðb  b  ð2c þ aÞK Þ  qi  ðb  b þ ð2c þ aÞK Þ;
>
> c þ a c þ a
>
>
>
>
: 1 ðb  aK  bÞ; if qi >
1
ðb  b þ ð2c þ aÞK Þ:
cþa cþa
(5.18)

Consequently, pj can be rewritten as (5.19):

8
> ab c 1
>
> þ ðb þ aK Þ; if qi < ðb  b  ð2c þ aÞK Þ;
>
> cþa cþa cþa
>
>
>
> acqi 1
>
< þ ð2cb þ abÞ;
2c þ a 2c þ a
pj ¼
>
> 1 1
>
> if ðb  b  ð2c þ aÞK Þ  qi  ðb  b þ ð2c þ aÞK Þ;
>
> c þ a c þ a
>
>
>
: ab þ c ðb  aK Þ;
>
if qi >
1
ðb  b þ ð2c þ aÞK Þ:
cþa cþa cþa
(5.19)
5 Generator Ownership of Financial Transmission Rights and Market Power 149

Now, based on the above analytic results, each FTR model is analyzed in the
following sections.

5.5.2.1 FTR Option Model

We have:
ij
Lemma 4. Firm i’s optimal output qi i (qiji ) with iji (iji ) is:
 
iji
b  b þ a 1 þ iji K
qi ¼ ; (5.20)
c þ 2a
 
iji
b  b  a 1 þ iji K
qi ¼ : (5.21)
c þ 2a

Proof. See Appendix.

ij ji
This shows that the larger iji , the larger qi i , while the larger iji , the smaller qi i .
Joskow and Tirole’s result (2000) corresponds only to (5.21) since they considered
only the flow direction from j to i.

5.5.2.2 FTR Obligation Model

We have:
Lemma 5. Firm i’s optimal output with an FTR obligation gi will be either
b  b þ að1 þ gi ÞK b  b  að1  gi ÞK
or :
c þ 2a c þ 2a
Proof. See Appendix.
Note that gi 2 ½1; 1 , where the sourcing direction is assumed positive. By
investigating the analytic representation of the optimal output, we can easily see that
by possessing larger gi , both the optimal aggressive and passive outputs will increase.
Although Joskow and Tirole’s model (2000) also considers FTR obligations, their
model cannot examine the whole characteristics of FTR obligations, i.e., the negative
revenue from FTR obligations, since they limited the direction of line flow. As stated in
3.4.2.1, their model actually corresponds to the FTR option model with jii
corresponding to negative gi . They concluded that if the firm i “holds financial rights,
these rights will enhance its market power”, but this conclusion depends on the
assumed directions of the flow and FTRs. The conclusion in this subsection is that,
by possessing larger positive gi , both the optimal aggressive and passive outputs will
increase. That is, larger FTR obligations will mitigate the right holding firm’s market
power in this case.
150 M. Joung et al.

5.6 Summary and Conclusion

As stated in the work of Borenstein et al. (2000), the full benefits of competition can be
achieved by connecting two markets with a sufficiently large capacity line so that each
generator would compete over the merged market instead of over a residual market of
its own. In this chapter, we have demonstrated how to analyze the impact of ownership
of FTRs on competition, and showed that, by introducing FTRs in an appropriate
manner, the physical capacity needed for the full benefits of competition can be
reduced. It has also shown that, by introducing FTRs, we may reduce the required
physical capacity of the transmission line that is necessary to achieve a pure strategy
equilibrium, particularly for achieving the unconstrained Cournot equilibrium that
gives the full benefits of competition of a merged market. We have provided separate
results for FTR option models and for an FTR obligation model in this chapter. This
enables the results to be applied to a market using a specific FTR model.
We also extended the FTR models by considering asymmetric markets and by
assuming that one of the markets is perfectly competitive. Asymmetry of markets
makes it possible for the ownership of FTRs to change market equilibrium from
the unconstrained Cournot equilibrium to a passive/aggressive equilibrium.
By constraining one market to be competitive, we could show a similar result to
that in the work of Joskow and Tirole (2000). Moreover, other results from the
same model were also obtained and some of them show that FTRs may reduce the
firm’s market power while Joskow and Tirole showed only the result of enhancing
the firm’s market power.

Appendix

This appendix provides proofs of the Lemmas.

Proof of Lemma 1. First, we consider the direction of option share from market i to j.
Suppose that there is no congestion. In this case, prices are equated across markets so
each market gets half of the total output of both firms. On the other hand, if there is
congestion, then the prices of the markets are different. Two congested situations can
be differentiated: one is to import K MW with line congestion, and the other is to export
K MW with line congestion. Here, I notice that line congestion can occur only when
the output difference of both firms is greater than 2K MW. More precisely, market i
imports with congestion when qi < qj  2K, and exports with congestion when qi >
qj þ 2K. In this setting, the profit of firm i is represented by the profit function pi :
5 Generator Ownership of Financial Transmission Rights and Market Power 151

8

 
>
> Pðqi  K Þqi þ iji K P qj þ K  Pðqi  K Þ  Cðqi Þ; if qi > qj þ 2K;
>
<
Pðqi þ K Þqi  Cðqi Þ; if qi < qj  2K;
pi ¼  
>
> q þ qj
>
:P i qi  Cðqi Þ; if qj  2K  qi  qj þ 2K;
2
(5.22)

where qi is firm i’s output and qj is firm j’s output.

Using the explicit forms of demand and costs from (5.1) to (5.2), the profit
function of firm i is:
8

  a
>
> qi ðaqi þ aK þ bÞ þ iji K a qi  qj  2aK  q2i  bqi  c; if qi > qj þ 2K;
>
> 2
>
< a 2
pi ¼ qi ðaqi  aK þ bÞ  2 qi  bqi  c; if qi < qj  2K;
> 
> 
>
> q þ qj a
>
: qi a i þ b  q2i  bqi  c; if qj  2K  qi  qj þ 2K:
2 2
(5.23)

From (5.23) and the definition, firm i’s optimal aggressive and  passive
 outputs
uoij þ ij uoij 
and Cournot best response output, which are denoted by qi K; i , qi ðKÞ,


and qobC
i qj , respectively, are obtained by (5.24), (5.25), and (5.26):
 
uoij þ
qi K; iji ¼ arg max
qi
h

  a i
 qi ðaqi þ aK þ bÞ þ iji K a qi  qj  2aK  q2i  bqi  c ;
2
(5.24)
h a i
uoij 
qi ðKÞ ¼ arg max qi ðaqi  aK þ bÞ  q2i  bqi  c ; (5.25)
qi 2
  
uoij C
 qi þ qj a
qi qj ¼ arg max qi a þ b  q2i  bqi  c : (5.26)
qi 2 2

By solving (5.24), (5.25), and (5.26), the optimal aggressive and passive outputs
and the Cournot best response output can be explicitly expressed as (5.27), (5.28),
and (5.29):
 
  b þ 1 þ iji aK  b
uo þ
qi ij K; iji ¼ ; (5.27)
2a þ a
152 M. Joung et al.

uoij  b  aK  b
qi ðKÞ ¼ ; (5.28)
2a þ a

uoij C
 a bb
qi qj ¼  qj þ : (5.29)
2ð a þ aÞ aþa

By comparing (5.27), (5.28), and (5.29) with (5.3), (5.4), and (5.5), we can easily
observe that (5.6), (5.7), and (5.8) hold.
Similarly, for the case in which firm i possesses an iji FTR option in the other
direction, the following results are obtained:

uoji þ b þ aK  b
qi ðKÞ ¼ ; (5.30)
2a þ a
 
  b  1 þ jii aK  b
uoji 
qi K; iji ¼ ; (5.31)
2a þ a

uoji C
 a bb
qi qj ¼  qj þ ; (5.32)
2ð a þ aÞ aþa

Therefore, we also observe that (5.9), (5.10), and (5.11) hold.

Q.E.D.
Proof of Lemma 3. In the FTR obligation model, the profit of each firm i is
represented by the profit function pi :
8

 
>
> Pðqi  K Þqi þ gi K P qj þ K  Pðqi  K Þ  Cðqi Þ; if qi > qj þ 2K;
>
<


Pðqi þ K Þqi  gi K Pðqi þ K Þ  P qj  K  Cðqi Þ; if qi < qj  2K;
pi ¼  
>
> qi þ qj
>
:P qi  Cðqi Þ; if qj  2K  qi  qj þ 2K;
2
(5.33)

where qi is firm i’s output and qj is firm j’s output.

Using the explicit forms of demand and costs of (3.1) and (3.2), the profit
function of firm i is rewritten such that:
8

  a
>
> qi ðaqi þ aK þ bÞ þ gi K a qi  qj  2aK  q2i  bqi  c; if qi > qj þ 2K;
>
> 2
>
<

  a 2
pi ¼ qi ðaqi  aK þ bÞ  gi K a qj  qi  2aK  2 qi  bqi  c; if qi < qj  2K;
>
>  
>
> q þ qj a
>
: qi a i þ b  q2i  bqi  c; if qj  2K  qi  qj þ 2K:
2 2
(5.34)
5 Generator Ownership of Financial Transmission Rights and Market Power 153

From (5.34) and the definition, firm i’s optimal aggressive and passive outputs
and Cournot best response output, which are denoted by qobþ ðK; gi Þ, qob ðK; gi Þ, and
obC

 i i
qi qj respectively, are obtained by (5.35), (5.36), and (5.37).
h

  a i
qobþ
i ðK; gi Þ ¼ arg max qi ðaqi þ aK þ bÞ þ gi K a qi  qj  2aK  q2i  bqi  c ;
qi 2
(5.35)
h

  a 2 i
qob
i ð K; g i Þ ¼ arg max q i ð aq i  aK þ b Þ  g i K a q j  q i  2aK  q  bq i  c ;
qi 2 i
(5.36)
  

 qi þ qj a
qobC
i qj ¼ arg max qi a þ b  q2i  bqi  c : (5.37)
qi 2 2

By solving (5.35), (5.36), and (5.37), the optimal aggressive and passive outputs
and the Cournot best response output can be explicitly expressed as (5.16), (5.17),
and (5.18).
Q.E.D.
ij
Proof of Lemma 4. The profit of firm i, pi i , with an FTR iji is represented as:
8 c  1
>
>  þ a q2i  ðb þ aK  bÞqi  a; if qi < ðb  b  ð2c þ aÞK Þ;
>
> cþa
>
> 
2
  
>
> ac
>
> c 1
>
>  þ q2i  b  ð2cb þ abÞ qi  a;
>
> 2 2c þ a 2c þa
>
<
ij 1 1
pi i ¼ if ðb  b  ð2c þ aÞK Þ  qi  ðb  b þ ð2c þ aÞK Þ;
>
> c þ a c þ a
>
>
> c
>      aiji K
>
>  þ a 2
  a þ  ij
 b   ðb  b þ ð2c þ aÞK Þ;
>
> q b 1 K q i a
>
> 2 i i
cþa
>
>
>
: 1
if qi > ðb  b þ ð2c þ aÞK Þ:
cþa
(5.38)
154 M. Joung et al.

ji
The profit of firm i, pi i , with an FTR jii is represented as:
8      
>
> c ji ajii K
>
>  þ a q 2
 b þ a 1 þ  K  b q  a  ðb  b  ð2c þ aÞK Þ;
>
> 2 i i i
cþa
>
>
>
> 1
>
> if qi < ðb  b  ð2c þ aÞK Þ;
>
> c þ a
>
<    
ji
i c ac 1
pi ¼  þ q  b
2
ð2cb þ abÞ qi  a;
>
> 2 2c þ a i 2c þ a
>
>
>
>
>
>
1
ðb  b  ð2c þ aÞK Þ  qi 
1
ðb  b þ ð2c þ aÞK Þ;
>
> if
>
> c þ a c þ a
>
>  
>
:  c þ a q2  ðb  aK  bÞqi  a; 1
if qi > ðb  b þ ð2c þ aÞK Þ:
2 i
cþa
(5.39)

Since there is no strategic response from market j, firm i faces the above profit
ij ji
function to maximize. Each of pi i and pi i has three different regions with respect to
qi and we need to compare the maximum profit in each region to identify firm i’s
optimal output. Since we can observe that the possession of FTRs only affects the
third row of (5.38) and the first row of (5.39), we need to consider only these two
rows in order to assess the effect of FTR rights. So, suppose that the maximum
profit is obtained by the third row of (5.38) or the first row of (5.39) with the FTR
ij
option iji and jii, respectively. Then, firm i’s optimal output qi i (qjii) with iji (jii) will
be (5.20) ((5.21)).
Q.E.D.
g
Proof of Lemma 5. We denote by pi i firm i’s profit with an FTR obligation gi. It is
given by:
8  
> c ag K
>
>  þ a q2i  ðb þ að1  gi ÞK  bÞqi  a þ i ðb  b  ð2c þ aÞK Þ;
>
> 2 c þa
>
>
>
> 1
>
> if qi < ðb  b  ð2c þ aÞK Þ;
>
> cþa
>
>    
>
> ac
>
>
c 1
< þ q2i  b  ð2cb þ abÞ qi  a;
g 2 2c þ a 2c þ a
pi i ¼
>
> 1 1
>
> if ðb  b  ð2c þ aÞK Þ  qi  ðb  b þ ð2c þ aÞK Þ;
>
> cþa cþa
>
>  
>
> c ag K
>
>  þ a q2i  ðb  að1 þ gi ÞK  bÞqi  a  i ðb  b þ ð2c þ aÞK Þ;
>
> cþa
>
> 2
>
>
>
: 1
if qi > ðb  b þ ð2c þ aÞK Þ:
cþa
(5.40)
5 Generator Ownership of Financial Transmission Rights and Market Power 155

To examine the effect of FTR obligations, we suppose that the maximum profit
is obtained either by the first row or by the third row of (5.40). Then, firm i’s optimal
b  b þ að1 þ gi ÞK b  b  að1  gi ÞK
output will be either or .
c þ 2a c þ 2a
Q.E.D.

References

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deregulated electricity industry. Rand J Econ 31:294–325
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Chapter 6
A Merchant Mechanism for Electricity
Transmission Expansion

Tarjei Kristiansen and Juan Rosellón

6.1 Introduction

The analysis of incentives for electricity transmission expansion is not easy. Beyond
economies of scale and cost sub-additivity externalities in electricity transmission are
mainly due to “loop flows” that come up from complex network interactions.1 The
effects of loop flows imply that transmission opportunity costs are a function of the
marginal costs of energy at each location. Power costs and transmission costs depend
on each other since they are simultaneously settled in electricity dispatch. Loop flows
imply that certain transmission investments might have negative externalities on the
capacity of other (perhaps distant) transmission links (see Bushnell and Stoft 1997).
Moreover, the addition of new transmission capacity can sometimes paradoxically
decrease the total capacity of the network (Hogan 2002a).

This paper was originally published as: Kristiansen T, Rosellón J (2006) A merchant mechanism
for electricity transmission expansion. J Regul Econ 29(2):167–193. We are grateful to William
Hogan for very useful suggestions and discussions. We also thank Ross Baldick, Ingo Vogelsang,
and an anonymous referee for insightful comments. All remaining errors are our own. Part of this
research was carried out while Kristiansen was a Fellow, and Rosellón a Fulbright Senior Fellow,
at the Harvard Electricity Policy Group, Center of Business and Government, John F. Kennedy
School of Government of Harvard University. Rosellón acknowledges support from the Repsol-
YPF-Harvard Kennedy School Fellows Program and the Fundación México en Harvard, as well as
from CRE and Conacyt.
1
See Joskow and Tirole (2000), and Léautier (2001).
T. Kristiansen (*)
KEMA Consulting GmbH, Kurt-Schumacher Strasse 8, Bonn D-53113, Germany
e-mail: [email protected]
J. Rosellón
División de Economı́a, Centro de Investigación y Docencia Económicas (CIDE) and DIW Berlin,
Carretera México-Toluca 3655, Lomas de Santa Fé, México D.F. 01210, Mexico
e-mail: [email protected]

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 157

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9_6,
# Springer-Verlag London 2013
158 T. Kristiansen and J. Rosellón

The welfare effects of an increment in transmission capacity are analyzed by

Léautier (2001). The welfare outcome of an expansion in the transmission grid
depends on the weight in the welfare function of the generators’ profits relative to
the consumers’ utility weight. Incumbent generators in load pockets are not in general
the best agents to carry out transmission expansion projects. Even though an increase
in transmission capacity might allow them to increase their revenues due to increased
access to new markets and higher transmission charges, such gains are usually
overcome by the loss of their local market power.
The literature on incentives for long-term expansion of the transmission network is
scarce. The economic analysis of electricity markets has been reduced to short-run
issues, and has typically assumed that transmission capacity is fixed (see Joskow and
Tirole 2003). However, transmission capacity is random in nature, and it jointly
depends on generation investment.
The way to solve transmission congestion in the short run is well known. In a power
flow model, the price of transmission congestion is determined by the difference in
nodal prices (see Hogan 1992, 2002b). Yet, there is no consensus with respect to the
method to attract investment to finance the long-term expansion of the transmission
network, so as to reconcile the dual opposite incentives to congest the network in the
short run, and to expand it in the long run. Incentive structures proposed to promote
transmission investment range from a “merchant” mechanism, based on long-term
financial transmission right (LTFTR) auctions (as in Hogan 2002a), to regulatory
mechanisms that charge the transmission firm the social cost of transmission
congestion (see Léautier 2000; Vogelsang 2001; Joskow and Tirole 2002).
In practice, regulation has been used in England, Wales and Norway to promote
transmission expansion, while a combination of planning and auctions of long-term
transmission rights has been tried in the Northeast of the U.S. A mixture of regulatory
mechanisms and merchant incentives is alternatively used in the Australian market.
In this paper we develop a merchant model to attract investment to small-scale
electricity transmission projects based on LTFTR auctions. Locational prices give
market players incentives to initiate transmission investments. FTRs provide trans-
mission property rights, since they hedge the market player against future price
differences. Our model further develops basic conditions under which FTRs and
locational pricing provide incentives for long-term investment in the transmission
network.
In meshed networks, a change in network capacity might imply negative
externalities on transmission property rights. Then, in the process of allocation of
incremental FTRs, the system operator must reserve certain unallocated FTRs so that
the revenue adequacy of the transmission system is preserved. In order to deal with this
issue, we develop a bi-level programming model for allocation of long-term FTRs and
apply it to different network topologies.
The structure of the paper is as follows. In Sect. 6.2 we carry out an analytical
review on the relevant literature on electricity transmission expansion. In Sect. 6.3
we develop our model. We first introduce FTRs and the feasibility rule, and then
address the rationale for FTR allocation and efficient investments. We develop
general optimality conditions as well. In Sect. 6.4, we carry out applications of our
6 A Merchant Mechanism for Electricity Transmission Expansion 159

model to a radial line, and to a three-node network. Next, we describe the welfare
implications in Sect. 6.5. In Sect. 6.6 we provide concluding comments.

6.2 Literature Review

There exist some hypotheses on structures for transmission investment: the market-
power hypothesis, the incentive-regulation hypothesis, and the long-run financial-
transmission-right hypothesis. The first approach seeks to derive optimal transmission
expansion from the power-market structure of power generators, and takes into
account the conjectures of each generator regarding other generators’ marginal costs
due to the expansion (Sheffrin and Wolak 2001; Wolak 2000, and The California ISO
and London Economics International 2003). The generators’ bidding behaviors are
estimated before and after a transmission upgrade, and a real-option analysis is used to
derive the net present value of transmission and generation projects together with the
computation of their joint probability.
The model shows that there are few benefits of transmission expansion until
added capacity surpasses a certain threshold that, in turn, is determined by the
possibility of induced congestion by the strategic behavior of generators with market
power. The generation market structure then determines when transmission expan-
sion yield benefits. Additionally, many small upgrades of the transmission grid are
preferable to large greenfield projects when cost uncertainty is added to the model.
The contribution of this method is that it models the existing interdependence of
transmission investment and generation investment within a transportation model with
no network loop flows. However, as pointed out by Hogan (2002b), the use of a
transportation model in the electricity sector is inadequate since it does not deal with
discontinuities in transmission capacity implied by the multidimensional character of a
meshed network.
The second method for transmission expansion is a regulatory alternative that relies
on a “Transco” that simultaneously runs system operation and owns the transmission
network. The Transco is regulated through benchmark regulation or price regulation so
as to provide it with incentives to invest in the development of the grid, while avoiding
congestion. Léautier (2000), Grande and Wangensteen (2000), and Harvard Electricity
Policy Group (2002) discuss mechanisms that compare the Transco performance with
a measure of welfare loss due to its activities. Joskow and Tirole (2002) propose a
surplus-based mechanism to reward the Transco according to the redispatch costs
avoided by the expansion, so that the Transco faces the complete social cost of
transmission congestion.
Another regulatory alternative is a two-part tariff cap proposed by Vogelsang
(2001) that addresses the opposite incentives to congest the existing transmission
grid in the short run, and to expand it in the long run. Incentives for investment in
expansion of the network are achieved through the rebalancing of the fixed part and the
variable part of the tariff. This method tries to deepen into the analysis of the cost and
production functions for transmission services, which are not very well understood in
the economics literature. Nonetheless, to achieve this goal Vogelsang needs to define
160 T. Kristiansen and J. Rosellón

an output (or throughput) for the Transco. As argued in the FTR literature (Bushnell
and Stoft 1997; Hogan 2002a, b), this task is very difficult since the average physical
flow through a meshed transmission network is not well defined.
The third approach is a “merchant” one based on LTFTR auctions by an
independent system operator (ISO). This method deals with loop-flow externalities
in that, to proceed with line expansions, the investor pays for the negative
externalities it generates. To restore feasibility, the investor has to buy back suffi-
cient transmission rights from those who hold them initially, or the ISO retains some
unallocated transmission rights (proxy awards) during the LTFTR auction to protect
unassigned rights while simultaneous feasibility of the system protects the rights of
the existing FTR holders. This is the core of an LTFTR auction (see Hogan 2002a).
Joskow and Tirole (2003) criticize the LTFTR approach. They argue that the
efficiency results of the short-run version of the FTR model rely on perfect-
competition assumptions, which are not real for transmission networks. Moreover,
defining an operational FTR auction is technically difficult2 and, according to these
authors, the FTR analysis is static (a contradiction with the dynamics of transmission
investment). Joskow and Tirole analyze the implications of eliminating the perfect
competition assumptions of the FTR model.
First, market power and vertical integration might impede the success of
FTR auctions. Prices will not reflect the marginal cost of production in regions
with transmission constraints. Generators in constrained regions will then withdraw
capacity in order to increase their prices, and will overestimate the cost-saving gains
from investments in transmission.3
Second, lumpiness in transmission investment makes the total value paid to
investors through FTRs less than the social surplus created. The large and lumpy
nature of major transmission upgrades requires long-term contracts before making
the investment, or temporal property rights for the incremental investment.
Third, contingencies in electricity transmission impede the merchant approach
to really solve the loop-flow problem. Moreover, existing transmission capacity and
incremental capacity are stochastic. Even in a radial line, realized capacity could be
less than expected capacity and the revenue-adequacy condition would not be met.
Even more, the initial feasible FTR set can depend on random exogenous variables.
Fourth, an expansion in transmission capacity might negatively affect social
welfare (as shown by Bushnell and Stoft 1997).

2
No restructured electricity sector in the world has adopted a pure merchant approach towards
transmission expansion. Australia has implemented a mixture of regulated and merchant approaches
(see Littlechild 2003). Pope (2002), and Harvey (2002) propose LTFTR auctions for the New York
ISO to provide a hedge against congestion costs. Gribik et al. (2002) propose an auction method based
on the physical characteristics (capacity and admittance) of a transmission network.
3
Generators can exert local power when the transmission network is congested. (See Bushnell 1999;
Bushnell and Stoft 1997; Joskow and Tirole 2000; Oren 1997; Joskow and Schmalensee 1983; Chao
and Peck 1997; Gilbert et al. 2002; Cardell et al. 1997; Borenstein et al. 1998; Wolfram 1998;
Bushnell and Wolak 1999.)
6 A Merchant Mechanism for Electricity Transmission Expansion 161

Fifth, a moral hazard “in teams” problem arises due to the separation of transmis-
sion ownership and system operation in the FTR model. For instance, an outage can be
claimed to be the consequence of poor maintenance (by the transmission owner) or of
negligent dispatch (by the system operator).4 Additionally, there is no perfect coordi-
nation of interdependent investments in generation and transmission, and stochastic
changes in supply and demand conditions imply uncertain nodal prices. Likewise,
there is no equal access to investment opportunities since only the incumbent can
efficiently carry out deepening transmission investments.
Hogan (2003) responds to the above criticisms by arguing that LTFTRs only grant
efficient outcomes under lack of market power, and non-lumpy marginal expansions
of the transmission network. Furthermore, Hogan argues that regulation has an
important role in fostering large and lumpy projects, and in mitigating market power
abuses.
As argued by Pérez-Arriaga et al. (1995), revenues from nodal prices typically
recover only 25 % of total costs. LTFTRs should then be complemented with a fix-
price structure or, as in Rubio-Oderiz and Pérez-Arriaga (2000) a complementary
charge that allows the recovery of fixed costs.5 This fact is recognized by Hogan
(1999) who states that complete reliance on market incentives for transmission
investment is undesirable. Rather, Hogan (2003) claims that merchant and regulated
transmission investments might be combined so that regulated transmission invest-
ment is limited to projects where investment is large relative to market size, and lumpy
so that it only makes sense as a single project as opposed as to many incremental small
projects.
Hogan also responds to contingency concerns.6 On one hand, only those contin-
gencies outside the control of the system operator could lead to revenue inadequacy of
FTRs, but such cases are rare and do not represent the most important contingency
conditions. On the other hand, most of remaining contingencies are foreseen in a
security-constrained dispatch of a meshed network with loops and parallel paths. If one
of “n” transmission facilities is lost, the remaining power flows would still be feasible
in an “n
1” contingency constrained dispatch.

4
An example is the power outage of August 14, 2003, in the Northeast of the US, which affected
six control areas (Ontario, Quebec, Midwest, PJM, New England, and New York) and more than
20 million consumers. A 9-s transmission grid technical and operational problem caused a cascade
effect, which shut down 61,000 MW generation capacity. After the event there were several
“finger pointings” among system operators of different areas, and transmission providers. The
US-Canada System Outage Task Force identified in detail the causes of the outage in its final
report of April, 2004. It shows that the main causes of the black out were deficiencies in corporate
policies, lack of adherence to industry policies, and inadequate management of reactive power and
voltage by First Energy (a firm that operates a control area in northern Ohio) and the Midwest
Independent System Operator (MISO). See US-Canada Power System Outage Task Force (2004).
5
In the US, transmission fixed costs are recovered through a regulated fixed charge, even in those
systems that are based on nodal pricing and FTRs. This charge is usually regulated through cost of
service.
6
See Hogan (2002a, b, 2003).
162 T. Kristiansen and J. Rosellón

Hogan (2003) also assumes that agency problems and information asymmetries are
part of an institutional structure of the electricity industry where the ISO is separated
from transmission ownership and where market players are decentralized. However,
he claims that the main issue on transmission investment is the decision of the
boundary between merchant and regulated transmission expansion projects. He argues
that asymmetric information should not necessarily affect such a boundary.
Hogan (2002a) finally analyzes the implications of loop flows on transmission
investment raised by Bushnell and Stoft (1997). He analytically provides some
general axioms to properly define LTFTRs so as to deal with negative externalities
implied by loop flows. We next present a model that develops the general analytical
framework suggested by Hogan (2002a).

6.3 The Model

Assume an institutional structure where there are various established agents

(generators, Gridcos, marketers, etc.) interested in the transmission grid expansion.
Agents do not have market power in their respective market or, at least, there are in
place effective market-power mitigation measures.7 Also assume that transmission
projects are incrementally small (relative to the total network) and non-lumpy so that
the project does not imply a relatively large change in nodal-price differences.
However, although projects are small, they might change or not the power transfer
distribution factors (PTDFs) of the network.8
Under an initial condition of non-fully allocation of FTRs in the grid, the auctioning
of incremental LTFTRs should satisfy the following basic criteria in order to deal with
possible negative externalities associated with the expansion.
An LTFTR increment must keep being simultaneously feasible ( feasibility rule).
1. An LTFTR increment remains simultaneously feasible given that certain currently
unallocated rights (or proxy awards) are preserved.
2. Investors should maximize their objective function (maximum value).

7
In fact, market power mitigation may be a major motive for transmission investment. A generator
located outside a load pocket might want to access the high price region inside the pocket. Building
a new line would mitigate market power if it creates new economic capacity (see Joskow and
Tirole 2000).
8
Examples of projects that do not change PTDFs include proper maintenance and upgrades (e.g.
low sag wires), and the capacity expansion of a radial line. Such investments could be rewarded
with flowgate rights in the incremental capacity without affecting the existing FTR holders (we
assume however that only FTRs are issued). In our three-node example in Sect. 6.6.2, PTDFs
change substantially. In certain cases, the change in PTDFs could not exist (see Appendix 3) or be
small if, for example, a line is inserted in parallel with an already existing line (see Appendix 3). In
a large-scale meshed network the change in PTDFs may not be as substantial as in a three-node
network. However the auction problem is non-convex and nonlinear, and a global optimum might
not be ensured. Only a local optimum might be found through methods such as sequential
quadratic programming.
6 A Merchant Mechanism for Electricity Transmission Expansion 163

3. The LTFTR awarding process should apply both for decreases and increases in
the grid capacity (symmetry).
The need for proxy awards arises whenever there is less than full allocation of the
capacity of the existing grid. This occurs prominently during a transition to an
electricity market when there is reluctance to fully allocate the existing grid for all
future periods. Hence FTRs for the existing grid are short term (this period), but
investors in grid expansion seek long term rights (next period). Full allocation of the
existing grid seems necessary but not sufficient for defining and measuring incremen-
tal capacity. Hogan explains though that defining proxy awards is a difficult task. We
next address this issue in a formal way in the context of an auction model designed to
attract investment for transmission expansion.

6.4 The Power Flow Model and Proxy Awards

Consider the following economic dispatch model9:

Max Bðd
gÞ
Y;u2U

s: t: ð6:1Þ

Y ¼ d
g; (6.2)

LðY; uÞ þ tT Y ¼ 0 (6.3)

KðY; uÞ  0 (6.4)

where d and g are load and generation at the different locations. The variable Y
represents the real power bus net loads, including the swing bus SðY T ¼ ðYs ; Y
ÞÞ:
T

Bðd
gÞ is the net benefit function,10 andt is a unity column vector,tT ¼ ð1; 1; . . . ; 1Þ
All other parameters are represented in the control variable u. The objective equation
(6.1) includes the maximization of benefit to loads and the minimization of generation
costs. Equation (6.2) denotes the net load as the difference between load and genera-
tion. Equation (6.3) is a loss balance constraint where LðY; uÞ is a vector which denotes
the losses in the network. In (6.4) KðY; uÞ, is a vector of power flows in the lines, which
are subject to transmission capacity limits. The corresponding multipliers or shadow

9
Hogan (2002b) shows that the economic dispatch model can be extended to a market equilibrium
model where the ISO produces transmission services, power dispatch, and spot-market coordina-
tion, while consumers have a concave utility function that depends on net loads, and on the level of
consumption of other goods.
10
Function B is typically a measure of welfare, such as the difference between consumer surplus
and generation costs (see Hogan 2002b).
164 T. Kristiansen and J. Rosellón

prices for the constraints areðP; lref ; ltran Þ for net loads, reference bus energy (or loss
balance) and transmission constraints, respectively.11
The locational prices P are the marginal generation cost or the marginal benefit
of demand, which in turn equals the reference price of energy plus the marginal cost
of losses and congestion. With the optimal solution ðd  ; g ; Y  ; u Þ and the
associated shadow prices, we have the vector of locational prices as:

PT ¼ rCðg Þ ¼ rBðd Þ ¼ lref tT þ lref rLY ðY  ; u Þ þ lTtran rKY ðY  ; u Þ (6.5)

If losses12 are ignored, only the energy price at the reference bus and the marginal
cost of congestion contribute to set the locational price.
FTR obligations13 hedge market players against differences in locational prices
caused by transmission congestion.14 FTRs are provided by an ISO, and are assumed
to redistribute the congestion rents. The pay-off from these rights is given by:

FTR ¼ ðPj
Pi ÞQij (6.6)

where Pj is the price at location j, Pi is the price at location i, and Qij is the directed
quantity injected at point i and withdrawn at point j specified in the FTR. The FTR
payoffs can take negative, positive or zero values.
A set of FTRs is said to be simultaneously feasible if the associated set of net
loads is simultaneously feasible, that is if the net loads satisfy the loss balance and
transmission capacity constraints as well as the power flow equations given by:
X f
Y¼ tk
k

LðY; uÞ þ tt Y ¼ 0;
KðY; uÞ  0 (6.7)
P
where tkf is the sum over the set of point-to-point obligations.15
k

11
When security constraints are taken into account (n
1 criterion) this is a large-scale problem,
and it prices anticipated contingencies through the security-constrained economic dispatch. In
operations the n
1 criterion can be relaxed on radial paths, however, doing the same in the FTR
auction of large-scale meshed networks may result in revenue inadequacy. We do not use the
n
1 criterion in our paper.
12
In the PJM (Pennsylvania, New Jersey and Maryland) market design, the locational prices are
defined without respect to losses (DC-load flow model), while in New York the locational prices
are calculated based on an AC-network with marginal losses.
13
FTRs could be options with a payoff equal to max (ðPj
Pi Þ Qij ,0).
14
See Hogan (1992).
15
The set of point-to-point obligations can be decomposed into a set of balanced and unbalanced
(injection or withdrawal of energy) obligations (see Hogan 2002b).
6 A Merchant Mechanism for Electricity Transmission Expansion 165

If the set of FTRs is simultaneously feasible and the system constraints are
convex,16 then the FTRs satisfy the revenue adequacy condition in the sense that
equilibrium payments collected by the ISO through economic dispatch will be greater
than or equal to payments required under the FTR forward obligations.17
Assume now investments in new transmission capacity. The associated set of new
FTRs for transmission expansion has to satisfy the simultaneous feasibility rule too.
That is, the new and old FTRs have to be simultaneously feasible after the system
expansion. Assume that T is the current partial allocation of long-term FTRs, then by
assumption it is feasible ðKðT; uÞ  0Þ . Suppose there is to be a total possible
incremental award, and that a fraction of the possible awards is reserved as proxy
awards for the existing grid with the remainder provided to the incremental investor as
representing the proportion that could only be awarded as a result of the investment.
Let a be the scalar amount of incremental FTR awards, and ^t the scalar amount of
proxy awards. Furthermore let d be directional vector18 such that ad is the MW
amount of incremental FTR awards, and ^td is the MW amount of proxy awards
between different locations. Any incremental FTR award ad should comply with
feasibility rule in the expanded grid. Hence we must have K þ ðT þ ad; uÞ  0, where
Kþ corresponds to capacity of the expanded grid.
When certain currently unallocated rights (proxy awards) ^td in the existing
grid must be preserved, combined with existing rights they sum up to T þ ^td .19
Then Kþ should also satisfy simultaneous feasibility so that KðT þ ^td; uÞ  0, K þ
ðT þ ad; uÞ  0, and K þ ðT þ ^td þ ad; uÞ  0 for incremental awards ad.
A question then arises regarding the way to best define proxy awards. One
possibility is to define them as the “best use” of the current network along the same
direction as the incremental awards.20 This includes both positive and negative
incremental FTR awards. The best use in a three-node network may be thought of
as a single incremental FTR in one direction or a combination of incremental

16
This has been demonstrated for lossless networks by Hogan (1992), extended to quadratic losses
by Bushnell and Stoft (1996), and further generalized to smooth nonlinear constraints by Hogan
(2000). As shown by Philpott and Pritchard (2004) negative locational prices may cause revenue
inadequacy. Moreover, in the general case of an AC or DC formulation to ensure revenue
adequacy the transmission constraints must satisfy optimality conditions (in particular, if such
constraints are convex they satisfy optimality). See O’Neill et al. (2002), and Philpott and
Pritchard (2004).
17
Revenue adequacy is the financial counterpart of the physical concept of availability of
transmission capacity (see Hogan 2002a).
18
Each element in the directional vector represents an FTR between two locations and the
directional vector may have many elements representing combinations of FTRs.
19
Proxy awards are then currently unallocated FTRs in the pre-existing network that basically
facilitate the allocation of incremental FTRs and help to preserve revenue adequacy by reserving
capacity for hedges in the expanded network.
20
Another possibility would be to define every possible use of the current grid as a proxy award.
However, this would imply that any investment beyond a radial line would be precluded, and that
incremental award of FTRs might require adding capacity to every link on every path of a meshed
network. The idea of defining proxy awards along the same direction as incremental awards
originates from a proposal developed for the New Zealand electricity market by Transpower.
166 T. Kristiansen and J. Rosellón

FTRs defined by the directional vector d; depending on the investor preference. Hogan
(2002a) suggests two ways of defining “best use”:

Preset proxy preferences ðpÞ

y^ ¼ T þ ^td;
^t 2 arg max f^tpdjKðT þ tdÞ  0g ð6:8Þ
t

or,

Investor preferences ðbðadÞÞ

y^ ¼ T þ ^td;
 
^t 2 arg min þ
max fbðadÞjK ðT þ td þ adÞ  0g
t a0
KðTþtdÞ0

In the preset proxy formulation the objective is to maximize the value (defined by
prices p) of the proxy awards given the pre-existing FTRs, and the power flow
constraints in the pre-expansion network. In the investor preference formulation the
objective is to maximize the investor’s value (defined by the bid functions for different
directions, bðadÞ) of incremental FTR awards given the proxy and pre-existing FTRs
and the power flow constraints in the expanded network, while simultaneously calcu-
lating the minimum proxy scalar amount that satisfies the power flow constraints in the
pre-expansion network.
We will use as a proxy protocol the first definition. We next analyze the way to use
this protocol to carry out an allocation of LTFTRs that stimulates investment in
transmission.

6.5 The Auction Model

Assume the preset proxy rule is used to derive prices that maximize the investor
preference bðadÞ for an award of a MWs of FTRs in direction d. We then have the
following auction maximization problem:

Max bðadÞ
a;^t;d

s:t:
K þ ðT þ adÞ  0;
K þ ðT þ ^td þ adÞ  0;
^t 2 arg max ftpdjKðT þ tdÞ  0g;
t
kdk ¼ 1;
a  0: ð6:9Þ
6 A Merchant Mechanism for Electricity Transmission Expansion 167

In this model, the investor’s preference is maximized subject to the simultaneous

feasibility conditions, and the best use protocol. We add a constraint on the (two-)
norm21 of the directional vector to preclude the trivial case d ¼ 0 . We want to
explore if such an auction model approach can produce acceptable proxy and incre-
mental awards. We next analyze this issue within a framework that ignores losses,
and utilizes a DC-load flow approximation.
The auction model is a nonlinear optimization problem of “bi-level” nature.22
There are two optimization stages. Maximization is non-myopic since the result of
the lower problem (first stage) depends on the direction chosen in the upper problem
(second stage).23 Bi-level problems may be solved by first transforming the lower
problem (i.e. the allocation of proxy awards) into to a set of Kuhn-Tucker equations
that are subsequently substituted in the upper problem (i.e. the maximization of the
investors’ preference). The model can then be understood as a Stackelberg problem
although it is not intending to optimize the same type of objective function at each
stage.24
The Lagrangian (L) for the lower problem is:

Lð^t; d; lÞ ¼ ^tpd
lT ðKðT þ ^tdÞÞ

where lT is the Lagrange multiplier vector associated with transmission capacity

on the respective transmission lines before the expansion. It is the Lagrange multi-
plier of the simultaneous feasibility restriction for proxy awards. The Kuhn-Tucker
conditions are:
@Lð^t; d; lÞ @Lð^t; d; lÞ
¼ 0;  0;
@ ^t @l
@Lð^t; d; lÞ
lT ¼ 0; l  0
@l
The transformed problem is then written as:
Max bðadÞ
a;^t;d;l

s:t:
K þ ðT þ adÞ  0; ðoÞ
K þ ðT þ ^td þ adÞ  0; ðgÞ

21
We use “two-norm” to guarantee differentiability.
22
See Shimizu et al. (1997).
23
The model could also be interpreted as having multiple periods. Although we do not explicitly
include in our model a discount factor, we assume that it is included in the investor’s preference
parameter b.
24
Other examples in the economics literature where an upper level maximization takes the
optimality conditions of another problem as constraints are given in Mirrlees (1971), Brito and
Oakland (1977), and Rosellón (2000).
168 T. Kristiansen and J. Rosellón

@Lð^t; d; lÞ
¼ 0; ð yÞ (6.10)
@ ^t

@Lð^t; d; lÞ
lT ¼ 0; ðzÞ (6.11)
@l

@Lð^t; d; lÞ
 0; ðeÞ
@l

kdk ¼ 1; ð’Þ
a  0; ðkÞ
l0 ðpÞ

where o; g; y; z; e; ’; k and p are Lagrange multipliers associated with each constraint.

More specifically, o is the shadow price of the simultaneous feasibility restriction for
existing and incremental FTRs; g is the shadow price of the simultaneous feasibility
restriction for existing FTRs, proxy awards and incremental FTRs; y; z; e are the
shadow prices of the restriction on optimal proxy FTRs; ’; k are the shadow prices of
the non-negativity constraints for a and l, respectively; and p is the shadow price of
the unit restriction on d.
The Lagrangian of the auction problem is:

Lða; ^t; d; l; OÞ ¼bðadÞ
oT ðK þ ðT þ adÞÞ

@Lð^t; d; lÞ

gT ðK þ ðT þ ^td þ adÞÞ
yT
@ ^t
 
^
@Lðt; d; lÞ ^
@Lðt; d; lÞ

zT lT þ eT
@l @l
þ ’ T ð 1
k d k Þ þ k T a þ pT l ð6:12Þ

where O ¼ ðo; g; y; z; e; ’; k; pÞ denotes the vector of Lagrange multipliers.

Kuhn-Tucker conditions for the upper problem are:
 þ T
@Lða; ^t; d; l; OÞ @bðadÞ @K ðT þ adÞ
¼
o
@a @a @a
 þ T
@K ðT þ ^td þ adÞ

gþk¼0 ð6:13Þ
@a
 þ T
@Lða; ^t; d; l; OÞ @K ðT þ ^td þ adÞ
¼
g
@ ^t @ ^t
 2 T  2 T
@ Lð^t; d; lÞ @L ð^t; d; lÞ

lz þ e¼0 ð6:14Þ
@ ^t@l @ ^t@l
6 A Merchant Mechanism for Electricity Transmission Expansion 169

 þ T
@Lða; ^t; d; l; OÞ @bðadÞ @K ðT þ adÞ
¼
o
@d @d @d
 þ T  2 T
@K ðT þ ^td þ adÞ @ Lð^t; d; lÞ

g
y
@d @d@ ^t
 2 T  2 T  
@ Lð^t; d; lÞ @ Lð^t; d; lÞ @ kd k T

lz þ e
’ ¼ 0 ð6:15Þ
@d@l @d@l @d
 2 T  T
@Lða; ^t; d; l; OÞ @ Lð^t; d; lÞ @Lð^t; d; lÞ
¼
y
z þ p ¼ 0; (6.16)
@l @l@ ^t @l

@Lða; ^t; d; l; OÞ
¼
K þ ðT þ adÞ  0; (6.17)
@o

@Lða; ^t; d; l; OÞ
¼
K þ ðT þ ^td þ adÞ  0 (6.18)
dg

@Lða; ^t; d; l; OÞ @Lð^t; d; lÞ

¼
¼ 0; (6.19)
@y @ ^t

@Lða; ^t; d; l; OÞ @Lð^t; d; lÞ

¼
lT ¼ 0; (6.20)
@z @l

@Lða; ^t; d; l; OÞ @Lð^t; d; lÞ

¼  0; (6.21)
@e @l

@Lða; ^t; d; l; OÞ
¼ 1
kdk ¼ 0; (6.22)
@’

@Lða; ^t; d; l; OÞ
¼ a  0; (6.23)
@k

@Lða; ^t; d; l; OÞ
¼ l  0; (6.24)
@p

@Lða; ^t; d; l; OÞ
oT ¼ 0; o  0; (6.25)
@o

@Lða; ^t; d; l; OÞ
gT ¼ 0; g  0; (6.26)
@g

@Lða; ^t; d; l; OÞ
eT ¼ 0; e  0; (6.27)
@e
170 T. Kristiansen and J. Rosellón

kT a ¼ 0; k  0; (6.28)

pT l ¼ 0; p  0 (6.29)

@Lð^t; d; lÞ
The constraint ¼ 0 is redundant when the preset proxy preference (p) is
@l
@Lð^t; d; lÞ
non-zero, since it is a sub-gradient of the constraint lT ¼ 0, and e is therefore
@l
zero when p is non-zero. We show in a later example that y and ’ are zero because the
associated constraints are redundant. The binding constraint in the lower level problem
@Lð^t; d; lÞ
is lT ¼ 0, since some transmission constraints are fully utilized by proxy
@l
awards.
This is a nonlinear and non-convex problem, and its solution depends on the
investor-preference parameters, the current partial allocation (T), and the topology
of the network prior to and after the expansion.25 A general solution method utilizing
Kuhn-Tucker conditions would be through checking which of the constraints are
binding.26 One way to identify the active inequality constraints is the active set
method.27 In this paper we solve the problem in detail for different network topologies,
including a radial line and a three-node network.

6.6 Simulations

6.6.1 Radial Line

Let us first analyze a radial transmission line that is expanded as in Fig. 6.1.
The corresponding optimization problem is:

Max b12 ad12

a;^t;d

s:t:
T12 þ ad12  Cþ
12

25
According to Shimizu et al. (1997), the necessary optimality conditions for this problem are
satisfied. The objective function and the constraints are differentiable functions in the region
bounded by the constraints. A local optimal solution and Kuhn-Tucker vectors then exist.
26
There are other methods available such as transformation methods (penalty and multiplier), and
non-transformation methods (feasible and infeasible). See Shimizu et al. (1997).
27
This method considers a tentative list of constraints that are assumed to be binding. This is a
working list, and consists of the indices of binding constraints at the current iteration. Because this
list may not be the solution list, the list is modified either by adding another constraint to the list or
by removing one from the list. Geometrically, the active set method tends to step around the
boundary defined by the inequality constraints. (See Nash and Sofer 1988).
6 A Merchant Mechanism for Electricity Transmission Expansion 171

Fig. 6.1 An expanded line and its feasible expansion

T12 þ ^td12 þ ad12  Cþ 12

^tðd12 Þ 2 arg max ftp12 d12 jT12 þ td12  C12 g
t
kd12 k ¼ 1;
a0 ð6:30Þ

where C12 is the transmission capacity of the network before the expansion, Cþ 12 is
the transmission capacity of the network after the expansion, and b12 is the investor
preference. The first order conditions of the lower maximization problem can then
be added as constraints to the upper problem:
Max b12 ad12
a;^t;d12 ;l

s:t:
T12 þ ad12  Cþ 12
T12 þ ^td12 þ ad12  Cþ
12
p12 d12
ld12 ¼ 0
lðC12
T12
^td12 Þ ¼ 0 ð6:31Þ

T12 þ ^td12  C12

d212 ¼ 1
a; l  0

Since the grid is being expanded, the constraint on simultaneous feasibility of

incremental FTRs T12 þ ad12  Cþ 12 is non-binding. The solution to this problem
provides the values for the decision variables, and shadow prices.28 First, d12 ¼ 1,
because the network is being expanded. Additionally g ¼ b12 which implies that the
higher the value of the investor-preference parameter b12 the more the investor values
post-expansion transmission capacity (its marginal valuation of transmission capacity
increases with the bid value).

28
The mathematical derivation of these values is presented in Appendix 1.
172 T. Kristiansen and J. Rosellón

Fig. 6.2 Three-node network

with expansion of line 1–2

Fig. 6.3 Feasible expansion

of FTRs

Similarly, we get l ¼ p12 which implies that the higher the value of the preset
proxy preference parameter p12 the higher marginal valuation of pre-expansion
transmission capacity. Other results are y ¼ 0, z ¼ g=p12 ¼ b12 =p12 and e ¼ 0. This
was expected since only one restriction for the lower problem is binding because
the two other are redundant. The value of the binding Lagrange multiplier equals
the ratio between the investor’s bid value and the preset proxy parameter.
It also follows that ’ ¼ 0 which is to be expected because the directional vector d
is non-zero. Furthermore, ^t ¼ C12
T12, which means that for given existing rights
the higher the current capacity the larger the need for reserving some proxy FTRs
for possible negative externalities generated by the expansion. Proxy awards are
auctioned as a hedge against externalities generated by the expanded network.
We finally get a ¼ Cþ ^ þ
12
T12
t ¼ C12
C12 , which shows that the optimal
amount of additional MWs of FTRs in direction d directly depends on the amount of
capacity expansion. Transmission capacity is in fact fully utilized by proxy awards
(in the pre-expansion network), and by incremental FTRs (in the expanded net-
work). Likewise, the investor receives a reward equal to the MW amount of new
transmission capacity that it creates.
6 A Merchant Mechanism for Electricity Transmission Expansion 173

6.6.2 Three-Node Network with Two Links

We now consider a three-node network example from Bushnell and Stoft (1997)
where there is an expansion of line 1–2. The network is illustrated in Fig. 6.2 and
the feasible expansion in Fig. 6.3.
The network expansion problem for identical links and FTRs between buses 1–3
and 2–3 is formulated as:

Max aðb13 d13 þ b23 d23 Þ

a;^t;d

s:t:
2 1
ðT13 þ ad13 Þ þ ðT23 þ ad23 Þ  C13
3 3
2 1
ðT13 þ ^td13 þ ad13 Þ þ ðT23 þ ^td23 þ ad23 Þ  C13
3 3
1 2
ðT13 þ ad13 Þ þ ðT23 þ ad23 Þ  C23
3 3
1 2
ðT13 þ ^td13 þ ad13 Þ þ ðT23 þ ^td23 þ ad23 Þ  C23 ð6:32Þ
3 3

1 1
ðT13 þ ad13 Þ
ðT23 þ ad23 Þ  C12
3 3
1 1
ðT13 þ ^td13 þ ad13 Þ
ðT23 þ ^td23 þ ad23 Þ  C12 ð6:33Þ
3 3

1 1

ðT13 þ ad13 Þ þ ðT23 þ ad23 Þ  C21
3 3
1 1

ðT13 þ ^td13 þ ad13 Þ þ ðT23 þ ^td23 þ ad23 Þ  C21
3 3

^tðdÞ 2 arg max ftðp13 d13 þ p23 d23 Þg

t
ðT13 þ td13 Þ  C13
ðT23 þ td23 Þ  C23
kdk ¼ 1
a0

Appendix 2 presents the calculations to obtain the power transfer distribution

factors (PTDFs) for the post expansion network. In Fig. 6.3 the pre-existing FTRs in
the direction 2–3 do not use the full capacity of the pre-expansion network and become
infeasible after inserting line 1–2. The preference is for FTRs in the direction 1–3 for
transmission expansion. As seen from Fig. 6.3 the maximum amount of proxy and
incremental FTRs in the direction 1–3 that can be obtained is 1,100, and corresponds to
the point where the 1–3 and 1–2 transmission capacity constraints intersect.
174 T. Kristiansen and J. Rosellón

In solving this problem, we get29:

ð1=3g1
1=3g2 Þ
d13 ¼  1=2
ð2=3g1 þ 1=3g2
zlÞ2 þ ð1=3g1
1=3g2 Þ2

ð2=3g1 þ 1=3g2
zlÞ
d23 ¼  1=2
ð2=3g1 þ 1=3g2
zlÞ2 þ ð1=3g1
1=3g2 Þ2

C12
a¼
d13
ðC13
T13 Þ
^t ¼
d13

ðb13 þ Bb23 þ g2 ðB=3
1=3ÞÞ

g1 ¼
ð2=3 þ B=3Þ

1
g2 ¼ ½b13 ð1 þ 3A
B
2A
ABÞ
ð1
B
AB þ AÞ
þ b23 ðB þ 3AB
B2
2A
ABÞ

zl ¼ ð1 þ AÞg1
Aðb13 þ b23 Þ

with
C12
A¼
ðC13
T13 Þ
1 ðC13
2C12
T23 Þ
B¼
ð1 þ AÞ ðC13
T13 Þ

where g1 and g2 are the Lagrange multipliers associated with transmission capacity on
the lines 1–3 and 1–2, respectively, in the expanded network, and z is the multiplier
associated with the Kuhn-Tucker condition regarding transmission capacity in the pre-
expansion network for the line 1–3. This line has the Lagrange multiplier l associated
with it before expansion. So as to characterize the solution to our model, we now
calculate the Lagrange multipliers and decision variables for particular parameter
values. In particular, we find the solution for the allocation presented in Fig. 6.3.
We assume the following bid values, preset proxy preferences and pre-existing amount
of FTRs:

b13 ¼ 40; b23 ¼ 10;

p13 ¼ 60; p23 ¼ 10;
T13 ¼ 100; T23 ¼ 800

29
The detailed mathematical derivation of solutions to program (6.32) is presented in Appendix 1.
6 A Merchant Mechanism for Electricity Transmission Expansion 175

From these parameters we find that the marginal value of transmission capacity on
line 1–3 and line 1–2 are g1 ¼ 39:6 and g2 ¼ 33:6, respectively. Thus the investor
values transmission capacity on line 1–3 more than on line 1–2. We find that the
product of the Kuhn-Tucker multiplier and the transmission capacity multiplier for the
line 1–3 is zl ¼ 37.
Likewise, the values of the decision variables are calculated as:

d13 ¼ 0:958; d23 ¼
0:287;

a ¼ 208; ^t ¼ 835

The MW amount of awarded proxy FTRs in the direction 1–3 is ^td13 ¼ 800, and
the amount of awarded incremental FTRs is ad13 ¼ 200. The amount of incremental
1–3 FTRs corresponds to the new transmission capacity on line 1–2 that the investor
has created. There is also an allocation of proxy FTRs such that the full capacity of
line 1–3 is utilized. Similarly the proxy awards in direction 2–3 is ^t d23 ¼
240, and
the amount of awarded incremental FTRs is ad23 ¼
60. The amount of incremental
2–3 FTRs is minimized and corresponds to 20 % of the reduction (300) in pre-existing
FTRs. The incremental 2–3 awards are mitigating FTRs, and are necessary to restore
feasibility. The investor is then responsible for additional counterflows so that it pays
back for the negative externalities it creates. The solution is indicated by the black
arrow in Fig. 6.3 and consists of both pre-existing and incremental FTR awards
amounting to T13 þ ad13 ¼ 300 and T23 þ ad23 ¼ 740. The allocation of incremental
2–3 FTRs is minimized because the model takes into account that one line is expanded,
and some of the pre-existing FTRs become infeasible after the expansion.
This illustrates that the amount of incremental FTRs in the preference direction
must be greater than zero such that feasibility is restored. Both the proxy and
incremental FTRs exhaust transmission capacity in the pre-expansion and expanded
grid, respectively. The proxy FTRs help allocating incremental FTRs by preserving
capacity in the pre-expansion network, which results in an allocation of incremental
FTRs amounting to the new transmission capacity created in 1–2 direction.30 The
proxy awards are transmission congestion hedges that can be auctioned to electricity
market players in the expanded network.31
In the example provided by Bushnell and Stoft (1997), the investor with pre-
existing FTRs chooses the most profitable incremental FTR based on optimizing its

30
Note that this result will depend on the network interactions. In some cases the amount of
incremental FTRs in the preference direction will differ from the new capacity created on a
specific line. However, it will always amount to the new capacity created as defined by the scalar
amount of incremental FTRs times the directional vector.
31
Whenever there is an institutional restriction to issue LTFTRs there will be an additional
(expected congestion) constraint to the model. A proxy for the shadow price of such a constraint
would be reflected by the preferences of the investor that carries out the expansion project
(assuming risk neutrality and a price taking behavior). The proxy award model takes the “linear”
incremental and proxy FTR trajectories to the after-expansion equilibrium point in the ex-post
FTR feasible set to ensure the minimum shadow value of the constraint.
176 T. Kristiansen and J. Rosellón

final benefit. The investor is then awarded a mitigating incremental 1–2 FTR with
associated power flows corresponding to the difference between the ex-ante and ex-
post optimal dispatches. The pre-existing FTRs correspond to the actual dispatch of the
system and become infeasible after expanding line 1–2, and therefore a mitigating 1–2
FTR32 is allocated so that feasibility is exactly restored (that is, the investor “pays
back” for the negative externalities to other agents). There is no allocation of proxy
awards because the pre-expansion network is fully allocated by FTRs before the
expansion. The amount of incremental FTRs is minimized because they represent a
negative value to the investor and decrease its revenues from the pre-existing FTRs.

6.7 The Auction Model and Welfare

Bushnell and Stoft (1997) demonstrate that the increase in social welfare will be at
least as large as the ex-post value of new contracts, when the FTRs initially match
dispatch in the aggregate and new FTRs are allocated according to the feasibility rule.
In particular, if social welfare is decreased by transmission expansion, the investor will
have to take FTRs with a negative value (If social welfare is increased there will be free
riding). With only the aggregate match of FTRs and dispatch, some agents might still
benefit from investments that reduce social welfare, whenever their own commercial
interests improve to an extent that more than offsets the negative value of the new
FTRs. Further, Bushnell and Stoft show that incentives for expansion that reduce
social welfare would be removed if FTRs for each agent as a perfect hedge and match
their individual net loads. In such a case, FTRs allocated under the feasibility rule
ensure that no one will benefit from an expansion that reduces welfare.
Although apparently similar, our mechanism and its implications on welfare are
different from those in the Bushnell and Stoft (1997) model. Bushnell and Stoft
analyze the welfare implications of transmission expansion given matching of
dispatch both in the aggregate and individually. In our model, we assume unallocated
FTRs both before and after the expansion, so that there is no match in dispatch.33
However, the proxy award mechanism developed in this paper implies nonnegative
effects on welfare in the sense that future investments in the grid cannot reduce the
welfare of aggregate use for FTR holders. The reason is that simultaneous feasibility is
guaranteed before and after the enhancement project so that revenue adequacy is also
guaranteed after expansion. Only those non-hedged agents in the spot market might be
exposed to rent transfers. For feasible long term transactions identified ex ante, the
FTRs provide perfect congestion hedges for the existing grid or for any future grid that
develops under the feasibility rule. However, FTRs cannot provide perfect hedges

32
The incremental 1–2 FTR can be decomposed into a 1–3 FTR and a 3–2 FTR.
33
Additionally, Bushnell and Stoft explicitly define loads, nodal prices, and generation costs so
that the effects on welfare are measured as the change in net generation costs. In contrast, we do
not define a net benefit function of the users of the grid in terms of prices, generation costs or
income from loads. Alternatively, our model maximizes the investors’ objective function in terms
of incremental FTRs.
6 A Merchant Mechanism for Electricity Transmission Expansion 177

ex post for all possible transactions. A similar property carries over to any welfare
analysis under FTRs.
More formally, suppose we have a social welfare function B for dispatch in a
single period. Also assume that there is no uncertainty, that all functions are known,
and that agents are price takers in the electricity and FTR markets. A simple welfare
model associated with transmission expansion D is34:

Max BðY  þ DÞ
D
s:t: ð6:34Þ

K þ ðY  þ DÞ  0

where

Y  2 arg maxfBðYÞjKðYÞ  0g

Then Y  is the dispatch that maximizes social welfare without the expansion. Let
þ
D be the dispatch that would be provided as an increment due to transmission
expansion. Dþ solves program (6.34). Note that if Pþ ¼ rBðY  þ Dþ Þ, then under
reasonable regularity conditions Dþ is also a solution to:

Max Pþ D
D
s:t: ð6:35Þ

K þ ðY  þ DÞ  0

Formulation (6.35) is interpreted as the maximization of congestion rents for the

incremental allocation D.
In the context of Bushnell and Stoft assumptions,35 suppose no w that the current
allocation of FTRs T satisfies T ¼ Y , then (6.35) would award the maximum value of
incremental FTRs. In this case, we need not know the full benefit function. We could
rely on the expander to estimate Pþ , and provide this preference ranking function as
part of the bid. Then solving (6.35) would give the maximum value incremental award
for expansion K þ , and this award would preserve the welfare maximizing property of
the FTRs for the expanded grid.36

34
We are grateful to William Hogan for the insights in the formulation of the following model.
35
See Bushnell and Stoft (1997, pp. 100–106).
36
This is however a particular type of welfare maximization since, as opposed to Bushnell and
Stoft, costs of expansion are not addressed.
178 T. Kristiansen and J. Rosellón

Now suppose that (for some reason) T 6¼ Y . To preserve simultaneous feasibility

the constraint K þ ðT þ DÞ  0 should be imposed. A natural (second best) rule
might be:

Max Pþ D
D
s:t: ð6:36Þ

K þ ðY  þ DÞ  0

K þ ðT þ DÞ  0

Y  2 arg maxfBðYÞjKðYÞ  0g

Hence, the existing users of the grid could continue to do as before the expansion,
and the expander receives the incremental values arising from the expansion. Then the
example in Hogan (2002a, p. 12; see also Appendix 3) illustrates the case of a
beneficial expansion where the only solution to (6.36) is D ¼ 0 so that the expansion
project does not occur. In fact, K þ ðT þ DÞ  0 cannot be relaxed without violating
the critical property of simultaneous feasibility. We illustrate the argument in the
following examples.
Consider the example in Hogan (2002a, p. 12) illustrated in Fig. 6.4. Here the
dispatch in the pre-existing network does not match the current allocation of FTRs.
The limiting constraints for the dispatch are the 1–3 and 2–3 constraints. Likewise, the
limiting constraints for the current allocation of FTRs are the 1–2 and 1–3 constraints.
Assume that the incremental dispatch in the 1–3 and 2–3 directions may be caused by
the increased capacity of line 1–3. The relevant constraints areK þ ðY  þ DÞ  0for the
current dispatch and K þ ðT þ DÞ  0 for the current allocation of FTRs. The
corresponding objective is Max Pþ þ
13 D13 þ P23 D23 . Then the following constraints
would apply for the specific network topology:

2 1
ðT13 þ D13 Þ þ ðT23 þ D23 Þ  Cþ
13
3 3

2 1
ðY13 þ D13 Þ þ ðY23 þ D23 Þ  Cþ
13
3 3

1 2
ðT13 þ D13 Þ þ ðT23 þ D23 Þ  C23
3 3

1 2
ðY13 þ D13 Þ þ ðY23 þ D23 Þ  C23
3 3

1 1
ðT13 þ D13 Þ
ðT23 þ D23 Þ  C12
3 3
6 A Merchant Mechanism for Electricity Transmission Expansion 179

Fig. 6.4 Dispatch Y does not match the current allocation of FTRs

1 1
ðY13 þ D13 Þ
ðY23 þ D23 Þ  C12
3 3

1 1

ðT13 þ D13 Þ þ ðT23 þ D23 Þ  C21
3 3

1 1

ðY13 þ D13 Þ þ ðY23 þ D23 Þ  C21
3 3

First assume that T13 ¼ 1100; T23 ¼ 500 and Y13 ¼ 900; Y23 ¼ 900 and
that the incremental benefit of expansion is greater in the 1–3 direction than in the
2–3 direction. Also assume that Cþ 13 ¼ 1000. We notice that the mismatch between
the dispatch and existing FTRs is Y13
T13 ¼
200 and Y23
T23 ¼ 400.
Furthermore, the marginal expansion occurs from the current dispatch to where
the 1–3þ and 2–3 transmission constraints intersect. This amounts to the incremen-
tal dispatch D13 ¼ 200 and D23 ¼
100. If the above numbers are substituted in
the constraints we find that the transmission capacity constraint for line 1–2
and existing FTRs are violated because 13 ðT13 þ D13 Þ
13 ðT23 þ D23 Þ ¼ 13 ð1100 þ
200Þ
13 ð500
100Þ ¼ 300 > C12 ¼ 200 . Hence the expansion does not occur.
Conversely, assume that the location of the current dispatch and existing FTRs
are interchanged so the mismatch between the dispatch and existing FTRs is
Y13
T13 ¼ 200 and Y23
T23 ¼
400 and assume that the marginal benefit of
the expansion is greater in the 2–3 direction than in the 1–3 direction. Then the
incremental dispatch would be D13 ¼ 0 and D23 ¼ 300: In this case the 2–3
transmission capacity constraint would be violated for the existing FTRs 13 ðT13 þ
D13 Þ þ 23 ðT23 þ D23 Þ ¼ 13 900 þ 23 ð900 þ 300Þ ¼ 1100 > C23 ¼ 900.
Similar problems would arise with rules such as preserving proxy awards to
allow for any possible dispatch on the existing grid, where the only expansions
180 T. Kristiansen and J. Rosellón

incented would be those that added to every constraint in the system, virtually
foreclosing the possibility of investment under this rule.
Given the complicated externalities of electric grid, a first best system based on
decentralized property rights is not known. Traditionally, all investment decisions
relied on central decisions by regulators under certification of need. This often
produced regulatory gridlock precisely because of the grid externalities considered
here (not to mention the siting and environmental issues). The FTR feasibility rule
always preserves the property that the incidence of any welfare reductions falls to those
whose transaction were not selected ex ante to be hedged by FTRs. In dealing with the
aggregate welfare effects, the second best motivation is shown in (6.35) (without going
all the way to (6.36)). In the absence of the known welfare function or the possibility of
allocating all the existing grid, the total award is divided between proxy awards and
incremental awards for the investor. The proportional part of the resulting total award
that could be achieved with the existing grid is preserved as a proxy award. The
remainder is assigned to the investor. Subject to this rule, the total award is chosen to
maximize the market value of the incremental award to the investor. Presumably this
would reinforce the incentive for the investor to provide an accurate estimate of the
market value. Given the prices, the special case of FTRs matching dispatch or T ¼ Y 
(considered by Bushnell and Stoft 1996, and Bushnell and Stoft 1997) is consistent
with this rule, and the welfare maximizing results apply. In the case where there is not a
full allocation of the existing grid, the likely result is that there would be more scope for
welfare reducing investments. The need for regulatory oversight would not be
eliminated, but the intent is that the scope of the regulatory issues would be reduced.
Since proxy award mechanisms are in use and more are under development, further
investigation of the private incentives, welfare effects and regulatory implications
would be of value.

6.8 Concluding Remarks

We proposed a merchant mechanism to expand electricity transmission. Proxy

awards (or reserved FTRs) are a fundamental part of this mechanism. We defined
them according to the best use of the current network along the same direction of
the incremental expansion. The incremental FTR awards are allocated according
to the investor preferences, and depend on the initial partial allocation of FTRs
and network topology before and after expansion.
Our examples showed that the internalization of possible negative externalities
caused by potential expansion is possible according to the rule proposed by Hogan
(2002a): allocation of FTRs before (proxy FTRs) and after (incremental FTRs) the
expansion is in the same direction and according to the feasibility rule. Under these
circumstances, the investor will have the proper incentives to invest in transmission
expansion in its preference direction given by its bid parameters. Likewise the larger
the existing current capacity the greater the number of FTRs that must be reserved in
order to deal with potential negative externalities depending on post network topology.
6 A Merchant Mechanism for Electricity Transmission Expansion 181

Our mechanism of long term FTRs is basically a way to hedge market players from
long-run nodal price fluctuations by providing them with the necessary property
transmission rights. The main purpose of the four basic criteria that support our
model (feasibility rule, proxy awards, maximum value and symmetry) were to define
property rights for increased transmission investment according to the preset proxy
rule. However, the general implications on welfare, and incentives for gaming are still
an open research question.
Although our model is specifically designed to deal with loop flows, and the
security-constrained version of our model can take care of contingency concerns,
our proposed mechanism is to be applied to small line increments in meshed transmis-
sion networks. LTFTRs are efficient under non-lumpy marginal expansions of the
transmission network, and lack of market power. Regulation has then an important
complementary role in fostering large and lumpy projects where investment is large
relative to market size, and in mitigating market power. Since revenues from nodal
prices only recover a small part of total costs, LTFTRs must be complemented with a
regulated framework that allows the recovery of fixed costs. The challenge is to
effectively combine merchant and regulated transmission investments or, as Hogan
(2003) puts it, to establish a rule in practice for drawing a line between merchant and
regulated investment.

Appendix 1

Solution to Program (6.30)

The Lagrangian of the problem is:

Lða; ^t; d12 ; l; OÞ ¼ b12 ad12 þ g Cþ ^

12
T12
ða þ tÞd12

yðp12 d12
ld12 Þ
zðlðC12
T12
^td12 ÞÞ
þ eðC12
T12
^td12 Þ þ ’ 1
d212 þ ka þ pl ð6:37Þ

where g; y; z; e; ’; k; and p are the multipliers associated with the respective

constraints.
At optimality the Kuhn-Tucker conditions are:

@Lða; ^t; d12 ; l; OÞ

¼ b12 d12
gd12 ¼ 0; (6.38)
@a

@Lða; ^t; d12 ; l; OÞ

¼ ab12
ð^t þ aÞg
ðp12
lÞy
@d12
þ lz^t
e^t
2d12 ’ ¼ 0; ð6:39Þ

@Lða; ^t; d12 ; l; OÞ

¼
gd12 þ lzd12
ed12 ¼ 0; (6.40)
@ ^t
182 T. Kristiansen and J. Rosellón

@Lða; ^t; d12 ; l; OÞ

¼ d12 y
ðC12
T12
^td12 Þz ¼ 0; (6.41)
@l

@Lða; ^t; d12 ; l; OÞ

¼ Cþ ^
12
T12
ða þ tÞd12 ¼ 0; (6.42)
@g

@Lða; ^t; d12 ; l; OÞ

¼
ðp12 d12
ld12 Þ ¼ 0; (6.43)
@y

@Lða; ^t; d12 ; l; OÞ

¼
lðC12
T12
^td12 Þ ¼ 0; (6.44)
@z

@Lða; ^t; d12 ; l; OÞ

¼ ðC12
T12
^td12 Þ ¼ 0; (6.45)
@e

@Lða; ^t; d12 ; l; OÞ

¼ 1
d212 ¼ 0; (6.46)
@’

@Lða; ^t; d12 ; l; OÞ

¼ a > 0; k ¼ 0; (6.47)
@k

@Lða; ^t; d12 ; l; OÞ

¼ l > 0; p ¼ 0; (6.48)
@p

g; e  0 (6.49)

Equation (6.46) gives d12 ¼ 1. Equation (6.38) gives g ¼ b12. Equation (6.43) gives
g ¼ b12 , (6.40) z ¼ g=p12 ¼ b12 =p12 (e is zero because the constraint is redundant),
and (6.41) y ¼ 0. From this it follows (6.39) that ’ ¼ 0 Furthermore (6.44) gives
^t ¼ C12
T12 . Equation (6.42) implies that a ¼ Cþ ^ þ
12
T12
t ¼ C12
C12 .

Solution to Program (6.32)

The Lagrangian of the problem is:

Lða; ^t; d; l; OÞ ¼
 
2 1
aðb13 d13 þ b23 d23 Þ þ g1 C13
ðT13 þ ð^t þ aÞd13
ðT23 þ ð^t þ aÞd23 ÞÞ
3 3
 
1 1
þ g2 C12
ðT13 þ ð^t þ aÞd13 þ ðT23 þ ð^t þ aÞd23 ÞÞ
3 3

zðlðC13
ðT13 þ ^td13 ÞÞ ð6:50Þ
6 A Merchant Mechanism for Electricity Transmission Expansion 183

þ eðC13
ðT13 þ ^td13 ÞÞ

þ ’ 1
d213
d223 þ ka þ pl

where g1 and g2 are the Lagrange multipliers associated with transmission capacity on
the lines 1–3 and 1–2 in the expanded network, respectively. z is the multiplier
associated with the Kuhn-Tucker condition of transmission capacity in the pre-
expansion network for line 1–3. This line has the Lagrange multipliers l associated
with it before expansion. e is the investor’s marginal value of transmission capacity in
the pre-expansion network when allocating incremental FTRs. The normalization
condition has the multiplier ’ and the non-negativity conditions have the associated
multipliers k and p. The first order conditions are:
 
@Lða; ^t; d; l; OÞ 2 1
¼ ðb13 d13 þ b23 d23 Þ
d13 þ d23 g1
@a 3 3
 
1 1

d13
d23 g2 ¼ 0; ð6:51Þ
3 3

@Lða; ^t; d; l; OÞ 2 1
¼ ab13
ð^t þ aÞg1
ð^t þ aÞg2
@d13 3 3
þ zl^t
e^t
2’d13 ¼ 0; ð6:52Þ

@Lða; ^t; d; l; OÞ 1 1
¼ ab23
ð^t þ aÞg1 þ ð^t þ aÞg2
@d23 3 3

2’d23 ¼ 0; ð6:53Þ
   
@Lða; ^t; d; l; OÞ 2 1 1 1
¼
d13 þ d23 g1
d13
d23 g2
@ ^t 3 3 3 3
þ d13 zl
d13 e ¼ 0; ð6:54Þ

@Lða; ^t; d; l; OÞ
¼
zðC13
T13
^td13 Þ ¼ 0; (6.55)
@l

@Lða; ^t; d; l; OÞ 2
¼ C13
ðT13 þ ð^t þ aÞd13 Þ
@g1 3
1

ðT23 þ ð^t þ aÞd23 Þ ¼ 0; ð6:56Þ
3

@Lða; ^t; d; l; OÞ 1
¼ C12
ðT13 þ ð^t þ aÞd13 Þ
@g2 3
1
þ ðT23 þ ð^t þ aÞd23 Þ ¼ 0; ð6:57Þ
3
184 T. Kristiansen and J. Rosellón

@Lða; ^t; d; l; OÞ
¼
lðC13
ðT13 þ ^td13 ÞÞ ¼ 0; (6.58)
@z
@Lða; ^t; d; l; OÞ
¼ ðC13
T13
^td13 Þ ¼ 0; (6.59)
@e
@Lða; ^t; d; l; OÞ
¼ 1
d213
d223 ¼ 0; (6.60)
@’

@Lða; ^t; d; l; OÞ
¼ a > 0; k ¼ 0; (6.61)
@k

@Lða; ^t; d; l; OÞ
¼ l > 0; p ¼ 0; (6.62)
@p

The solution for the first order conditions is given by:

ð1=3g1
1=3g2 Þ
d13 ¼  1=2
ð2=3g1 þ 1=3g2
zlÞ2 þ ð1=3g1
1=3g2 Þ2

ð2=3g1 þ 1=3g2
zlÞ
d23 ¼  1=2
ð2=3g1 þ 1=3g2
zlÞ2 þ ð1=3g1
1=3g2 Þ2

C12
a¼
d13
ðC13
T13 Þ
^t ¼
d13

ðb13 þ Bb23 þ g2 ðB=3
1=3ÞÞ

g1 ¼
ð2=3 þ B=3Þ

1
g2 ¼ ½b13 ð1 þ 3A
B
2A
ABÞ
ð1
B
AB þ AÞ
þ b23 ðB þ 3AB
B2
2A
ABÞ

zl ¼ ð1 þ AÞg1
Aðb13 þ b23 Þ

with

C12
A¼
ðC13
T13 Þ
1 ðC13
2C12
T23 Þ
B¼
ð1 þ AÞ ðC13
T13 Þ
6 A Merchant Mechanism for Electricity Transmission Expansion 185

Appendix 2

This appendix derives the power transfer distribution factors (PTDFs) for the three-
node network with two parallel lines, and where all lines have identical reactance.
The net injection (or net generation) of power at each bus is denoted Pi. We have the
following relationship between the net injection, the power flows Pij and phase
angles yi (Wood and Wollenberg 1996):
X X1
Pi ¼ Pij ¼ ðyi
yj Þ
j j
xij

where xij is the line inductive reactance in per unit.

We can write the power flow equations as:
2 3 2 32 3
P1 2
1
1 y1
4 P2 5 ¼ 4
1 2
1 5 4 y2 5
P3
1
1 2 y3

The matrix is called the susceptance matrix. The matrix is singular, but by declaring
one of the buses to have a phase angle of zero and eliminating its row and column from
the matrix, the reactance matrix can be obtained by inversion. The resulting equation
then gives the bus angles as a function of the bus injection:
    
y2 2=3 1=3 P2
¼
y3 1=3 2=3 P3

The PTDF is the fraction of the amount of a transaction from one node to another
node that flows over a given line. PTDFij,mn is the fraction of a transaction from
node m to node n that flows over a transmission line connecting node i and node j.
The equation for the PTDF is:

xim
xjm
xin þ xjn

PTDFij;mn ¼
xij

where xij is the reactance of the transmission line connecting node i and node j and
xim is the entry in the ith row and the mth column of the bus reactance matrix.
Utilizing the formula for the specific example network gives:

PTDF12;13 ¼ 1=3; PTDF13;13 ¼ 2=3; PTDF23;13 ¼ 1=3;

PTDF12;23 ¼
1=3; PTDF13;23 ¼ 1=3; PTDF23;23 ¼ 2=3
PTDF21;13 ¼
1=3; PTDF21;23 ¼ 1=3
186 T. Kristiansen and J. Rosellón

Fig. 6.5 Three-node network with expansion in one line

Fig. 6.6 Feasible expansion FTR set

Appendix 3

Transmission Investment That Does Not Change PTDFs

An example on an investment that does not change the PTDFs of the network is
shown in Fig. 6.5 where there is an expansion of line 1–3 from 900 to 1,000 MW
transmission capacity. The associated feasible expansion FTR set is shown in
Fig. 6.6. We observe that whatever feasible FTRs that existed before expansion,
none of these will become infeasible after the expansion.
6 A Merchant Mechanism for Electricity Transmission Expansion 187

Fig. 6.7 Three-node network where a line is inserted in parallel with an existing line

Fig. 6.8 Feasible expansion FTR set

Transmission Investment That Does Change PTDFs

Figure 6.7 shows a three-node network where a line is inserted in parallel with an
existing line between the nodes 2 and 3. Inserting a parallel line with identical
reactance as the existing line halves the total reactance between nodes 2 and 3. As a
result the PTDFs of the expanded network change.

PTDF12;13 ¼ 1=3 and PTDF13;13 ¼ 2=3

change to

PTDF12;13 ¼ 0:4 and PTDF13;13 ¼ 0:6:

188 T. Kristiansen and J. Rosellón

Furthermore, the inserted line has identical transmission capacity to the existing
one so that the total transmission capacity is doubled between the buses 2 and 3.
However, the simultaneous interaction of the reactances and transmission capacities
changes the feasible expansion FTR set as illustrated in Fig. 6.8. Then some of the
pre-existing FTRs may become infeasible.

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Chapter 7
Mechanisms for the Optimal Expansion
of Electricity Transmission Networks

Juan Rosellón

7.1 Introduction

Electricity transmission grid expansion and pricing have received increasing attention
in recent years.1 Transmission networks provide the fundamental support upon which
competitive electricity markets depend. Congestion of transmission networks might
increase market power in certain regions, put entry barriers to potential competitors in
the generation business, and in general reduce the span of competitive effects. A well
functioning transmission network is a critical component of wholesale and retail
markets for electricity.
The formal analysis of adequate incentives for network expansion in the electricity
industry is complicated due to externalities generated by the physical characteristics of
electricity itself as well as due to cost sub-additivity and economies-of-scale features

This paper was previously published as: Rosellón J (2009) Mechanisms for the optimal expansion of
electricity transmission networks. In: Evans J, Hunt LC (eds) International handbook on the economics
of energy. Edward Elgar Publishing, UK.
Support from Conacyt (p. 60334) and from Pieran-Colegio-de-México is gratefully acknowledged.
1
Problems related with coordination and capacity to the transmission network partly caused power
outages in the northeast of the US during 2003, which affected more than 20 million consumers
and six control areas (Ontario, Quebec, Midwest, PJM, New England, and New York), and shut
down 61,000 MW of generation capacity. Similar recent events in other parts of the world such as
UK, Italy, Sweden, Brazil, Argentina, Chile New Zealand, and Germany (incidence of E.ON Netz
that blacked out large chunks of Europe in 2006) also awakened the interest in the factors that
ensure reliability of transmission grids.
J. Rosellón (*)
División de Economı́a, Centro de Investigación y Docencia Económicas (CIDE),
Carretera México-Toluca 3655, Mexico, D.F 01210, Mexico
German Institute for Economic Research (DIW Berlin), Mohrenstrasse 58, Berlin 10117, Germany
e-mail: [email protected]; [email protected]

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 191

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9_7,
# Springer-Verlag London 2013
192 J. Rosellón

of the grid.2 Externalities in electricity transmission are mainly due to “loop flows”,3
which arise from interactions in the transmission network.4 The effects of loop flows
imply that transmission opportunity costs and pricing critically depend on the marginal
costs of power at every location. Energy costs and transmission costs are not indepen-
dent since they are determined simultaneously in the electricity dispatch and the spot
market. Then, certain transmission investments in a particular link might have nega-
tive externalities on the capacity of other transmission links.
The analysis of incentives for transmission investment is further complicated since
equilibria in forward electricity transmission markets has to be coordinated with
equilibria in other markets such as the energy spot market, the forward energy market,
and the generation capacity-reserves market.5 Likewise, electricity pricing is a com-
plex issue since electricity is not storable, and because it has to simultaneously guide
long-term investment decisions by transmission companies as well as to ration
demands in the short run due to congestion. Furthermore, the effects of an increase
in transmission capacity are uncertain. For instance, the net welfare outcome of an
expansion in the transmission grid depends on the weight in the welfare preferences of
the generators’ profits relative to the consumers’ weight.6 Generation revenues gains,
due to improved access to increased transmission charges and new markets, might be
overcome by the loss of local market power.
The institutional structure of the system operator, and its relationship with the
transmission network, are also key components that define the alternatives that might
attract new investment to the grid. There exist three possible structures for a system
operator.7 The first structure is an independent system operator (ISO) – different from
the company that owns the transmission grid – that is decentralized and intrudes to
the least possible extent in the markets. The second is a centralized ISO that controls
and coordinates the markets. The third is an integrated company, the transmission
company (Transco), which combines ownership of the transmission network with
system operation.8

2
Vogelsang (2006).
3
Loop flow is the characteristic of electricity that takes it through all available routes (path of least
resistance) to get from one point to another. For instance, if a second line becomes available that is
identical to a first line, the electricity that had been flowing over the first line will “divide” itself so
that half of it will remain flowing through the first line and the other half will flow over the second
(see Brennan et al. 1996).
4
Joskow and Tirole (2000), and Léautier (2001).
5
Wilson (2002).
6
Léautier (2001),
7
Wilson (2002).
8
In practice, the ISO model has been used in Argentina, and Australia. System operation is carried
out by the ISO and transmission ownership is carried out by another independent company, the
Gridco. ISOs also exist in California, New England, New York, Pennsylvania-New Jersey-
Maryland (PJM), and the Texas. ISO practical experiences and proposals have been centralized.
The Transo model has been typically used in practice in the UK, Spain and the Scandinavian
countries.
7 Mechanisms for the Optimal Expansion of Electricity Transmission Networks 193

The economic analysis of electricity markets has typically concentrated on short-

term issues such as short-run congestion management, and nodal pricing. However,
investment in transmission capacity is long-run in nature as well as stochastic. In the
short run, the difference of electricity prices between two nodes in a power flow model
defines the price of congestion.9 Nevertheless, an “optimal” way to attract investment
for the long-term expansion of the transmission network is still an open question both
formally, and in practice.10
There are two main disparate (non-Bayesian) analytical approaches to transmission
investment: 11 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 (performance-based-regulation (PBR) approach).12 Practical approaches
to transmission expansion have then to a large extent been designed according to
particular criteria as opposed to being based on general economic theory, or on the
more specific regulatory economics literature. In this paper, I review in Sects. 7.2 and
7.3 recently developed approaches for PBR and merchant mechanisms. Likewise, in
Sect. 7.4 I provide insights so as to build a comprehensive approach that combines both
mechanisms in a setting of price-taking electricity generators and loads.

7.2 The Incentive-Regulation Approach to Transmission

Expansion

The PBR approach to transmission expansion relies on incentive-compatible

regulatory mechanisms for a Transco. Such mechanisms provide the firm with
incentives to make efficient investment decisions as well as to earn enough

9
Hogan (2002b).
10
Vogelsang (2006).
11
A third alternative method for transmission expansion seeks to derive optimal transmission
expansion from the power-market structure of electricity generation, and considers conjectures
made by each generator on other generators’ marginal costs due to the expansion (Wolak 2000).
This method uses a real-option analysis to derive the net present value of both transmission and
generation projects through the calculation of their joint probability. Transmission expansion only
yields benefits until it is large enough compared to a given generation market structure. Likewise,
many small upgrades are preferable to large greenfield project.
12
Vogelsang (2006) makes a division between Bayesian and non-Bayesian mechanism for trans-
mission expansion. The Bayesian approach derives from the merger of the principal agent theory
and the optimal pricing approach, and implies a theoretical framework supported by the Revelation
Principle but that does not in general translate into rules that regulators can apply directly.
According to the canonical model of regulation, under asymmetric information the need for prices
to provide incentives arises when transfers from the regulator are not possible (Laffont 1994).
Non-Bayesian mechanisms arise from more practical reasons so as to improve inadequacies
associated to rate-of-return regulation. Then PBR regulation, including price-caps and yardsticks,
were developed as non-Bayesian instruments to promote cost-minimization. However, the appli-
cation of PBR to network industries has been scarce, mainly due the lumpy and long-term nature of
networks, such as the electricity grid.
194 J. Rosellón

revenues to recover capital and operating costs.13 In the international practice,

PBR schemes for transmission expansion have been basically applied in England,
Wales and Norway to guide the expansion of the transmission network. In the case
of the two first countries, transmission pricing has been typically separated from
energy pricing. A regulatory mechanism based on an “out-turn” has been used
there. The out-turn is the difference between the price actually paid to generators
and the price that would have been paid absent congestion. An “uplift management
rule” is then applied to the Transco responsible for the full cost of the out-turn, plus
any transmission losses. In Australia, a combination of regulatory mechanisms and
merchant incentives has been implemented.14 Argentina has also relied on a
combined regulatory-merchant approach under an ISO regime with nodal
pricing.15
The formal analyses of PBR mechanisms for transmission expansion basically rely
on comparing a Transco’s performance with a measure of welfare.16 The Transco is
penalized for increasing congestion costs in the network, and is responsible for the
costs of congestion it creates and the needed investment to relieve it. For instance,
Joskow and Tirole (2002) propose a simple surplus-based mechanism to provide the
Transco with enough incentives to expand the transmission network. The idea is to
reward the Transco according to the redispatch costs avoided by the expansion, so that
the Transco faces the entire social cost of congestion. Such a mechanism would
presumably eliminate the problems associated with lumpiness and loop flows, but it
could still be subject to manipulation of bids in the energy market by a Transco that is
vertically integrated with generation. Even with no vertical integration, generators
might invest no more than what is needed to match existing transmission capacity.
An alternative PBR approach is to explicitly study the nature of transmission cost
and demand functions (Vogelsang 2001). The monopolistic nature of a for-profit
Transco that owns the complete transmission network is isolated. This scheme might
also be applied in a combined institutional structure where a (centralized) ISO takes
care of the short-run market, and an independent transmission company handles
investment issues. Regulation of transmission must then solve the duality of incentives
for the transmission firm both in the short run (congestion), and in the long run
(investment in network expansion). Conditions for optimal capacity expansion have
been studied by the peak-load pricing literature: the per-unit marginal cost of new
capacity must be equal to the expected congestion cost of not adding an additional unit
of capacity.17 However, there is still the question on how price regulation can provide
incentives to reach such a stage.

13
Léautier (2000), Grande and Wangensteen (2000), Vogelsang (2001), and Joskow and Tirole
(2005).
14
Littlechild (2003).
15
Littlechild and Skerk (2004a, b).
16
Gans and King (1999), Léautier (2000), Grande and Wangensteen (2000), Joskow and Tirole
(2002).
17
Crew et al. (1995).
7 Mechanisms for the Optimal Expansion of Electricity Transmission Networks 195

Price-cap mechanisms deal with regulation of “price level” and regulation of “price
structure.”18 Price level regulation refers to the long-run distribution of rents and risks
between consumers and the regulated firm. Applied alternatives for level regulation
typically include cost-of-service, price-cap, and yardstick regulations. Price structure
regulation refers to the short-run allocation of benefits and costs among distinct types
of consumers. Alternatives for regulation of price structure include price bands,
flexible price structures as well as fixed or non-fixed weight regulation.19 As in other
network industries, electricity transmission price-level regulation is applied together
with inflation (RPI) and efficiency factors (X), and a cost-of-service check every
5 years.
Price structure regulation is used by Vogelsang (2001) to solve transmission
congestion, in the short run, as well as capital costs and investment issues in the long
run. In a two-part tariff regulatory model with a variable (or usage) charge, and a fixed
(or capacity) charge, the variable charge is mainly based on nodal prices and relieves
congestion. Recuperation of long-term capital costs is achieved through the fixed
charge that can be interpreted as the price for the right to use the transmission network.
The fixed charge can also provide incentives for productive efficiency and, if it
does not affect the number of transmission consumers, allocative efficiency – i.e.,
convergence to the Ramsey price structure – can be intertemporally achieved.20
The basic model proposed in Vogelsang (2001) is:

max pt ¼ pt qt þ Ft N  Cðqt ; K t Þ

subject to

Ft  Ft1 þ ðpt1  pt Þqw =N

qt  K t

where:
Ft ¼ fixed fee in period t.
pt ¼ variable fee in period t.
qt ¼ real oriented energy flow in period t (in kWh).
Kt ¼ available transmission capacity in period t.
w ¼ type of weight.
N ¼ number of consumers
The transmission cost function c(q,K) reflects the sunk cost nature of transmission
investment and has the following form:

18
Brown et al. (1991).
19
Vogelsang (1999).
20
Baldick et al. (2007), provide practical guidelines for allocation among consumers of the costs
of transmission expansion.
196 J. Rosellón

Cðqt ; K t1 Þ ¼ Cðqt1 ; K t1 Þ; 8 qt ; qt1  K t1

Cðqt ; K t Þ ¼ Cðqt ; K t1 Þ þ f ðK t1 ; I t Þ; for qt > K t1

where investment It is such that

I t ¼ K t  K t1

Assuming that constraints are binding, and that mt is the Lagrange multiplier of
the capacity constraint, the first order condition with respect to pt is:



@qt @C
p þm  t
t t
¼ qw  qt
@pt @q

For the optimal level of investment, q* ¼ K* it is true that mt ¼ 0, so that the

first order condition yields the (equilibrium) Ramsey rule:


w 
@C q
p  t ¼ t
t
e
@q q 1

where e is the price elasticity of demand.

The proper incentives for efficient investment in the expansion of the network in the
Vogelsang model are reached by the rebalancing of fixed and variable charges.
Likewise, incentives for investment crucially depend on the type of weights used.
For instance, a Laspeyres index uses the quantity of the previous period as weight for
the price so that the Transco will intertemporally invest until its transmission tariffs
converge to Ramsey prices. However, this will not occur automatically since the firm
faces a tension between short-run gains from congestion, and increases in capacity
investment. These results are true only if it is assumed that cost and demand functions
are stable, and that the Transco does not use strategic conduct in setting its prices.21 In
the case of changing cost and demand functions, or non myopic profit maximization,
convergence to Ramsey prices under the Laspeyres index cannot be guaranteed.22
Thus, when there is congestion in capacity the Transco will expand the network
because its profits increase with network expansion when congestion variable charges
are marginally larger than the marginal costs of expanding capacity. On the contrary,
in times of excess capacity, the variable charge of the two-part tariff will be reduced
causing an increase in consumption. The fixed charge, in turn, increases so that total
income augments despite the decrease in the variable charge. As a consequence,
the Transco ceases to invest in capacity expansion, and net profits expand since
costs do not increase.

21
See Vogelsang 1999, pp. 28–31.
22
See Ramı́rez and Rosellón (2002).
7 Mechanisms for the Optimal Expansion of Electricity Transmission Networks 197

The pure price-cap approach in Vogelsang (2001) however relies on simplifying

assumptions that are rarely met in practice. Transmission demand functions are
assumed differentiable and downward sloping, while transmission marginal costs
curves are supposed to cut demand only once. These assumptions are generally invalid
since, under loop flows, an expansion in a certain transmission link can result in
decreases of other network links leading to discontinuities in the marginal-cost
function.23 Likewise, transmission activity is considered as a physical output
(or throughput) process as opposed to a transmission output defined in terms of
point-to-point transactions.24 This task is impossible since the physical flow through
a meshed transmission network cannot be traced (Bushnell and Stoft 1997; Hogan
2002b, c).25
One of the main problems of PBR mechanisms is their inconsistency with timing
issues of transmission networks. Vogelsang (2006) then proposes a framework based
on the distinction of utra-short periods, short periods and long periods. The ultra short-
period is motivated by real-time pricing of point-to-point transmission services, and
there are no possibilities within this period for costs reductions. So, the main
allocative-efficiency problem is price rationing of congested inputs. The short-period
coincides with the application of (RPI-X) factors, and is also the period for the
calculation of fixed fees. The long period is given by the regulatory lag of the PBR
mechanisms; that is, the time between (cost-of-service) tariff revisions (of typically
5 years). The long period crucially depends on the regulatory commitment so as to
avoid ratcheting.
In the Vogelsang (2001) mechanism, investment in the grid occurs at the beginning
of each period while fixed fees are calculated at the end of the period. Therefore, this
mechanism implicitly lumps together the short period and the long period, and
assumes that investments do not occur beyond such period. The Vogelsang (2006)
mechanism on the contrary combines the ultra-short, short and long periods and allows
for the possibility of no investment for several short periods or even for times beyond a
long period. This mechanism then depends on previous price performance of the
mechanism in the past as well as on the long-run certainty provided by revisions
based on rate-of-return regulation.

23
Hogan (2002a)
24
See Hogan et al. (2010) for a redefinition of transmission outputs in terms of point-to-point
FTRs.
25
An application of the Vogelsang (2001) PBR model is carried out in Rosellón (2007) for the
electricity transmission system in Mexico, under stable demand growth for electricity. Three
scenarios are studied: (a) a single Transco providing transmission services nationally and that
applies postage-stamp tariffs; (b) several regional companies that separately operate in each of the
areas of the national transmission system, and that charge different prices; and (c) a single Transco
owns all the regional systems in the nation but that charges different prices in each region.
Achieved capacity and network increases are highest under the first scenario, while higher profits
are implied by the second approach. These results are found to critically depend on two basic
effects; namely, the “economies-of-scale effect” and the “discriminatory effect”. The economies-
of-scale effect produces greater capacity and network expansion whereas the discriminatory effect
increases profit.
198 J. Rosellón

The combined approach for all types of periods in Vogelsang (2006) relies on a
combination of Vogelsang (2001) and the incremental surplus subsidy scheme (ISS).26
According to the ISS, the firm receives a subsidy in each period equal to the difference
between the last period´s profit and the current-period´s consumer-surplus increase. In
Vogelsang (2006), the subsidy is financed through the fixed fee of a two-part tariff and
consumer surplus is calculated with a verifiable approximation. The Vogelsang (2001)
price-cap constraint is then used in Vogelsang (2006) for pricing in the ultra-short and
short periods, together with an (RPI-X) adjustment for short periods and a profit
adjustment at the end of long periods. Prices would then be average revenues from
ultra-short periods. The (RPI-X) adjustments would affect only the fixed fees, and
partially counteract any consumer-surplus increases handed to the Transco.

7.3 Merchant Transmission Investment

The merchant approach to transmission expansion is based on auctions of financial

transmission rights (FTRs) that seek to attract voluntary participation by potential
investors. Incremental FTRs provide market-based transmission pricing that attracts
transmission investment since it implicitly defines property rights. FTR auctions are
carried out within a bid-based security-constrained economic dispatch with nodal
pricing (which includes a short-run spot market for energy and ancillary services) of
an ISO. The ISO runs a power flow model that provides nodal prices derived from
shadow prices of the model’s constraints.27 FTRs are subsequently derived from nodal
price differences. Due to the long-run nature of electricity transmission, the ISO
allocates long-term (LT) FTRs through an auction so as to protect the holders from
future unexpected changes in congestion costs. Therefore, LTFTR auctions work in
parallel with LT generation contracts.28 The long-run concept is important for trans-
mission expansion projects for investors. They usually have a useful life of approxi-
mately 30 years, so that auctions allocate FTRs with durations of several years. An
FTR can in practice materialize in an obligation, a flowgate right or an option.
“Point-to-point” (PTP) forward obligations are in practice the most feasible

26
Sappington and Sibley (1988), and Gans and King (1999).
27
The typical power-flow model framework is that of a centralized ISO that maximizes social
welfare subject to transmission-loss and flow-feasibility constraints in a spot market. In practice,
this model has been applied in Argentina, Australia, and several regions in the United States
(Pennsylvania-Maryland-New Jersey (PJM), New York, Texas, California). The economic dis-
patch model can also be understood within a static competitive equilibrium model. The producing
entity is an ISO that provides transmission services, receives and delivers power, and coordinates
the spot market. Meanwhile, consumers inject power into the grid at some nodes and remove
power out at other points. See Hogan (2002b).
28
FTRs give their holders a share of the congestion surpluses collected by the ISO under a binding
constraint. The quantity of FTRs is normally fixed ex ante and allocated to holders. This reflects
the capacity of the network. The difference between allocated FTRs and actual transmission
capacity provides congestion revenues for the ISO. FTRs are defined in terms of the difference
in nodal prices. See Joskow and Tirole (2002).
7 Mechanisms for the Optimal Expansion of Electricity Transmission Networks 199

instruments, while PTP options and flowgate rights are of limited applicability.29 PTP-
FTR obligations can be either “balanced” or “unbalanced”. Through a balanced
PTP-FTR a perfect hedge is achieved, while an unbalanced PTP-FTR obligation is a
forward sale of energy.
An example of an FTR auction is the New York ISO’s allocation of transmission
congestion contracts as a hedge for congestion costs, both in the short run and long
run.30 Incremental FTRs are allocated to parties that pay for the expansion only if the
new FTRs are made possible by the expansion. FTR awards are mainly derived from
investors’ choices but the ISO might also identify some needed incremental
FTRs. When investors choose new FTRs for transmission expansion, simultaneous
feasibility31 of both the already existing FTRs and the new FTRs must be satisfied,
because both flows and amount of transferred power among nodes is modified by the
expansion. The ISO also temporarily reserves some feasible FTRs prior to the expan-
sion project. Auctions are carried out both for short-term FTRs (6 months) and
LTFTRs (20 years). LTFTRs are allocated before short-term FTRs through auctioned
and unauctioned mechanisms. The unauctioned mechanism simply reserves capacity
for sales in later auctions, while in an LTFTR auction investors reveal their preferences
for expansion FTRs by assigning to each one a certain positive weight. Investors’
preferences are maximized preserving simultaneous feasibility together with all pre-
expansion FTRs. Losses are included in the dispatch and only balanced PTP-FTRs are
defined to provide payments for congestion costs but not for losses. 32
A mixture of planning and auctions of long-term transmission rights has also been
applied in PJM. The centralized PJM-ISO applies an LTFTR approach within a DC
(Direct Current)-load dispatch model where locational prices differ according to
congestion. PTP-FTRs are thus defined for congestion-cost payments. Revenues
from FTRs are returned to owners of the transmission capacity in order to defray
capital, operation and maintenance costs. Secondary FTR markets have also devel-
oped in several regions of the Northeast of the USA. FTR secondary markets are
generally imbedded in the ISO’s dispatch process so that their revenue adequacy is
met.33 Whenever there is need for an FTR between any two nodes, it is usually possible
to derive it from nodal-price differences. Likewise, FTRs can be traded within various
time frameworks (such as weeks, months and years). Nonetheless, no restructured
electricity sector in the world has adopted a pure merchant approach to transmission
expansion. The auction-planning combination has also being considered in

29
Flowgate rights are defined in terms of the constraints implied from limits in the selling of
capacity (Hogan 2000).
30
Pope (2002).
31
A set of FTRs is simultaneously feasible if the associated set of net loads satisfies the energy
balance and transmission capacity constraints, as well as the power flow equations.
32
Other LTFTR allocation practical mechanisms are provided by Harvey (2002), and Gribik et al.
(2002).
33
Revenue adequacy is the financial counterpart of the physical concept of availability of
transmission capacity. FTRs meet the revenue-adequacy condition when they are also simulta-
neously feasible (Hogan 1992).
200 J. Rosellón

New Zealand and Central America, while in Australia a combined merchant-

regulatory approach has been attempted.34
The formal analyses of FTR auctions can be subdivided into long-term and short-
term models. The short-run FTR models provide efficiency results only under strong
assumptions of perfect competition, such as: absence of market power and sunk costs,
an ISO without an internal preference on effective transmission capacity, complete
future markets, lack of uncertainty over congestion rents, nodal prices that internalize
network externalities and that reflect consumers’ willingness to pay, as well as non-
increasing returns to scale.35 The lifting of these assumptions would imply inefficient
results on the use of FTRs. For instance, whenever market power exists, prices will not
reflect the marginal cost of production. Generators in constrained regions will with-
draw capacity (increasing generation prices), which would overestimate the cost-
saving gains from investments in transmission. Likewise, market power in the
FTR market by a generator provides an incentive to curtail output so as to make
FTRs more valuable.36
Additionally, increasing returns and lumpiness in transmission investment imply
that social surplus created by transmission investments will be greater than the value
paid to investors through FTRs. This is why investors in transmission expansion
projects would prefer LT contracts, and exclusive property rights (at least temporarily)
in the use of increased capacity. To this, it must be added that existing transmission and
incremental capacities cannot be well defined since they are of stochastic nature. Even
in a radial line, realized capacity could be less than expected capacity so that the
revenue-adequacy condition is not met. Stochastic changes in supply and demand
conditions imply uncertain nodal prices as well.
More importantly, for meshed networks with loop flows an addition in transmission
capacity in a link of the network might result in an actual reduction of capacity of other
links. This, combined with asymmetry of information among the different agents in
the electricity industry (generators, ISO, and transmission owners), might result in
negative social value.37
All these insights are deemed as relevant by the long-term FTR model. LTFTR
auctions grant efficient outcomes under lack of market power and non-lumpy marginal
expansions of the transmission network.38 Regulation thus has an important role in
large and lumpy projects in order to mitigate market power and let LTFTR auctions
efficiently attract investors. In particular, market-power alleviation in the FTR market
could be fostered by keeping transmission-owner buyers and sellers of LTFTRs under
strict enforcement of open access to their grid facilities.

34
Littlechild (2003).
35
Joskow and Tirole (2005).
36
Joskow and Tirole (2000), Léautier (2001), and Gilbert et al. (2002).
37
Hogan (2002a), and Kristiansen and Rosellón (2006).
38
Hogan (2003).
7 Mechanisms for the Optimal Expansion of Electricity Transmission Networks 201

Additionally, contingency and stochastic concerns are mainly taken care by a

security-constrained dispatch of a meshed network with loops and parallel paths.39
Likewise, agency problems and information asymmetries are indeed part of an
institutional structure of an electricity industry where the ISO is separated from
transmission ownership, and where market players are decentralized. However, the
boundary between merchant and regulated expansion projects can hardly be affected
by asymmetry of information. The need for regulation is therefore acknowledged in
LTFTR auction mechanisms, and complete reliance on market incentives for trans-
mission investment is thus undesirable. Rather, merchant and regulated transmission
LTFTR mechanisms could be combined so that regulated transmission is used for
projects that are lumpy (where only a single project makes sense as opposed to many
small projects), and large (relative to the market size). 40
The implications of loop flows on transmission investment have also received
detailed consideration by the LTFTR literature. A first seminal idea is to require the
agent making an expansion to “pay back” for the possible loss of property rights of
other agents.41 A new transmission link creates in turn a new feasible set that requires a
redispatch of the net loads at each node. Loads and associated FTRs that were not
previously feasible (pre-investment) become feasible (post-investment), while other
pairs of loads (and associated FTRs) that were feasible might become infeasible. In this
process, the expansion link might reduce social welfare when it is a binding constraint
on low-cost generation schedules. Thus, to restore feasibility, the investor in the new
link must buy back sufficient rights from initial holders.
Further, LTFTR auctions designed for small-scale networks subject to relatively
marginal expansions, might rely on several axioms in order to solve the loop-flow
dilemma.42 The LTFTR auction should maximize the investors’ objective function,
both for decreases and increases in grid capacity. More importantly, under an initial
condition of incomplete allocation of FTRs the transmission energy balance and
capacity constraints, as well as the power flow equations, must be satisfied for the
existing and incremental FTRs. Simultaneous feasibility should also prevail given that
certain currently unallocated rights – or proxy awards – are preserved. Under these
assumptions, and when FTRs are simply defined as point-to-point obligations, LTFTR
will not reduce social welfare of the hedged agents.
Additionally, proxy awards are to be defined according to the best use of the current
grid along the same direction that the incremental FTRs were awarded. “Best” is
defined in terms of preset proxy references so that proxy awards maximize the value of
such references. Given a proxy rule, the auction is carried out in order to maximize the
investor’s preferences to award the needed FTRs in the direction of the expansion,
subject to the simultaneously feasibility conditions and the “best” rule. Kristiansen and

39
Hogan (2002b).
40
Hogan (1999, 2000).
41
Bushnell and Stoft (1997).
42
Hogan (2002a), and Kristiansen and Rosellón (2006).
202 J. Rosellón

Rosellón (2006) develop a bi-level programming model for allocation of long-term

FTRs according to the best rule, and apply it to different network topologies.
When the preset proxy rule is used, Kristiansen and Rosellón (2006) derive
prices that maximize the investor preference bðadÞ for an award of a MWs of FTRs
in direction d:

Max bðadÞ
a;^t;d

s:t:
K þ ðT þ adÞ  0;
K þ ðT þ ^td þ adÞ  0;
^t 2 arg max ftpdjKðT þ tdÞ  0g;
t
kdk ¼ 1;
a  0:

where K þ ðT þ adÞ  0 and K þ ðT þ ^td þ adÞ  0 d are the feasibility constraints for
“existing plus incremental FTRs (T þ ad)” and “existing plus proxy plus incremental
FTRs ðT þ ^td þ adÞ”, respectively. This is a nonlinear and non-convex problem, and
its solution depends on the parameter values, the current partial allocation (T), and the
topology of the network prior to and after the expansion.43 Simultaneous technical
feasibility is shown to crucially depend on the investor-preference and the proxy-
preference parameters. Likewise, the larger the current capacity the greater the need to
reserve some FTRs for possible negative externalities generated by the expansion
changes.
However, as previously argued, the described LTFTR mechanism implies that
future investments in the grid cannot decrease the welfare of FTR holders only. FTRs
cannot provide perfect hedges ex post for all possible transactions. The FTR feasi-
bility rule always preserves the property that the incidence of any welfare reductions
falls to those whose transaction were not selected ex ante to be hedged by FTRs. The
special case of FTRs matching dispatch is consistent with welfare maximization, but
in the case where there is not a full allocation of the existing grid, the likely result is
that there would be more scope for welfare reducing investments. The need for
regulatory oversight would then not be eliminated with FTR auctions, but the intent
is that the scope of the regulatory intervention would typically be reduced.
In an applied European transmission-market context, Brunekreeft et al. (2005)
argue that unregulated merchant investment should also be complemented with a
light-handed regulatory approach so as to increase welfare. In the welfare-competition
trade-off, welfare should be more relevant so that third-party-access and must-offer

43
A general solution method utilizing Kuhn-Tucker conditions would check which of the
constraints are binding. One way to identify the binding inequality constraints is the active set
method. Kristiansen and Rosellón (2006) solve the problem in detail with simulations for different
network topologies, including a radial line and three-node networks.
7 Mechanisms for the Optimal Expansion of Electricity Transmission Networks 203

provisions are not necessary in the European Union regulations that promote unregu-
lated merchant investments in electricity transmission (see also Brunekreeft and
Newbery 2006). Likewise, cross-border transmission issues are much relevant in the
European case. Market coupling mechanisms with voluntary participation are neces-
sary due to the politically infeasibility of implementing a location-marginal-pricing
mechanisms. Kristiansen and Rosellón (2010) carry out an application of the merchant
FTR model for transmission expansion to the trilateral market coupling (TLC) border
arrangements in Europe (such as the TLC among Netherlands, Belgium and France).
The potential introduction of FTRs to the TLC is part of a wider interest in Europe for
hedging products for cross-border trade, and congestion management by several
regulatory bodies at the European continental level as well as at the national levels
(e.g., Spain, France, and Italy). The model of an ISO that reserves some proxy FTR
awards and resolves the negative externalities derived from transmission expansion is
simulated for the interconnector between France and Belgium. Such a project is shown
to be feasible under the proposed FTR auction system. Other likely projects – such as
an interconnector that invests in parallel to an existing line, or a third interconnector
that links to the TLC arrangement thus forming a three-node network (such as an
undersea cable from France to the Netherlands, or the links with Nord Pool or
Germany) – are possible. These examples show that FTR-supported expansion
projects in Europe could be technically and financially feasible. However, the actual
employment of FTRs in TLC arrangements would also require clear definitions of the
roles of system operators and power exchanges, daily settlements in implicit auctions
between power exchanges, as well as the identification and provision of appropriate
risk-sharing and regulatory incentives.44

7.4 The Combined Merchant-Regulatory Approach

As seen in the previous sections, there is not yet in theory or in practice a single system
that guarantees an optimal long-term expansion of all types of electricity transmission
networks. This is especially true for non-Bayesian mechanisms, which are usually
designed for allocative and productive efficiency improvements in the short run.
However, the distinct study efforts suggest a second-best standard that combines the
above seen merchant and PBR transmission models so as to reconcile the dual short-
run incentives to congest the grid, and the long-run incentives to invest in expanding
the network.45 The merchant mechanisms are easiest to understand for incrementally

44
See also Brunekreeft et al. (2005).
45
This would be an alternative approach to the previously seen model in Vogelsang (2006).
A main difference would be that the combined merchant-regulatory approach mainly focuses in
generalizing the price-cap constraints for electricity transmission (as in Vogelsang 2006) within a
power flow model. Likewise, this combined model aims to redefine the output of transmission in
terms of PTP transactions (or incremental FTRs) as well as to seriously tackle the “heroic”
assumption of smooth well-behaved transmission cost functions of the models in Vogelsang
2001, 2006, and Tanaka 2007.
204 J. Rosellón

small expansions in meshed networks under an ISO environment. The price-cap

method seeks to regulate a monopoly Transco. Thus, “small” transmission expansion
projects might rely on the merchant approach while “large and lumpy” projects could
be developed through PBR incentive regulation, that combines price-level and price
structure regulation so as to reconcile short-run and long-run incentives.46
More specifically, LTFTR auctions could be used within regions with meshed trans-
mission networks regions of the country for marginal expansions,47 while price-cap
methodology – that also takes care of the loop flow issue – could be applied to develop
the large lumpy links among such regions. In this section, I analyze the basic elements
needed to construct a coherent framework for the latter issue.
As previously discussed, the basic PBR model on a regulatory approach to trans-
mission expansion postulates cost and demand functions with fairly general smooth
properties, and then adapts some known regulatory adjustment processes to the
electricity transmission problem. A concern with this approach is that the properties
of transmission cost and demand functions are scarcely known and suspected to differ
from usual functional forms. The assumed well-behaved cost and demand properties
may actually not hold for a transmission firm. Loop-flows imply that certain
investments in transmission upgrades might cause negative network effects on
other transmission links, so that capacity is multidimensional. Thus, the transmission
capacity cost function can be discontinuous.
There have been some recent developments that tackle the issue of defining a price-
cap model for transmission expansion within a power flow-model, so as to define a
system that is coherent under loop flows. One such attempt, Tanaka (2007), derives
optimal transmission capacity from the effects of capacity expansion on flows and
welfare. A welfare function is maximized with respect to capacity subject to the
Transco’s budget constraint, which is further defined as the difference between
capacity cost and congestion rents. Various incentive mechanisms are then analyzed
since the Transco alone would prefer to maximize the difference between congestion
rents and costs, rather than social welfare. A Laspeyres-type price-cap on nodal prices
is shown to converge to optimal transmission capacity over time under its budget
constraint. A second mechanism is a two-part tariff cap also based on Laspeyres
weights. Finally, another mechanism based on an incremental surplus subsidy,
where the regulator observes the actual cost but not the complete cost function, is
analyzed. These two last mechanisms are also shown to achieve optimal transmission
capacity over time but without a budget constraint. However, Tanaka (2007) still relies
on the big assumption of a well-behaved capacity cost functions for electricity
transmission.
Another recent model, Hogan et al. (2010) (HRV), combines the merchant and
regulatory approaches in an environment of price-taking generators and loads.

46
Of course, this includes (RPI-X) adjustments together with cost-of-service tariff reviews at the
end of each regulatory lag.
47
The Kristiansen and Rosellón (2006) model is an example of a concrete merchant mechanism
designed for small line increments in meshed transmission networks.
7 Mechanisms for the Optimal Expansion of Electricity Transmission Networks 205

A crucial aspect is to redefine the transmission output in terms of incremental LTFTRs

in order to apply the basic price-cap mechanism in Vogelsang (2001) to large and
lumpy meshed networks, and within a power flow model. Very importantly, the HRV
model does not make any previous assumption on the behavior of cost and demand
transmission functions. In this model, the Transco intertemporally maximizes profits
subject to a cap on its two-part tariff, so that choice variables are the fixed and the
variable fees. The fixed part of the tariff plays the role of a complementary charge that
recovers fixed costs, while the variable part is the price of the FTR output, and is then
based on nodal prices.
In the HRV model there is a sequence of auctions at each period t where participants
buy and sell LTFTRs. LTFTRs are assumed to be point-to-point balanced financial
transmission right obligations. The Transco maximizes expected profits at each
auction subject to simultaneous feasibility constraints, and a two-part-tariff cap con-
straint. The transmission outputs are the incremental LTFTRs between consecutive
periods. The model first defines the least cost solution for the network configuration
that meets a given demand. Over the domain where it q ¼ 0 (i.e., no losses):
    t 
c q; K t1 ; Ht1 ¼ Min c K ; K t1 ; H t ; H t1 Ht q  K t :
K t 2K;Ht 2 H

where:
3 2
x
6 0 7
6 7
6 0 7
P 6 7
qt ¼ the net injections in period t (FTRs are derived from: ttj ¼ qt ; ttj ¼ 6 7
6 : 7)
j 6 : 7
6 7
4 þx 5
0
Kt ¼ available transmission capacity in period t
Ht ¼ transfer admittance matrix at period t
it ¼ a vector of ones

cðK t ; K t1 ; H t ; H t1 Þ is the cost of going from one configuration to the next. For a
DC load approximation model, the Transco’s profit maximization problem is then
given by:
 t 
Max pt
¼ t t
qðt Þ  q t1
þ Ft N t  cðK t ; K t1 ; H t ; H t1 Þ
t ;F
t t

subject to

tt Qw þ Ft N t  tt1 Qw þ Ft1 N t
206 J. Rosellón

where:
t t ¼ vector of transmission prices between locations in period t
Ft ¼ fixed fee in period t
Nt ¼ number of consumers in period t

w
Qw ¼ ðqt  qt1 Þ

w ¼ type of weight.
The price cap index is defined on two-part tariffs: a variable fee tt and a fixed fee
F where the output is incremental LTFTRs. The weighted number of consumers Nt
is assumed to be determined exogenously. When the demand and optimized cost
functions are differentiable the first order optimality conditions yield:

rqðt  rq c Þ ¼ Qw  ðqðtÞ  qt1 Þ

The results of this model then show convergence to marginal-cost pricing (and to
Ramsey pricing) under idealized weights, while under Laspeyres weights there is
evidence of such a convergence under more restrictive conditions.48 Likewise, trans-
mission cost functions are shown to have typical economic properties under a variety
of circumstances. This holds, in particular, if the topology of all nodes and links is
given and only the capacity of lines can be changed, which implies that unusually
behaved cost functions require modification of the network topology.
The HRV mechanism is further tested for different network topologies in Rosellón
and Weigt (2011). Firstly, the behavior of cost functions (in terms of FTRs) for distinct
network topologies is studied. Secondly, the HRV regulatory model is incorporated in
a MPEC (mathematical program with equilibrium constraints) problem and tested for
three-node networks. Finally, the HRV mechanism is applied to Northwestern Europe.
The results of the cost function analysis in Rosellón and Weigt (2011) show how, due
to loop flows, rather simplistic extension functions can lead to mathematical problem-
atic global cost function behavior. Furthermore, the linkage between capacity exten-
sion and line reactances, and thus the flow patterns, leads to complex results that are
highly sensitive to the underlying grid structure. However, for modeling purposes the
logarithmic cost form leads to nonlinearities with non-smooth behavior thus making it
demanding with respect to calculation effort and solver capability. Quadratic cost

48
Under Laspeyres weights – and assuming that cross-derivatives have the same sign – if goods
are complements and if prices are initially above to marginal costs, prices will intertemporally
converge to marginal costs. When goods are substitutes, this effect is only obtained if the cross
effects are smaller than the direct effects. If prices are below marginal costs the opposite results are
obtained.
7 Mechanisms for the Optimal Expansion of Electricity Transmission Networks 207

functions show a generally continuous behavior that makes them suitable for modeling
purposes. In an overall analysis, the piecewise linear nature of the resulting global
costs functions makes the derivation of global optima feasible. Hence, the testing of
HRV regulatory model as an MPEC problem in Rosellón and Weigt (2011) results in a
Transco expanding the network so that prices develop in the direction of marginal
costs. These results are confirmed when the MPEC approach is tested using a
simplified grid of Northwestern Europe with a realistic generation structure. The
nodal prices that were subject to a high level of congestion converge to a common
marginal price level.
These results show then that the HRV mechanism has the potential to foster
investment into congested networks in an overall desirable direction, satisfying the
simultaneous-feasibility and revenue-adequacy constraints. However, further analysis
is needed to estimate impacts of externalities such as the generation implications on the
Transco’s behavior. Furthermore, the extension functions and restrictions have to be
adjusted for a better representation of real world conditions, particularly with regards
to the lumpiness of investments as well as property-right issues, and existing long term
transaction contracts.

7.5 Concluding Remarks

Network expansions are relevant in many parts of the world such as in the European
electricity market. Due to the liberalization processes initiated in the late 1990s, former
national electricity networks with only limited cross border capacities should now
build the infrastructure for emerging wide energy markets. However, in Europe
10 years after the first liberalization efforts the extended network is still segmented
into several regional and national sub networks with little expansion incentives
between countries. Other regions in the world face similar problems too. Deeper
understanding of the factors that determine a reliable framework for the investment
in transmission networks is therefore of utmost importance.
In this chapter, I addressed the developments in the literature regarding merchant
and PBR non-Bayesian mechanisms, as well as their combination, for non-vertically
integrated firms. A combined merchant-regulatory mechanism to expand electricity
transmission was analyzed. The merchant mechanism in Kristiansen and Rosellón
(2006) for marginal increments in small links of severely meshed networks is such that
internalization of possible negative externalities caused by potential expansion is
possible according to the proxy rule: allocation of FTRs before (proxy FTRs) and
after (incremental FTRs) the expansion is in the same direction and according to the
feasibility rule. For large and lumpy networks, the HRV mechanism redefines trans-
mission output in terms of incremental LTFTRs in order to solve the loop-flow issue.
Constructing the output measure and property rights model in terms of FTRs provides
the regulatory model with a connection to the merchant investment theory, and adapts
the known regulatory adjustment processes in the network economics literature to the
electricity transmission problem.
208 J. Rosellón

Of course much future research effort would be of value. Although some progress
have been made,49 the HRV model needs to characterize in detail piecewise cost
functions when changes in topology are incorporated, as well as to address global
rather than local optimality properties of incentives. Likewise, since proxy award
mechanisms are in use and more are under development, further analytical investiga-
tion of the private incentives, welfare effects and regulatory implications would very
useful. Finally, formal research on the relationship between FTR auctions and social
welfare is needed. Such analysis would require a new model that from its origin
provides an FTR mechanism that simultaneously addresses the expansion problem,
and that maximizes social preferences as well.

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Chapter 8
Long Term Financial Transportation Rights:
An Experiment

Bastian Henze, Charles N. Noussair, and Bert Willems

8.1 Introduction

One challenge facing operators of network infrastructure, such as gas pipelines and
electricity grids, is that large new investments in capacity must be undertaken as
overall demand increases. In the European Union alone, roughly 200 Billion Euro
must be invested in the energy transport networks (gas and electricity) by 2020
(MEMO/10/582). However, there is a considerable risk that an operator’s estimates
of future demand might prove too optimistic, irreversible investments would be
undertaken, and some of the capacity would sit idle or underused. On the other
hand, failing to expand capacity sufficiently would result in lost profits and lower
welfare than under optimal capacity provision.
One possible method for encouraging better infrastructure investment decisions
is to attempt to reveal private information that users have about future demand. One
way to do this is to organize a market for forward contracts. In addition to its
information revelation function, forward contracting has other attractive properties.
It can reduce risk for the network operator, because it makes his income less
dependent on spot market prices, which might be quite volatile. The contracts can
also reduce the risk for network users, who can use forward contracts to hedge
against spot market price and quantity fluctuations. The forward market might also

B. Henze • B. Willems (*)

Tilec & CentER, Department of Economics, Tilburg University, P.O. Box 90153, 5000 LE
Tilburg, The Netherlands
e-mail: [email protected]; [email protected]
C.N. Noussair
CentER, Department of Economics, Tilburg University, P.O. Box 90153, 5000 LE Tilburg,
The Netherlands
e-mail: [email protected]

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 211

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9_8,
# Springer-Verlag London 2013
212 B. Henze et al.

make the spot market more efficient as traders exploit arbitrage opportunities
between the spot and forward markets.1
A Long-Term Financial Transmission (Transportation) Right or LTFTR (Hogan
1992; Bushnell and Stoft 1996; Hogan et al. 2010) is a type of forward contract that
has been proposed specifically for energy markets. The holder of an LTFTR obtains
a payment equal to the spot price of the commodity, in this case access to the network.
The payment is received regardless of whether or not the owner of the LTFTR obtains
units on the spot market. Bushnell and Stoft (1996, 1997) have proposed the use of
such financial transmission rights (FTRs) in the American electricity sector, and
Kristiansen and Rosellón (2006) have done so for the electricity sector. In both
cases, the authors argue that investment decisions would improve. Joskow and
Tirole (2000) show that a financial transmission right, is strategically equivalent to
a physical transmission right with a use-it-or-lose-it condition. This is a requirement
that a user purchasing capacity must pay for it regardless of whether or not he uses it,
with the unused capacity resold to other users.
In this chapter we describe a laboratory experiment that considers the behavior
of LTFTR. The structure of the experimental environment is informed by European
policy issues. The parameters are chosen based on conditions characteristic of the
European gas and electricity markets. The LTFTR are allocated with a uniform
price sealed bid auction with lowest-accepted-bid pricing. Although this auction
type is not incentive compatible (see for example Draaisma and Noussair 1997),
experiments show that it typically allocates the items sold to the demanders with the
greatest valuations (Alsemgeest et al. 1998). The auction also has the advantage
that it yields a revealed demand curve, rather than only market prices, and thus can
be especially informative to the network operator about future demand.
Gas pipelines and electricity grids are typically natural monopolies which are
regulated in some manner to limit market power. In the European Union, incentive
regulation in the form of revenue and price caps is increasingly common in energy
transmission and distribution (Cambini and Rondi 2010). Therefore, in our experi-
ment, we impose a price cap on the network operator. Thus, we study the implemen-
tation of an LTFTR within a framework of incentive regulation. While cap regulation
without LTFTR encourages investment that reduces marginal cost, it does not create
additional incentive on its own to expand capacity. Indeed, under some conditions it
can lower the expected profits from capacity expansion (Vogelsang 2010). Thus,
there is scope for a system of LTFTR to improve capacity investment decisions.
For the demand and cost functions chosen for our experiment, the LTFTR
auctions are expected to often yield market prices that exceed the price cap. By
requiring bidders to pay the market price, we preserve the relationship between
bidders’ payoffs and bidding strategies that would exist without the price cap. Thus,
the array of bids can remain informative about underlying demand. The difference
between the price that the buyers pay and the price cap is kept by the experimenter,
and can be thought of as government revenue.

1
Other benefits of forward contracting appear in oligopoly settings (see for example Allaz and
Vila 1993 and Holmberg 2011).
8 Long Term Financial Transportation Rights: An Experiment 213

In Sect. 8.2, we provide a brief introduction to the methodology of economic

laboratory experiments. In Sect. 8.3, we review experimental studies on electricity
markets and forward contracts. We detail the design of our experiment in Sect. 8.4;
our results are presented in Sect. 8.5. Section 8.6 concludes.

8.2 The Experimental Approach

An experimental economy is one that the researcher creates for the purpose of
answering one or more specific research questions. The traditional approach,
laboratory experimentation, typically involves human participants interacting in a
paradigm that reproduces the features the researcher deems essential in capturing
the economics of the setting of interest. The setting could be that of a theoretical
model, an extension or modification of a previously-studied experimental environ-
ment, or an industry or market of interest outside the laboratory. Experiments
may be conducted with the purpose of testing theories, generating new theories,
comparison of different institutional arrangements, or evaluation of policy
proposals, among other objectives (see Smith 1994).
In our opinion, experiments are appropriately viewed as complementary to
theoretical and other empirical approaches in economics. They allow the researcher
to control the environment, observe key variables with certainty, and eliminate
measurement error. The experiment can be replicated by other researchers. Some
environments that are intractable to theoretical analysis can be studied. New policy
proposals that have never been implemented, and thus for which there are no data,
can be evaluated before they are taken the field. Their performance can be compared
to theoretical benchmarks, to the status quo, or to alternative proposals, holding all
else equal. The experimenter can change the environment or institutional structure
exogenously to establish causal relationships. This approach parallels the use of
agent-based modeling, which can achieve the same ends with behavioral assumptions
that the researcher specifies exogenously. Experiments with human subjects allow the
behavior to be generated endogenously from the interaction of human agents with the
environment and institutions, in which they have been placed.
Experiments considering policy questions typically differ in a number of ways
from the field environments they are meant to represent. These differences include
the size of monetary stakes, the scale of the economy, some aspects of the economic
environment, and in the fact that the experiment is conducted in a laboratory. The
stakes in the experiment are on the order of US$15 an hour, which is thought to be
sufficient to motivate participating individuals to attempt to attain high values of the
objective functions they have been assigned. The participants are typically univer-
sity students. This subject pool is used because it is a large pool that is accessible to
researchers at relatively low cost, but also because it facilitates replication, which
can be done at other universities. Some aspects of the field environment may be
difficult to create or not essential to the economics of the task at hand. In such cases
the experimenter resorts to similar simplifications as theorists do, for example
modeling a firm as if it were one profit-maximizing individual, using a partial
214 B. Henze et al.

equilibrium framework, or introducing permanent commitment to a current policy.

Finally, the experiments are typically conducted in an experimental laboratory
where the researcher can exercise control over participant communication and
answer the questions that subjects have.2 In our view, it falls on those skeptical of
experimental methods to argue how any of these differences would change the
conclusion of a specific study.

8.3 Previous Experiments on Electricity Markets

and Forward Contracting

A complete overview of all relevant experimental studies on electricity markets and

forward contracting is beyond the scope of this chapter, and we review only the
most closely related studies. For a more complete overview of experiments on
electricity markets, see Kiesling (2005) or Staropoli and Jullien (2006). For a more
general review of policy-oriented experimental work, see Normann and Riccuti
(2009).
In our experiment, which is described in Sect. 8.4, we use uniform-price sealed-bid
auctions to allocate both LTFTR and capacity on the spot market. Some other
experimental studies have also studied environments modeled on electricity markets,
and used auctions on either the demand or the supply side. Rassenti et al. (2003a) find
that demand side bidding on a spot market successfully counteracts the exploitation of
market power on the part of a network operator. Rassenti et al. (2003b) find that a
uniform price auction leads to more efficient allocations than a discriminatory auction
in an experimental electricity market. Noussair and Porter (1992) compare uniform-
price sealed-bid auctions with highest-rejected-bid pricing and English clock auctions
in an experimental electricity market, in which supply shortfalls may occur and
rationing must take place ex-post. They find that the uniform price auction generates
more efficient allocations than the English clock.
Other studies have considered the behavior of auctions where generators make
offers to sell electricity to a power grid (see for example Denton et al. 2001; Abbink
et al. 2003; and Vossler et al. 2009). This work suggests that our choice of auction
would not generate undue inefficiency compared to alternative auction forms.
Two previous experimental studies focus specifically on investment in supply
capacity in energy markets. They differ from our work in that they consider the
generation and supply of energy rather than transport. They also differ in that they
both consider an oligopolistic industry while our interest here is in a monopoly
network operator. Kiesling and Wilson (2007) study an automated mitigation
procedure (AMP), an alternative to a price cap, as a mechanism to control price

2
There is an ongoing debate about whether the scrutiny placed on subjects in the laboratory affects
the observed level of socially-oriented behavior in non-market interactions (see Levitt and List
2007). We are not aware of an argument in a similar vein that has been made with regard to market
experiments.
8 Long Term Financial Transportation Rights: An Experiment 215

spikes in wholesale power markets. They find that AMP does not decrease capacity
investment compared to a benchmark of unregulated prices. Williamson et al.
(2006) also consider investment in additional capacity in an experiment designed
to study wholesale electricity markets. The market is an unregulated oligopoly.
They observe investment close to the Cournot-Nash equilibrium level on average,
but with a bias in the mix between marginal and baseload capacities.
There is also an experimental literature that investigates forward contracting.
Krogmeier et al. (1997) and Phillips et al. (2001) compare markets, in which
contracts are concluded before production. These can be thought of as forward
markets. Le Coq and Orzen (2006) study an environment with an explicit forward
market structure. These studies all report that a forward market is characterized by
lower prices, greater quantity traded, and greater efficiency than is the case when
contracting occurs on a spot market. Brandts et al. (2008) consider, in an experi-
mental setting designed to model an electricity market, the effect of adding a forward
wholesale market for electricity. They study a situation with imperfect competition
between sellers and no demand uncertainty, so that forward contracting has no risk
hedging function. They report that the addition of a forward market lowers prices
and increases production, for both quantity and supply function competition.
We are aware of only one previous experiment that considers financial trans-
mission rights. Kench (2004) compares a system of financial rights to one of
physical rights. In his environment, network users obtain a random initial allocation
of rights. They can then trade the rights with other users. This differs from our
experiment, where users purchase rights from the network operator. He finds that
physical rights provide more accurate market signals than financial rights. Physical
transmission rights are allocated more efficiently than the financial transmission
rights. Network users pay a penalty if physical transmission capacity remains
unused. Network users compete more aggressively to obtain physical rights,
because they would be unable to transport energy without them. In a setting with
financial rights, generators are less active in the transmission rights market, because
they also have the option to wait, and to trade energy in the spot market. Further-
more, network users that have not bought financial transmission rights and are
therefore unhedged, bid strategically in the spot market and reduce efficiency.

8.4 The Experiment

Four sessions were conducted at the CentERlab experimental facility, at Tilburg

University, Tilburg, The Netherlands. The experiment was computerized, and
employed the Ztree platform (Fischbacher 2007). All participants were undergraduate
students at Tilburg University, most of whom were majoring in economics or business.
Subjects participated in three independent sequences of periods. One participant
was in the role of network operator and four were in the role of network user in each
session. Each individual remained in the same role for the entire session. Initially,
there was a twelve period training sequence, which did not count toward
participants’ earnings, followed by two 30 period sequences which did count.
216 B. Henze et al.

The data from the last 30-period sequence, during which the subjects were the most
experienced, is presented here. The experimental sessions lasted from 3 to 3.5 h.
A quiz on the instructions was used to select participants. Out of eight subjects
recruited for each session, only five were allowed to participate in the remainder of
the experiment. The top performer on the quiz was assigned to the role of the
network operator. The next four highest scorers were the network users. Those with
the three lowest scores were asked to leave the experiment. The instructions and the
quiz took on average between 60 and 75 min to complete. Earnings averaged 30.94
Euro for participants in the role of network operators and 24.31 Euro for those in the
role of users.
The regulator was automated, and kept a fixed price cap policy in place through-
out the session. Regulator revenue was not rebated to participants and is thus
assumed to be spent outside the sector.
Market demand for access to the network in each period t is a discrete approxi-
mation of a function of the form Dt ¼ a  2b gt qt, where a and b are constants, qt is the
quantity of access supplied, and gt is a growth parameter. Individual demand is
privately known to users.
Access to the network is supplied by one monopolistic operator, who can sell a
quantity up to its current capacity. The installation of additional network capacity is
in itself costless for the operator. However, each unit of capacity carries a mainte-
nance cost of c in each period, regardless of whether or not it was actually sold. This
cost c can be interpreted as the leasing cost or rental price of network capacity.
Network capacity cannot be reduced at any time. There is no depreciation or scrap
value for capacity. Kt denotes the total capacity of the network in period t, and K0 is
the initial network capacity. We require that Kt  Kt1 for all t.
The 30 periods are divided into five blocks of six periods each (Table 8.2). At the
beginning of the first period of each block, each of the four users observes her
individual demand for each period in the current block. The users then decide
whether or not to increase the valuations from their initial level for their first two
units. They can do so by either a relatively small fixed value κLOW , a relatively large
fixed value κHIGH, or 0. This decision remains in effect for every period of the current
block. To increase their valuations, users incur per-period costs of γ LOW , γ HIGH , or 0,
respectively.
This opportunity to increase one’s valuations is meant to represent the take-
or-pay contracts that are common in Europe. These are long-term contracts that a
network user, typically a gas company, makes with upstream suppliers. These
contracts can be very profitable, but are also costly to break, which occurs if
delivery of the contracted quantity does not occur. These contracts lead to greater
user valuations for the corresponding units of network capacity. The cost to users of
increasing these valuations represents the various costs of concluding such a
contract and the penalty that one incurs if the contracted quantity is not exchanged.
At the beginning of the first and fourth periods of each block, the network
operator decides whether or not to increase the capacity of the network (Table 8.2).
ΔK MAX denotes the maximum amount of additional capacity which can be installed
8 Long Term Financial Transportation Rights: An Experiment 217

Table 8.1 Parameters of the experiment

Parameter Value Description
a 80 Intercept parameter in aggregate demand function
b 5 Slope parameter in aggregate demand function
c 10 Per period cost for one unit of network capacity
pcap ¼ f cap 15 Price cap
κ Low 20 Low optional increase of the highest two valuations of a network user
κ High 40 High optional increase of the highest two valuations of a network user
γ lOW 10 Per period cost for raising highest two valuations by κ Low
γ High 20 Per period cost for raising highest two valuations by κ High
K0 4 Initial network capacity
ΔK Max 5 Maximum possible investment at each investment opportunity

Table 8.2 Timing of activity

Period within six
period block
1 2 3 4 5 6
Users learn their individual valuations for periods 1–6 X
Network users bid for LTFTR capacity X
Operator builds additional network capacity, sells all capacity in LTFTR X X
Users decide whether to raise their highest two valuations at a cost X
Spot auction X X X X X X

at one time. Users are informed of changes in network capacity before they submit
their bids in the spot auction.
The parameters of the experimental environment are listed in Table 8.1. They are
chosen to ensure that key variables and ratios take on similar values in the experi-
ment as in the field. See Henze et al. (2012) for details.
During each period, units of access to capacity are sold in a multi-unit uniform-
price sealed-bid auction with lowest-accepted-bid pricing (Table 8.2). Users can
submit one bid for each one of their valuations. The network operator then chooses
the quantity of access to offer. If the operator offers q units, the q highest spot
auction bids are accepted. Accepted bidders pay a per-unit price equal to the q-th
highest bid. This is the market price p for the current period.
An auction for LTFTR is also conducted in the first period of each six-period
block. This auction takes place after the network users have been informed about
their valuations, but prior to their decision about whether to increase their
valuations, as well as prior to the network operator’s decision to install additional
capacity. The LTFTR are forward contracts which pay the network user who
obtains them the spot price of one unit of network access in each period of the
current block. The payment is made whether or not the LTFTR holder obtains units
in the spot market.
The forward auction for LTFTR is also organized as a uniform price sealed-bid
auction with lowest-accepted-bid pricing. All network users pay the same per-unit,
218 B. Henze et al.

Fig. 8.1 Forward market

(Upper panel) and spot Price
market (Lower panel) Forward Demand

f
Regulatory Profit
f cap
Network Operator’s Profit
c

Capacity
K

per-period market price f and there is a price-cap of f cap ECU (Experimental

Currency Units, the unit of account in the experiment) in place. If the market price
exceeds the cap, the operator receives f cap ECU per unit of the product while
network users pay the market price f . If the market price exceeds the cap, the
difference is kept by the regulator and considered as government revenue.
The network operator must offer to sell every unit of current capacity in both the
forward and the spot auctions. All of the revenue from the spot auction is trans-
ferred to individuals holding forward contracts. Thus, its profit is determined
exclusively in the forward market. The spot market is in essence a secondary
market.
The allocation of surplus to users, the operator and the government is illustrated in
Fig. 8.1. In the left panel of the figure, the revealed demand in the forward LTFTR
auction is shown as the dashed line labeled “Forward Demand”. The profit to the
network operator is given by ðf cap  cÞ  K; and regulator payoff by ðf  f cap Þ  K.
The panel on the right presents the spot market. The revealed demand in the spot
market is illustrated with the dashed line labeled “Spot Demand”. The surplus of the
buyers in the spot market is given by the darker area. The auction revenue, indicated
as p  K is transferred from buyers in the spot market to holders of LTFTRs, and thus
8 Long Term Financial Transportation Rights: An Experiment 219

Capacity
20

18

16

14

12

10

8
Session 1
6
Session 2
4 Session 3
Session 4
2 Simulation

0
1 4 7 10 13 16 19 22 25 28 Period

Fig. 8.2 Time path of capacity in each session and benchmark simulation

ðp  f Þ  K indicates the profit accruing to holders of LTFTR. The sum of both areas
is the total profit of network users.

8.5 Results

Figure 8.2 illustrates the time path of capacity in each of the four sessions. The fifth
time series in the figure, entitled simulation, is the capacity trajectory generated by
a simulated profit maximizing network operator. This simulated agent is assumed to
have perfect foreknowledge of future demand, but is subject to the price cap of
15 ECU that was present in the experiment. The simulation assumes that all four
network users committed to the largest possible demand increase in each period.
The figure shows that at the outset, capacity averages 5.25 compared to the
simulated level of 8, the difference likely due to the fact that the forward-looking
simulation anticipates future demand growth. The ratio of actual to benchmark
capacity improves over time from an average of 0.656 in period 1 to 0.833 in period
20 before decreasing again to 0.764 in period 30. There is a clear separation
between sessions 1 and 4, which achieve close to the optimal capacity trajectory
and sessions 2 and 3, which are characterized by low investment. The forward-
looking network operator under the simulation anticipates a decrease in demand
that occurs from periods 14 and 18 and slows her capacity expansion, while the
human operators slow their investment somewhat later. When demand picks up
again in the late periods, the network operators in sessions 1 and 4 expand capacity
as a result, while the other two fail to do so sufficiently.
220 B. Henze et al.

Welfare (ECU)
1000

800

600

400 Session 1
Session 2
Session 3
Session 4
Simulation
200
1 4 7 10 13 16 19 22 25 28 Period

Fig. 8.3 Time path of welfare in each session and benchmark simulation

Figure 8.3 illustrates the total welfare realized in the market, given as the total of
consumer surplus, producer surplus, and regulator revenue, in each of the four
sessions. The figure also includes the welfare along the simulated optimal trajectory.
The figure shows that sessions 1 and 4 attain welfare levels close to the optimal level
after a few periods, while sessions 2 and 3 consistently attain levels considerably
lower than the benchmark level. The greater capacity in sessions 1 and 4 relative to
the other two sessions is closely associated with greater welfare.
The distribution of surplus among agents follows a similar pattern in the
experimental data as in the simulation. In the simulation, the payoff to the network
operator averages 1,710 ECU (8.1 % of total surplus), that of the four users together
averages 16,460 (each user receiving 19.5 % of total surplus), and the revenue to the
regulator averages 2,910 (13.8 % of total). In the actual experiment, the shares were
7.5 %, 17.6 %, and 22.1 %, for the network operator, average individual user, and
regulatory authority. The greater than predicted prices in the experiment result in
more revenue to the regulator, since the price the operator receives is capped.
As a measure of welfare, we consider the efficiency of the outcome. The
efficiency is the fraction of the maximum possible surplus that is actually realized
in the experiment, and is a standard measure of welfare in experimental economics.
We define Total Efficiency ηTot t in period t as the total welfare realized in each
period, Wt , the sum of consumer surplus, network operator’s profit and regulatory
revenue, divided by the maximum possible total welfare for the same period given
the demand and cost profile in the experiment, Wt , and thus ηTot t ¼ Wt =Wt .

Wt is calculated by simulating the decisions of a benevolent social planner under
the assumption that there is no price cap in place. The simulated benchmark for
8 Long Term Financial Transportation Rights: An Experiment 221

a profit maximizing network operator, with perfect foresight but subject to the price
cap we set in the experiment, generates efficiency of 99.5 %. This indicates that the
price cap is set nearly optimally, and represents close to a best case scenario of
incentive regulation. Total efficiency equals 82.3 % and 78.5 % in sessions 2 and 3,
while it is 88.8 % and 87.0 % in sessions 1 and 4.
We distinguish between two components within the efficiency measure:
(1) allocative and (2) dynamic efficiency. Allocative efficiency is a measure of
the ability of the market to award the current existing capacity to the demanders
with the greatest valuations. If all units are not sold to the highest-valued users,
there is allocative inefficiency. The allocative efficiency ηat in period t is defined as
ηat ¼ Wt =Wto ðKt Þ. Wto ðKt Þ is the welfare level resulting from allocating the current
capacity Kt to the users with the highest valuations.
The other component, dynamic efficiency, is a measure of the optimality of the
time profile of capacity investment. Dynamic efficiency is the fraction of the
globally optimal welfare level that could be attained with an efficient allocation
of the actual current capacity.3 Global optimality requires both optimal allocation
of existing capacity and a socially optimal investment time trajectory. Dynamic
efficiency is defined as ηdt ¼ Wto ðKt Þ=Wt .
In our data, the average allocative efficiency is 94.6 % and dynamic efficiency is
88.0 %. Figure 8.4 gives the time path of dynamic and static efficiency in each
session, and reports as well the average level over all periods. Most of the efficiency
loss in sessions 2 and 3 is because investment is low, and this is reflected in low
dynamic efficiency. The forward auction, in conjunction with the spot market
which serves the function of a secondary market, performs well in allocating the
existing capacity to the demanders with the highest valuations. However, the
forward auction in some sessions does not induce the appropriate level of
investment.
Figures 8.5 and 8.6 show the time series of spot and forward prices in the four
sessions, respectively, as well as under the benchmark simulation. There are a
variety of patterns evident in the figures. In the simulation, the spot price begins
at 50, falls to 10 in period 4, and remains between 10 and 20 for the rest of the
30-period horizon. In general, observed prices are considerably greater than along
this benchmark trajectory. In the early periods, spot prices in sessions 1 and 3 are
much greater than the benchmark level early on, reaching more than 3.5 times that
level by period 11. In session 3, the spot price remains high for the rest of the
session. Session 2 tracks the baseline level closely until period 18 and then exhibits
an increase to a higher level, which is then sustained. In session 4, prices conform
closely to the benchmark level.
Forward prices exhibit similar heterogeneity across sessions, both with regard to
their differences from the benchmark prediction and differences from concurrent
spot prices. In session 3, forward prices are much higher than the simulated level,

3
Dynamic efficiency in a particular period can exceed 100 % if a network operator overinvests
compared to the social planner, who maximizes the sum of welfare over all 30 periods.
222 B. Henze et al.

Static Efficiency
105%

95%

85%

75%

65%
Session 1 94%
55% Session 2 95%
Session 3 94%
Session 4 95%
45%
Dynamic Efficiency
105%

95%

85%

75%

65%
Session 1 93%
Session 2 87%
55%
Session 3 82%
Session 4 90%
45%
1 4 7 10 13 16 19 22 25 28 Period

Fig. 8.4 Time path of static and dynamic efficiency in each session

though they are also modestly lower than spot prices. In session 1, forward prices
are much lower than spot prices, though still somewhat greater than the benchmark
level. In session 4, forward prices are modestly lower than spot prices, but track
each other fairly well, converging to close to the benchmark. In session 2, forward
prices are much lower than spot rises, though they are close to the benchmark
scenario.
Table 8.3 gives the value of (a) ft  st, (b) |ft  st|, and (c) σ(ft  st), averaged
over the 30 periods of each session. These are the average difference between forward
and spot prices, as well as the average absolute value and standard deviation of the
difference. Also included in the table are the number of times that forward prices
change over the 30 periods (9 is the maximum possible number of instances), and the
average absolute value of such changes. The table reveals some interesting patterns.
The first is that the difference is negative in all four sessions, indicating that
forward prices are typically lower than eventual spot prices. This might be due to
the use of an auction to allocate the LTFTR. A one-sided auction allows for
8 Long Term Financial Transportation Rights: An Experiment 223

Spot Price
(ECU / Unit)
120
Session 1
Session 2
100
Session 3
Session 4
80 Simulation

60

40

20

0
1 4 7 10 13 16 19 22 25 28 Period

Fig. 8.5 Time path of spot prices in each session and benchmark simulation

Forward Price
(ECU / Unit)
100
Session 1
90
Session 2
80 Session 3
Session 4
70 Simulation

60

50

40

30

20

10

0
1 4 7 10 13 16 19 22 25 28 Period

Fig. 8.6 Time path of forward prices in each session and benchmark simulation

strategic underbidding, which could lower prices, while the passive seller does not
behave strategically to offset this effect. The resulting low prices, if not properly
interpreted by the network operator, might create an impression on the part of the
operator that future demand is lower than it really is, and dampen investment.
224 B. Henze et al.

Table 8.3 Differences between spot and forward prices and changes in forward prices
Session 1 Session 2 Session 3 Session 4
ft  s t 31.8 20.4 1.7 3.9
|ft  st| 34.0 24.4 8.0 8.3
σ(ft  st) 34.0 20.1 12.9 10.0
Count(ft+1 6¼ ft) 5 3 4 5
|ft+1  ft| for ft+1 6¼ ft 3.6 9.0 13.8 8.0

The second pattern is that there is no relationship between the level of efficiency
or capacity provision with the level, absolute value, or variance of the difference
between spot and future prices. Session 1, in which capacity investment is close to
optimal and efficiency is relatively high, has the greatest discrepancy between spot
and future prices, and the greatest variability of the difference. On the other hand,
session four, the other market with close to optimal investment and welfare levels,
has a below-average discrepancy between spot and forward prices with below-
average variability. Thus, overall efficiency is not correlated with the predictive
power of the forward market for subsequent spot prices.
The third pattern is that the LTFTR markets tend to be characterized by modestly
more frequent but smaller prices changes in the more efficiently operating markets.
These relatively smooth price patterns in forward prices in sessions 1 and 4 may
increase the credibility of the LTFTR prices in the view of the network operator in
guiding his investment decisions.

8.6 Conclusion

In this chapter we have reported the results of four experimental sessions in which a
network operator uses LTFTR to establish a forward market for her capacity. The
experimental environment contains some distinctive features of energy markets.
Demand exhibits an increasing trend, but varies unpredictably. Network users have
more information about future demand than the network operator. A small number
of network users have some market power in both the spot and LTFTR markets.
The network operator is subject to cap regulation.
The data show that market behavior varies considerably among different
sessions, despite the fact the underlying structure is the same in every way, except
for the identity of the individuals participating, who are randomly drawn from the
same subject pool. The four sessions we have conducted yield four different
scenarios about how spot prices, LTFTR prices, investment, and welfare
can interact. In session 1, capacity moves along a trajectory close to the optimum.
However, spot prices are much greater than forward prices for most of the session,
and thus forward prices give biased signals about future demand. Session 2 is
also characterized by spot prices that are much greater than forward prices, and
convergence of forward prices to levels close to those observed under the
8 Long Term Financial Transportation Rights: An Experiment 225

benchmark simulation. However, capacity remains consistently short of the optimal

level, and this exerts a considerable, negative effect on efficiency. Here, the
network operator may interpret the low forward prices as an indicator of low future
demand and not invest sufficiently. Session 3 has forward prices more or less in line
with spot prices, and thus forward prices are good predictors of spot prices.
Although both prices are high relative to an optimal scenario, they do not induce
a sufficient level of investment, and capacity and welfare remain low. Here, the
high prices appear to arise as a response to low capacity, but the network operator
fails to respond to the price signals. In session 4, forward and spot prices track each
other fairly closely, exhibiting a decreasing trend over time. Despite the trend,
capacity investments are made consistently over the time horizon and high welfare
levels result. The decreasing prices over time appear to be a response to increasing
capacity.
These results suggest that what can be expected if LTFTRs are implemented
depend on several factors. How the network operator interprets the data from the
LTFTR market is very important. If he takes high or increasing prices as a
willingness to pay for an increase in capacity, he may invest more in response.
On the other hand, if the LTFTR market is viewed as being driven by speculative
demand unconnected to the underlying commodity, the operator may not respond to
the price signals it generates. If the operator fails to correct for strategic
underrevelation of demand in the LTFTR market, he may believe that demand is
likely to decline in the future and withhold investment in response. On the other
hand, if he fully corrects for this and interprets prices in that context, strategic
behavior will not affect investment decisions.

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Chapter 9
FTR Properties: Advantages and Disadvantages

Richard Benjamin

9.1 Introduction

While financial transmission rights (FTRs) were developed as a hedge for loca-
tional price risk,1 their advocates envision them as a multifaceted tool, providing
revenue sufficiency for contracts for differences, distributing the merchandizing
surplus an independent system operator (ISO) or regional transmission operator
(RTO) accrues in market operations, and providing a price signal for transmission
developers.
While several economists have addressed the question of whether allocating
incremental FTRs to developers will induce efficient grid expansion,2 the issue of
FTR allocation for the existing grid has basically flown under the radar. Economists
generally argue that opening the electricity sector to competition will increase
efficiency and thus decrease costs. While costs have indeed fallen,3 retail electricity
prices have not followed.4 And while the exercise of market power has been well
documented, both in the U.S. and the U.K electricity market, another, more subtle
factor may be propping up retail rates as well. The rules for FTR distribution for the
existing grid, FTR market settlement, and the treatment of FTRs in rate cases all
have important implications for retail rates. Seemingly innocuous decisions may

1
See Hogan (1992).
2
See, e.g., Oren et al. (1995), Wu et al. (1996), Bushnell and Stoft (1996a, b, 1997), Hogan (1998),
Barmack et al. (2003), Brunekreeft (2004), Calviou et al. (2004), Keller and Wild (2004), Bogorad
and Huang (2005), and Joskow and Tirole (2005).
3
See, e.g. Fabrizio et al. (2007) and Knittel (2002).
4
See, e.g. Apt (2005) and Taber et al. (2006). This conclusion in not unanimous, however (see, e.g.
Joskow 2006).
R. Benjamin (*)
Round Table Group, Inc, 1074 Springhill Ct, Gambrills, MD 21054, USA
e-mail: [email protected]

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 227

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9_9,
# Springer-Verlag London 2013
228 R. Benjamin

have helped to inflate retail rates in restructured states above those in their tradi-
tional counterparts.
A second basic issue that has gone mostly unnoticed is the difference between
wholesale electricity market settlements in theory and in practice, and the
implications of this difference for the hedging characteristics of locational marginal
pricing (LMP). While FTRs serve as a perfect hedge against transmission
congestion in theory, the same is not true in practice when load is not settled at
the LMP.
Finally, as Siddiqui et al. (2005) have shown, FTR markets are themselves
flawed. Siddiqui et al. (2005) found that FTR market participants were systemati-
cally unsuccessful at hedging larger risk exposures. This paper studies the
implications of allocation of FTRs for the existing grid and RTO FTR market
rules on retail rates (i.e., the distributional aspects of FTR allocation), FTR hedging
properties, and FTR inefficiencies. Section 9.2 provides a brief review of transmis-
sion pricing. Section 9.3 offers background on FTR allocation, both for the extant
grid and grid additions. Section 9.4 then examines FTR allocation using a two-node
model. It makes the point that FTR allocation has important distributional
implications. In particular, it shows that FTR allocation is an important determinant
of the ability of restructured markets to hold down the retail price of electricity to
consumers. Section 9.5 examines the hedging qualities of FTRs in a three-node
model. It shows that RTO FTR practices create a divergence between the theoreti-
cal result of perfect hedging and FTR hedging in practice. It also shows, through a
counterexample, that even in theory, FTRs cannot universally serve as a perfect
congestion hedge. Section 9.6 offers a further discussion of the hedging aspect of
FTRs. Section 9.7 presents data demonstrating the magnitude of FTR cost-inflating
factors in United States RTOs and ISOs. Section 9.8 presents observations on FTR
properties. Section 9.9 offers suggestions for further research and concludes.

9.2 Transmission Pricing

In order to do justice to any discussion of the properties of FTRs, one must first
discuss transmission pricing, emphasizing LMPs, as developed by Schweppe et al.
(1988).
Hsu (1997) divides the overall costs for a transmission network into four major
components: returns and depreciation of capital equipment, operation and mainte-
nance to ensure the network is robust, losses incurred in transmitting power, and
opportunity costs of system constraints. He adds that marginal cost pricing of
transmission services defines the impact on the overall system costs when one
additional megawatt is injected or withdrawn at some node. According to Hsu
(1997), these costs include two major components: marginal losses throughout the
network and the opportunity costs of not being able to move cheaper power due to
9 FTR Properties: Advantages and Disadvantages 229

transmission line congestion. Hsu (1997) argues that under an ideal marketplace,
transmission service charges should equal the short-run marginal costs of providing
that service. This is the standard argument that locational marginal prices should
include a congestion component. The overwhelming majority of energy economists
seemingly agree with the interpretation of congestion charges as opportunity costs.5
Rosellón (2003) agrees that there is a general consensus regarding the marginal cost
of electricity transmission usage.
Oren et al. (1995) stands in sharp contrast, however. This work counters that the
opportunity cost component is based on an improper analogy to transportation
costs and arbitrage theory. The authors state that the idea is that if the good is priced
at level pA at location A then the price at any other location B cannot exceed pA plus
the cost of transportation from A to B. Oren et al. (1995) argue that marginal
transmission losses can be interpreted as the equivalent of a transportation cost, and
that in the absence of such losses, nodal price differences would reflect no physical
transmission costs. Nodal price differences, however, reflect the welfare gain from
relieving the congestion between nodes A and B. The authors argue that the
transportation analogy is misplaced; because in electricity networks there is no
active competition among transmission operators to carry electrons over their
wires. In electricity networks, transmission constraints and their pricing are deter-
mined by the action and judgments of grid operators rather than by the
decentralized decision making of transmission companies and their clients. Oren
et al. (1995) conclude that, as a consequence, a better analogy to the differences in
nodal prices is an externality tax imposed by a network operator. They further
argue that nodal price differentials are not appropriate for allocating congestion
rents across the network, and thus an alternative mechanism to allocate network
congestion rents has to be designed. The authors do acknowledge, though, that
locational prices equal the marginal valuation of net benefits at different locations,
and thus provide the right incentives for consumption and generation decisions,
both in the short run and the long run.

9.3 Background on FTRs and FTR Allocation

Hogan (1992) developed FTRs as a tool for allocating scarce transmission capacity
(“the congested highway”). He argues that defining FTRs as the right to locational
price differences, (the sum of the loss and congestion components) between busses
provided correct short-run incentives for transmission system use. In the short run, a
holder of FTRs should be indifferent between physically delivering power between
two nodes or financial compensation if loop flow or system contingencies prevent
physical delivery. He sees this tradeoff as the key to providing complementary

5
See, e.g. Borenstein et al. (2000), Brunekreeft (2004), Bushnell and Stoft (1997), Chao and Peck
(1996), Green (1997), Hogan (1992), Joskow and Tirole (2000), Kristiansen (2005a), Rosellón
(2003), and Rotger and Felder (2001).
230 R. Benjamin

long-term transmission capacity rights for new generation. An FTR holder can
honor any long-term delivery commitment by either physical delivery or using FTR
revenue to purchase power at the point of delivery, thus guaranteeing the economic
viability of such transactions and solving the problem of loop flow preventing
physical delivery of generation under contract. Hogan’s mechanism envisions a
two-part tariff for transmission usage, with fixed charges for long-term transmission
access, and short-run congestion charges.
Since Hogan’s seminal work, different variants of FTRs have been proposed.
Hogan’s original proposal has since been labeled “point-to-point FTR obligations.”
Chao and Peck (1996, 1997) propose flowgate FTRs. Flowgate FTRs are constraint-
by-constraint hedges that convey the right to collect payments based on the shadow
price associated with a particular transmission constraint (flowgate) (Kristiansen
2005a). The other determining factor for FTR type is obligation versus option. An
obligation FTR compels payment for price differences, where an option FTR gives
the holder the option to receive the price difference, which the holder will use
provided the (directional) price difference is positive. Since obligation-type FTRs
are the most common in practice and the most closely scrutinized in the literature,
this chapter focuses on this type.
Kristiansen (2005a) differentiates between FTRs allocated for grid expansions
and for the extant grid. He notes that they can be given to those who invest in
transmission line or to load-serving entities (LSEs) and others who pay fixed cost
transmission rates, either through direct allocation or through an auction process in
which the LSE is allocated auction revenue rights (ARRs) that can be used to
purchase FTRs. Kristiansen (2005a) states that FTRs for existing transmission
capacity can be allocated based on existing transmission rights or agreements
(historical and entitlements), auctioned off, or so that their benefits offset the
redistribution of economic rents arising from tariff reforms, inter alia.

9.4 Distributional Aspects of FTR Allocation

As Benjamin (2010) notes, researchers studying FTRs generally take allocation as

given, thus ignoring the implications of FTR allocation on the marketplace. This
section looks at this issue in detail in the contexts of a two-node and a three-node
model.
The two-node model is the most straightforward way to examine the distribu-
tional aspects of FTR allocation. Denote as i and j two nodes connected by a single
transmission line. Let the first node represent a generation pocket, connected with a
load pocket by a single transmission line, which we assume to be congested
(day-ahead), so as to create a difference in day-ahead prices at the load and genera-
tion pockets, denoted pi and pj, respectively, with pj > pi. For simplicity we also
assume a single generator at each node, producing quantities qi and qj, with q ¼
qi + qj. Assume further that there is no load at node i (Fig. 9.1).
Denote the proportion of load covered by long-term bilateral contracts as a, so
that the proportion not covered under contract is 1  a. As per Hogan, FTRs
9 FTR Properties: Advantages and Disadvantages 231

Fig. 9.1 The two-node model

Node i: Node j:
Price = pi Price = pj
Dispatch = qi Dispatch = qj
Load = q

Table 9.1 Settlements for non-contract power when the RTO allocates FTRs to generator i
Settlements
Entity Energy FTRs Net


Generator i ð1  aÞpi qi ð 1  aÞ pj  pi qi ð1  aÞpj qi
Generator j ð1  aÞpj qj ð1  aÞpj qj
LSE j  ð1  aÞpj q  ð1  aÞpj q

Table 9.2 Settlements for non-contract power when the RTO allocates FTRs to the LSE
Settlements
Entity Energy FTRs Net
Generator i ð1  aÞpi qi ð1  aÞpi qi
Generator j ð1  aÞpj qj ð1  aÞpj qj



LSE j  ð1  aÞpj q ð1  aÞ pj  pi qi  ð1  aÞ pi qi þ pj qj

provide revenue sufficiency for the proportion of output covered by long-term

contract. For that not covered by contracts, though, FTR allocation has
important distributional implications. First let us assume that the RTO allocates
FTRs from i to j to generator i. Settlements for this case are shown in Table 9.1,
below:
Now let us examine the difference when the RTO allocates the FTRs to the LSE
serving load at j (Table 9.2).
We may graph these results as follows (Fig. 9.2).
Area (a) represents energy payments received by generator (i), while areas
(a) plus (b) represent energy payments received by generator (j). Area (b) represents
total FTR revenue.
When the RTO allocates FTRs to generator i, the LSE serving node j ends up
paying the load-pocket price for all energy procured, regardless of the source
(That is, the total of Areas (a) through (c), or ð1  aÞq), for total energy consump-
tion. However, Under cost-based regulation, load-pocket energy procurement costs
would be only


ð 1  aÞ p i qi þ pj qj ; (9.1)

that is, the sum of Areas (a) and (c).

Let us assume that the market is in long-run equilibrium, so that bids reflect
embedded cost. Then the difference between the net amount the LSE pays in the
232 R. Benjamin

Fig. 9.2 Settlements for P

power not under long-term
(b)
contract
(1-a) pj

(c)
(1-a) pi
(a)

qi q = qi + qj Q

market when the RTO allocates the FTRs to it and the amount it pays when the RTO
allocates FTRs to generators is the same as the difference between the cost that the
LSE would pay for producing that power itself (i.e., if it were a vertically integrated
utility) versus the amount it has to pay for that power in the competitive market,
when it is not allocated the FTRs. We may thus calculate the cost inflation factor for
the LSE purchasing power in the competitive market (relative to the cost of power
procurement for the vertically-integrated utility), as


ð 1  aÞ pj  pi q i
; (9.2)
q

or Area (b)/q.
The argument that allocating FTRs to generator i inflates the cost of electricity
for consumers merits further discussion. In the traditional marketplace, the
vertically-integrated utility (VIU) incurs a cost of

TC ¼ ci qi þ cj qj (9.3)

to serve the load pocket, where TC is total cost, and ck is embedded cost of
generation, k ¼ i, j. In the United States, many economists have argued that the
primary goal of restructuring is to reduce retail electricity rates, that is, to decrease
pk below ck sufficiently to make deregulation cost-effective.6 However, as argued
above, FTR “misallocation” adds another factor inflating the cost of power to
consumers in competitive electricity markets.
The question remains as to whether there remain any dynamic arguments for
allocating FTRs to generator i. That is, will allocating FTRs to generator i facilitate
attainment of the long-run equilibrium? Firstly, the desirable long-run equilibrium

6
See, e.g. Fabrizio et al. (2007) and Joskow (2006). Deregulation may decrease prices by
providing incentives for existing plants to improve their performance, and by providing price
signals to new generating capacity and grid expansions (although, as mentioned above, the latter
point is controversial). Joskow notes that restructuring in the U.K. was driven by the ideological
commitment of the Thatcher government to competition as an alternative to regulated monopoly
(p. 2), while the primary political selling point for competition in the United States was that it
would benefit consumers by leading to lower costs and lower prices.
9 FTR Properties: Advantages and Disadvantages 233

where generation at node i earns a normal return is in no way contingent on this

generator receiving FTRs. By the standard argument, short-run prices at i will
induce generation to enter or exit up to the point where all node i generators receive
zero economic profit. Let us denote the price corresponding to normal economic
profit as pN. That is, pN is equal to long-run average total cost of generation at
node i,

pN ¼ LRACi : (9.4)

If generators at node i do not receive an allocation of FTRs, then, by the standard

argument, price at node i will gravitate toward pN in the long run.
Now let us assume that node i generators are allocated FTRs. The most straight-
forward method of demonstrating the long-run equilibrium is to assume that there
is now load at both nodes.7 Let us assume for sake of simplicity, that generator i is
able to sell a constant amount of output, regardless of the amount of entry. Denote
the amount generator i sells at node i as qi, and the amount sold at j as qj. Next,
assume that we are in the original long-run equilibrium, with pi = pN : Generator i’s
total revenue is composed of two parts: (1) revenue from energy market
settlements, and (2) revenue from FTR settlements, as shown in (9.5)


TR ¼ pi q þ pj  pi qj ¼ pi qi þ pj qj (9.5)

where TR is total revenue. Since pj > pi = pN , generator i is making positive

economic profits. This will encourage other firms to enter until economic profits
are again equal to zero. Since quantities are assumed to be unchanged, entry must
occur until


pN qi  pj  pN qj
pi ¼ (9.6)
qi

That is to say, the node i price must fall sufficiently to dissipate all FTR revenue
earned. In this equilibrium, there is no price distortion, because LSEs pay genera-
tion at i only enough for them to receive a normal return. The informational
assumptions required for this equilibrium to obtain, however, are fantastic. That
is, while it is difficult enough for a potential entrant to estimate the profitability of
entry based on rapidly fluctuating electricity prices, asking the entrant to simulta-
neously gauge the profitability of future FTR revenues complicates the decision
drastically. Therefore, by Occam’s Razord,8 it would be counterproductive to
allocate FTRs to node i generators in response to long-run equilibrium concerns.

7
Otherwise, we would have to let entry decrease the amount of power sold by each generator,
resulting in inefficient excess capacity.
8
Occam’s razor, (the law of parsimony, economy or succinctness), is a principle that generally
recommends that, from among competing hypotheses, selecting the one that makes the fewest new
234 R. Benjamin

Note, though, that the analysis above does not preclude the possibility of
merchant transmission investment being financed by incremental FTRs. Fundamen-
tally, the issues of FTR allocation for the existing grid and for grid additions remain
conceptually separate. Additionally, let us note that retail customers will ultimately
pay for grid expansion, regardless of whether transmission additions are built by
merchants and financed by FTR revenues, or by load-serving entities and financed
through retail-rate adders. In the first case, LSEs pay congestion charges, either by
buying FTRs to hedge congestion or paying congestion charges directly. In the
second case, transmission expansions are amortized in retail rates. Thus, the only
potential difference in retail-rate impacts is the risk that FTR revenues exceed the
cost of the project. Numerous works, however, indicate that exactly the opposite
will be the case because FTR revenues cannot be expected to fully-finance new
transmission projects.9 Thus, merchant transmission stands on its own merits,
independent of the discussion in this paper.
By the above argument, then, the amount by which FTR allocation inflates the
wholesale price of electricity relative to cost-based regulation depends on (1) to
which party the FTRs are allocated, (2) the portion of electricity under long-term
contract, (3) the amount of electricity imported into load pockets, and (4) the price
difference between load-pocket and unconstrained generation. Let us defer discus-
sion of point (1) briefly. Point (2) adds an additional argument for encouraging
long-term contracting in the marketplace. Papers such as Blumsack et al. (2006),
Rothkopf (2007), and Lave et al. (2007a, b) argue that maximizing the amount of
capacity under long-term (and particularly “life-of-the-plant”) contracts increase
the competitiveness of wholesale electricity markets. Here, we find that in addition
to any competitiveness issues, proliferation of long-term contracts will decrease
any inflation of procurement cost for LSEs who are not allocated FTRs for load-
pocket transactions and either have to pay the spot price for these transactions or
purchase FTRs in the secondary market to hedge their spot-price exposure. Point (3)
demonstrates that while increased transmission into a load pocket can bring more
low-cost power into the area, load-pocket consumers will not benefit unless their
LSE is allocated FTRs for such transactions or the transmission expansion reduces/
eliminates the difference in LMPs. Correspondingly, Point (4) notes that the
severity of the price distortion depends on the relative efficiency of generation in
the load pocket to unconstrained generation. The older, less efficient the generation
in the load pocket, the greater the distortion.
The distributional impact of FTR allocation ultimately depends on state
regulators’ treatment of FTR revenues. Suppose the state allows the LSE to keep
all FTR revenues as profit, instead of crediting the amount against retail rates. The
only distributional question regarding FTR allocation is whether generator i’s
stockholders (when the generator receives the FTRs) or the LSE’s stockholders

assumptions usually provides the correct one, and that the simplest explanation will be the most
plausible until evidence is presented to prove it false. (thank you, Wikipedia)
9
See fn. 1, above.
9 FTR Properties: Advantages and Disadvantages 235

benefit.10 In either case, retail rates will be inflated, as per (9.2). When the state
rebates FTR revenues against retail rates, the redistributional results are telling. If
the RTO allocates FTRs to LSEs who are required to credit FTR revenues against
electricity-procurement costs, then the LSE’s customers will benefit from lower
retail rates. Otherwise, Generator i’s stockholders once again benefit. Given that
support for electricity restructuring in the United States has extended as far as the
consumer’s energy bill, distributional concerns call for allocating FTRs to LSEs.
Making the assumptions that energy and capacity markets are competitive yields
two additional results
Result 1 When all load in a two-node model is covered by FTRs, if the RTO
allocates FTRs to the LSE serving the load pocket, then the LSE’s cost of procuring
wholesale energy is simply the cost of electricity generation.
Result 1 follows from the argument that bids in the electricity markets will
reflect embedded costs in long-run equilibrium, whether the transaction occurs in
the spot market or the bilateral contract market. In this case, retail rates will fall
provided the restructured company is more efficient than its traditional VIU
counterpart.
When FTRs are allocated to generator i, however, load-pocket consumers pay
the marginal price of (load-pocket) electricity production for all electricity con-
sumed. As argued above, this result may act to inflate the retail price of electricity in
restructured markets. In traditional markets, consumers pay the average of the
embedded cost of all electricity produced, but in restructured markets, this is the
case only if FTRs are allocated to LSEs. Section 9.7 examines the amount that retail
rates have been inflated by all FTR market imperfections, as data limitations
frustrate the effort to disentangle the separate effects.11
Result 2 In the perfectly competitive two-node model, as above, allocation of FTRs
to the LSE serving the load pocket aligns the private and social incentives for
transmission expansion, provided that the state regulatory agency allows the LSE
to keep all of the cost savings attributable to the transmission expansion.
Result 2 holds because, as per Leautier (2001) and Joskow and Tirole (2005), the
social benefit from transmission expansion in the perfectly competitive market is
equal to the redispatch cost savings attributable to the new line. This redispatch cost
savings is also the LSE’s benefit from building the line, provided the state allows
the LSE to keep this savings.
Result 2 starts with the basic proposition that transmission expansion allows the
substitution of less-expensive for more-expensive generation, reducing redispatch

10
See Benjamin (2008), though, for a discussion of mechanisms made possible when load-pocket
LSEs retain these revenues.
11
Returning to the discussion of Sect. 9.3, allocation of auction revenue rights (ARRs) to FTR
holders complicates matters further by introducing disparity between payments to LSEs and
congestion revenues. Notice that the law of one price still applies for sale of electricity at each
node, but see Lave et al. (2004), pp. 17–18 for an argument against paying the market-clearing
price to all generation.
236 R. Benjamin

costs; and that this redispatch-cost savings is the value added of transmission
expansion.12 Next, it recognizes that the traditional investor-owned utility (IOU)
serves the dual role of LSE and builder of the extant transmission system. Because
the IOU serves these two roles, it reduces its own cost of procuring power for its
retail customers when it builds new transmission. Because the IOU bears the full
(social) cost of building new transmission (ignoring environmental externalities),13
if it reaps the full benefit of transmission expansion, it will necessarily make
socially optimal decisions if it is allowed to reap the full benefit of transmission
expansion. Note that this is a sufficient, but not necessary condition for optimality.
The state regulator may decide to decrease retail rates in this case, provided that it
leaves the utility with at least a normal return to investment.
Result 2, of course, is not robust to increasing complexity of the transmission
system. In meshed networks with loop flow, there will be many beneficiaries of
transmission expansion, not simply a single LSE and its customers. Thus,
remunerating transmission projects based on redispatch costs savings is no longer
a simple exercise, but is fraught with the problem of potential free-riding.14 This
result does fit in nicely with Benjamin (2008), however, in that it provides further
insight into the economics of load-pocket management. This result also adds
explicit theoretical justification for the argument that transmission projects that
alter nodal prices should not be done on a merchant basis. As noted already, again
referencing Joskow and Tirole (2005) and Leautier (2001), the social justification
for such projects is the redispatch cost savings they create, rather than incremental
FTRs.
At first blush, Results 1 and 2 seem to yield conflicting recommendations
regarding distribution of FTR revenue accruing to the LSE (Result 1 suggesting
that it be refunded to retail ratepayers, so as to equate retail rates in restructured
markets with those in traditional markets, Result 2 suggesting that the LSE keep
these revenues). However, they are no more than variations on a theme, with Result
1 suggesting that incremental transmission be financed separately in retail rates,
while Result 2 would have it financed directly through FTR revenues. Such a choice
is ultimately in the hands of the regulator. Given that transmission expansion often
alters nodal prices, regulators would be wise to finance transmission expansions in
retail rates, as opposed to incremental FTR allocation.15

12
Of course, this proposition also ignores the reliability-enhancing character of transmission,
which is of great value as well.
13
Although the transmission financing literature ignores questions such as scenic and environ-
mental impacts of new transmission lines, NIMBY has a strong impact on transmission siting
decisions, complicating actual transmission siting decisions.
14
But see Benjamin (2007) for thoughts on how to award redispatch cost savings to transmission
builders in meshed networks.
15
Indeed, FERC has taken this tack in Order 679, “Promoting Transmission Investment Through
Pricing Reform,” 113 FERC 61,182.
9 FTR Properties: Advantages and Disadvantages 237

Fig. 9.3 Three-node load Node B

Load = 1,300 MW
pocket diagram Node B Generator
Capacity = 1,300 MW
B Dispatch = 1,300 MW
Bid = $50/MWh
Node A Generator
Capacity = 700 Node C
Dispatch = 600 Load = 700 MW
Bid = $60/MWh A C Node C Generator
Capacity = 300 MW
Capacity AC=AB= BC= 400 Dispatch = 100 MW
Bid = $180/MWh

9.5 Hedging Aspects of FTRs Under Load Aggregation

Questions regarding the hedging characteristics of FTRs are generally relegated to

situations where contingencies limit actual transmission capability below expected
network capability, so that the merchandizing surplus will not fully finance
allocated FTRs. Such inquiries, however, assume that load is settled on a nodal
basis, when, in fact, it generally is not. For example, load in PJM is settled on a
zonal basis, which has also been the plan in California under MRTU since it was
MD02.16 And the “perfect” hedge provided by FTRs is not robust to changes in
settlements, as we will see below.
We illustrate this point using a three-node network, as it provides a richer set of
results than does the two-node framework. First we examine a load pocket in a
three-node network. While the RTO will dispatch some load-pocket generation for
voltage support, in this example we motivate the dispatch of local generation as
necessary to serve load as well. Denote the three nodes as A, B, and C, and assume
that B and C both have local load, and that A, B, and C are all generation nodes.
Assume all lines have equal impedance, so that 2/3 of the power generated at node
A will flow on line AC, with 1/3 flowing on lines AB and BC, while 1/3 of the
power generated at node B will flow on lines AB and AC, with 2/3 flowing on line
BC. Let all lines have a capacity of 400 MWs. Finally, let the loads at nodes B and C
be 1,300 and 700 MWs, and capacities at nodes A, B, and C be 700; 1,300; and
200 MWs, respectively. The diagram for the example follows (Fig. 9.3):
In this case, 400 MW of the 600 MW of generation at node A will flow on line
AC, making the latter a binding constraint. With 200 MW flowing on lines AB and
BC, neither is binding. As there is excess generation capacity at nodes A and C,
node A and node C LMPs are the corresponding bid values of $60/MWh and
$180/MWh, respectively. Since there is no excess generation at node B, an incre-
ment of load at node B would be met by an additional one-half MW from nodes

16
That is, Market Redesign and Technology Upgrade and Market Redesign 2002.
238 R. Benjamin

Table 9.3 Settlements for non-contract power when the RTO allocates FTRs to the buyer
Day-ahead energy and settlements
Net energy
Energy LMP Load-weighted Energy Net price
Entity (MWh) ($/MWh) LMP ($/MWh) payment ($) FTRs ($) payment ($) ($/MWh)
Gen. A 600 60 n/a 36,000 0 36,000 60
Gen. B 1,300 120 n/a 156,000 0 156,000 120
Gen. C 100 180 n/a 18,000 0 18,000 180
Load B 1,300 120 141 183,300 0 183,300 141
Load C 700 180 141 98,700 72,000 26,700 38.14

A and C (in order to satisfy the constraint on line AC), so the LMP at node B is
simply ½(60 + 180) ¼ 120.
Due mainly to political constraints, RTOs generally settle load on a weighted-
average basis. A common concern for municipal utilities located in a transmission-
constrained area is that because they are generally small, their service area fits
entirely inside the constrained area. They would face high prices if load were settled
on a nodal basis. Such is not a concern under weighted-average settlements,
because their price simply becomes the zonal average price.
Let us also assume that B and C are the only nodes in the load-aggregation zone.
The weighted-average price for load settlements is then

ð1; 300  120Þ þ ð700  180Þ

¼ $141=MWh:
2; 000

Now assume that load at node C receives the full allotment of FTRs with source
of node A that sink at node C (AC FTRs).17 The value of each FTR is equal to the
difference in nodal prices between node C and node A, or

$180  $60 ¼ $120=MWh:

Since the LSE serving load at C holds 600 MWs of AC FTRs, The LSE receives

$120  60 ¼ $72; 000=hour

in FTR settlements. Total settlements are then as follows (Table. 9.3):

We may examine the hedging impacts of FTR allocation with respect to load at
both nodes B and C. First, note that FTRs cannot hedge node-B load against

17
Allocating 600 MWs of AC FTRs to load at node C is consistent with PJM’s practice of
distributing ARRs according to historical usage patterns (as long as we make the simplistic
assumption that node B consumption and output have historically been equal).
9 FTR Properties: Advantages and Disadvantages 239

congestion charges, because congestion creates a difference between the bid-price

and LMP at a single node, and FTRs do not hedge against such an eventuality.18
The best that node-B load can hope for is to convince the RTO that it should be
allocated a share of the line AC FTRs, but this is contrary to the standard practice of
allocating FTRs according to historical usage patterns.
The second point of note is that average pricing of load can over-hedge load-
pocket consumption. This is the case in our example if the LSE at node C is
allocated all of the AC FTRs. Assuming that the load pocket will have the highest
nodal price, the average price paid by the node C LSE will be lower than the node C
LMP, creating a subsidy of (LMP(C)—Weighted Average Price) per MWh. If load
at nodes B and C are served by the same entity, this is a wash, but it is precisely
because not all load in a zone is served by the same entity that RTOs employ nodal
pricing, so this is a concern.

9.6 Further Thoughts on Hedging

A central strength of FTRs remains that properly defined FTRs serve as the perfect
hedge for contracts for differences. Bushnell and Stoft (1997) show that FTRs
supply revenue adequacy for CFDs, allowing for a fully hedged, fixed-price con-
tract between traders. Indeed, the literature on managing electricity market risks
echoes Bushnell and Stoft’s analysis. Consider Deng and Oren (2006):
A 1-MW bilateral transaction between two points in a transmission network is charged (or
credited) the nodal price difference between the point of withdrawal and the point of
injection. At the same time (assuming that transmission rights are fully funded), a 1 MW
FTR between two points is an entitlement (or obligation) for the difference between the
nodal prices at the withdrawal node and the injection node. Thus regardless of how
the system is dispatched, a 1 MW FTR between two nodes is a perfect hedge against the
uncertain congestion charge between the same two nodes.19

We may demonstrate this result borrowing Bushnell and Stoft’s (1997)

(Table 9.4).
As one may readily see, absent FTRs, the supplier will not receive the full
contract price for power
produced, but rather the contract price minus the nodal
price difference pj  pi .
This analysis, however, begs a further question: What impact does the introduc-
tion of LMP and FTRs have on the contract market? That is, were bilateral market
participants better off before, or after the introduction of LMP and FTRs? To

18
Further, one cannot expect long-term contracting to rectify the situation, because generators
have no incentive to sign long-term contracts for anything less than the expected LMP at node B,
as the California crisis made abundantly clear.
19
Deng and Oren (2006), pp. 950–951. See also Liu and Wu (2007), Sarkar and Kharparde (2008),
and Yu et al. (2010).
240 R. Benjamin

Table 9.4 Using FTRs to Payment

provide revenue adequacy for
bilateral trades Contract or market Supplier at node i demander at node j
Spot market pi  q  pj  q



CFD for q at Pc Pc  pj  q  Pc  pj  q


FTR for q from i to j pj  pi  q
Total Pc  q Pc  q

answer this question, let us assume that the FTR market

once again satisfies the
efficient market hypothesis, so that PFTR = E pj  pi . If we further assume that the
long-term contract market is competitive, then in a restructured market, the contract
price, Pc , will equal the competitive contract price, Pc , where the competitive
contract price yields normal economic profit to the marginal generator, plus the
price of an FTR, or


Pc ¼ Pc þ E pj  pi (9.7)

Provided that the node i LSE receives the all of revenue from FTR sales from
node i to node j (generally through auction revenue rights, see e.g. PJM (2009),
Joskow (2005), and Kristiansen (2005b, 2008)), both the seller and the buyer
receive/pay the expected net price, Pc :20 However, to the extent that FTR auction
results contain a stochastic component and the parties are risk averse, then both the
buyer and seller are made worse off by the introduction of LMP and FTRs!
Likewise, to the extent that market imperfections persist in the FTR market,21
the introduction of LMP and FTRs produces lasting inefficiency in the long-term
contract market.
This observation brings us back to Oren et al.’s (1995) contention that nodal
price differences do not reflect opportunity cost because transmission operators do
not compete with each other to carry electrons over their wires, but rather reflect an
externality tax imposed by the system operator. Under this interpretation, electricity
transactions under long-term contract arguably deserve a “tax-break,” as they help
to limit electricity spot-market price volatility. That is to say, there is nothing to
stop the system operator from simply settling power under contract at the contract
price, while eliminating the FTRs corresponding to the contracted energy. As
argued above, doing so would both increase market efficiency and make parties
to bilateral contracts better off. Admittedly, this would make existing FTR markets
even thinner, but as per Benjamin (2010), the system operator might simply allocate
FTRs to LSEs to cover actual power transactions. This would serve the dual

20
The seller/buyer receives/pays Pc = Pc þ E pj  pi according to the energy contract and pays/


receives E pj  pi in the FTR auction.
21
See Deng et al. (2010).
9 FTR Properties: Advantages and Disadvantages 241

purposes of (1) further encouraging generators to sign long-term power contracts,

and (2) give LSEs leverage in the long-term contract market, helping push down the
price of power in imperfectly functioning long-term electricity markets towards the
generator’s embedded cost, improving the efficiency of restructured electricity
markets.

9.7 FTR Cost Inflation

This section measures the net costs flowing to market participants after accounting
for revenues FTRs provide to hedge their transactions. It starts with an analysis at
the RTO level, then proceeds to the LSE level. At the RTO level, net costs
associated with FTRs consist of the costs of running the FTR markets themselves
(FTR administration fees), the difference between congestion charges incurred in
settlements and revenues collected through FTRs and ARRs,22 legal settlements the
RTO pays stemming from FTR market disputes, any construction costs incurred in
establishing FTR or long-term FTR facilities, and FTR defaults. These figures are
shown for ISO-NE, NYISO, and PJM in Table 9.5 below.23 Appendix A elucidates
on the data sources for these values.
From 2006 to 2008, these values ranged from $244 to $625 million. As the data
show, FTR market imperfections result in hundreds of millions of dollars of
expenses paid by ratepayers yearly. To put these figures into perspective at an
RTO level, I compare them with total costs of RTO operations for these three years
in Table 9.6.
NYISO exhibits the greatest FTR market issues, with costs ranging from 149 %
to 358 % of RTO operating costs from 2006 to 2009. This fact is mainly attributable
to NYISO’s practice of fully-funding FTRs. NYISO has been revenue insufficient
in both the day-ahead and real-time markets, due to (1) transmission line deratings
spurred by thunderstorm alerts (TSRs), and, particularly in 2008, (2) circuitous
transactions—that is, fictional contract paths which exacerbate congestion and
system operations. In the first 7 months of 2008, circuitous transaction scheduling
around Lake Erie caused hundreds of millions of dollars in FTR underfunding.
The problems in NYISO, as well as participant defaults in PJM helped fuel FTR
cost inflation from 46 % of total RTO operating costs in 2006 to 116 % of RTO
operating costs in 2008. These numbers provide additional support to economists
such as Apt (2005), Blumsack et al. (2006), Lave et al. (2004, 2007a, b), Morey

22
Each of the RTOs allocates ARRs to market participants, generally based on historical system
usage. ARRs give their holders claims to the revenues collected in the FTR auctions held by RTOs.
ARR holders may then either keep the ARRs or translate them into FTRs, through processes that
differ from RTO-to-RTO. The difference between congestion and total ARR and FTR payments is
known as “unhedged congestion.”
23
Data for the Midwest ISO and the California ISO did not provide comparable estimates, and are
not included.
242 R. Benjamin

Table 9.5 FTR Cost inflation factors (in thousands of dollars)

Legal
FTR Unhedged settle- Long-term FTR
RTO Year admin. fees congestion charges ments FTRs defaults Totals
ISO NE 2006 270 7,423 n/a n/a n/a 7,693
NYISO 2006 2,337 211,000 n/a n/a n/a 213,337
PJM 2006 2,092 21,024 n/a n/a n/a 23,116
Totals 2006 4,699 239,447 0 0 0 244,146
ISO-NE 2007 315 7,334 n/a 719 n/a 8,368
NYISO 2007 2,074 252,000 1,542 n/a n/a 255,616
PJM 2007 10,204 28,036 n/a n/a 26,303 64,543
Totals 2007 12,593 287,370 1,542 719 26,303 328,527
ISO-NE 2008 476 8,627 n/a 960 n/a 10,062
NYISO 2008 2,648 504,000 n/a n/a n/a 506,648
PJM 2008 10,538 52,249 n/a n/a 45,943 108,730
Totals 2008 13,661 564,876 0 960 45,943 625,440

Table 9.6 FTR costs as a percentage of RTO operating costs

Net FTR costs RTO operating costs FTR costs as a percentage
RTO Year ($ thousands) ($ thousands) of RTO operating costs
ISO-NE 2006 7,693 114,938 6.69
NYISO 2006 213,337 142,945 149.24
PJM 2006 23,116 274,536 8.42
Totals 2006 244,146 532,419 45.86
ISO-NE 2007 8,368 119,278 7.02
NYISO 2007 255,616 147,545 173.25
PJM 2007 64,543 281,194 22.95
Totals 2007 328,527 548,017 59.95
ISO-NE 2008 10,062 120,571 8.35
NYISO 2008 506,648 141,395 358.32
PJM 2008 108,730 277,895 39.13
Totals 2008 625,440 539,861 115.85

et al. (2005), Morrison (2005), and Rothkopf (2007) calling for changes in
deregulated electricity markets.
At the LSE level, the ideal way to measure the retail-rate impact of FTRs would
be to extract data from LSE retail-rate filings. However, these filings almost
universally do not present this level of detail. Given this data limitation, I use
FERC Form No. 1 data to estimate unhedged congestion for all entities operating in
RTO or ISO markets and making FERC Form No. 1 filings for the years 2006
9 FTR Properties: Advantages and Disadvantages 243

Table 9.7 FTR overhedging

Positive net Net transmission rights as a percentage of Retail rate impact
year transmission rights gross transactions ($/MWh)
2006 $203,052,352 7.793 0.741
2007 $240,146,073 8.269 0.811
2008 $360,401,276 8.482 1.014

through 2008.24 FTR data is spotty at best for years before 2006, dictating the initial
year of the data set. Statistics used to calculate unhedged congestion is found on
page 397 the utility’s Form No. 1 filing, as shown in Appendix B. These values
appear under various categories such as transmission rights, congestion, auction
revenue rights, transmission rights-sales, and transmission rights-purchases. Data
was also gathered for total sales to ultimate consumers (Form No. 1, page 300, line
10), as well as gross transactions. Gross transactions are computed as the sum of
absolute values of net purchases (account 555) and net sales (account 447), as found
on Form No. 1, page 397.25 As one cannot determine, a priori, whether the utility is
using FTRs as a hedge for sales or purchases, it is prudent to simply include both
transaction categories. Figures for net transmission rights are obtained from Form
No. 1, page 397 as well.
The data of Appendix B confirm the prediction of distributional impacts of FTR
allocation. Of the 21 utilities listed, ten were underhedged in each of the 3 years,
while six were overhedged for each of the years for which congestion data was
available.26 FTRs therefore systematically overhedge some utilities, while
underhedging others. To estimate the retail-rate impact of FTR revenue surpluses
and shortages, I divided net transmission rights by MWhs in total sales to ultimate
consumers. Estimates range from pennies per MWh to $5.35/MWh for Central
Vermont in 2007. To estimate the scale of FTR under/overfunding per transaction
undertaken by utilities in RTO markets, I divided net FTRs by gross transactions, in
dollars. Appendix B lists this information as well.
Consistent with the data obtained at the RTO level, LSE-level data also shows
that the rate impact of FTR market imperfections has increased over the past
3 years. Summary figures are given in Tables 9.6, 9.7, and 9.8 below.
Whereas this conclusion was largely dependent upon the NYISO market at the
RTO level, it is independent of NYISO at the LSE level, because, as per footnote
28, firms operating solely in this market are omitted. In both cases, the data

24
The FERC requires all major electric utilities to make Form No. 1 Filings. FERC defines
“major” as having (1) one million MWh or more; (2) 100 MWh of annual sales for resale;
(3) 500 MWh of annual power exchange delivered; or (4) 500 MWh of annual wheeling for others
(deliveries plus losses). Because NYISO uplifts a large portion of congestion costs, I omit firms
operating solely in this market.
25
The accounting convention used on page 397 is to list debits as positive figures, and credits as
negative values.
26
Congestion data for Wisconsin Power was not provided for 2006. One might also interpret these
differences as containing a component due to risk aversion of the various market participants.
244 R. Benjamin

Table 9.8 FTR underhedging

Negative net Net transmission rights as a percentage Retail rate impact
Year transmission rights of gross transactions ($/MWh)
2006 $124,454,187 6.083 0.285
2007 $172,250,364 5.981 0.406
2008 $209,070,380 9.446 0.579

demonstrates that FTR markets are not maturing, or, at least, their kinks are getting
not smaller, but rather larger over time. The distributional aspect of FTR
settlements is sizeable, with average rate deflation of over 1 dollar per MWh for
those who benefited, and costing an average of $0.58/MWh for those whose costs
were inflated in 2008.

9.8 Observations

This section comments on the ability of FTRs to serve the four functions they have
been proposed to serve: (1) providing a hedge for nodal price differences,
(2) providing revenue sufficiency for contracts for differences (CFDs), (3)
distributing the merchandizing surplus an ISO or RTO accrues in market
operations, and (4) providing a price signal for transmission and generation
developers.
Let us examine each of these functions in turn.
1. Hedging. As Sect. 9.4 shows, once load aggregation enters the picture, FTRs are
no longer the perfect hedge as envisioned in theory. The political constraints that
have served to thwart load settlement at LMPs have seen to that. Further, though,
the hedging properties of FTRs were developed in the context of long-term
bilateral contracts. As we have seen, when these contracts are not in place, FTRs
serve as a hedge to only the holder, with important distributional consequences.
2. Distributing the Merchandizing Surplus. While FTRs still serve to distribute the
RTO’s merchandizing surplus, the choice of FTRs to distribute the
merchandizing surplus is arbitrary. Any number of mechanisms might serve
this function. And as the analysis of Sect. 9.7 shows, FTRs constitute a quite
expensive method of serving this function.
3. FTRs as a Price Signal. The ability of FTRs to signal transmission and genera-
tion development has come into question, and rightly so. Both experience and
even theory show that FTR value serves only as a very imprecise signal of need
for new investment. To be fair, though, the difference spoken of between
congestion rent and congestion (redispatch) cost arises only because transmis-
sion investment is lumpy. On the margin, the two are the same. To the
9 FTR Properties: Advantages and Disadvantages 245

economist, for whom marginal analysis is king, the assumption that FTRs and
LMPs should provide the correct price signals is only natural.
Finally, note that nothing in this analysis precludes FTRs as an instrument for
funding transmission grid expansions. Allocating incremental FTRs to a grid
developer does not alter the fundamental recommendation that FTRs should
match physical trades, as long as incremental FTRs are simultaneously feasible.
RTOs which issue FTRs for grid additions would necessarily run minimal FTR
markets, as parties transacting over incremental lines wish to hedge congestion
costs. However, as per FERC Order 679, as well as numerous works on the subject,
a sea change has already taken place with respect to funding new transmission
through incremental FTR allocation.27

9.9 Conclusions

This paper examines the properties of FTRs, delving into their advantages and
disadvantages. Using a two-node model it finds that if the ISO allocates FTRs to the
LSE serving the load pocket, then the LSE’s cost of procuring wholesale energy is
simply the cost of electricity generation and that allocation of FTRs to the LSE
serving the load pocket aligns the private and social incentives for transmission
expansion, provided that the state regulatory agency allows the LSE to keep the cost
savings. The paper argues that the first result is more relevant, though, because the
second result breaks down when congestion reduction alters nodal prices. The paper
then shows that under zonal pricing of load, FTRs no longer serve as a perfect hedge
against congestion costs, as well as showing that, even in principle, FTRs do not
necessarily serve as a perfect hedge for congestion. The work goes on to examine
the magnitude of distributional consequences and inefficiencies caused by FTR
allocation and FTR market imperfections. It shows that the magnitudes are great,
mounting to hundreds of millions of dollars per year, with average distributional
affects in the range of $1 to + $0.5/MWh. It further calls into question the notion
of FTRs as a hedge, arguing that while FTRs may serve as a “perfect hedge” for
transmission congestion, this does not accord with the standard definition of a hedge
as an instrument to hedge the variability of a firm’s profit. Finally, the paper argues
that while FTRs serve wonderfully as a complement to contracts for differences in
providing revenue sufficiency for contracts for differences, their success in serving
other of their proposed functions is lacking. Based on these observations, and the
current state of restructured electricity markets, the paper concludes that RTOs
should undertake a far less ambitious FTR program, limiting them to their hedging
function (with trading in secondary markets limited to hedging purposes for

27
But see Benjamin (2011), Gans and King (2000), Hogan et al. (2010), Rosellón (2003), Rosellón
et al. (2011), Rosellón and Weigt (2011), and Vogelsang (2001), inter alia, for further thoughts on
this matter.
246 R. Benjamin

transmission expansions financed by FTRs). The paper argues that allocating FTRs
to LSEs while carving out energy served under long-term contracts will boost the
negotiating position of LSEs in the long-term contract market, bringing the price of
contract power closer to a generator’s embedded cost while simultaneously reduc-
ing the cost of energy LSEs procure in the real-time market.

Appendix A: Data Sources

FTR administration charges are the expense the RTO incurs in running the trans-
mission rights market and are found on p. 322 of the RTO’s FERC Form 1 filing
(available at http://www.ferc.gov/docs-filing/forms.asp). I use these figures for all
RTOs except PJM. PJM’s FTR administration value is ambiguous, because one
may measure it using the “Transmission Rights Market Facilitation” entry on
p. 322, or the “Schedule 9–2” entries, found on p. 302. The former measures the
cost PJM incurs in running its FTR markets. For 2007 and 2008 these values are
$1,582,839 and $1,581,491, respectively. The latter measures the revenue that PJM
collects from FTR administration fees. This revenue stream has two parts. The first
is to FTR holders based on FTR megawatts and hours each FTR is in effect. For
January 1, 2008 through December 31, 2010, the rate for this fee is $0.0027/MWh,
subject to quarterly refund for revenue over-collection. The second is a charge to
FTR auction participants based on the number of hours associated with each FTR
obligation bid submitted in an FTR auction. The values for these two categories are
given on p. 322 as two separate Schedule 9–2 entries. I use these values for PJM’s
FTR Administration charges because they are the amounts paid by LSEs (and other
market participants).
The second category, unhedged congestion osts, is an estimate based on data
found in the RTO’s state of the market reports for 2007 and 2008. Because data
supplied varies from RTO to RTO, differing methods of calculation are unavoid-
able and different interpretations are possible.
Let us start with PJM. Since June 1, 2003, PJM has allocated ARRs to network
service and long-term, firm point-to-point transmission service customers. These
customers may take their allocated ARRs or the underlying FTRs through a self-
scheduling process. The PJM market monitoring unit (MMU) argues for measuring
the effectiveness of ARRs and FTRs as a hedge against congestion by comparing
the revenue received by ARR and FTR holders with the congestion across the
corresponding paths. That is, it adds total payouts of ARR and FTR holders and
subtracts the amount FTR holders paid at auction to determine ARR plus FTR
payouts. It then compares this value with total congestion charges on the underlying
transmission paths. Table 9.4 lists these amounts that the PJM MMU has computed
for the 2006–2007 and 2007–2008 planning periods.
ISO-NE’s annual markets report lists both day-ahead and real-time congestion
charges and total revenue generated in FTR auctions. Therefore one might use
either day-ahead or real-time congestion charges minus total auction revenue to
9 FTR Properties: Advantages and Disadvantages 247

estimate unhedged congestion in ISO-NE. I use day-ahead congestion charges

minus FTR auction revenue to approximate unhedged congestion. Day-ahead
congestion charges are the values that LSEs pay for congestion as calculated in
the day-ahead energy market. Differences between real-time dispatch and the day-
ahead schedule can cause real-time congestion charges to differ from day-ahead
values. While there are two basic causes of this difference: (1) difference between
load forecasts and actual load, and (2) generation or transmission outages/derating,
the latter is the more important, so I will focus on it. Because ISO-NE settles the
real-time market on deviations from the day-ahead market, real-time congestion
can be either positive or negative.28 In recent years, real-time congestion in ISO-NE
has been negative due to transmission outages/deratings. Because load is settled on
a day-ahead basis, outages/deratings will not affect the amount of congestion
payments by ISO-NE LSEs, so I approximate unhedged congestion based on day-
ahead, instead of real-time congestion figures. The estimate is imprecise because
deviations between forecasted and actual load do occur. LSEs are “fully-hedged” if
the revenue they collect in FTR auctions is equal to or greater than this value. Thus,
unhedged congestion is approximated by any positive difference between
congestion costs minus rights to auction revenues (ARRs). One may find the
requisite data at ISO-NE 2008 Annual Markets Report, pp. 72–74 and ISO-NE
2007 Annual Markets Report, pp. 124, 129.
The 2008 State of the Market Report for the NYISO does not list unhedged
congestion charges as such. But one may approximate the impact of FTR29 market
imperfections in NYISO as day-ahead market plus balancing market congestion
revenue shortfalls since NYISO fully funds FTRs. When revenue shortfalls occur in
NYISO FTR markets, NYISO makes up the difference through uplift charges to
load. Thus every dollar shortfall translates into a dollar increase in charges to load.
In 2006, day-ahead and real-time congestion revenue shortfalls were $40 million
and $171 million, for a total of $211 million. In 2007, day-ahead and real-time
congestion revenue shortfalls were $93 million and $159 million, respectively, for a
total of $252 million. The respective figures for 2008 were $179 million and $325
million, for a total of $504 million. The marked increase in these values in 2008 was
due largely to market manipulation, in the form of circuitous transaction scheduling
around Lake Erie in the first 7 months of the year.30

28
Real-time congestion is positive if real-time dispatch changes to allow more power to flow over
transmission lines, some of which are congestion. It is negative if, say, a transmission outage or
derating allows less power to flow over transmission lines.
29
Called transmission congestion contracts, or TCCs in NYISO.
30
For further information, see New York ISO 2008 State of the Market Report, Section II.
248 R. Benjamin

Of the other three categories, two, legal settlements and FTR defaults are non-
recurring expenses associated with litigation and non-payment of FTR settlements,
respectively. The third, “long-term FTRs” is construction expenses (apparently
associated with a new facility to house a long-term FTR market command center).
All of this data is found in the RTO annual market reports mentioned above.

Appendix B: FTR Information by Major Utility

Net
transmission
Total sales to Net rights as a Estimated
Gross ultimate transmission percentage of retail rate
transactions consumers rights gross impact
Company Year ($1,000) (MWh) ($1,000) transactions ($/MWh)
ALLETE, Inc. 2006 70,028 9,078 2,774 3.962 0.306
2007 137,512 9,001 349 0.254 0.039
2008 84,432 9,138 256 0.303 0.028
Appalachian Power 2006 37,937 30,328 1,289 3.397 0.042
Company 2007 238,847 33,875 2,876 1.204 0.085
2008 74,775 34,210 676 0.904 0.020
Atlantic City Electric 2006 309,142 9,931 13,058 4.224 1.315
Company 2007 259,767 10,187 3,652 1.406 0.358
2008 297,238 10,089 9,175 3.087 0.909
Central Vermont Public 2006 22,608 2,284 931 4.119 0.408
Service 2007 19,672 2,320 12,420 63.138 5.353
Corporation 2008 26,014 2,259 2,109 8.107 0.934
Columbus Southern 2006 24,171 19,567 863 3.571 0.044
Power Company 2007 136,463 22,009 1,281 0.939 0.058
2008 41,885 22,206 733 1.749 0.033
Connecticut Light & 2006 230,529 23,638 301 0.131 0.013
Power Company 2007 239,656 24,032 16,734 6.982 0.696
2008 296,607 23,145 1,482 0.500 0.064
Dayton Power & Light 2006 123,059 14,767 3,907 3.175 0.265
Company 2007 181,162 15,234 6,073 3.352 0.399
2008 191,910 14,932 7,753 4.040 0.519
Delmarva Power & 2006 13,607 13,479 14,271 104.879 1.059
Light Company 2007 40,730 13,685 26,530 65.137 1.939
2008 34,100 13,016 34,100 100.000 2.620
Duke Energy Indiana, 2006 174,074 28,592 13,686 7.862 0.479
Inc. 2007 274,658 29,734 37,685 13.721 1.267
2008 324,148 28,548 16,594 5.119 0.581
Duke Energy 2006 39,078 3,884 198 0.506 0.051
Kentucky, Inc. 2007 78,321 4,142 883 1.127 0.213
2008 75,771 4,041 663 0.875 0.164
Pacific Gas & Electric 2006 94,875 84,421 2,061 2.173 0.024
Company 2007 135,839 86,313 1,744 1.284 0.020
2008 204,414 88,269 19,065 9.326 0.216
Potomac Electric 2006 30,095 26,488 23,688 78.709 0.894
Power Company 2007 23,650 27,451 38,552 163.008 1.404
2008 64,325 26,863 37,674 58.568 1.402
(continued)
9 FTR Properties: Advantages and Disadvantages 249

Net
transmission
Total sales to Net rights as a Estimated
Gross ultimate transmission percentage of retail rate
transactions consumers rights gross impact
Company Year ($1,000) (MWh) ($1,000) transactions ($/MWh)
Public Service 2006 74,479 8,034 2,899 3.892 0.361
Company of New 2007 81,837 8,132 2,735 3.342 0.336
Hampshire 2008 109,935 7,926 3,070 2.793 0.387
Public Service Electric 2006 46,149 43,678 242 0.524 0.006
& Gas Company 2007 65,525 44,709 5,082 7.756 0.114
2008 56,484 43,734 4,554 8.062 0.104
San Diego Gas & 2006 20,662 9,508 2,295 11.107 0.241
Electric Company 2007 36,912 10,087 2,425 6.570 0.240
2008 94,017 12,320 4,063 4.322 0.330
Southern California 2006 314,249 88,729 44,584 14.187 0.502
Edison Company 2007 305,066 88,805 18,235 5.977 0.205
2008 338,565 89,809 79,434 23.462 0.884
UGI Utilities, Inc. 2006 N/A 1,030 118 N/A 0.114
2007 2,466 1,016 2,512 101.870 2.473
2008 1,706 1,003 430 25.192 0.429
Upper Peninsula Power 2006 18,974 800 152 0.800 0.190
Company 2007 20,000 861 409 2.046 0.475
2008 15,893 848 2,289 14.400 2.699
Virginia Electric & 2006 651,585 76,149 144,694 22.207 1.900
Power Company 2007 894,392 79,892 114,281 12.777 1.430
2008 1,404,890 78,664 271,778 19.345 3.455
Wisconsin Power & 2006 204,678 28,189 0 0.000 0.000
Light Company 2007 125,467 10,852 15,565 12.406 1.434
2008 185,604 10,529 8,084 4.355 0.768
Wisconsin Public 2006 180,812 10,580 26,163 14.470 2.473
Service 2007 259,946 11,106 22,694 8.730 2.043
Corporation 2008 207,869 10,892 11,866 5.708 1.089

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Chapter 10
FTRs and Revenue Adequacy

Guillermo Bautista Alderete

10.1 Introduction

With the implementation of electricity markets, the provision of transmission rights

has become a natural extension. Transmission rights can be of the flowgate or
financial types and have been developed to manage the risk posed by volatile
congestion costs. A financial transmission right (FTR) is an instrument to hedge
source-to-sink congestion and entitles its holder the right – or obligation- to collect
a payment when congestion arises in the energy market. The basic definition of an
FTR consists of a source and a sink node that identify the point-to-point direction of
the right, a MW award that is constant for the full life term of the instrument, a time
of use for which the instrument is settled and a life term which identifies the period
over which the instrument is valid. Although the definition is point-to-point, FTRs
are not necessarily limited to be defined between individual nodes, load zones or
trading hubs are aggregated nodes widely used for FTRs.
Nowadays, most of FTR markets offer obligation type,1 for which the holder has
either the right to collect a payment when congestion occurs in the energy market or the
obligation to pay when the congestion in the energy market is in the opposite direction
to the FTR definition. The payment or charge is computed as the price differential
between the sink and source nodes times its MW award. An FTR option, in contrast,
provides only the upside benefit to its holder since there is no charge to the holder when
congestion is in the opposite direction of the FTR (Lyons and Fraser 2000). Since

The ideas expressed in this chapter are solely those of the author and do not represent any official
position from the California ISO.
1
The Pennsylvania, New Jersey, Maryland (PJM) market offers both obligation and option types
of FTRs.
G.B. Alderete (*)
California Independent System Operator, Folsom, CA 95630, USA
e-mail: [email protected]

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 253

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9_10,
# Springer-Verlag London 2013
254 G.B. Alderete

FTRs are only financial instruments, the payments or charges are independent of the
actual use of the transmission system by their holders; this separation provides
efficiency by not interfering with the optimal operation of the system. FTRs hedge
only congestion costs, even though there have been several theoretical proposals to
have instruments to also hedge losses (Rudkevich and Bagnall 2005).
Markets using locational marginal prices, mainly throughout the United States,
have put in place mechanisms to provide participants with financial transmission
rights (Alsac et al. 2004). Such mechanisms are usually allocation or auction
processes run by an Independent System Operator (ISO). Regardless of the means
to acquire FTRs, the hedging properties of the instruments are the same. After the
initial release, FTRs can be traded bilaterally. The definition of the processes to
release financial transmission rights is mainly driven by the specific needs of a
given market. Regardless of the means to release FTRs, an ISO needs to limit the
overall amount of FTRs that can be feasibly released. A simultaneous feasibility
test is the underlying process to determine the amount of FTR awards. When FTRs
are modelled in the release processes, such as auctions, the source and the sink used
to define every FTR represents bilateral trades for which injections and withdrawals
of power determine the power flow contributions in the transmission system. Thus,
any set of FTRs that can be released has to be a feasible power flow, in which no
transmission constraints are violated. The transmission system used in the release
processes represents as close as possible the transmission system and configuration
that will be used later in the energy market. Since the release process is usually
driven by an optimization engine, the optimal solution or set of feasible FTRs is
determined by considering simultaneously all FTRs. Thus, the optimal set of FTRs
is necessarily simultaneously feasible as FTRs will provide counter-flows to each
other. By using a simultaneous feasibility test to determine the optimal set of FTRs
to be awarded, revenue adequacy can be ensured. Revenue adequacy is the condi-
tion in which sufficient money from the forward energy market is collected to cover
all FTR payments over a given period of time. Revenue adequacy is the subject of
analysis throughout this chapter.

10.2 Nomenclature

This section introduces the notation and acronyms used throughout this chapter.

10.2.1 Acronyms

ATC Available Transfer Capability

AC Alternate Current
CAISO California Independent System Operator
(continued)
10 FTRs and Revenue Adequacy 255

CRR Congestion Revenue Right

DC Direct Current
LMP Locational Marginal Price
FTR Financial Transmission Right
OTC Operating Transfer Capability

10.2.2 Symbols

F, Fp:u: Revenue adequacy in dollars or per unit, respectively

lt;i Locational marginal price at node i for hour t
ls Locational marginal price at the slack node
dt;i Demand at node i in interval t
gt;i Generation at node i in interval t
tjl Financial transmission right award from node j to node l
i, l Index for nodes in the system
t Index for hour
T Set of hours for a given accounting period, say, a calendar month
I Set of nodes in a transmission system
pv Share of revenue gap for participant v
d~v Average demand of participant v
zFTR
k
Equivalent power flow on constraint k due to injections from FTRs
zk Upper limit for transmission constraint k
Fk Revenue adequacy on transmission constraint k
~ti Equivalent power injection from all FTRs at node i
Si;k Sensitivity factor for transmission constraint k due to power injection at node i
mk Shadow price associated with transmission constraint k
g; g Dual variables associated with generation limits
B; B Dual variables associated with demand limits
a; b Bid factors for supply and demand
G Susceptance matrix
H Reactance matrix
d Vector of nodal angles

10.3 Simultaneous Feasibility Test

The release of FTRs is done through an optimization process that determines the
optimal set of FTRs that are simultaneously feasible. This is implemented using a
network model as similar as possible to the model used in the forward energy
market, including both the transmission configuration and constraints. The
256 G.B. Alderete

transmission constraints are related to physical and operational limitations such as

thermal limits, and voltage and stability. Contingencies2 and nomograms that define
simultaneous path limits need also to be modeled. All these constraints are well
known as security constraints.
Since FTRs hedge only congestion, this justifies to certain extent not modeling
losses and reactive power in the FTR market. In general, DC-based models for
FTRs markets are used among ISOs; one exception is the New York market that
uses an AC model for FTRs (Alsac et al. 2004). Among other considerations, the
DC model assumes that there is sufficient voltage support throughout the system
and thus the voltage profile can be maintained at 1 p.u.3 Therefore, the reactive
power component can be disregarded from the full network formulation (Wood and
Wollenberg 1996). However, the energy market may include losses and reactive
power and this may create a gap. In the actual transmission system, limits are
defined for full apparent power. If DC models are used in the FTR market then the
capacity that the reactive power would use in the transmission elements need be
considered. Also transmission limits may need to get adjusted to represent voltage
constraints of the transmission system. A simple but crude way to account for losses
and even reactive power is to reduce system- or element-wise the transmission
limits by a given percentage.
Linearity is the main advantage of using the DC model which allows modeling
the point-to-point FTRs as balanced trades, with MW injections equals to MW
withdrawals. One implicit consideration of the simultaneous feasibility test is that all
FTRs are exercised; this is required because counter-flows are part of the feasibility
while determining the set of FTRs. The simultaneous feasibility test is implicit in the
clearing process of the FTR markets. The FTR auctions, for instance, are simply a
process to find a solution of a security constrained optimal power flow where the
objective function is to maximize the utility function of FTR bidders while enforcing
the base and contingency (typically n-1 type) transmission constraints. Such constraints
are usually linearized power flows. In DC-based models with linear (or even quadratic)
objective function and linear constraints, linearity implies that the feasible set is convex
and, thus, any solution found will be a global solution (Nocedal and Wright 1999). This
is the theoretical foundation to ensure revenue adequacy for FTRs under the premise
that the same network model is used also in the forward energy market (Hogan 1992).
With a DC model, obviously, there is the implication that lack of realism could also
lead to issues with revenue adequacy; this aspect, however, is difficult to quantify. If an
AC model is used in the FTR market, revenue adequacy cannot be guaranteed due to
the non convexities (Lesieutre and Hiskens 2005). Since the control area of an ISO is

2
The n-1 contingency is usually the most common security constraint used in the operation of a
power systems and accounts for the loss of a single generator or transmission element in the
system.
3
P.u. stands for per unit and is used in power systems studies to handle calculations with different
voltage levels.
10 FTRs and Revenue Adequacy 257

typically connected to neighboring control areas, loop flows may also create revenue
adequacy issues.

10.4 How to Measure Revenue Adequacy

Revenue adequacy is inherently a financial notion related to an electricity market;

since it materializes in the settlements of a market, it is defined in monetary terms as
the balance of the money inflows (congestion rents) and outflows (FTR payments)
of the FTR account,
8 9
X <X   X  =
F¼ lt;i dt;i  gt;i  tjl lt;l  lt;j (10.1)
t2T
: i2I ðj;lÞ2I
;

The monetary value, however, is not a good indicator of the size of the market
and, thus, it may not be a reference of the extent of adequacy. Instead, a widely used
metric of revenue adequacy among ISOs is the revenue adequacy as the proportion
of available congestion rents to the amount of FTR payments,
PP  
lt;i dt;i  gt;i
¼P P  
t2T i2I
Fp:u: (10.2)
tjl lt;l  lt;j
t2T ðj;lÞ2I

Depending on the specific features of the market, revenue adequacy may be

composed of other elements such as exemptions for existing transmission, auction
revenues and reimbursed FTR payments. The goal of a market operator is obviously
to attain a revenue adequacy of 100 % (zero dollar gap). This ideal value represents
the best tradeoff between the number of FTRs awarded to market participants and
the ability to fully fund such FTRs; a value smaller than 100 % indicates a revenue
inadequacy. A sustained revenue adequacy greater than 100 % (an excess of
money) may also be an indication of an inefficiency due to having, for instance, a
process that is too restrictive or conservative in releasing FTRs, and depriving
participants of more hedging opportunities.
The engineering notion of revenue adequacy can be simply stated as the require-
ment of allocating as much transmission capacity in the form of financial transmis-
sion right as transmission capacity made available in the energy market. This notion
can be quantified in terms of available transfer capability (ATC).4 Although the
engineering notion of revenue adequacy can also be defined in terms of the total

4
Operating Transfer Capability (OTC) refers to the nominal values of transmission constraints.
Once any reserved capacity is discounted, one may refer to the Available Transfer Capacibility
(ATC) which is the transmission capacity that is made available to the market.
258 G.B. Alderete

available transfer capability (MW), this metric would turn out a futile exercise since
it does not have a meaningful interpretation of the overall market condition.

10.5 Causes of Revenue Inadequacy

The theoretical concept to ensure revenue adequacy relies on two factors: (1) use of
the same shift factors, and (2) the enforcement of the same constraints in both the
FTR and the forward energy market. In real-life markets, however, it is not possible
to satisfy such conditions all the time due to the inherent changing nature of a power
system. In a mature market, the set of transmission constraints may be well defined
and remain relatively constant over time, reducing the mismatch of constraints
enforced between markets and reducing, consequently, the room for inadequacies.
During the evolution of a relatively new market, in contrast, transmission
constraints may be developing. This, compounded with the inherent timing of
running the FTR market well ahead of the energy market (in some markets there
may be leading times of a few months), may result in some constraints not enforced
in the FTR market, creating the potential for revenue inadequacies.
A more typical cause, however, are derates of transmission elements. Transmis-
sion limits may change due to system conditions, including operational needs and
weather. Derates, which are the fact of modifying the normal rate of a transmission
constraint, happen all the time in a transmission system. The limits used in the FTR
market cannot fully account for derates that will happen because derates will be
known until close to real-time operation of the system. There may be only a few
planned derates known by the time the FTR is run, but other derates, such as forced
derates, will take place in the last moment. This typically leads to overestimate the
transmission capacity released as FTRs.
The use of different shift factors is typically the main cause of revenue shortfalls
and is mainly driven by outages. Similar to derates, some planned outages may be
known by the time the FTR market is run, but many other outages, typically forced
outages, cannot be known until real-time operations. Outages change the system
configuration and result in different shift factors. Thus, if FTRs were released with
certain configuration and then the energy market runs with some last-moment
outages, there is an increase possibility of revenue shortfalls. For this reason, one
of the main concerns among ISOs is how to account for outages in the network
model used to run the FTR markets. Empirical results show that using the nominal
OTC values in the FTR market usually results in an over allocation of FTRs since
any outages or derates will further constraint the energy market, resulting in less
congestion rents to fund FTRs.
Figure 10.1 shows the daily revenue adequacy for CRRs during 2010 in the
California ISO market.5 The bars in blue stand for the daily revenue adequacy,

5
In the California ISO markets, FTRs are named Congestion Revenue Rights (CRRs).
10 FTRs and Revenue Adequacy 259

0.4

0.2
Revenue Adequacy(MM $)

–0.2
Derate of PACI Derate of path 26
–0.4 Intertie branch group due to
fires
–0.6 Binding of the
SCE-PCT-IMP-BG
–0.8

Nov-10

Dec-10
Jan-10

Feb-10

Mar-10

Apr-10

May-10

Jun-10

Jul-10

Aug-10

Sep-10

Oct-10
CRR Revenue Adeqacy Daily Revenue Adequacy Average

Fig. 10.1 Trend of daily revenue adequacy in 2010 in the California ISO market

while the line in red shows the average daily revenue adequacy over a calendar
month. Positive values stand for revenue surplus while negative values stand for
deficiencies. For illustration purposes, large revenue shortfalls are a reference to
system events. Derates in two major transmission paths resulted in large revenue
shortfalls, while the enforcement of a new transmission constraint also drove
revenue deficiencies. In the CRR market, the limits used to model such constraints
could not account for all derates that happened in actual operation of the system and
many of them were not known by the time the CRR market was run. With both the
energy and the CRR markets being recently new, compounded with the CRR
market running a few months ahead, a new transmission constraint was introduced
in the market after the CRR market was run, resulting in a more restrictive energy
market with less congestion rents available to fund all the amount of CRRs that
were awarded without having such a constraint.

10.6 Allocation of Revenue Adequacy Gaps

Revenue adequacy is one of the main items for CRRs monitored and studied by
ISOs since this is the primary indication of the overall condition of the process to
release transmission rights. Indeed, depending on the specific design, revenue
inadequacy is also the concern of various market players, since revenue shortfalls
may be socialized among certain participants of the market. For instance, if full
funding for FTRs is guaranteed then any revenue shortfall will be offset by some
means. Usually, some market participants, such as load serving entities or trans-
mission owners, will be charged the revenue shortfall. If the revenue shortfall is
260 G.B. Alderete

systematic and the charge is not spread to all participants, however, this becomes a
transfer of wealth from one subset of participants to another. On the other hand, this
same set of participants that are charged to cover for revenue shortfall may be the
same participants to be paid when a revenue surplus exists. One approach to
allocate any shortfall or surplus of revenue, say, to load serving entities, is by
using a pro-rata approach

d~v
pv ¼ P F (10.3)
d~v
v2V

where pv is the payment uplift for each market participant subject to the revenue
gap. This payment can be calculated over a period, as short as an hour, but typically
over a longer accounting period such as a month. Depending on the case, d~v can
represent hourly average cleared demand (or measured load) or average energy
over a specific accounting period for participant v.
A second alternative to attain revenue adequacy is a pro-rata adjustment of FTR
payments. That effectively reduces the FTR payments among all FTR holders in a
proportion such that FTRs payments are covered up to the amount of available
congestion rents. The revenue adequacy ratio defined by Expression (10.2) can be
used as the pro-rate value to adjust all FTR payments. This alternative, however,
introduces certain degree of uncertainty as CRRs no longer hedge up to its nominal
value. There may also be the approach of rolling revenue gaps over accounting
periods. If a current month, for instance, has a revenue inadequacy, the difference
may be rolled over the upcoming periods expecting that future months have a
surplus. In the California ISO, for instance, CRRs are fully funded and any revenue
gaps – surpluses or shortfalls- are covered through uplifts to measured demand. In
the New York ISO, in contrast, any revenue gap is allocated to transmission owners.
In PJM and MISO markets, FTRs are rather scaled pro-rata.

10.7 Practical Issues of Revenue Adequacy

Since revenue adequacy is a metric obtained from the FTR settlements, revenue
adequacy is naturally calculated as a market-wise metric. When multiple transmis-
sion elements are congested at the same time, it is not possible to accurately identify
the root cause of revenue gaps – shortfalls or surpluses – from values available in
settlements. This is so because settlements are calculated on a nodal basis, which
represents the overall impact on prices of congestion arising from multiple
constraints. Fundamentally, revenue adequacy is no more than releasing as much
transmission capacity in the FTR market as capacity is made available in the
forward energy market. Revenue adequacy can be evaluated at its most fundamen-
tal element, which is on a transmission constraint basis. Conceptually, each
10 FTRs and Revenue Adequacy 261

transmission constraint needs to be revenue adequate, making the overall market

adequate as well. In real-life markets, however, it is not possible to attain this
concept given all the factors impacting the conditions of the energy market.
Usually, some transmission constraints experience revenue shortfalls and others
have revenue surpluses; overall they partially offset each other and the overall
revenue adequacy condition will mask that effect. The engineering notion of
revenue adequacy, using the concept of available transfer capability, yields the
explicit identification of the revenue gaps at its most fundamental level: by each
transmission element.
The following derivation is based on the well known linearized DC power flows of
a locational marginal pricing scheme, which was implemented in the California ISO
markets to identify the root causes of revenue inadequacies (CAISO 2010). This
approach exploits the linearity and superposition of DC power flows and identifies the
relationship between the financial and engineering notion of revenue adequacy. The
DC optimal power flow is ubiquitous in the technical literature and is next presented
for completeness of the description of this chapter. This model takes into account
only congestion since it is a lossless representation of the transmission system.
Let us consider a DC OPF in its simplest form where supply and demand are
cleared using an LMP scheme for one single trading interval (Bautista Alderete
2010),

min a T g  bT d
Gd ¼ g  d
Hd   z (10.4)
s:t: g  g  g
d  d  d

where a; b are the transposed vectors of cost and benefit bid parameters; g; d are the
vectors of generation and demand, respectively; G; H are the Susceptance and
Reactance matrices, while  z is the vector of transmission constraint limits. The
vector of nodal angles is defined by the symbol d. The objective function is to
minimize the social cost as defined by the supply and demand bids, the first
constraint stands for the nodal power balance, the second constraint stands for the
transmission limits, while the last two constraints stand for the lower and upper
limits of bids. The Lagrangian function for this minimization problem yields the
following expression,

Lðg; d; d; l; mÞ ¼ aT g  bT d  lT ðGd  g þ dÞ  mT ðHd  zÞ

 
 g g  g  gðg  gÞ  Bðd  dÞ  Bðd  dÞ (10.5)

where l; m; g; g; B; B are the dual variables (multipliers) associated to each

constraint of the DC OPF. In particular, the variables l; m associated with the
262 G.B. Alderete

power balance and the flow limit constraints, respectively, are used as prices. The
variable l stands for the locational marginal prices at each node i, while the variable
m stands for the price of each transmission constraint.
The first order optimality conditions of this Lagrangian yields an equilibrium
point. Since this is a linear programming problem, a solution for the Lagrangian
yields also an optimal point for the market (Nocedal 1999). For the sake of this
derivation, let us consider only the optimality conditions with respect to the variable
of nodal angles d, i.e.

GT l þ H T m ¼ 0 (10.6)

If this expression is multiplied by the vector of nodal angles, one obtains

lT Gd þ mT Hd ¼ 0 (10.7)

Introducing the power balance constraint and the transmission limits from the
DC OPF (10.4), the following expression is obtained:

l T ð g  d Þ þ mT 
z¼0 (10.8)

Expanding the vectors in its scalar elements and rearranging terms yields
X X
li ðdi  gi Þ ¼ mk zk (10.9)
i2I i2K

In this lossless transmission system, the locational marginal prices have the
energy and congestion components only. Since the energy component is unique
across all nodes of the system, locational price differentials are only due to
congestion. If congestion arises, then congestion rents exist and are calculated as
the difference between charges to demand and payments to supply as defined by the
left hand side term of Expression (10.9). This is how the actual settlement of
forward energy markets is done. The right hand side of Expression (10.9) provides
the equivalence of the congestion rents in terms of transmission constraints. This
term is the basic relationship needed to identify the root causes of revenue inade-
quacy since congestion is fundamentally accrued over each congested element and
represented at each node of the system.
The composition of a locational marginal price for a lossless power system is
ubiquitous in the technical literature and is defined by two components: marginal
energy and congestion prices
X
li ¼ ls þ Si;k mk (10.10)
k2K

where ls is the price at the slack node and represents the marginal energy
component. This composition is derived from the fact that congestion accrued on
10 FTRs and Revenue Adequacy 263

a transmission constraint is distributed and priced throughout the system’s nodes

according to the flow impact of each node to the given transmission constraint, as
defined by the shift factors Si;k .
In the calculation of FTR payments, the settlement process of an ISO computes
the overall payments for all FTRs based on the price differential of LMPs between
the two given nodes used to define each FTR,
X  
y¼ tjl ll  lj (10.11)
ðj;lÞ2I

Since this is usually based on DC power flows, Expression (10.11) can be

arranged using the relationship of shift factors and shadow prices of transmission
constraints given in Expression (10.10) to yield the following relationship
! !
X X X X X
y¼ ~ti li ¼ ~ti Si;k mk ¼ mk Si;k ~ti (10.12)
i2I i2I k2K k2K i2I

where ~ti is the net nodal injections calculated as the algebraic summation of all MW
quantities from all FTRs having node i in its definition of either source or sink. The
term within parenthesis is the product of shift factors times nodal injections from
FTRs and stands for the equivalent power flow estimated from nodal injections of
FTRs. These are the equivalent power flows if the FTR injections and withdrawals
from sources and sinks were actually materialized with the shift factors of the
energy market. This is simply the equivalent MW value of the FTR payments, and
is also the counterpart of the power flows in the energy market needed to estimate
revenue adequacy, i.e.
X  
y ¼ mk zFTR
k (10.13)
k2K

Both expressions (10.9) and (10.13) can be expanded to account for multiple
trading intervals by just adding the sub-index t, and then be used to substitute the
corresponding terms in Expression (10.1) in order to give rise to an alternate
expression for revenue adequacy
( )
X X X XX  
F¼ mt;k 
zt;k  mt;k zFTR
t;k ¼ mt;k zt;k  zFTR
t;k (10.14)
t2T k2K k2K t2T k2K

This expression provides a natural interpretation of revenue adequacy in an

engineering context, by pricing any gap between the transmission capacity made
available in the FTR and energy markets, accruing over all transmission constraints
and all intervals of the accounting period. Obviously, this also allows estimating
revenue adequacy of each transmission constraint over an accounting period, i.e.
264 G.B. Alderete

X  
Fk ¼ mt;k zt;k  zFTR
t;k (10.15)
t2T

This expression provides with a formal definition of several intuitive features of

revenue adequacy that are not possible to visualize with Expression (10.1) used in
the actual settlements of markets. This expression also uses the actual transmission
limits 
zk for each transmission constraint in the energy market while the equivalent
power flows zFTRk from FTRs are not explicitly bounded. Instead, the FTR power
flows are bounded implicitly by the amount of FTRs released in the FTR markets,
which in turn were bounded by the transmission limits in the FTR market. The
estimated power flows from FTRs usually differ from the transmission limits used
in the FTR market because (1) not all constraints in the FTR may be binding and (2)
the power flows used the shift factors from the energy market which internalizes all
the changes occurred in the energy market in comparison to the FTR market.
The shadow prices of transmission constraints, m, which are a by-product of the
optimization process to clear the energy market, are nonzero prices that indicate the
associated cost of relaxing a transmission constraint. If a transmission constraint is
not binding, usually the shadow price will be zero and, consequently, the gap of
transmission capacity between the energy and the FTR markets has no impact at all
in revenue adequacy, even if there was an over allocation of transmission capacity
in the FTR market for this transmission constraint.
The overall revenue adequacy is composed of the revenue adequacy of each
transmission constraint and Expression (10.15) explicitly allows such a calculation.
This is not possible with Expression (10.1) as the impact of each transmission
constraint has been decomposed and aggregated at each node in what becomes the
marginal congestion component. This feature becomes relevant to identify the root
cause of revenue gaps because each transmission element can be analyzed inde-
pendently. System-wise revenue adequacy masks the offsetting between revenue
surpluses and deficiencies accrued among different transmission elements; this
becomes more pronounced in meshed network where multiple transmission
constraints are congested simultaneously. For instance, in the California ISO
market for CRRs (CAISO 2010), there was a revenue surplus of $66,000 in October
2010, which represents about 100 % of revenue adequacy given the size of the
congestion market of $7 million. This value, however, does not provide insights
whether surpluses in some constraints offset shortfalls in others. With the metric of
revenue adequacy per constraint, it can be observed that indeed there was systemic
revenue shortfall in the IPPADLN branch group6 which was fully offset by
the revenue surplus on the IID-SDGE branch group, as observed in Fig. 10.2.
This metric helped unveil a mismatch between the capacity released in the CRR

6
Branch groups, transmission corridors or inter-tie constraints are just different types of transmis-
sion constraints used in the California ISO markets. Such elements are usually identified with
acronyms or names related to the area of their physical location.
10 FTRs and Revenue Adequacy 265

$2.00
Revenue Adequacy (Millions)

$1.50

$1.00

$0.50

$0.00

-$0.50

-$1.00

-$1.50
11-Oct

13-Oct

15-Oct

17-Oct

19-Oct

21-Oct

23-Oct

25-Oct

27-Oct

29-Oct

31-Oct
1-Oct

3-Oct

5-Oct

7-Oct

9-Oct

IID-SCE_BG IPPDCADLN_BG PALOVRDE_ITC

NOB_BG PACI_ITC MARBLE_BG
24804_DEVERS _230_24806_MIRAGE SYLMAR_AC_BG Other

Fig. 10.2 Daily revenue adequacy in August 2010 in the California ISO. Revenue adequacy is
organized by transmission element

market and the capacity released in the energy market due to the enforcement of
different constraints in the energy market.
The underlying condition to ensure revenue adequacy is that the same amount of
transmission capacity is made available in both the energy and the FTR markets.
This requires that (a) the same transmission constraints are enforced in both markets
and (b) the same transmission configuration (as defined by the shift factors) is used.
From expression (10.15) it is clear that if a transmission constraint is not enforced in
the FTR market but is enforced in the energy market, there is a likelihood that
revenue deficiencies will occur since the gap of transmission is inherently bounded
to be negative. This obviously has its root in the fact that the constraint is not being
enforced in the FTR market and, hence, the release of transmission capacity for
FTRs over that specific transmission constraint is unlimited.

10.8 Revenue Neutrality

Using the engineering notion of revenue adequacy, the ratio of revenue adequacy
for transmission constraint k can be stated as follows
P
mt;k 
zt;k
Fp:u:k ¼ P
t2T
(10.16)
mt;k zFTR
t;k
t2T

For the ideal condition of a revenue adequacy of 100 %, the left hand side term
of Expression (10.16) has a value of unity and yields
266 G.B. Alderete

X X
mt;k zFTR
t;k ¼ mt;k zt;k (10.17)
t2T t2T

This relationship is quite intuitive and stands for the requirement that the money
paid to FTRs over constraint k matches the money collected in rents over the same
constraint k. In real life markets, the ATC in the energy market zt;k may change as
much as every hour. Similarly, the power flows computed from the nodal injections
from FTRs, zFTRt;k , will change as often as hourly due to changes in the shift factor
values used in the calculation of the power flows. Such changes are mainly due
transmission system outages, switching or different operating points. From a point
of view of the FTR market, however, the amount of FTRs released is a constant and
unique value for the full accounting period. For instance, a monthly auction will
release FTRs that are defined for the same MW amount for the whole month.
Therefore, from a revenue adequacy point of view, the power flow defined by the
FTRs over a transmission constraint can be seen as constant value and derived
directly from Expression (10.17)
P
mt;k 
zt;k
¼ P
t2T
zFTR (10.18)
t;k
mt;k
t2T

It is worth noticing that this MW value obtained from Expression (10.17) is

based solely on the outcome of the energy market, namely shadow prices of the
transmission constraints and ATC available, which only have an impact when
constraints are binding. This calculation can be done only after the fact once the
accounting period is complete; i.e., it is based on historical performance of the
energy market. This value for revenue neutrality indicates what would have been
the ideal transmission capacity released in the FTR market to attain a revenue
adequacy of 100 % once the energy market materialized and, therefore, represents
the ideal transmission limit for constraint k to be enforced in the FTR market.
Obviously, there is no guarantee that historical values are a close representation of
future occurrences. Nonetheless, this metric provides the means to analyze the
pattern of revenue adequacy on specific and problematic transmission constraints
and can help find out deeper issues such as persistent over allocation of FTRs on
specific constraints due, for instance, to modeling of outages or derates.
For instance, the California ISO has been able to develop the CRR revenue
neutrality metric. Figure 10.3 shows the revenue neutrality point for one specific
transmission path (Paloverde Intertie) in the California ISO control area. Such point
is estimated based on the market outcomes during the full calendar season of 2010
for on-peak time of use. This plot also shows the OTC duration curve of the intertie
with the line in blue, while the dotted line in green is the average CRR amount in
MW released in such a constraint. The duration curve is built by sorting from the
highest to the lowest MW value. The curve reads by referencing what percentage of
10 FTRs and Revenue Adequacy 267

3,500

3,000
Transmission Capacity (MW)

2,500 Potential Revenue surplus Potential Revenue shortfall

2,000

1,500

1,000

500
OTC OTC Breaking Point Average CRR Released

0
0%

9%

18%

27%

36%

45%

54%

63%

72%

81%

90%

99%
Fig. 10.3 Duration curve for Operating Transfer Capability of Palo Verde Intertie for calendar
season 1, 2010

the time the OTC value has been higher than a given MW value. For instance, about
34 % of the time the OTC value of this intertie was the nominal value (no derates).
This OTC value includes the capacity on the path associated with encumbered
rights which is capacity reserved and not made available in the markets, neither for
CRRs nor for energy. If such reserved capacity is discounted, then the remaining
capacity is the well-known ATC. In this case, the breakeven point is slightly below
the CRR value which means that on this intertie and for the given period there was a
slight revenue surplus, implying the amount of transmission capacity over this
transmission capacity released in the CRR markets was adequate. This metric and
its analysis give a reference about the right amount of transmission capacity needed
to be released to attain revenue neutrality, and therefore, can be a straight indicator
of systemic issues about the modeling of the transmission system in the CRR
market to help improve revenue adequacy.
The duration curve goes from the nominal value on the left hand side through
lower values on the right hand side; the variations result from derates happening
during the actual operation of the system. As can be observed, about 5 % of the time
this intertie was heavily derated to about 1,000 MW, less than a third of its nominal
value. On one hand, when the system elements are derated to such extent,
congestion on such elements will lead inevitably to large revenue deficiencies.
On the other hand, when elements are at nominal values or lightly derated, revenue
surplus could be observed. From the point of view of the FTR market, the break-
even point for revenue adequacy represents a MW value at which revenue surpluses
collected in some intervals will balance the revenue shortfalls of other intervals so
that over all the accounting period they offset each other.
268 G.B. Alderete

10.9 Factors to Consider for Revenue Adequacy

In its more general terms, revenue adequacy is the fact that there is enough money
from the energy market to pay all FTRs holdings. The fundamental concept,
however, is more specific. It refers that given a market outcome, say, for one
hour or one trading day, the congestion rents from the energy market will be
sufficient to pay the FTR holdings for that same hour or day. In a broader context,
different markets have adopted variations of the concept for revenue adequacy.
These variations respond to other market design aspects and specific needs. The
following are some variations that can be considered when determining what
factors to use for revenue adequacy.
• Revenue adequacy on an hourly basis over an accounting period. The main
factor in revenue adequacy is the inherent system changes, such as derates and
outages that may alter the transmission configuration and limits. Such changes
may lead to revenue shortfalls in some hours, while other hours can accrue
revenue surpluses. Since the forward market, such as the day-ahead market,
usually has time intervals of an hour and FTRs usually are settled only at the
day-ahead prices, the smallest interval for which revenue adequacy can be
calculated is an hour. With changes happening from hour to hour, however,
calculation of hourly revenue adequacy may become unnecessary. For instance,
if revenue gaps – surpluses or shortfalls- are allocated to demand and let us
assume that there are shortfalls in 1 h and surplus in the next one, such hourly
settlements are going to implicitly offset each other. Revenue adequacy is
usually settled over a full accounting period such as a calendar month or season.
In this way, revenue adequacy is a more reflective metric of the FTR process
rather than a by-product of the dynamic system conditions over short periods.
Naturally, the accounting period can span over the life term of FTRs. In other
instances, revenue shortfalls or surpluses can be rolled over from period to
period and allowed to offset.
• Day-ahead market versus real-time market. Settlements for FTRs are usually
based on day-ahead prices. Since LMP-based markets usually rely on a two-step
settlement (day-ahead and real-time), congestion rents may also arise in the real-
time market and, thus, can also be put in the funds to pay FTRs. Sometimes, the
moneys from settling the real-time market congestion, however, can be negative
and this effectively reduces the funds available to pay FTRs.
• Congestion versus losses. FTRs are designed to hedge congestion arising from
the day-ahead market. Although some academic concepts for financial
instruments to also hedge losses have been proposed, currently only FTRs for
congestion are available among markets. On the other hand, an LMP-based
market will also have losses rents similar to congestion rents. Depending on
the market design, such losses rents may also be included in the funds to pay for
FTRs; in this context, losses rents serve as a buffer against revenue deficiencies.
10 FTRs and Revenue Adequacy 269

• Auction rents. Depending on the specifics of the design, in instances where there
are FTR auctions, the FTR auction revenues may also be used to fund FTR
payments.
• Existing transmission rights. Based on contractual arrangements, markets may
have to accommodate existing transmission rights. Such rights are exempt from
congestion. This means that congestion rents from the day-ahead market need to
be reduced to account for such exemptions, and this effectively account for the
existing transmission rights.
• Reimbursements of FTR payments. It is well known that the ownership of FTRs
may be an extra incentive for profit seeking opportunities (Joskow and Tirole
2000). Markets usually have a process to screen and identify instances where
FTR payments may have been increased due to participants’ actions in the
energy market. For instance, virtual bidding may increase the value of certain
FTRs. In such instances, the portion of the FTR value that fails to pass certain
test is not paid (or the participant is required to reimburse that quantity
depending on the settlements configuration). The money from this process can
also be used to fund the FTRs payments, or from another point of view, these
proceeds effectively reduce the overall FTR payments used in the determination
of revenue adequacy.

10.10 Final Remarks

Given the fact that revenue adequacy is an indication of the health of the processes
to release FTRs; a shortfall indicates that too many FTRs were released. It is
important to understand the intricacies of the process to identify potential mecha-
nism to control revenue adequacy. The main problem is the uncertainty associated
with outages and derates. Processes to release FTRs, such as auctions and
allocations, usually rely on deterministic approaches, where the system transmis-
sion configuration and transmission limits are defined a priori. This is further
compounded with the timing for running the FTRs processes well ahead of the
energy market, which in some instances can amount to a few months ahead. Ideally,
one could derate the OTC of each transmission constraint to a level that represents
what historically has been available. Since this approach would rely on historical
performance to account for future releases, there is no guarantee that previous
performance would occur. Nonetheless, this approach somehow would be more
conservative than just ignoring the likelihood of derates and outages and use the
nominal OTC, which in turn would lead to revenue shortfall more frequently since
there is no room for any change happening in the operation of the system. When
there insufficient historical data, it is more plausible to identify constraints that
systematically drive revenue deficiencies and they can be target more specifically.
When the metric to identify individual revenue adequacy of transmission
constraints is not available, the simplest approach can be to derate by a given factor
the entire set of transmission constraints. The drawback of this system-wise derate
270 G.B. Alderete

is that revenue shortfalls may be concentrated in certain regions of the system and
some regions would be funding deficiencies from others, affecting certain market
participants.

References

Alsac O, Bright JM, Brignone S (2004) The rights to fight price volatility. IEEE Power Energy
Mag 2:47–57
Bautista Alderete G (2010) Competition in electricity markets: modelling and economics. Ed.
VDM Verlag, Germany
CAISO (2010) Annual market performance report. Folsom, USA. www.caiso.com. Accessed
December 2010
Hogan W (1992) Contract networks for electric power transmission. J Regul Econ 4:211–242
Joskow P, Tirole J (2000) Transmission rights and market power on electric power networks.
RAND J Econ 31:450–487
Lesieutre BC, Hiskens A (2005) Convexity of the set of feasible injections and revenue adequacy
in FTR markets. IEEE Trans Power Syst 20:1790–1798
Lyons K, Fraser H (2000) An introduction to financial transmission rights. Electr J 13:31–37
Nocedal J, Wright S (1999) Numerical optimization, Springer series in operations research.
Springer, New York
Rudkevich A, Bagnall J (2005) Loss hedging rights: a final piece in the LMP puzzle. In: 38th
PHICSS, Hawai, pp 1–7
Wood AJ, Wollenberg BF (1996) Power generation, operation and control. Wiley, New York
Chapter 11
Trading FTRs: Real Life Challenges

Jose Arce

11.1 Introduction

The problem of trading FTRs can be understood as one of decision making under
uncertainties, where the boundary conditions are set by the laws of physics that
govern the electric power flows. Under this setup, a typical FTR desk has to deal not
only with standard roles of trading financial products, but also with technical ones
of power analytics. Building and operating a successful FTR business is a complex
enterprise, with multiple factors to consider. Additionally, the still exotic nature of
the product makes standard solutions from the trading industry difficult to use.
Accordingly, this chapter describes some of the challenges we currently face while
trading FTRs in the US, covering three aspects of the business.
The first one deals with the process of building an FTR portfolio and executing
the trade (Sect. 11.2). The idea is to go over the different steps mentioning standard
practices and most relevant challenges, which are described in the subsections:
Data, Analysis, Portfolio Construction, and Trade Execution. The second one
(Sect. 11.3) covers alternatives for managing risk and the role played by the FTR
desk. Also here, the goal is to describe current situation and open issues, which are
elaborated in the sub-sections: Managing Current Exposure, Risk Management,
Interaction with Other Desks, and Profile of the “FTR Trader”. The third one
(Sect. 11.4) mentions a potential evolution of the FTR business. A brief description
of alternative scenarios is mentioned in the sub-section: Next Steps. Finally, this
chapter concludes with a summary of challenges we encounter in the real life
operation of an FTR business.

J. Arce (*)
Maple Analytics, 590 Broadway #2, Somerville, MA 02145, USA
e-mail: [email protected]

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 271

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9_11,
# Springer-Verlag London 2013
272 J. Arce

11.2 Building an FTR Portfolio and Executing Trade

11.2.1 Data

Currently in the US there are six markets where it is possible to trade FTRs: PJM,
MISO, ISONE, NYISO, CAISO, and ERCOT (The ISO/RTO Council 2012). The
general concepts are the same in all of them; however, there are differences in
implementation. The first barrier faced in dealing with FTRs is the lack of standards
in producing and publishing relevant market data. This problem has implications in
three sub-problems: gathering, normalizing, and storing in database. The first one
deals with identifying the best places to collect and implementing systematic
processes to capture data. The second one relates to the most laborious task,
normalizing the data which includes, among other things, mapping different
names to the same physical element and with the same format. This task cannot
be fully automated, requiring laborious manual intervention. And finally, the third
one refers to the efficient storage of data in master database. The main source of raw
data comes from the ISOs which can be classified as indicated in Table 11.1
There is an additional set of data coming from ISOs’ meetings (committees,
subcommittees, task forces, working groups, etc.) which provide very valuable
information. In small to mid-size companies, the task of following these meetings
is performed by the FTR desk, however this additional function is difficult to
accomplish properly, considering the number of activities to cover. Large
organizations, on the other hand, have Market Affairs teams or Regulatory Policy
teams dedicated to this function. However, due to the technical details involved, it
is difficult for them to identify exactly what may be valuable for different areas of
the company. Sometimes, companies complement their coverage subscribing to
services provided by Market Specialists/Consultants.
In general, the topics discussed in these meetings are relevant to the FTR
business, however, on specific instances they are critical to understand or value
substantial changes in the market. Companies that can translate this type of
information into trading signals have a clear advantage. Definition of new
interfaces, retirement of reliability must run units, implementation of special
protection schemes on active binding constraint, redefinition of load pockets,
derates on critical facilities, are few examples of topics presented in some of the
mentioned meetings and that generally impact the market.
Unfortunately, it is usually difficult to automate the identification and collection
of relevant information from written documents (or voice records). State of the art
software that can interpret text/voice, like the ones used in equities trading
(RavenPack 2012), should facilitate this task.
In addition, there are services provided by third parties that help having a better
picture of the market dynamics. Some of them are listed in Table 11.2.
Clearly, the objective in this initial step is to concentrate, normalize, and store all
these diverse data in an efficient manner. However, implementing and managing
this task is very challenging.
11 Trading FTRs: Real Life Challenges 273

Table 11.1 Data from ISOs

LMPs DA/RT/5 min RT prices
Day Ahead (DA) and DA/RT/5 min RT binding constraints DA/
Real Time (RT) markets Congestion RT/5 min RT transmission shadow prices
FTR market FTR auction results Inventory of FTRs
Binding constraints
Prices
Network representation Transmission system Network model
Operating procedures
Monitor elements
Contingent elements
LMP/FTR models Nodes available for trading (CPNodes)
Hubs, Aggregated
Interfaces, Flowgates, Nomograms
CPNode changes New CPNodes
Terminated CPNodes
Operation DA/RT realization Load
Inter-tie flows
Wind power
Weather Temperature
Thunderstorm alerts (TSA)
Transmission outages Active
Scheduled
Operation Historical bidding data Generation bids
FTR bids
Planning Transmission/ Transmission upgrades
generation Generation queues
Retirements

An operation covering PJM and MISO which is evaluating to build an infra-

structure to manage 2 years of data would have to consider for instance the
following requirements:
• Dimensionality: building database with around 210 tables, three billion records,
and 400 GB of disk space
• Dispersion of data sources: maintaining 15 web data collectors (scrapers)
• Lack of standards: mapping and normalizing 50,000 records
The scale of this problem is equivalent to the one managed by a leader mobile
telecom operator serving four million customers.

11.2.2 Analysis

The next step is to process the data looking for trading signals. Here we consider
two alternative approaches, one based on fundamental analysis, and the other based
on quantitative analysis.
274 J. Arce

Table 11.2 Data from third Historical prices

parties
Normalized market data FTR inventories
Generation status RT production
Outages
Flows data RT power flows
Market intelligence Price forecasts
Congestion forecasts
Policy Policy meeting reports
Environmental issues
FERC filings
Geopolitics
Weather Temperature forecast
Seasonal forecasts
Storms
Wind Wind profile
Wind forecast
Wind power production
Water Reservoir levels
Precipitations
Snow pack levels
Fuels Inventories
Over the counter (OTC) Prices for tradable products

The fundamental based approach relies on the fundamentals of power systems to

explain the occurrence of congestion. There are different options to perform this
analysis but all of them share the principle of linking congestion events with
particular scenarios of supply, demand, transmission, and operation of the system.
AC and DC Power Flow models, Optimal Power Flow analysis, Unit Commitment
Security Constrained OPF simulations, are some of the concepts or methodologies
commonly used to perform this task (Wood and Wollenberg 1996). Typically, this
analysis is performed using some of the standard software products available in the
industry (e.g. PSSE, PowerWorld Simulator, DAYZER, SCOPE, GEMAPS).
The quantitative based approach relies on principles of statistical analysis to
process large amounts of data to identify overall trends. There are different
alternatives to perform this task but all of them share the same idea of objectively
identifying trends or patterns out of noisy data. Linear and Non-Linear Regressions,
Data Mining, Time Series Analysis, Principal Component Analysis, are some of the
concepts or methodologies commonly used to perform this task (Nisbet et al. 2009).
In this case, the analysis is done using proprietary models written in technical-
oriented programming languages (e.g. Matlab, Mathematica, R, C#, Java)
For both approaches, the process follows the sequence indicated in Fig. 11.1.
The objective in this step, independently of the approach, is to obtain trading
signals. In terms of FTRs, trading signals refer to bullish or bearish views on
congestion. However, if the inputs for the quantitative approach are prices, then
trading signals could be source-sink paths.
11 Trading FTRs: Real Life Challenges 275

Fig. 11.1 Analysis flowchart

Trading
Data Black Box
Signals

Scenarios

Table 11.3 Drivers

Seasonality Periodic patterns such as summer weather triggering specific BCs
Wind Speed and persistence above threshold creating oversupply scenarios and
congesting weak links
Thunderstorms System operates in conservative manner when TSA is declared, adding
pressure to the transmission system (N-2 secure instead of N-1 secure)
Fundamental Upgrades in the grid reduce/eliminate historical BCs, and sometimes shift the
changes problem to new BCs
Outages Short-term generation/transmission outages creating localized congestion
Chronic Devices operating close to their limit almost permanently
problems

To finish, it is necessary to quantify the relevance of the simulated signals

(ranking), which are obtained comparing expectation (edge) relative to dispersion
(conviction).
Some of the challenges include:
• Confidence in data: unfortunately, it is not rare to observe changes in relevant
published information after the auction is closed, invalidating the simulated
signals.
• Technology barrier: building and processing complex simulations (e.g. Unit
Commitment Security Constrained OPF runs) for large systems is still beyond
most operations’ technical capabilities.

11.2.3 Portfolio Construction

In context of the standard optimization problem solved by the ISOs, congestion

refers to transmission binding constraints (BCs), which are specified as monitor
element (monitor) and contingent element (contingency) (Schweppe et al. 1998).
Not all BCs share the same drivers, therefore, they have different behaviors. Some
of these drivers are listed in Table 11.3. In order to be systematic in this classifica-
tion, it is necessary to quantify these behaviors (e.g. using higher moments).
One of the main differences between FTRs and other financial products is that
the selection of the contract to trade, source-sink path (path), is a decision variable.
Depending on the strategy, it may be even more relevant selecting a path than
pricing it.
276 J. Arce

$/MWh

MW

Fig. 11.2 Step function bid curve

Here, it is necessary to remark that a path is impacted by active BCs with

positive or negative contribution depending on its exposure. Accordingly, a long
exposure refers to paths that have positive correlation to a target BC, receiving
positive revenues when the BC is active. Bullish views tend be expressed by paths
with long exposure to the associated BC. On the other hand, a short exposure refers
to paths that have negative correlation to a target BC, receiving negative revenues
when the BC is active. Bearish views tend to be expressed by paths with short
exposure to the related BC. Following the same logic, a long-short exposure refers
to paths that have positive correlation to one target BC and negative correlation to a
different one. Combining bullish and bearish views can be expressed by paths with
long-short exposures. In addition, counterflow is a particular case of exposure to a
BC different from the desired one. In general the expression refers to adverse
congestion that produces revenues with the opposite sign to the expected when
initiated the trade.
In markets with limited number of CPNodes, it is difficult to select source-sink
pairs that have exposure to a single or dominant BC. Here there are two side effects
to consider, one is the cost of paying for undesired BCs, and the other is counterflow
risk. In the case of Obligation FTRs, the second issue is maybe FTR Traders’ most
feared risk. To address this problem, some ISOs have implemented Option FTRs
(Pameshwaran and Muthuraman 2009).
The construction of the bidding curve requires definition of Auction, Period,
Source, Sink, Time of Use (On Peak, Off Peak), Trade Type (Buy, Sell), Hedge
Type (Obligation, Option), Price, and Volume. To simplify the pricing for different
periods, it is usual to work in $/MWh terms and then convert it to $/MWPeriod
before submitting. In this problem, Price, Volume and Shape of the Bidding Curve
are the key decision variables. Figures 11.2 and 11.3 describe the accepted formats
for bidding curves.
An interesting characteristic of FTRs is that price (P) and quantity (Q) are
unknown before executing the trade. We only have control over maximum price
to pay/minimum price to receive, and maximum volume to clear. So, FTR auction
simulators are built to evaluate contingent performances of the working portfolio.
Adjustments in bidding curves are made until differences between simulated and
target portfolios are acceptable. Finally, we obtain the portfolio to be submitted in
the FTR auction.
11 Trading FTRs: Real Life Challenges 277

Fig. 11.3 Piece-wise bid

curve
$/MWh

MW

Some notable challenges include:

• Counterflow risk: limited number of CPNodes available for trading Obligation
FTRs (in some ISOs) makes difficult selecting source-sink paths with limited
counterflow exposure. Furthermore, not all ISOs have Option FTRs.
• P and Q are unknown: acquiring FTRs from auctions adds a new layer of
complexity in the risk taking process. The uncertainty associated with price
and quantity results in getting a cleared portfolio different from the targeted one.

11.2.4 Trade Execution

The trade execution is a simple process; however, there are some requirements to
satisfy and validations to perform. The first requirement is related to collateral to
support FTR bids. Here again, each ISO has different level of collateralization
requirement according to its credit policy, but all of them share the principle that to
participate in the FTR auction, a market participants has to have sufficient capital.
Then, the CPNodes used in the different paths have to be valid for the particular
FTR auction we plan to submit. For example, CPNodes valid for prompt auctions
may not be necessarily valid for non-prompt auctions. Sometimes, during early
stages of the portfolio construction the valid CPNode list for the next auction is not
available, therefore it is a good practice to implement a CPNode validation step.
Furthermore, it is necessary to convert the target portfolio to the accepted format
(xml files). Although this formatting process is not complex, the cost paid for
mistakes here can be enormous. For example, changing sources for sinks automati-
cally converts long exposures into short exposures (or vice versa), or using the
wrong number of hours for a given period changes the bidding prices.
The submission is implemented electronically, through secure sites, uploading
xml files manually or through programmatic interfaces. As mentioned before, the
cost of operational mistakes in this step could be high. Therefore, a prudent step is
to validate that the submitted portfolio is exactly the portfolio we wanted to submit.
After this final validation, the trading execution is concluded. Auction results, in
general, are published within 10 days.
278 J. Arce

Some relevant challenges in FTR trade execution are:

• Prone to costly mistakes: it is common to have several auctions overlapping
during the same period of time. For small/mid-size operations, in particular, this
issue creates substantial pressure when controlling and validating different
portfolios/auctions. In large operations, on the other hand, this problem is
reduced; however, distractions from crowded trading floors work against them
too. Compounded by the fact of dealing with an almost illiquid product, mistakes
in trading execution could be just too high to bear.
• Execution infrastructure: building a robust infrastructure is critical to mitigate
execution risk. However, here also the lack of standards creates some frictions
that require special treatments.

11.3 Managing Risk and the Role Played by the FTR Desk

11.3.1 Managing Current Exposure

Currently, and depending on the ISO, it is possible to trade FTRs from 3 years to
1 month forward (Long-Term: 1–3 years, Annual: 1 year, Balance of the Year: less
than 1 year, Monthly: 1 month).
This temporal discretization goes in line with different market needs. The power
market evolves over time, so does our trading signals, convictions and target
portfolios. So, it is common to start accumulating core positions in Long-Term
Auctions and/or Annual Auctions and then adjusting the portfolio in Monthly/
Balance of the Year Auctions. The last opportunity we have for implementing
this strategy is during the Monthly Auction just before delivery.
However, because of the few opportunities we have to trade (in comparison with
other financial products), it is very difficult to arrive to delivery with a balanced
portfolio. An alternative to improve this situation is to trade FTRs in secondary
markets. Most ISOs have implemented an environment for this purpose. Unfortu-
nately, participation has been minor. On the other hand, attempts to build a bilateral
market for predefined paths have gained some interests. However, the reality is that
most FTR paths target idiosyncratic factors which are difficult to match in bilateral
trades, limiting the attractiveness of the concept.
During delivery, the FTR portfolio is subject to DA congestion. In case we prefer
to get exposed to RT congestion, then it is possible to do it using some of the daily
DA-RT swaps available in the market. The most common DA-RT product is Virtual
Bidding (VB) (Metin et al. 2010), which is a contract specified by hour and
CPNode. There are two products, INC that settles as the difference in LMPs
between DA and RT, and DEC that settles as the difference in LMPs between RT
and DA.
The strategy requires to INC at source and DEC at sink of the FTR we want to
get exposure from RT market. This strategy is easy to implement however
11 Trading FTRs: Real Life Challenges 279

transaction cost can be significant. Furthermore, there is volumetric risk when

clearing unbalanced portfolio results in net long/short exposure to absolute LMP
instead of desired locational spread. Additionally there is spread risk which refers to
price taker strategy predisposed to unlimited DA congestion cost.
To address these risks, some ISOs have implemented a product that trades
balanced spreads (e.g. Up to Congestion contracts in PJM), which settles as the
difference in LMPs between RT and DA (PJM 2012). In this case the strategy
requires using the same source and sink of the FTR we want to get exposure from
RT market. In case they are not available, then use some proxy CPNodes at the
expense of getting different BCs’ exposure. The main advantage here is that this
product solves both volumetric and spread risks.
There are two other aspects of relevance about these DA-RT contracts. The first
one relates to Transaction Costs, which sometimes can be significant. Furthermore,
these costs are known after the fact, turning it difficult to incorporate properly in the
trading strategy. Moreover, this friction limits the success of its original goal of
improving convergence between DA and RT markets.
The second one is more controversial, and is related to the impact that this
activity has in DA results. These strategies, Virtual Injections and Virtual
Withdraws, create additional power flows in the DA solution, and consequently
affect DA congestion. Furthermore, in the case of using proxy CPNodes, DA
congestion may diverge from the expected based on fundamentals (phantom
congestion). However, the most problematic issue arrives when strategic bidding
creates DA congestion on purpose to increase FTR revenues (or the value of any
other contract that settles on DA prices). Strict monitoring is necessary to identify
and mitigate these behaviors.
In the OTC market, the alternatives for proper portfolio rebalancing are even
more limited. Even though there are products that have good liquidity (ICE 2012),
the main limitation is the weak correlation between these OTC products and FTR
portfolios. A reason for this observation is that the typical factors that explain most
dynamics in OTC products are less relevant for FTR portfolios. On the contrary,
specific FTR paths provide complementary value to OTC portfolios.
Based on these reasons, the concept of active portfolio management to optimize
current exposure is difficult to implement in the case of FTRs.
Some of the current challenges include:
• Liquidity: opportunities to trade FTRs are few, in general once a month with
limited volume in reconfiguration auctions. Furthermore, the secondary market
has not developed as anticipated, and the OTC products are poorly correlated
with FTRs.
• Transaction costs: during delivery, there is a possibility to move part of the DA
exposure to RT, however transaction costs for VB (including operating reserve
charges, volumetric and spread risks) have worked against this strategy.
280 J. Arce

11.3.2 Risk Management

It is necessary to consider the different components of risk involved in the whole

process before, during, and after the auction. Before the auction, the main risks
come from inaccuracies in data, assumptions, models, and/or their usage in Analy-
sis and Portfolio Construction steps. Procedures to control this type of risk include
performing quality control of data, validating models and hypothesis, and verifying
most recent published information. Within the risk management process, these risks
tend to be part of Operational Risk and Modeling Risk considerations.
During the auction, the main risks come from operational mistakes and/or
technology failures during Trade Execution. Procedures to control these risks
include submitting preliminary portfolios to test own infrastructure/technology,
performing validation of submitted portfolio against target portfolio, and building
and testing technology back-up infrastructure. Within the risk management process,
these risks tend to be part of the Operational Risk and Execution Risk concerns.
After the auction, the main risks come from the impact of realized congestion on
cleared portfolio. Here, it is important to recognize two levels of realizations. On
one hand, a normal range, where congestion is related to drivers such as weather
events, unexpected outages, over/under-commitment, etc., which tend to produce
transitory patterns. On the other hand, an extraordinary range, where congestion is
related to a permanent pattern change. Furthermore, and primarily due to non-
storage nature of electricity (wholesale level) and operational constraints (ramping,
operating procedures, localized inflexibility due to outages), it is observed that tail
events are a lot more common in FTRs than in other energy products (i.e.
leptokurtosis) (Adamson et al. 2010). Within the risk management process, these
risks tend to be part of the Market Risk, Liquidity Risk, and Credit Risk concerns.
Additionally, Underfunding Risk and Default Risk require special considerations.
The standard risk management role includes periodic evaluation of Value at Risk
(VaR), which tends to provide a good indication of risk involved in a portfolio for a
normal range of realizations. To complement this metric, some forms of Stress
Testing and Concentration Analysis are also performed looking for risk associated
with realizations in the extraordinary range. These evaluations are part of the
Market Risk assessment and are described below.
• VaR: the maximum loss that will not be exceeded with a given probability
(confidence level) over a given period of time. In general, a simulative model
is created, using historical congestion realizations adjusted by seasonality and
giving more weights to more recent realizations. This approach is very flexible
and easy to implement, however it ignores congestion patterns not present in the
historical sample.
• Stress Testing: this analysis is performed for specific scenarios looking for
extreme realizations. The key issues are, calculating net exposure for different
BCs, and defining under which circumstances the portfolio is exposed to
counterflow.
11 Trading FTRs: Real Life Challenges 281

• Concentration Analysis: the basic approach is to use a risk aggregator to convert

source-sink paths in net exposure (MW) for each branch monitored in DA
market.
Sometimes to complement these three metrics, the risk management function
also calculates Conditional Value at Risk (CVaR) that is more sensitive to the shape
of the loss distribution in the tail of the distribution (Uryasev 2001).
With this information, the risk manager evaluates Liquidity Risk. The basic idea
is to make sure that the company has allocated enough capital to the FTR account to
pay invoices. Given the uncertainties and assumptions involved in different
calculations, a conservative approach is to keep liquid funds to pay invoices equals
to a multiple of the current VaR.
Additionally, on a daily basis, a common metric used by different roles within
the organization is the Profit and Loss (PL) report. Standard reports include Year to
Date PL, Month to Date PL, and Today’s PL. Sometimes Inception to Date PL is
also included. Here it is important to clarify the difference between Realized PL and
Marked to Market PL.
• Realized PL: results from calculating the difference between DA revenues and
FTR auction cost. This PL is replicable by anyone (FTR inventories and DA
prices are public information).
• Marked to Market PL: results from calculating the difference between future DA
revenues (represented by a market quote) and the corresponding FTR auction
cost. The challenge here is that there is no liquid forward market for FTRs. As a
result, it is common to use models to estimate future revenues adjusted by a
liquidity factor. In this case, this model-driven PL is more difficult to replicate
and may create disagreements.
These PL refer to gross values, therefore to obtain the net PL it is necessary to
include in the calculation Underfunding, Defaults, and Fees/Adjustments.
• Underfunding: in some ISOs FTR is not a fully funded contract, therefore PL has
to be adjusted by this factor. Basically, if the transmission capacity sold ahead of
time in the auction is more than the available transmission capacity during
delivery, then the ISO does not collect enough revenues to pay its obligations.
This problem is not minor, and is currently a topic of debate.
• Defaults: in case of default events, the ISO socializes the incurred losses among
market participants proportional to their participation in the different markets
administered by the ISO (even participants with no FTR positions share part of
the default cost).
• Fees and Adjustments: there are some administrative fees per bid and cleared
position as well as adjustments in case of corrections in prices or other factors
that require proper considerations.
In context of bilateral contracts, the concept of credit risk deals with credit
exposure and credit quality associated with counterparties; where credit exposure
refers to the magnitude of the risk and credit quality refers to the likelihood of
282 J. Arce

the risk. In the case of FTRs, where there is no specific counterparty besides the ISO,
the concept of credit risk is adjusted to include Underfunding and socialized Defaults.
Additionally, the risk involved with policy changes is not minor, also, very
difficult to quantify. An alternative approach to deal with regulatory risk is to have
an active participation in the different policy meetings relevant to the business.
However, as mentioned in section on data (Sect. 11.2.1), this task is not easy to
address effectively.
Moreover, some return on risk metrics (e.g. Sharpe ratio) can mislead the risk the
portfolio is running if it is not analyzed properly. As explained in section Managing
Current Exposure (Sect. 11.3.1), most FTR paths are accumulated in Long-Term/
Annual Auctions, therefore setting portfolio’s performance until delivery. A good
Sharpe ratio could just reflect that a dominant position acquired in Long-Term
Auction is suddenly in the money due to a particular congestion pattern, but does
not say much about the other “sleeping” paths.
Finally, and given the specific characteristics of FTRs, it is beneficial to also
include some risk management practices used for Alternative Investments, for
example similar to the ones described in (Jorion 2009).
Some of the remaining challenges on FTR risk management include:
• Underfunding: this issue is nowadays a serious concern, at the extreme of
making some trading strategies unprofitable. Furthermore, the problem is even
adding risk to standard hedges that are not working as designed.
• MtM models: MtM PL is a metric generally requested not only by groups within
the company but also by investors. However, its value can be challenged,
creating additional burden to the desk.
• Path dependence: portfolio performance is strongly dependent on the FTR paths
locked in during Long-Term/Annual Auctions, therefore simplistic performance
metrics could underestimate the portfolio’s risk.
• Choosing proper risk management approach: standard models for quantifying
risk do not necessarily apply to FTRs. Furthermore, even if risk is properly
quantified, nature of product makes difficult to rebalance the portfolio. There-
fore, some risk management approaches used for Alternative Investments may
be a good complement.

11.3.3 Interaction with Other Desks

Originally, with a single price per control area (or power pool), the focus of
transmission analysis was primarily concentrated on inter-ties. However, the arrival
of locational pricing shifted the focus to the transmission system within control
areas. The immediate reaction has been to allocate more resources to transmission
analysis, and then build an FTR desk. Currently, there are multiple players
participating in the FTR business such as investment banks, hedge funds, private
equity shops, proprietary desks, global energy companies, merchant power plants,
municipalities, utilities, cooperatives, service providers, etc.
11 Trading FTRs: Real Life Challenges 283

Table 11.4 Management, researchers/analysts, and risk takers roles

Management
Head of trading In charge of the whole risk taking process
Portfolio In charge of particular risk taking desk
manager
Researchers/analysts
Strategists Provide analytics and research to risk takers, converting data into trading
signals
Meteorologists Supply weather forecasts and different reports on temperature, wind,
hurricanes, precipitation
Data/IT In control of data gathering
Managing storage space in database
Server maintenance in context of a 24 h operation
Backup process
Market affairs Communicate relevant information from different meetings
Quantify impact of policy changes
Risk takers
OTC Term Trades long-term dynamics, directional power contracts,
(directional) highly correlated to fuel prices, overlapping interests
with natural gas desks
Term (heat rates) Trades long-term dynamics, relative value contracts
(power prices/fuel prices), idiosyncratic to the power
business
Options Trades medium-term/short-term dynamics, still an exotic
desk in most operations, limited liquidity beyond short-
term horizons
Basis Trades medium-term dynamics, locational spread
contracts, similar to FTR if traded within the same ISO,
additional component of supply stack function if traded
between different ISOs
OTC Cash Trades short-term dynamics, directional power contracts,
highly correlated to fundamental drivers
ISOs FTR Trades medium-term/long-term dynamics, congestion
specific contract
VB Trades short-term dynamics, directional or locational
spreads
Up to congestion Trades short-term dynamics, locational spreads
Physical RT Trades according to physical power needs, 24 h operation
Origination/sales Structured Trades long-term dynamics, satisfying customized deals
products
Exchanges Quants Trades very short-term dynamics, state of the art
technology-driven business

Independently of the type of player, it is common to have Management,

Researchers/Analysts, Risk Takers, and Back Office personnel. The arrival of the
FTR desk creates an interesting dynamics, in particular with the Power Desks and
Back Office roles. A brief description of these different roles and the link with the
FTR desk is described in Tables 11.4 and 11.5.
The strong link between FTR desk and these roles comes from the current
relevance that congestion has in power prices. Therefore, it is observed that the
284 J. Arce

Table 11.5 Back Office roles

Back Office
Risk Measures and manages everything related with risk
management
Settlement Reconciles PL (realized and MtM PL), including underfunding, fees, and
adjustments
Accounting Monitors liquidity situation and implements budgeting plan for different needs
Compliance/ Guarantees compliance with company and market requirements
legal Providing legal support and interpretation of different regulations
Human In charge of recruiting needs (critical role)
resources

desk is a permanent provider of congestion views for different scenarios and time
horizons. In particular, it is highly requested when a new congestion pattern arrives
in the market. Consequently, nowadays the FTR desk plays a central function
within the Power business.
In this case also, the arrival of this new product impacted these teams. In
particular, its exotic nature has forced the FTR desk to be creative to explain its
business and to be flexible to adapt to standard company’s requirements.
Some main challenges on the interaction of desks include:
• Diverse interests: the difficulty comes not only from satisfying multiple and
sometimes conflicting interests but also from explaining nature of FTR business
to diverse audiences.
• Integration: even though the relevance of the FTR desk in the trading floor has
increased, its true value that comes from a full integration has been difficult to
materialize.

11.3.4 Profile of the “FTR Trader”

The traditional trading business separates roles among IT, Data, Analytics, and
Trading. However, in the case of the FTR business, these roles tend to be self-
contained within the FTR desk. Therefore, the “FTR Trader” performs tasks beyond
the standard ones. Accordingly, this new profile requires proficiency according to
the ones presented in Table 11.6.
Clearly, it is difficult to find candidates who score high in these four skills.
Therefore, a more realistic proposal is to build a team with members complementing
each other. The recruiting effort is not minor, on one hand the pool of experienced
talent is not big (FTR is still a niche), and on the other hand the job itself is very
demanding. There is consensus among recruiters that there are only three true job
interview questions (Bradt 2011), which in terms of the FTR business refer to:
1. Can you do the job? This question is the one generally addressed in the
interviews, where technical skills and specific knowledge (i.e. Transmission,
11 Trading FTRs: Real Life Challenges 285

Table 11.6 Skills according to new trading profile

Transmission Be capable to analyze complex dynamics and identify the right trading signals,
skills in general associated with formal education in engineering, physics, or
mathematics
Risk taking Be able to convert systematically trading signals in profitable trading strategies,
properly quantifying opportunities and risks, skills in general obtained with
formal education in economics or finance
IT/data Be proficient to design and implement sophisticated and scalable IT infrastructure
according to the needs of a data-intensive 24 h operation, skills gained not only
with formal education in computer science but also with experience in real life
implementation
Interpersonal Be flexible to accommodate challenging schedules and demanding projects, be able
to adjust to emotional swings associated with financial outcomes, and finally
(and may be most important) be able to work well within a team

Risk Taking, IT/Data) are evaluated. Moreover, the answers can be quantified
properly and comparison among candidates is easier.
2. Will you love the job? This one refers to comparing expectation with reality of
the open position. Most of the time the “FTR Trader” has to deal with tasks that
can be considered tedious and sometime even repetitive/boring but in the end
result critical to the overall success (e.g. normalizing data, reading long reports,
analyzing power flow cases). It is very important to communicate this reality to
the candidate looking for honest feedbacks.
3. Can we tolerate working with you? Sometimes also known as “The Airport
Test”, this question focus on the candidate’s interpersonal skills and how well
he/she fits within the existing team’s working culture.
Finally, after building the FTR team and working together for 1 or 2 years, the
desk starts to consolidate.
The main two challenges presented in this section are:
• Recruiting: the pool of experienced talent is not big enough to satisfy current
hiring needs. Moreover, recruiting out of school requires substantial investment
in training and coaching.
• Building and consolidating: finding the right candidates is only part of the
challenge, it is even more difficult to keep them long enough to consolidate
the business. Consolidation is a process that takes time, unfortunately many
companies are not patient enough to make it a reality.

11.4 Potential Evolution of the FTR Business

11.4.1 Next Steps

A natural evolution should occur to both the product FTR and the FTR desk. The
first one would require addressing some of the issues indentified in this chapter,
in particular underfunding and liquidity. The second one would require
286 J. Arce

institutionalizing the whole trading process. This will be even more necessary if
additional areas within the US and/or other countries decide to implement LMPs
and FTRs.
Also, a good integration between FTR and Structured Products desks providing
liquidity beyond the time horizon covered by FTR auctions would be necessary.
Tolling agreements, customized deals, load serving contracts, are some of the
transactions that require hedging basis risk. Nowadays, this is difficult to achieve
considering the limited quotes beyond liquid hubs. That is where FTR desks should
appear in the process pricing competitively illiquid locations and working close by
Structured Products desks implementing these multipart deals.
Besides, a better interaction with state of the art Quant desks would add
complementary skills to this technology intensive business. As time evolves it is
becoming more evident of the critical role played by technology in a more
globalized business environment.
Here, some of the challenges include:
• Evolution and consolidation: the real challenge in the next years would be for
the current FTR desks to adjust fast enough to a more global and sophisticated
trading environment, and for the FTR concept to consolidate as a liquid financial
instrument.
• Expanding beyond the US: attempts to transition towards full LMPs and FTRs in
some countries have not evolved beyond initial discussions.

11.5 Conclusions

In the last 10 years, the FTR business has evolved substantially, with more markets
to trade and more sophisticated FTR operations. During the early days, traders with
their own spreadsheets and simplistic models participated in the market. Nowadays,
there are several teams of researchers approaching the problem in a more quantita-
tive manner, running highly sophisticated trading platforms, turning FTRs in a
technology driven business.
Moreover, the low correlation between FTRs and global financial markets has
made this product very appealing. This fact has attracted the interest from financial
institutions and a diverse set of investors. Furthermore, over time, it is expected that
the area covered by LMPs and FTRs be sizable enough to allow even more
attractive business opportunities.
However, there are still multiple challenges to address before realizing the full
value associated with the concepts of LMPs and FTRs. Some of them, as seen from
the proprietary trading side, have been discussed in this chapter and are summarized
as follows:
• Data: The volume, dispersion of sources, and lack of standards makes the data
management problem the first obstacle to pass. The scale of this problem
11 Trading FTRs: Real Life Challenges 287

requires highly sophisticated solutions. However, normalizing data also involves

tedious manual intervention.
• Analysis: Independently of the approach, fundamental-based or quantitative-
based, it is critical to have reliable data. Unfortunately, it is not rare to
observe changes in relevant published information after the auction is
closed, invalidating the simulated signals. Furthermore, building and processing
complex simulations for large systems is still beyond most operations’ technical
capabilities.
• Portfolio Construction: The limited number of CPNodes available for trading
Obligation FTRs (in some ISOs) makes difficult to select source-sink paths with
limited counterflow risk. Option FTRs present an interesting solution to this
problem, but unfortunately only two ISOs offer the product and not for all
CPNodes. Furthermore, acquiring FTRs from auctions adds a new layer of
complexity in the risk taking process. The uncertainty associated with price
and quantity results in obtaining a cleared portfolio different from the original
targeted portfolio.
• Trade Execution: The reality of having several auction deadlines overlapping
during the same period of time, distractions from crowded trading floors,
pressure of dealing with an almost illiquid product, and compounded by the
nature of electronic execution, results in a process that is naturally prone to
costly mistakes.
• Managing Current Exposure: Comparing with other financial products, the
opportunities to trade FTRs are very few, in general once a month with limited
volume in reconfiguration auctions. Furthermore, the secondary market concept
has not developed as anticipated, and the OTC products are poorly correlated
with FTRs. As a result, and for most practical terms, a portfolio of FTRs is
considered illiquid. During delivery, there is a possibility to move part of the DA
exposure to RT; however, transaction costs (including operating reserve charges,
volumetric and spread risks) have worked against this strategy. Based on these
reasons, the concept of active portfolio management to optimize current expo-
sure is difficult to implement.
• Risk Management: Currently, underfunding is a hot issue. The severity of this
problem turns some trading strategies unprofitable. Besides this problem, the
standard models for quantifying risk do not apply necessarily to FTRs. More-
over, even if risk is properly quantified, the nature of this product makes difficult
to rebalance the portfolio. Therefore, some risk management approaches used
for Alternative Investments may be a good complement.
• Interaction with other Desks: The strong link between FTR and the different
Power Desks comes from the current relevance that congestion has in power
prices. Therefore, the FTR desk is a permanent provider of congestion views for
different scenarios and time horizons. In particular, it is highly requested when a
new congestion pattern arrives in the market. Consequently, nowadays the desk
plays a central function within the Power business. Also, the arrival of this new
product impacted Back Office as well. In particular, its exotic nature has forced
the FTR desk to be creative to explain its business. Summarizing, the relevance
288 J. Arce

of the FTR desk in the trading floor has increased, however, its true value that
comes from a full integration has been difficult to materialize.
• Profile of the “FTR Trader”: The traditional trading business separates roles
among IT, data, analytics, and trading. However, in the case of the FTR business,
these roles tend to be self-contained within the FTR desk. Therefore, the “FTR
Trader” performs tasks beyond the standard ones. Accordingly, this new profile
requires proficiency in transmission, risk taking, and IT/data. Additionally, on
the interpersonal side, he/she has to be able to tolerate the always demanding
trading environment. Besides the difficulty in recruiting the right candidates, the
business consolidation is a process that takes time.
• Next Steps: The real challenge in the following years would be for the current
FTR desks to adjust fast enough to a more global and sophisticated trading
environment, and for the FTR concept to consolidate as a liquid financial
instrument.

Acknowledgements The Author would like to thank Dr. Carlos Larisson from UNSJ and
Dr. Fernando Olsina from CONICET and UNSJ for reviewing early versions of this chapter and
for their constructive suggestions. However, the Author is the only responsible for errors that may
have occurred.

References

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coordinated auctions. Energy Econ 32:771–778
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only-three-key-job-interview-questions. Accessed 6 June 2012
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6 June 2012
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varseminar/Jorion-CAIA-isk_Management.pdf. Accessed 6 June 2012
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Chapter 12
Participation and Efficiency in the New York
Financial Transmission Rights Markets

Seabron Adamson and Geoffrey Parker

12.1 Introduction

As many authors have observed, the allocation of scarce transmission capacity

presents a major market design challenge. The electric power system is subject to
generation and transmission technology constraints that make it difficult to define
tradable property rights for physical transmission. This difficulty has led
economists to instead create markets for financial transmission rights (FTRs) settled
against the congestion price component of locational marginal prices (LMPs)
(Hogan 1992). This market structure has been increasingly adopted in the United
States and other countries.
While there has been a substantial literature on the relative attractiveness of FTR
markets over other market design, there has been significantly less empirical
analysis of how these markets have performed in practice. In this chapter, we
trace the operation of the one of the earliest FTR markets, operated by the New
York Independent System Operator (NYISO). In particular, we present new analy-
sis showing how the mix of firms that have participated in the NYISO FTR markets
has changed over time. We also summarize the econometric analysis of Adamson
et al. (2010) on FTR market efficiency and learning over time.

12.2 Transmission Congestion Pricing in New York

NYISO, along with the Pennsylvania, New Jersey, Maryland Interconnection

(PJM), was one of the first LMP markets in the United States and has conducted
periodic FTR auctions since 1999. The NYISO publishes day-ahead and real-time

S. Adamson (*) • G. Parker

Tulane Energy Institute, Tulane University, New Orleans, LA 70118, USA
e-mail: [email protected]; [email protected]

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 289

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9_12,
# Springer-Verlag London 2013
290 S. Adamson and G. Parker

Fig. 12.1 NYISO load zones (Source: NYISO)

Table 12.1 Zones and import zone names in NYISO

Zone Zone name Zone Zone name
A West I Dunwoodie
B Genesee J New York City
C Central K Long Island
D North HQ Hydro Quebec
E Mohawk Valley PJM PJM
F Capital IMO Ontario
G Hudson Valley ISONE New England
H Millwood

LMPs at numerous points across New York State’s power grid, which has a
complex interconnected topology. These LMPs include a congestion price compo-
nent reflecting the impact of transmission constraints.
Under the NYISO market design generators are considered to generate at their
bus, while loads are considered to consume in a load zone. The NYISO grid is
divided into 11 load zones – labeled “A” to “K” as shown in Fig. 12.1 below – plus
4 import zones that are used to price imports and exports to and from the neighbor-
ing PJM and ISO-New England markets in the US and the Ontario (IESO) and
Hydro Quebec (HQ) markets in Canada.
Prices are denoted in dollars per megawatt-hour. For example, a generator which
produces 100 MW for an hour at a specific node x within Zone A will be paid 100
times the node x price for that hour while a load at a specific node z of 10 MW in
Zone J will pay 10 times the local price for that hour (Table 12.1).
12 Participation and Efficiency in the New York Financial Transmission Rights. . . 291

Congestion price (West-NYC) - $/MWh

Fig. 12.2 Example of 160
NYISO congestion prices
over a day (Source: Adamson 140
et al. 2010)
120

100

80

60

40

20

0
0 4 8 12 16 20
Hour

12.3 New York Financial Transmission Rights Markets

Although this spot market pricing system is effective at addressing the realities of
power flow on an interconnected grid, on its own it poses substantial financial risks
for both generators and users of power. As can be seen in Fig. 12.2, there can be
substantial congestion price volatility across a single day. This example shows the
hourly congestion charge (per MWh) in each hour for a hypothetical bilateral
transaction between the West Zone (Zone A) and New York City (Zone J) for
1 day in early July 2008.
Given the magnitude and volatility of congestion prices in an LMP market, a
method is needed to hedge the price risks posed by spot power prices that vary from
location to location and by hour. In response to this problem, Hogan (1992)
proposed a system of financial hedging contracts designed to mitigate the compo-
nent of this risk associated with congestion. These financial hedging contracts –
fundamentally similar to financial swaps – pay the owner of the congestion contract
the quantity (in MW) times the congestion price difference between a specified
Point of Injection (PoI) and Point of Withdrawal (PoW) for each hour in the term of
the contract. These FTRs are called “transmission congestion contracts” or “TCCs”
in the NYISO lexicon; we will use the more standard “financial transmission rights”
term in this chapter. In the NYISO markets, FTRs play the role that ordinary point-
to-point transmission rights play in physical market designs, although in this case
they act solely as financial swaps and have no direct effect on system operations.
For example, a monthly FTR might be defined with a PoI of Albany and a PoW
of New York City. For each hour in the month, the FTR holder is paid the difference
between the NYC and Albany congestion prices. FTR payments over an hour (or
longer periods) can be negative – an FTR is an obligation to pay the sum of
congestion price differences even if this sum is negative.
NYISO has conducted periodic FTR auctions since 1999. Market participants
include utilities, marketers, generators and financial firms such as banks and hedge
292 S. Adamson and G. Parker

funds. In New York, FTRs have been sold for varying durations – ranging from
1 month to 2 years. As described above, a 1-month FTR is the right to hourly
differences between congestion prices at two specified locations for the period of a
calendar month. Since the FTR is defined as an obligation, and not an option, it may
have a negative value, in which case a reverse auction is used to allocate it. Both
positive and negative FTRs are allocated in the same auction. An auction of FTRs
covering a month is conducted early in the preceding month, so that a FTR covering
the month of November, for example, will be auctioned in early October.

12.4 Participation in New York FTR Auctions

NYISO publishes extensive data on its FTR auctions; this information specifically
identifies the market participant that was awarded the FTR, the contract duration,
the price paid, and the POI/POW pair that defines the FTR.1 Note that the dataset
identifies only FTRs awarded, but does not identify bidding firms that did not win in
the auction.
In the first New York auctions, FTRs were generally of short duration, with a
term of less than or equal to 6 months. In 2001 and 2002, more longer-term (e.g.
2 years) FTRs were offered, but this trend has since reversed and more recently
1 year and shorter FTRs have become the norm, as shown in Fig. 12.3.
The NYISO dataset also includes data on grandfathered FTRs. These FTRs were
awarded to market participants in the early days of NYISO operations to replace
pre-existing physical transmission rights in the grid, before market opening. Many
New York utilities had such rights, some of which were of very long duration.
Under the NYISO tariff, these holders of existing transmission rights had the option
to convert them into FTRs and many did so. As these FTRs were not awarded in the
auctions, and represented existing transmission rights in the grid, these have been
excluded from our analysis.
Using the NYISO data, it is possible to examine trends in the number and POI/
POW locations of FTRs awarded and to classify the market participants awarded
FTRs. FTR market participants have been divided into five classes for this analysis:
• Utilities: This category includes New York investor-owned utilities, state
agencies that serve loads in NYISO (such as the New York Power Authority)
and a number of smaller municipal utilities. Out-of-state utilities acquiring FTRs
in the NYISO auctions – which would typically be done by a competitive
marketing group – are not included in this category.
• Generators/marketers: This category includes the major NYISO generators,
out-of-state utilities selling power into NYISO, and the power marketing
firms, many of which are part of combined generation/marketing firms.

1
http://www.nyiso.com/public/about_nyiso/understanding_the_markets/financial_markets/. Accessed
17 Sept 2011.
12 Participation and Efficiency in the New York Financial Transmission Rights. . . 293

160
> 1 year
1 year
Quarterly FTR Volume Awarded (GW) 140 < 1 year

120

100

80

60

40

20

0
Q4-99 Q2-01 Q4-02 Q2-04 Q4-05 Q2-07 Q4-08 Q2-10

Fig. 12.3 Quarterly FTR awards by contract duration (Source: NYISO)

• Retailers: The competitive retail sector in New York consists of firms which
primarily market electricity directly to individual end-use customers.
• Banks: The major Wall Street investment banks, through various proprietary
and commodity trading desks, are active in the NYSIO FTR markets.
• Funds: This category includes non-bank hedge funds and trading groups. Many
of the funds most active in the NYISO market are specialized entities; some of
which that focus almost entirely on the FTR markets in NYISO and other U.S.
markets.
It is not possible, using this data, to classify neatly those FTRs acquired for
“speculation” versus “hedging” purposes. Some generalizations, however, can be
made. Utility and retailer FTR purchases, given the nature of these firms, have most
likely been made to hedge congestion risk. For example, a New York City utility or
retailer that had a purchase contract with a generator upstate, but had load
obligations downstate, would be exposed to risk in the congestion component of
LMPs; this could be hedged using FTRs. At the opposite extreme, hedge funds and
other specialized trading groups generally do not have offsetting load exposures
and their FTR purchases most likely represent allocations of purely speculative
capital.
The FTRs purchased by generators/marketers and the bank trading desks cannot
be classified a priori as being for hedging or speculative purposes. These entities
both engage in speculative trading but also have extensive portfolios of power
positions that FTRs can help to hedge. For example, an upstate generator could sell
power under a contract to a downstate customer fixing the price at the customer’s
294 S. Adamson and G. Parker

180 Banks
Funds
160 Gens/marketers
Quarterly FTR Volume Awarded (GW) Retailers
140 Utilities

120

100

80

60

40

20

0
Q4-99 Q4-00 Q4-01 Q4-02 Q4-03 Q4-04 Q4-05 Q4-06 Q4-07 Q4-08 Q4-09 Q4-10

Fig. 12.4 FTR awards by participant type and quarter (Source: NYISO)

location; an FTR could then be used to hedge the congestion component of the basis
risk. Similarly, a bank trading desk may enter into a swap position with a customer
in one zone but have some of the risk offset by a corresponding purchase in another
zone. Again this risk could be managed using FTRs. Overall however, both the
marketers and investment banks are known to allocate significant amounts of
speculative capital to FTR trading and at least a significant fraction of these total
volumes likely represent speculative transactions.
Figure 12.4 shows the total volume of FTRs awarded (in gigawatts) in NYISO
by quarter, broken down by category of market participant. The volume of FTRs
awarded by NYISO grew quickly in 2000 and 2001, and has remained largely stable
ever since.
The primary trend apparent in Fig. 12.4 is the increasing importance of financial
sector firms (banks and funds) over time. These two classes of market participants
were of minimal significance in the early days of the NYISO FTR markets but now
represent approximately half of all FTR volumes. Conversely, retailers were
important in the 2000–2005 period, but are no longer significant FTR market
participants, reflecting perhaps the state of the competitive retail market in New
York. The share of FTRs awarded to utilities has remained relatively constant over
the period.
The most congested major interfaces in the NYISO system are those that cross
into the downstate New York City and Long Island zones (Zones J and K in
Fig. 12.1). For FTRs with a POI or POW in Zones J and K, a similar pattern
emerges in Fig. 12.5 in terms of market participation, with a somewhat higher share
of financial sector FTRs awarded to funds in comparison to investment banks.
Utilities received a larger share of these FTRs, reflecting perhaps their interest in
hedging risks associated with power purchase contracts upstate.
12 Participation and Efficiency in the New York Financial Transmission Rights. . . 295

60
Banks
Funds
50
Quarterly FTR Volume Awarded (GW)

Gens/marketers
Retailers

40
Utilities

30

20

10

0
Q4-99 Q4-00 Q4-01 Q4-02 Q4-03 Q4-04 Q4-05 Q4-06 Q4-07 Q4-08 Q4-09 Q4-10

Fig. 12.5 FTR awards involving New York City/Long Island zones (Source: NYISO)

40
Banks
Funds
35
Gens/marketers
Quarterly FTR Volume Awarded (GW)

Retailers
Utilities
30

25

20

15

10

0
Q4-99 Q4-00 Q4-01 Q4-02 Q4-03 Q4-04 Q4-05 Q4-06 Q4-07 Q4-08 Q4-09 Q4-10

Fig. 12.6 FTRs awarded solely within New York City/Long Island Zones (Source: NYISO)

The trend of increasing share of FTRs awarded to financial sector firms is even
stronger for FTRs that have both a POI and POW within Zones J and K (New York
City and Long Island), as shown in Fig. 12.6. Few of these FTRs have been acquired
by utilities, and since 2007 the majority of FTRs within NYC/LI have been awarded
296 S. Adamson and G. Parker

to specialist funds. The investment banks have played a smaller role in this
component of the FTR auctions. The funds’ focus on zones J and K may not be
surprising given that there appear to be participation and informational costs unique
to the NYC/LI market that have prevented transaction profits from being eliminated
(Adamson et al. 2010).

12.5 Efficiency of New York FTR Auctions

FTRs settled against day-ahead locational congestion prices allows congestion

price risks to be hedged, while allowing the system operator to centrally commit
and dispatch all generation units while meeting transmission security constraints.
The FTR-based market design thus allows market participants to hedge price risk
while allowing the system to maintain least cost unit commitment and dispatch.
In LMP-based markets, such as New York, longer-term contracts (including
FTRs) are effectively financial hedges settled against spot prices. In the case of
FTRs, these are spot congestion price differences. Examining the efficiency of FTR
markets in an LMP-based design such as that of NYISO therefore provides some
insights into the longer-term allocative efficiency of the whole market.
Several authors have examined FTR market efficiency, in many cases relying on
NYISO data. An early analysis concluded that the NYISO FTR market was highly
inefficient in its early operations, circa 2000–2001 (Siddiqui et al. 2005). Their
analysis examined only four auctions in the early years of the market (and is hence
based on only four independent data points). Adamson and Englander also
suggested that NYISO FTR auctions were initially highly inefficient, although
efficiency did improve somewhat over time (Adamson and Englander 2005).
A recent paper documented a significant divergence between spot and forward
prices for 1-month TCCs in the NYISO in 2006 and 2007, finding that forward
prices exceeded spot in 2006 and spot exceeded forward in 2007 (Hadsell and
Shawky 2009). As the authors of the paper themselves point out, the dependence of
realized congestion charges on large low frequency shocks (e.g., 2005s Hurricanes
Katrina and Rita) makes estimating the expected profit from forward contracts
using a short time series of observations problematic. Adamson, Noe, and Parker
analyzed a much larger and richer data set and the results of their analysis are
summarized below (Adamson et al. 2010).
From a more theoretical perspective, Deng, Oren, and Meliopoulos postulated
that the inherent design of these FTR auctions, rather than limits on price discovery
and information flows, may lead to inefficiency (Deng et al. 2004). In their model,
FTR auction clearing prices will differ from expected FTR payoffs, even if bidders
have perfect foresight, depending on the quantity of bids in the auction, due to the
simultaneous feasibility constraints imposed in the FTR auction design.
Below, we discuss the econometric models Adamson et al. (2010) used to test
hypotheses about FTR market efficiency and whether including a dynamic
12 Participation and Efficiency in the New York Financial Transmission Rights. . . 297

component in a learning model helps to improve the model fit. We then describe the
data set they used to estimate model parameters and their summary statistics.

12.6 Econometric Models to Test Efficiency and Learning

Learning has been studied by economists, perhaps most famously, in the analysis of
airplane manufacturing costs conducted by Wright (1936). Argote provides a
comprehensive review of learning models and econometric specifications (Argote
1999). Most of this analysis has been performed in log-linear models with the
underlying relation of a time variable to capture learning effects. However, in this
case neither realized spot prices nor forward FTR prices need must be positive.
Therefore, it is difficult to apply the standard log-linear learning framework to FTR
markets. Thus, Adamson et al. (2010) analyzed two econometric specifications that
do not require commitment to the unbiased forward rate hypothesis and do not
require positive prices.
Their base model is the classic joint hypothesis test for bias and efficiency in a
forward market (Engel 1996).

S t ¼ b0 þ b1 F t þ m (12.1)

St is the spot price in period t (in this case, the sum of realized congestion rents),
Ft is the forward price for delivery in period t (in this case, the price paid for the
FTR in the auction), and m is an error term. If the market is efficient, then the
intercept b0 will not differ systematically from zero and the constant term b1 will
not differ systematically from one.
The second, dynamic model is specified as:

St ¼ b0 þ b01 =ð1 þ tÞ þ b1 Ft þ b11 Ft =ð1 þ tÞ þ m (12.2)

The dynamic model relates spot prices to forward prices through a constant
linear relation (b01) subject to diminishing bias over time. This model also allows
the linear relation itself (b11) to vary over time so that the model approaches a long-
run equilibrium value. Learning is indicated by non-zero coefficients for these
dynamic effects. The joint hypothesis test of H0: b0 ¼ 0 and b1 ¼ 1 can be used
to examine the long run efficiency of the market.
298 S. Adamson and G. Parker

12.7 New York FTR Auction Data

To test the base and dynamic models discussed above requires data on the forward
FTR prices, and the realized spot congestion prices. This section describes the
operations of the New York FTR markets in more detail and how forward and spot
prices for FTRs are calculated.
Adamson et al. (2010) analyzed a large data set of all NYISO 1-month FTR
auctions over the period from September 2000 through June 2006.2 There were
2,250 unique PoI/PoW (source/sink) combinations in this data set, between both
points and zones within the NYISO control area. Each set of monthly results often
included prices for multiple contracts with the same source and sink zone.3
The spot congestion prices are subject to many of the same shocks and hence are
not independent. Therefore robust regression models were used to verify model
significance and correct standard errors (Huber 1964; White 1980).
Adamson et al. split their data set into four groups by contract type and geogra-
phy. First, their data set was separated by “positive” FTRs – those for which a
positive price was paid by the winning bidder in the auction – and “negative” or
“counterflow” FTRs, where the auction price is negative.4 The efficiency of positive
and negative contract auctions was found to be quite different so analysis was done
separately on positive and negatively priced contracts.
Adamson et al. also analyzed the New York City/Long Island region (Zones J
and K in Fig. 12.1) separately from the others. Congestion within these two zones is
qualitatively and quantitatively different from elsewhere in the NYISO, owing to
the very high load and generation density of the transmission system within this
region, especially during summer periods, and a complex pattern of voltage as well
as thermal constraints creating transmission congestion.5 Thus, the analysis was
split into four major groups: (1) positive contracts not solely within zones J and K,
(2) negative contracts not solely within zones J and K, (3) positive contracts solely
within zones J and K, and (4) negative contracts solely within zones J and K.
Table 12.2 shows the summary statistics for the time series data divided into
these four groups. FTR spot and forward prices are very fat tailed, with many more
extreme observations than one would expect from a normal distribution with a
similar variance (Corrado and Su 1996).

2
These data sets includes Day-Ahead congestion prices, TCC auction bids and TCC auction
results for over 9,000 FTRs as obtained from the NYISO website.
3
The “source zone” is the zone in which the POI is located and “sink zone” is the zone in which the
corresponding POW for the FTR is located.
4
For a counterflow FTR, the winning bidder is paid to take the FTR but has the obligation to pay
congestion rents to the TSO. Counterflow FTRs are sold in the same auctions as positive FTRs.
5
Significant parts of the New York City transmission grid are operated to a higher reliability
standard than the rest of the New York market: using an N-2 criterion rather than the usual N-1
standard (NYISO 2008).
12 Participation and Efficiency in the New York Financial Transmission Rights. . . 299

Table 12.2 Summary statistics for positive/negative FTRs by group

Group 1: Positive FTR contracts
Crossing outside zones J & K Mean Std. dev. Kurtosis Min Max N
Spot price (MW-month) $626 $1,887 28 $7,351 $19,618 2,719
Forward price (MW-month) $653 $1,693 34 $0 $22,520 2,719
Spot – forward $28 $1,360 44 $19,688 $11,226 2,719
Quantity (MW-month) 26 66 139 0 1,160 2,719
Transaction profit $ $4,039 $210,638 1,585 $2,807,776 $9,568,143 2,719
Group 2: Negative FTR contracts
Crossing outside zones J & K Mean Std. dev. Kurtosis Min Max N
Spot price (MW-month) $659 $2,543 28 $19,894 $3,703 2,992
Forward price (MW-month) $808 $2,415 25 $24,597 $0 2,992
Spot – forward $148 $1,489 46 $11,254 $21,847 2,992
Quantity (MW-month) 26 60 126 0 1,147 2,992
Transaction profit $ $3,060 $150,326 305 $1,658,063 $4,343,408 2,992
Group 3: Positive FTR contracts
Solely within zones J & K Mean Std. dev. Kurtosis Min Max N
Spot price (MW-month) $1,706 $3,221 20 $11,495 $36,852 1,923
Forward price (MW-month) $1,061 $1,484 12 $0 $12,500 1,923
Spot – forward $645 $2,917 15 $11,882 $29,358 1,923
Quantity (MW-month) 14 28 116 0 564 1,923
Transaction profit $ $10,962 $78,746 228 $849,082 $1,956,745 1,923
Group 4: Negative FTR contracts
Solely within zones J & K Mean Std. dev. Kurtosis Min Max N
Spot price (MW-month) $1,076 $2,961 14 $26,511 $11,500 1,625
Forward price (MW-month) $1,701 $2,102 11 $21,889 $0 1,625
Spot – forward $625 $2,644 12 $19,565 $21,776 1,625
Quantity (MW-month) 14 23 24 0 220 1,625
Transaction profit $ $4,489 $84,511 128 $1,207,868 $1,432,660 1,625
Source: Adamson et al. (2010)

10 10

5 5

0 0

-5 -5

-10
-10
Group 1: Total Transaction Profits ($M) by month Group 2: Total Transaction Profits ($M) by month
(Positive Contracts outside NYC/Long Island) (Negative Contracts outside NYC/Long Island)

Fig. 12.7 Total transaction profits by month ($M) for groups 1&2 (Source: Adamson et al. 2010)

Figure 12.7 presents transactions profits for contracts that cross outside the New
York City/Long Island market for positive and negative contracts. Figure 12.8
details transactions profits for contracts solely within the New York market for
both positive and negative contracts.
300 S. Adamson and G. Parker

10 10

5 5

0 0

2000_09
2001_01
2001_04
2001_07
2001_10
2002_02
2002_06
2002_11
2003_03
2003_06
2003_09
2003_12
2004_03
2004_06
2004_10
2005_01
2005_04
2005_07
2005_10
2006_01
2006_04
2000_09
2001_01
2001_04
2001_07
2001_10
2002_02
2002_06
2002_11
2003_03
2003_06
2003_09
2003_12
2004_03
2004_06
2004_10
2005_01
2005_04
2005_07
2005_10
2006_01
2006_04
-5 -5

-10 -10

Group 3: TotalTransaction Profits ($M) by month Group 4: Total Transaction Profits ($M) by month
(Positive Contracts within NYC/Long Island) (Negative Contracts within NYC/Long Island)

Fig. 12.8 Total transaction profits by month ($M) for groups 3&4 (Source: Adamson et al. 2010)

Table 12.3 Regression results for base and dynamic models – groups 1&2
Group 1: Positive Group 2: Negative
Model Base Dynamic Base Dynamic
Dep variable: S S S S
(B0) Constant 104.8*** 94.6*** 38.4 30.9
(30.9) (24.7) (22.4) (20.2)
(B1) Forward 0.798*** 0.919*** 0.864*** 0.944***
(0.057) (0.042) (0.041) (0.036)
(B01) 1/(1 þ t) 471 552
(392) (296)
(B11) Forward/(1 þ t) 1.75*** 1.76***
(0.20) (0.15)
Wald test [6.93]** [7.45]*** [16.4]*** [3.72]*
(B0 ¼ 0 & B1 ¼ 1)
N 2,719 2,719 2,992 2,992
Robust F statistic 196 164 436 238
R2 0.510 0.560 0.674 0.701
* p<0.05, ** p,0.01, *** p<0.001. Source: Adamson et al. (2010)

The left hand panel of Fig. 12.7 shows that initially transaction profits were
negative for positive contracts not entirely within New York City and Long Island.
After this initial period of about 12.5 years, transactions profits were on average
non-negative. The right hand panel of Fig. 12.7 presents transactions profits on
negative contracts not entirely within New York City/Long Island. Early transac-
tion profits were positive, followed by a final period in which transaction profits
were small in absolute size.
The left hand panel of Fig. 12.8 depicts the transactions profit on positive
contracts entirely inside the New York City/Long Island zones. Initially profits
were small in absolute magnitude. However, toward the end of the sample period,
very large positive profits were realized, the largest profit spike being associated
with Hurricanes Katrina and Rita in 2005, which created major shocks in US natural
gas markets and hence power prices. The right hand panel of Fig. 12.8 shows that
for negative contracts entirely in the New York City/Long Island zones the absolute
12 Participation and Efficiency in the New York Financial Transmission Rights. . . 301

Table 12.4 Regression results for base and dynamic models – groups 3&4
Group 3: Positive Group 4: Negative
Model Base Dynamic Base Dynamic
Dep variable: S S S S
(B0) Constant 725.4*** 684.7*** 116.5 206.3*
(86.9) (101.5) (90.3) (93.7)
(B1) Forward 0.924*** 1.170*** 0.701*** 0.819***
(0.090) (0.126) (0.064) (0.075)
(B01) 1/(1 þ t) 3,020** 4,199***
(1,065) (737)
(B11) Forward/(1 þ t) 9.73*** 5.36***
(1.81) (1.41)
Wald test [66]*** [68]*** [49]*** [17]***
(B0 ¼ 0 & B1 ¼ 1)
N 1,923 1,923 1,625 1,625
Robust F statistic 105 48 119 45
R2 0.181 0.193 0.248 0.252
* p<0.05, ** p,0.01, *** p<0.001. Source: Adamson et al. (2010)

Table 12.5 Expected long run spot – forward price differences

$/MW-month Group 1 Group 2 Group 3 Group 4
Mean forward price (in year 6) $598 $960 $1,131 $2,033
Expected spot price in long run $644 $876 $2,007 $1,458
Dynamic regression model standard error $1,258 $1,392 $2,894 $2,562
Expected long run spot – forward price $46 $84 $876 $575
Source: Adamson et al. (2010)

variability of contract profit was smaller. On average profits were positive through-
out the study period.
Tables 12.3 and 12.4 summarize results for the base and dynamic models for
each of the groups.
The results in Table 12.4 below indicate that the market for contracts solely
within the New York City/Long Island sample (zones J and K) was less efficient than
that for contracts that are outside New York City/Long Island. For positive contracts,
the constant (b0) was significantly above zero for both the static and dynamic model.
For negative contracts, the coefficient on forward price was significantly less than
one, leading to high positive expected spot – forward price differences.
Table 12.5 presents expected spot – forward price differences (per MW-month)
that are calculated using the parameters from the dynamic model. A “representa-
tive” contract price is modeled using the mean forward price seen in the last
12 months of the data set.
Expected spot – forward prices are positive for all four groups, but are much
larger for contracts that are within the New York City and Long Island zones.
However, the corresponding standard errors are much larger than the expected
profits in all cases and are especially large for groups 3 and 4, indicating a high
likelihood of negative profit on any given transaction.
302 S. Adamson and G. Parker

The implication of this table is that expected profits from participating in the
FTR market are positive, but are highly variable, indicating that many market
participants realize negative returns.

12.8 Conclusions

This chapter has presented descriptive data on the entities that have participated in
NYISO FTR auctions and how the efficiency of these auctions has changed over
time. The analysis shows that direct load-serving entities such as utilities and
competitive retailers have purchased a relatively small fraction of FTRs auction,
although they may have benefitted indirectly from energy price hedges sold to them
by generators and marketers (who were major FTR purchasers) in their load zone.
The most noteworthy aspect of the participation analysis has been the rapid rise in
importance of financial institutions (including bank trading desks and specialist
funds) in the New York FTR markets.
The importance of these financial sector entities in the NYISO FTR markets is
especially pronounced for FTRs with a POI and POW solely within the New York
City and Long Island zones. This may reflect the fact that this market appears to be
less efficient from an economic perspective and hence trading profits on average
may be larger. We have previously hypothesized that the costly modeling systems
and staff required to analyze this complex transmission system may limit the
willingness of firms to participate given the overall small size of the market, helping
preserve positive expected transaction profits over time.
From a broader market design perspective, the results of the analysis of
Adamson et al. (2010) are encouraging. Confirming the results of earlier analyses,
the initial efficiency of the FTR auctions was relatively low, although it improved
quickly over time, consistent with rapid learning by market participants. This
suggests that the overall forward-looking allocative efficiency of these FTR market
designs is generally robust.
Analysis of FTR auction data should allow a range of other research questions to
be addressed. The NYISO FTR market was one of the first to begin operations, but
subsequently several others have started in the United States. It may be
hypothesized that initial efficiency would be higher, or learning more rapid, in
these later markets, given that many of the same firms participate. The rich level of
firm-level data should allow hypotheses of firm entry and exit to be tested using
FTR market data.

References

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Adamson S, Noe T, Parker G (2010) Efficiency of financial transmission rights markets in

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Chapter 13
Experience with FTRs and Related Concepts
in Australia and New Zealand

E. Grant Read and Peter R. Jackson

13.1 Introduction

As one of the first Full Nodal Pricing (FNP) electricity markets, New Zealand was also
one of the first places where FTR concepts were developed and considered for
implementation, actually as early as 1989. Ironically, though, it is only now, after
more than two decades of discussion, that a limited FTR market seems likely to be
actually implemented. This long delay may be partly attributed to failures in the
regulatory process, but it also reflects the special circumstances facing the small
hydro-dominated New Zealand market, in which a relatively small group of vertically
integrated participants compete over a fairly sparse network, in which losses and
reserve support requirements play a more important role than line transfer limits,
per se. Thus there has been considerable debate over whether classical FTR concepts
are really suitable. We discuss several variant proposals, one of which is moving
toward implementation by 2012.
Although geographically close, the Australian market developed along very differ-
ent lines from the New Zealand market, both before and after reform. The market
design is zonal, not nodal, creating quite different hedging requirements for
participants, and raising quite different design issues. Congestion still occurs in such
a market, and still affects both dispatch and pricing outcomes, but the nature of that
impact depends significantly on whether the constraints involved are inter-regional,
intra-regional, or indeed trans-regional. Once again, variations on classical FTR
concepts have been developed to deal with these situations, both inter-regional and
intra-regional. We describe the simplified inter-regional hedging arrangement cur-
rently available, which employs a less precise mathematical representation of trans-
mission system realities than has been normal elsewhere, and was designed to
facilitate integration with financial markets. We also describe a generalised hedging

E.G. Read (*) • P.R. Jackson

University of Canterbury, Private Bag 4800, Christchurch 8140, New Zealand
e-mail: [email protected]

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 305

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9_13,
# Springer-Verlag London 2013
306 E.G. Read and P.R. Jackson

framework that has been developed, but not implemented, to address that limitation, as
well as deal with intra-regional and trans-regional hedging and contracting issues that
arise in zonal markets.

13.2 New Zealand Experience to Date

The first “FTR” concept discussed for implementation in New Zealand was not based
on the classic work of Hogan (1992). Read (1989) proposed a “shareholding” concept,
defined on a line-by-line basis, with participants receiving proportional shares of the
rents, rather than a fixed MW allocations. Thus, in some respects, it anticipated the
financial version of “Flow Gate Right” (FGR) concept later proposed by Chao et al.
(2000), and the “constraint based right” concept of Biggar (2006). In other respects it
was similar to the proportional rental share bundles auctioned under the Australian
SRA concept, discussed later.
This proposal was intended to reduce the potential distortion arising in Schweppe’s
nodal pricing proposal when the actions of a small group of users influence the price
differential. And it was supposed to incentivise optimal transmission investment, by
protecting those investors paying for a share of the line, as discussed by Read (1997a).
Such proportional shareholdings have the advantage of always being revenue ade-
quate, but they do not match the hedging requirement of a participant wanting to trade a
fixed MW quantity of power across the network, who would have to identify and
acquire a whole bundle of such rights, ideally covering all lines over which any of its
trade might flow, in order to be fully hedged. Thus, while the shareholding concept
could have been developed into an FGR like regime, it was only applied to simple
situations involving specific assets, and has not featured strongly in subsequent
discussions on meeting hedging requirements in the interconnected AC system.
Instead, the original design for the New Zealand electricity market, as described by
Read (1997a), proposed the introduction of FTRs in the classic form of Hogan (1992).
Implementation of that aspect of the market design was deferred, though, and subse-
quently become problematic. Read (1997b) notes that the sector had no regulator and,
once the centralised publicly owned organisations were dismembered and/or
privatised, there was no way of reaching consensus agreement on such matters, or
enforcing any agreement that might be reached. In the early days, allocation of rents
also seemed less urgent than other matters, partly because there was little congestion
and significant rents seldom arose.1
In the interim, rents were simply allocated back to those parties paying for various
parts of the transmission system. Parties paying for dedicated “connection assets”
receive all the rents collected on them but the aggregate rent involved is small. Since
they control the flow on those assets they are then indifferent as to whether the flow

1
This lack of congestion is partly an illusion. In a small market, a few major users can effectively
prevent a line reaching its upper flow limit, and without FTRs they are motivated to do so.
13 Experience with FTRs and Related Concepts in Australia and New Zealand 307

actually reaches its upper limit, or is controlled to some slightly lower level. Inter-
island HVDC transmission costs are allocated to South Island generators, and they
currently receive corresponding shares of the inter-island rents. This means that those
generators are approximately hedged against inter-island price differentials arising in
wet years, when they are exporting excess power to the North Island. But it also
means that those generators, who are all vertically integrated generator/retailers are
approximately hedged against inter-island price differentials arising in dry years,
when they are importing power from the North Island to meet South Island load
commitments. For the remainder of the system, though, transmission pricing gradu-
ally evolved away from the market-based regime proposed by Read (1997a) towards
a situation in which most participants simply pay a “postage stamp” charge covering
their share of the “inter-connected” intra-island AC transmission system costs, based
on a measure of peak load. Consequently, rents are also implicitly allocated in
proportion to peak load.
While, of itself, allocating rents in that way might be considered distortionary, it
may also be seen as reducing any distortion inherent in the allocation of transmission
costs. The parties paying transmission charges are either major users, or distribution
businesses, who generally pass the rents through to retailers operating in their distri-
bution areas. The formulae used differ by area, and a few smaller distribution
companies do not pass rents through at all. But, in principle, this provides all loads,
everywhere, with a proportional share of the rent an all AC system lines. And that
effectively provides a proportional hedge (roughly an FTR) from a notional island
Generation Weighted Average Price (GWAP) hub to a notional island Load Weighted
Average Price (LWAP) hub. Thus nationally diversified retailers, serving a propor-
tional share of load at each node, are effectively as fully hedged against intra-island
price differentials as they can be, given network capacity. Meanwhile, smaller regional
participants effectively hedge their position physically, by developing retail markets
close to their generation, and vice versa. Thus many parties see little to be gained by
more formal hedging arrangements.
When Transpower (2002) proposed, and developed the software for, a comprehen-
sive FTR market it was strongly opposed by most of the industry. In part, that
opposition stemmed from parties resisting the loss of revenue streams to which they
had become accustomed. Some participants saw little to gain, and others could not be
expected to welcome any regime that allowed competitors to access their “captive”
local markets more easily. But most participants also argued that the proposal was far
more complex than the situation demanded, and would impose unjustifiable costs on
parties who would be obliged to interface with the market, disadvantaging smaller
participants in particular. The work reported in Pritchard and Philpott (2005) also
raised fears that parties in a position to exercise market power in the spot market, and
thus effectively control the ultimate payout of FTRs, would be able to play more
complex strategic games in the FTR market, and potentially purchase FTRs that
actually strengthened market power in some retail markets. Participants interested in
penetrating regional markets where they might be exposed to incumbent market power
were concerned by this, and further concerned that Transpower’s proposal to only
offer FTRs a year or two ahead would not provide sufficient protection to justify
308 E.G. Read and P.R. Jackson

developing a long term regional retail position, or industrial supply contract. Thus
many parties felt that some kind of regionalised variation on the existing rental
allocation would be simpler, cheaper to implement, less prone to manipulation, and
might actually serve their hedging requirements better.
Responding to these concerns, Read (2002) proposed a hybrid regime. This
attempted to meet long term concerns over retail competition by making an automatic
allocation of shares in regional rental streams to loads, via whatever entities were
serving those loads. But it also proposed that those implicit hedging positions be
treated as a form of “Auction Revenue Right” (ARR), as discussed by Sarkar and
Khaparde (2008), and employed in the PJM and New England ISO markets, for
example. Thus they would be effectively convertible into explicit FTRs, to be traded
in a formal market perhaps up to a year ahead. Those recommendations were endorsed
by the Government, which issued a policy statement to the then newly formed
Electricity Commission, but little progress was actually made until quite recently.

13.3 Current New Zealand Developments

In recent years the locational hedging situation has received more attention, partly
because congestion rents have increased. But there has still been significant debate as
to whether the expense of establishing locational hedging arrangements was really
justified and, if so, what the arrangements should be. As noted above, many parties
already have implicit hedging arrangements, which suit their circumstances well
enough. There was concern, though, that, while major cities were reasonably well
served by competing retailers, the lack of any formal inter-regional hedging made it
difficult for North Island generators to compete in the South Island, and some smaller
regional markets had quite limited retail choice. So the focus has been on the potential
to increase competition by reducing the risk for out-of-region retailers to operate in
regional markets.
Potential economic gains have been reduced, though, by recent moves to re-allocate
assets between state-owned generators which have increased competition in the South
Island, and the potential gain from better competition in smaller regional markets is not
all that large, either. Nor has there been a clear consensus that FTRs, per se, are the best
way of dealing with the problem. Some regard them as just too expensive to imple-
ment, and too complex for smaller niche participants to deal with. Others still consider
that FTRs may actually worsen incumbent market power in smaller regional markets,
or even at the inter-island level.
For all these reasons, significant effort was expended on developing an alternative
“Locational Rental Allocation” (LRA) regime that would automatically assign rents to
loads in a way that mimicked the likely outcome of an efficient FTR market regime.
The preferred regime, as described by Read (2009), was in fact a hybrid FTR/LRA
regime that would effectively hedge all loads in each island to that island’s Generation
Weighted Average (GWAP) hub prices, with inter-island FTRs traded between
GWAP hubs. By construction (in a lossless system), the intra-island rents are just
sufficient to hedge between GWAP and the Load Weighted Average Price (LWAP),
13 Experience with FTRs and Related Concepts in Australia and New Zealand 309

and hence to hedge all loads to GWAP. The SPD market-clearing engine described by
Alvey et al. (1998) includes a piece-wise linear representation of line losses, implying
a hedgeable loss rental component, and a non-hedgeable loss cost component.2 Since
many parties argued that the LRA should not cover loss-induced differentials
at all (and in order to facilitate analytical comparisons) the LRA regime was
formulated in terms of explicitly allocating congestion rents on binding constraints,
using participation factors determined by converting MCE constraints into the generic
form of (13.1) below.
As Read (2009) notes, simply assigning rents in exact proportion to real time loads
would actually undo the effect of locational marginal pricing, effectively creating a
regional pricing regime for loads.3 Some parties have actually supported that
approach, moving the New Zealand market design closer to that in Australia, or
more exactly Singapore, where generators face nodal prices, but loads face a uniform
price across the whole island. That would obviously remove any intra-regional
hedging problem for loads, and allow generators to trade hedges at the GWAP hubs.
But the general consensus is that regional pricing would unacceptably compromise
efficient economic signalling. Thus it was proposed to base locational rental
allocations on some measure other than the actual load in the trading interval, such
as historic average load share for similar periods. This implies some compromise to
hedging effectiveness, but places a load that is allocated rents for a fixed MW quantity
in much the same situation as a load that is holding an FTR for the same quantity.4 Thus
it largely preserves the locational signalling advantages of nodal pricing, for opera-
tional purposes, because any incremental consumption faces the full nodal price.5
Long run locational signalling would still be compromised because, on average, the
LRA regime would still hedge loads to the chosen reference hub price, in this case
GWAP, without requiring any payment for that hedge.6 But this was only considered

2
The residual market settlement surplus must be all loss rents, and the residual nodal price
differences must be loss-induced. Since the piece-wise linearization represents an underlying
quadratic loss function, these two components are approximately equal, so the remaining surplus
should cover about half the loss-induced price differences.
3
If the local price is Pn, the effective price is just Pn
(Pn
GWAP) ¼ GWAP as in the IDMA
representation of a zonal market, discussed in Sect. 13.6 below.
4
Efficient signalling is still compromised to the extent that increasing consumption in one period
increases rental allocations in future periods, though. Consideration was given to excluding
periods in which congestion occurred from the historical load calculation, but this makes little
difference if congestion is infrequent. Distortion of pervasive loss-induced differentials is more
difficult to deal with, and some versions of this proposal excluded them entirely.
5
Read also notes that these dynamic signals are of limited relevance to small users, who do not
actually face spot prices, and argues that LRA actually improves on the status quo for large loads.
With no locational hedging available, they face a disproportionate second order signal to avoid
causing congestion, since the resultant high local prices would apply to their entire load. They are
thus incentivised to reduce consumption in favour of smaller loads which, being oblivious of the
second order considerations, effectively see the nodal price as a pure SRMC signal.
6
By way of contrast, if participants have to purchase FTRs they effectively pay the average
locational price differentials, in the FTR purchase price.
310 E.G. Read and P.R. Jackson

to be a major problem for new large electricity-intensive loads, which seem unlikely
for the foreseeable future.
In theory, it may be argued that a comprehensive FTR regime might produce a
better outcome, in terms of both hedging and economic signalling. But the advantage is
not actually clear, even apart from issues of complexity and expense, or concerns about
FTR market gaming. FTRs are perfectly suited to hedging the position of parties
wishing to trade a fixed MW amount for a fixed period from one node to another. But
very little of the power sold by New Zealand retailers is traded on that basis.
To compete in regional markets, a stand-alone retailer faces the hedging problem of
matching a continuously variable load pattern, across many nodes, with a set of energy
hedges, probably bought at a major trading hub. But a typical New Zealand retailer
also has some generation plant, and might well be interested in FTRs from its
generation nodes to a trading hub. Much of that capacity is hydro, though, with highly
variable output, so the pattern of FTRs required would be constantly changing.
The implied hedging requirements would be difficult to match well unless FTRs
were traded for quite short time intervals, and no small retailer has the resources to
deal with that kind of complexity. Conversely, it seems easy to devise allocation
formulae that match hedge quantities to loads at least as closely as seems likely under a
regime in which FTRs might only be traded in monthly blocks, and between only a
few participants.
Thus many participants felt that their needs would actually be better met by the
LRA regime than by even a comprehensive FTR regime. That was not a uniform
consensus, though. Some parties would prefer to wait for a more comprehensive intra-
island FTR regime, and Read (2009) points out that the LRA regime is not without its
own problems. First, it could create even worse localised market power problems than
an FTR market by automatically allocating FTR-like rental streams to incumbents
who may already have market power. Second, existing regional participants are rightly
concerned that they would face major risks if, having based their business on locating
generation near load, their load was now hedged to an island hub while their generation
was not. These are not reasons for rejecting an LRA based design, per se because both
problems could be overcome by applying LRA to net, rather than gross loads.
Equivalently, LRA could be applied to generation as well as consumption. This
would focus energy trading on the LRA hubs, and could provide an effective compro-
mise between the FNP/FTR paradigm, and the zonal paradigm employed in Australia,
for example. But there would be significant cost in switching to such a market design,
now that participants have established market positions based on the status quo. Thus,
while development of intra-island hedging is still on the agenda, the LRA proposal is
not being implemented at this time.
What is being implemented, though, is the inter-island FTR component of the
hybrid proposal, which most (but not all) agree will be beneficial. NZEA (2010)
discusses the background, and describes the original proposal, which has since been
modified by NZEA (2011a). Originally it was planned to hedge between island GWAP
hubs, because these would have desirable properties in terms of long term stability, and
13 Experience with FTRs and Related Concepts in Australia and New Zealand 311

form a suitable reference point for any future LRA regime.7 Thus encouraging trading
at those hub prices seemed desirable. However it has been decided to use the existing
trading hubs at the major North Island load centre of Auckland (Otahuhu, or OTA), and
the major South Island generation centre in the Waitaki valley (Benmore, or BEN). So
the planned “inter-island” FTR will not just hedge price differentials across the inter-
island HVDC link, but also across much of the North Island AC system. Even this
modest development is not without its conceptual difficulties and debates, though.
First, this is a hydro dominated system, with strong South–north flows in a wet year,
but similarly strong North–south flows in a dry year. This “tidal flow” situation also
implies that a conventional “obligation-inclusive” FTR will not fit the hedging
requirements of many parties. In a wet year, a typical South Island-based generator-
retailer will expect to be exporting power to the North Island, and want to hedge that
trade. In a dry year, the same party may expect to be importing power from the North
Island, and want to hedge that trade. Since inflow fluctuations are relatively unpredict-
able in New Zealand, and reservoirs are relatively small, the situation can change
rapidly, and a party wanting to hedge more than a few months ahead is likely to want to
cover both situations. But that cannot be done using any combination of obligation-
inclusive FTRs. By buying an obligation-inclusive South–north FTR, a South Island
generator would implicitly be committing to have that amount of power available to
send north, even in a dry year, and that is exactly the kind of commitment that a hydro
generator cannot afford to take on. Aversion to downside risk may well imply that even
a net exporter would offer a negative price for export FTRs on that basis. Thus it has
been decided that the market will include option FTRs from the beginning.
Second, there has been significant debate as to whether hedging should only cover
the congestion component of differentials or also include either the loss rental compo-
nent, or the entire inter-hub price differential (including loss costs as well). While some
have argued that loss costs and/or rentals are relatively small and stable, and need not
be covered, this is not actually the case. Hume (2009) reports that average transmission
system loses are only 3.7 %, but Fig. 9 in that paper implies instantaneous marginal
losses as high as 45 %, from one end of the transmission system to the other, and 35 %
between OTA and BEN, with the direction of the differential reversing due to tidal
flows. Monthly average loss differentials are lower, but loss-induced price differentials
also reflect the fact that losses must be (implicitly) bought in from a highly volatile spot
market, as may be seen from Fig. 13.1 in NZEA (2011b).
Figure 13.1 above shows that, while the average loss-induced price differential
may be only $1.28/MWh, from south to north, it swings from +$12/MWh down
to
$58/MWh over the period sampled, and accounts for a significant proportion of
the volatility in inter-island price differentials. After much debate, it has been decided
that inter-island FTRs will cover the full price differential, including the loss cost and

7
By construction (in a lossless system), the intra-island rents are just sufficient to hedge between
GWAP and the Load Weighted Average Price (LWAP), and hence to hedge all loads to GWAP.
312 E.G. Read and P.R. Jackson

60
Wet/North Flow

40

20

0
$/MWh

–20

–40

–60 Congestion

HVDC Risk/Reserve
–80
Loss
Dry/South Flow
–100
Jan 2008
Feb 2008
Mar 2008
Apr 2008
May 2008
Jun 2008
Jul 2008
Aug 2008
Sep 2008
Oct 2008
Nov 2008
Dec 2008
Jan 2009
Feb 2009
Mar 2009
Apr 2009
May 2009
Jun 2009
Jul 2009
Aug 2009
Sep 2009
Oct 2009
Nov 2009
Dec 2009
Jan 2010
Feb 2010
Mar 2010
Apr 2010
Fig. 13.1 OTA-BEN price differential components, by month (Source: NZEA 2011b)

rental components.8 This allows an obligation-inclusive FTR to be expressed as a

symmetrical “swap” contract similar to those which participants might enter into
between themselves, thus hopefully facilitating integration with the energy hedge
market trading regime, and boosting its liquidity.
Third, inter-island HVDC flows are often not constrained by a lack of link capacity,
per se, but by a relative shortage of (economic) instantaneous reserve to cover link
failure, in the receiving island. This is a major issue in a small system. At low to
moderate transfer levels the HVDC can normally cover its own reserve requirements,
by flows “failing-over” from one pole to the other,9 leaving a residual requirement that
is often less than the size of the largest unit operating in the receiving island. Beyond
that “self support” transfer level, though, the energy/reserve co-optimisation model
described by Read (2010) implies that the inter-island price differential will be set by
the marginal cost of reserve provision, that is the reserve market clearing price, plus
marginal losses, even when no “congestion” occurs. Figure 13.1 shows that this
accounts for a major part of the risk faced by inter-island traders, and cannot be
ignored by the hedging regime.
Covering price differentials due to losses and reserve support requirements has
major implications for FTR revenue adequacy. In both cases, there is not really a
binding capacity limit on which rents are generated, but rather an interaction between a
supply curve for loss/reserve, and a demand curve implied by the inter-island differ-
ence in energy price offers. In both cases, the rent will be less than that required to

8
Note that alternatives, such as covering only congestion costs, or loss rents but not loss costs,
would require us to calculate what those components actually were. But this could be done, as for
the LRA proposal.
9
The high inter-island differentials shown in Fig. 13.1 are partly due to this facility being
unavailable, with one pole out of service. Commissioning of a replacement will restore that
facility, but also greatly increase capacity. So, while inter-island flow limits will occur less
often, the proportion caused by congestion will most likely fall too.
13 Experience with FTRs and Related Concepts in Australia and New Zealand 313

hedge the observed flow, because loss and/or reserve support costs for that flow
must be covered. The loss cost is well defined by the need to buy energy to cover a
piece-wise linear loss curve, but the reserve support situation is less clear. The rent
generated by the inter-island price differential is not attributable to any constraint in the
transmission system, and not necessarily available for hedging trades across the
transmission system. With energy/reserve co-optimisation all reserve suppliers are
paid the market clearing price. If every MW of transfer, above the self support level,
required a MW of reserve support to be paid for from the inter-island settlement
account, then market participants would logically be looking to the reserve suppliers
(rather than to the transmission system owner) to provide hedging for those flows, out
of the rents implied by the difference between the market clearing reserve price, and
the offered supply curve (or actual cost of provision.)10
In practice, the situation is much less severe. First, there will be no reserve–induced
price differential so long as flows are below the self-support level. Second, the inter-
island transfer account should at least be assigned the rents corresponding to its self-
support level when flows do exceed it. Third, the costs of reserve provision are not all
charged to the party setting the reserve requirement, but shared between all parties
whose potential breakdown is covered by the reserve. In any case, it could be argued
that the cost of HVDC reserve support should be recovered from the industry in the
same way as other transmission system costs. On that basis, the current proposal,
actually avoids the problem of paying for reserve support by not deducting them from
the inter-island settlement surplus.
A revenue adequacy issue remains, though, because the market settlement surplus
will not cover actual loss costs. Perhaps more importantly, loss/reserve effects imply
price differentials in every period, so some payout will always be required on the full
FTR volume, even when flows are below that volume, and rents are only generated on
that lower flow.11 The fact that these factors increase average payout requirements is
not really a problem, because the extra premium that participants are expected to pay
for loss/reserve-inclusive FTRs should more than cover the extra payments required,
on average. FTR purchasers are effectively pre-purchasing a volatile stream of loss/
reserve-induced energy costs that, if the FTRs did not cover them, would eventually
have to be made up from the spot market. The FTR issuer does face increased risk,
though.
Read and Miller (2011) argue that the FTR provider could cover its risk by using the
auction proceeds to contract forward for losses and/or reserve support to cover the FTR
volume issued, while Philpott (2011) suggests using a more general set of “unbalanced
FTRs” (including loss contracts). If contracts for both loss and reserve support were
bid into the FTR market-clearing auction, we would get a trade-off, now, between the
forward demand for FTRs and loss/reserve support contracts, mirroring the future spot

10
This situation differs from that for losses, where rents implied by the piece-wise linear “loss
requirement curve” remain in the market settlement surplus.
11
By way of contrast, the classic revenue adequacy result rests on the assumption that price
differentials only arise when a constraint binds, at which time it will generate enough rent to cover
any FTR up to the binding limit.
314 E.G. Read and P.R. Jackson

market trade-off between the demand for inter-island transfer and the cost of losses and
reserve support. Studies conducted for the NZEA have confirmed that such contracts
could increase the volume of FTRs that can be offered without undue risk of scaling
due to revenue adequacy problems. Concerns have been raised about having the FTR
manager take an active role in other hedging markets, though. So, initially, it is planned
to scale back FTR offerings to levels at which revenue adequacy should not normally
be a problem, and then also scale back FTR payouts if necessary.
Finally, the issue arises as to what rent can legitimately be taken to support FTRs
that are only available between a limited set of hubs. Of course, standard revenue
adequacy results also apply to this limited FTR offering, and it has been argued that all
network rents should be left in the FTR support pool, in order to maximise FTR
firmness. But it is also clear that line capacity over which flows between the FTR hubs
cannot pass could be removed from the network without affecting the FTR revenue
adequacy test. It is not obvious why rents generated on the South Island AC system, for
example, should be used to support an inter-island hedging product for trades that do
not utilise any part of the South Island AC network. These rents also provide an
approximate form of hedging with respect to intra-regional price differences, in their
current form, and would be required to form the basis of any future intra-regional
hedging regime. Thus, while all parties will receive what are effectively ARRs
corresponding to their share of the rents used to support FTRs, some parties currently
receiving rents generated on capacity not required to support FTRs wish to continue
receiving those rents, pending further intra-regional hedging developments.
Thus only rents generated on what might be termed the “FTR support grid” will be
available to support FTRs, with the remainder being passed though to existing
recipients, as described by Miller and Read (2011). The FTR support grid does not
consist of a set of assets but, for each line, we take the rent generated by flows lying
between the maximum flows implied by possible inter-hub flow patterns in the forward
and reverse directions. Congestion rents are only generated when the line is fully
utilised in the actual dispatch, and the FTR support rent is taken to be the FTR support
capacity times the shadow price on line capacity. A similar calculation is performed for
“security constraints” involving multiple line flow variables. The calculation is
extended to apportion the loss rent implicit in the market settlement surplus between
inter-island and intra-island pools. That loss rental is generated by the shadow prices
on the loss tranches of the piece-wise linear representation. The market clearing
software does not report those shadow prices, but they can be inferred from the
solution, because the marginal cost of having to utilise a higher loss tranche is just
the cost of buying in more power at nodal energy prices. Thus it is possible to perform a
line by line calculation of loss rents generated, and to partition them using the same set
of extreme FTR flows used to partition congestion rents.12

12
Binding line limits and (on a much smaller scale) loss tranche limits both generate similar
pricing effects, inducing (positive or negative) rents to be collected on all lines in all loops in
which that line is involved. But what matters, for revenue adequacy of the inter-island FTR, is to
partition rents according to flows on lines where rent is generated, not where it is collected.
13 Experience with FTRs and Related Concepts in Australia and New Zealand 315

While NZEA (2011a) describes the Code changes required to implement the
arrangements above, the Code focuses more on securing the rental streams required
to develop the market, than on the market design itself. Many details remain to be
determined by the FTR market manager, in consultation with the Electricity Authority
and participants. Thus the final shape of the market may depend significantly on the
choice of FTR manager. To some, it seems natural that the FTR market manager
should be associated with the transmission system owner and/or system operator, since
they are experts on the capabilities of the transmission system. To others, it seems more
natural for the FTR market manager to be associated with an existing operator of hedge
markets, since they are experts on the design of financial products, and better placed to
integrate FTRs into the overall financial market framework.13 Whatever manager is
chosen, though, the market will initially provide Southward and Northward obligation-
inclusive and option FTRs, in monthly blocks, over a time horizon progressively
extending out to 2 years. Further developments could include adding further hubs,
reserve/loss support contracting,14 facilitation of secondary trading, or differentiation
of hedge products by degree of “balance” (as suggested by Philpott (2011)) or target
“firmness” (as suggested by Read and Miller (2011)). But such developments are
contingent on the success of the initial market arrangements, which has yet to be
demonstrated.

13.4 The Australian Market Context

“The Australian National Electricity Market” (NEM) was initially operated by the
National Electricity Market Management Company (NEMMCO), whose operations
were subsequently merged into the Australian Electricity Market Operator (AEMO).
The Australian Electricity Market Commission (AEMC) is responsible for policy
development. Although developed soon after, using a version of the same software,
the Australian market has quite a different structure from that in New Zealand, being
organised into regions corresponding to the States. The reasons for this are not just
historical or political. Each state is centred on a major population centre, and there has
historically been little development, and hence network complexity, close to state

13
This is an important issue in a small market, where fragmentation of trading platforms increases
the difficulty of achieving desirable liquidity on any one platform. Conversely, Fig. 13.1 suggests
that accurate modeling of possible congestion limits probably has less practical impact on revenue
adequacy than dealing with the loss and reserve costs issues. Read and Miller (2011) point out that,
for a small number of hubs, the FTR feasible region could be represented as the set of all possible
convex combinations of the extreme inter-hub flow patterns used to determine the rents available
for FTR support. (For the initial two hubs, this only involves the maximum forward/reverse flows
between them). Given a set of extreme flows determined by the System Operator, the FTR
manager could actually clear the FTR market without any direct knowledge of the transmission
system at all.
14
Possibly via an integrated auction somewhat similar to that proposed by O’Neill et al. (2002).
316 E.G. Read and P.R. Jackson

borders.15 The NEM initially covered the states of South Australia (SA), Victoria
(VIC), New South Wales (NSW) and Queensland (QLD), although the last was not
physically interconnected for some years after market start. Tasmania (TAS) subse-
quently joined the NEM, once it was connected to the mainland by HVDC cable.
Market prices are calculated every 5 min, but summed to form half hourly prices.
All participants in a particular region face essentially the same “regional reference
price”, which is calculated as the marginal cost of supply to the major regional load
centre, plus or minus a node-specific intra-regional loss factor, which is fixed annually.
Commercially, the NEM operates as if there were “notional interconnectors” linking
these regional reference nodes into a “tree” structure, with no loops.16 A piece-wise
linear loss function is calculated for each notional interconnector, by varying injection/
extraction at its source/sink under typical conditions.17
The physical transmission network does not exactly match the structure assumed
for commercial trading purposes, though. Thus NEMDE18 imposes constraints to
ensure that generator dispatch is actually feasible, given the loads and network
capacity available. But NEMDE cannot impose constraints on line flow variables,
because it does not contain a nodal model of the network, and hence of inter-nodal
flows. Instead, off-line studies have been used to create a large library containing
several thousand constraints that might need to be applied under particular load and
network conditions. In canonical LP form, the “Left Hand Side” (LHS) of each
constraint is an algebraic sum of interconnector flow and generator output terms,
each weighted by what we will call a “Constraint Participation Factor” (CPF), while
the RHS is a constant determined by the load/network conditions at the time.19
X X
CPFik  xi  RHSk ¼
CPFik  xi (13.1)
i2Variablesk i2Constantsk

These constraints are thus like the “generic” or “security” constraints often overlaid
on the basic network constraint structure in nodal models such as that of Alvey et al.
(1998). Initially, NEMDE constraints were expressed in a variety of ways, often
inherited from pre-market regional system operators. But CRA (2003a) showed that,
while a wide variety of constraint forms may achieve the same physical dispatch

15
One major exception relates to the Snowy Mountains hydro-electric development, which lies in
New South Wales, but close to the Victorian border, and which until recently formed a region of its
own (SNY).
16
South Australia, Victoria, New South Wales and Queensland form a chain, with the island of
Tasmania linked to Victoria.
17
Thus zero cross-border flow does not generally imply minimum losses, or zero marginal loss.
18
NEMDE is now the NEM market clearing engine, replacing a version of SPD.
19
We have expressed that RHS constant as a linear combination of terms, and multiplied by
1, so
as to facilitate discussion of a general pricing/hedging framework in Sect. 13.6.
13 Experience with FTRs and Related Concepts in Australia and New Zealand 317

outcome, the correct pricing outcome will only result if all constraints are consistently
“oriented” toward regional reference nodes.20 Thus, constraints derived in other ways
have been progressively “re-oriented”.21 Once expressed in this form, these constraints
play a fundamental role in providing a consistent theoretical framework for both intra-
regional “access” and inter-regional hedging in a zonal market. Before discussing that
framework, though, we describe current hedging arrangements in Australia.

13.5 The Current Australian Locational Hedging Framework

In a sense, intra-regional hedging is a non-issue in a zonal market. Provided a generator

is dispatched, it faces no price risk if contracting to sell at its own regional reference
price, because it will be paid that price, adjusted by a known loss factor. This is most
often the case, because regional networks have been developed in such a way as to
make intra-regional congestion relatively rare. When it does occur, though, it is
obviously not possible to dispatch all generators that wish to be dispatched at the
regional reference price. Thus they face a volume risk that may be described as
creating a “firm access problem”. Despite years of debate, work to resolve that problem
is still ongoing. But some of the approaches to resolve it are discussed below because
they effectively amount to exposing the participants involved to a form of nodal
pricing, and issuing them with instruments which, in combination with the regional
pricing arrangements, are effectively FTRs from their location to their regional
reference node.
The basic theoretical framework of inter-regional hedging in Australia was
established in a series of papers prepared by Putnam Hayes and Bartlett, including
PHB (1997). As an independent market/system operator, with no transmission asset
base, NEMMCO did not consider it appropriate to enter the business of issuing, or
operating markets in, financial instruments of any kind, including FTRs. Conversely,
by that stage, financial intermediaries were already developing some expertise in
creating financial instruments, or deals, to meet the hedging needs of participants.
Without access to the market settlements surplus, those deals were partially under-
pinned by offsetting swaps by parties wishing to trade in opposite directions, but also
involved some risk-taking by the issuing parties themselves. As a result, some parties
actually opposed the introduction of an FTR-type regime, because they believed that
the evidence showed that the sector’s inter-regional hedging requirements could be
met without access to the market settlements surplus. This theme has re-surfaced in
recent New Zealand debates, and it has been an ongoing challenge to convince some

20
In brief, this means that the participation factors referred to above must correspond to the
increase in the constraint LHS (e.g. the flow over a constrained line) if a notional 1 MW flow were
sent from the generator in question to the regional reference node. For simple line flow limits, these
CPFs are just PTDF’s using the regional reference node as “swing bus”.
21
This can be done by using regional energy balance equation(s) to substitute out for injection at
the regional reference node(s).
318 E.G. Read and P.R. Jackson

that, without such access, a swap market must either be perfectly balanced (thus
supporting a net inter-regional transfer of zero), or expose issuers to significant risk.
Having established that point, though, the design philosophy was not to “establish
an FTR market”, per se, but to make the “Inter-Regional Settlements Residue”
(IRSR)22 available to competing providers of inter-regional hedging products. It was
deemed inappropriate, in this relatively small national market, to divert liquidity away
from existing financial markets, or to create a competing “financial institution”. So the
goal was to foster liquidity in existing markets, and allow existing financial institutions
to use their financial market expertise to provide participants with integrated hedging
products, based on the IRSR, swaps or other instruments, to best cover the risks they
faced in those markets.
To operationalize hedging based on the IRSR, proportional bundles of inter-
regional rents are defined, such as “x% of the rents from NSW to Victoria, when
flow is in that direction” and auctioned as non-firm units in the Settlement Residue
Auction (SRA). The rents are determined by subtracting the value of export flows,
at the exporting region’s reference price, from the value of import at the importing
region’s reference price. Import/export flows are calculated from modeled
interconnector flows, using (annually) fixed proportions to apportion interconnector
losses to each regional reference node. Thus the calculation accounts for the cost of
interconnector losses, as well as the pricing impact of marginal losses, and all
constraints affecting inter-regional price differentials. Inasmuch as they are propor-
tional, these IRSR bundles are somewhat similar to the “shareholdings” of Read
(1989), or the Auction Revenue Rights available in some US markets. If the transmis-
sion system really did match the NEM market design, with no loops linking regions,
they would also be similar to (financial) “Flow Gate Rights” (FGRs) of the type
discussed by Chao et al. (2000). In reality, though, two complications arise.
First, the Australian market allows Market Network Service Providers (MNSPs) to
develop and operate “controllable” links whose capacity is offered into the market to
transport power between regions, at a price. Such MNSPs will operate when (after
adjustment for MNSP losses) capacity is offered at less than the inter-regional price
difference, and will collect rents when doing so. That rent does not form part of the
IRSR, though, and is only available for hedging purposes if the MNSP owners choose
to make it available to participants through their own market arrangements.23 Three
such (HVDC) links were actually developed, and two of those operated, to some
extent, in parallel to “regulated” interconnectors joining NEM regions. But Mountain
and Swier (2003) report that they have struggled to compete, and the only MNSP still
operating is the HVDC link between Tasmania and Victoria, which was built at the
instigation of, and is effectively controlled by, the dominant state-owned generator in
Tasmania. We understand that, by default, the dominant generator currently retains the

22
Initially known as “Inter-Regional Settlements Surplus” (IRSS), but later changed to “Inter-
Regional Settlements Residue” (IRSR) because it is not always positive.
23
The SRA auction makes no provision for inclusion of MNSP rentals in the auction process.
13 Experience with FTRs and Related Concepts in Australia and New Zealand 319

entire IRSR (and thus effectively FTRs) for both import and export over that link.
Tasmanian market arrangements are currently under review, though.
Second, inter-regional flows will typically be limited by constraints that are more
complex than simple bounds on a single interconnector flow. And that means that the
flow between any pair of regions can be effectively limited by any generator output,
load, or other inter-regional flow that appears in any binding constraint in which it
appears. CRA (2003b) analysed the pricing impacts of such constraints and concluded
that they can create a significant misalignment between physical flows, which
NEMDE optimises for actual network conditions, and the flows that might appear to
be optimal in the simplified NEM market model. And that means that the rents
collected on particular links may not match the hedging requirements of participants
particularly well, either.24
The auction design incorporates an extended price discovery process, in which no
party can “corner the market”. Initially, 25 % of the rent bundles for a particular quarter
were released four quarters in advance, then another 25 % three quarters in advance,
and so on.25 That process has since been progressively extended to include 12 quarterly
auctions spanning 3 years, each releasing 1/12th of the available units, defined in terms
of a notional interconnector capacity.26 Bids for SRA units may be submitted for each
particular connector/quarter or, within the same quarterly auction, as linked bids
defining a set of interconnector/quarter combinations.27 The SRA process is open to
standalone generators, integrated generator-retailers, and traders, with each group
accounting for about one third of purchases. There are 30 parties currently registered,
and 17 active in recent auctions, with current annual turnover of approximately
$120 m.
The SRA process commenced in 1999, and there have been various modifications
to interconnector specifications since then, due to upgrades to interconnector capacity,

24
In extreme cases power may actually flow across a border in a direction opposite to the price
difference, causing the IRSR to be negative. Originally, negative residues were offset against
positive residues within the same weekly sub-period, so SRA units could have negative values.
Recently this has been changed so that SRA units always have positive payouts, with any revenue
shortfall due to counter-price flow being effectively subtracted from the auction proceeds passed
through to TNSPs.
25
The proceeds of these auctions are deemed to belong to the parties providing the underlying
network capacity. However, the regulatory regime operates in such a way that those parties
effectively have no financial interest in the auction or IRSR outcomes, and are not therefore
incentivized to either provide, or withhold, capacity. Read (2008) suggests a regime that would
partially expose transmission providers to the outcome, with the aim of incentivizing maximum
economic capacity availability, but that suggestion has not been pursued further.
26
In theory, there is provision to carry unsold units forward to the following auction, but this does
not happen because units have unambiguously positive value, and always sell. Since the auction
process makes no provision for resale of units, the quantity available in each auction is constant for
each interconnector/direction.
27
Linked bids that are accepted are charged the sum of the individual component prices that
comprise the bid. But we understand this facility is seldom, if ever, used.
320 E.G. Read and P.R. Jackson

Table 13.1 Settlement residue auction statistics (Source: AEMO 2010, 2011)a
Payout: unit cost ratio
Quarters SRA share Average Standard deviation Hedge effectivenessb
Q1 45.93 % 1.42 0.60 – –
Q2 14.77 % 1.79 2.31 – –
Q3 17.57 % 0.99 0.51 – –
Q4 21.72 % 2.31 2.49 – –
Interconnectors Beta R2
SAVIC 3.03 % 0.99 1.52 0.167 0.077
VICSA 22.55 % 1.42 1.58 0.517 0.991
VICNSW 32.69 % 2.00 3.21 0.329 0.943
NSWVIC 20.69 % 0.84 1.18 0.206 0.713
NSWQLD 3.68 % 1.09 3.11 0.202 0.871
QLDNSW 17.36 % 2.13 2.82 0.489 0.579
Aggregate 100.00 % 1.59
a
The data here is aggregated for both directions, over the entire market history, and includes
changes in interconnector capacity, and unit definition. For the years over which the market
included a SNY region, the VI-SNY and SNY-NSW interconnector results have been aggregated
to represent a notional VIC-NSW interconnector
b
Although the SRA’s fractional share of rents is linear, R2 has been calibrated using the total sum
of squares from an affine approximation of the relationship

absorption of previously MNSP links, and changes to the NEM regional structure.28
There have also been two periods during which the characteristics of SRA units
changed: First, as a result of modification of the charging regime to re-balance rents
between generators in the SNY region and the SNY-NSW interconnector during the
2005–2007 CSP/CSC trial described later; Second, to eliminate negative settlement
residues, after 2010. Both changes were motivated by a desire to increase SRA unit
firmness, and that should have thus increased their value, but neither has (yet) operated
for long enough to form a judgement about actual impact on auction values. We are,
however, able to reach some broad conclusions from the full set of SRA proceeds and
payouts, as in Table 13.1. As expected, both total and per unit values vary significantly
between interconnectors, and between quarters. There is a strong seasonal pattern,
with most value arising in Q4 (Oct–Dec), and particularly Q1 (Jan–Mar), when
Australia’s summer peak in electricity demand occurs, with highly variable returns
as a result of “summer” events occurring in late Q4, or early Q2.
These auction results, and residues, align well with expectations based on
the physical characteristics of the system. Alignment with theoretical expectations
relating to risk management, is another issue. Assuming that auction participants are
risk averse, and that SRA units assist market participants by reducing the risks they
would otherwise face as a result of inter-regional trading activities, we would expect to
see SRA units sold at a premium to their expected value. At least, since speculators are
allowed to trade, we would expect competition to set a floor on unit prices not too far

28
Queensland was added in 2001, shortly after the scheme commenced, and the Snowy region
incorporated into New South Wales in 2008.
13 Experience with FTRs and Related Concepts in Australia and New Zealand 321

below their expected payout value. But the data in Table 13.1 does not really support
that hypothesis. Rather than paying a premium for risk, in aggregate purchasers of
SRA units have only paid 63 % of their actual value, as it has turned out.
This result is not explained by the time value of money. Even when units are
“purchased” 3 years in advance, the auction payment is not required until the quarter to
which the units actually apply. Nor does it seem to be explained by learning effects.
Even if the market only involved pure speculators, we might expect that the price
discovery process would tend to converge, so as to better reflect actual settlement
residues as more information becomes available in later auctions, with lower prices
reflecting significant uncertainty for units auctioned well in advance, and later auctions
clearing at something closer to actual payouts. But detailed examination of the data
reveals no such trend. At a broader level, we might also expect that discounts would
have reduced over the years, as the market learned the true value of units. But this is not
the case, either. The market appeared to be in approximate equilibrium after 3 years,
with cumulative revenue approximately matching cumulative payouts, to that point.
But there appears to have been a consistent discrepancy since then.
It is often suggested that SRA units are being sold at a discount because they are
“not firm”. AEMO (2011) attributes this lack of firmness to network outages, implicit
limitations on interconnector flow arising from the dispatch process, and flow reversals
within pricing periods. Loss effects also have a pervasive impact, as discussed below.
Based on accumulated quarterly price differences reported in AEMO (2010), settle-
ment residues could only support FTRS for about 39 % of nominal link capacity on a
firm basis over the period considered.29 But this does not really explain the large
observed discount to expectation. Figure 13.2 reveals that, while speculators face a
significant probability of making a loss on units for any particular interconnector/
quarter, the probability of making a loss on investment in a spread of interconnector
auctions is only 47 %, and this is strongly outweighed by the size of the profits made
when rents are high.
From an electricity market participant’s perspective, though, the issue is not the
variability of the SRA unit payout, but the correlation of that payout with their inter-
regional trading risks. Even though electricity market participants would obviously
pay a higher premium for firmer instruments, theory suggests that they should be
prepared to pay some premium for any instrument whose payout is positively
correlated with their inter-regional trading risks. We understand, anecdotally, that
some participants in the SRA process do behave in ways that suggest they are hedging
changes in their portfolio trading positions. But the fact that SRA units are consistently
sold at significant discounts suggests that NEM participants do not see the SRA as
providing a particularly effective risk management tool. Our analysis of the data
suggests that the apparent “lack of firmness” may be over-stated, though.
Figure 13.3 plots actual settlement residue against a full hedging requirement, as
defined by accumulated inter-regional price differentials, both on a per MW basis, for

29
Even if the transmission system was 100 % firm, rents should only cover half the (loss-induced)
inter-regional differential in periods with no congestion.
322 E.G. Read and P.R. Jackson

Cumulative Probability
1.0 Payout=Unit Cost

0.8

0.6 Overall
VICNSW
NSWQLD
0.4

0.2

Payout Ratio
2 4 6 8 10

Fig. 13.2 Cumulative payout ratio distribution for selected interconnectors (Source: AEMO
2011). This figure has been constructed by weighting interconnector/quarter results by the
$ value of auctioned units, so as to represent consistent pdfs of the payout ratio per $ invested

Available
Settlement
Residue
30,000
NSWQLD(X)
25,000 QLDNSW( )

20,000

15,000

10,000

5,000
Full Hedging
0 Requirement
0 20,000 40,000 60,000 80,000

Fig. 13.3 Hedging performance and firmness for selected interconnectors (Source: AEMO 2010, 2011)

some sample interconnectors, and shows “best fit” rays through that data.30 Table 13.1
reports β, the estimated ratio of the settlement residue to full hedging requirements,
and R2, the proportion of variation explained by the rays fitted, for all interconnectors.
Ideally, the correlation would be perfect, and this data would form diagonal lines with
β ¼ 1, and R2 ¼ 1. In reality β, is significantly less than unity for all interconnectors,

30
Better fits could be obtained for lines that did not pass through the origin. But such lines do not
represent the hedging available from an auction of proportional rental shares.
13 Experience with FTRs and Related Concepts in Australia and New Zealand 323

reflecting an inability for the SRA process to fully hedge the nominal interconnector
capacity. The degree of firmness varies significantly though.
For example, the VIC-SA interconnector has β ¼ 0.517, and R2 ¼ 0.991, in that
direction. Thus it can only support hedging of approximately 52 % of its nominal
interconnector capacity. This may be due to loss effects,31 or it may be that effective
inter-regional capacity is really much less than cross-border capacity, once intra-
regional flow requirements are accounted for. But the hedging it does provide on
that 52 % is actually quite “firm”. Thus a participant can quite effectively cover its
trading exposure by buying two SRA units for every MW of exposure. The fact that the
hedging available is (fairly) firm, but that the quantity available is only half the
nominal capacity, should really drive SRA unit prices up, not down.
In the reverse direction, though, (i.e. for SA-VIC) we only have β ¼ 0.167, and
R2 ¼ 0.077. Thus this link cannot reliably support hedging on even 17 % of nominal
interconnector capacity in that direction. This kind of situation typically occurs where
interconnector flows must compete with each other, or with variable intra-regional
flow requirements, for capacity on congested lines. Thus it is not possible to support
hedging up to the nominal capacity of each interconnector, simultaneously, because
the transmission system cannot simultaneously support flows up to that level, and the
proportion assigned to any particular interconnector depends on the dispatch of the
day. Proposals to improve hedging performance in that situation are discussed in
the next section.

13.6 Possible Developments in Australia

The NEM design, and the SRA process, would match reality if the interconnectors
really did link regions into an unlooped tree, and congestion could only occur on those
interconnectors. But that is not the case, and the market must somehow deal with the
real congestion issues, which affect market outcomes in ways that are not always
obvious. Three situations have caused particular concern: The inability of the market
to provide generators with “firm access” to sell all their output at their own regional
reference node; The way in which network constraints interact to cause IRSR accounts
to be non-firm even when the underlying transmission capacity is firm; And the way in
which “counter-price flows” can make the IRSR negative.
These issues have been considered more than once, and another review is currently
underway (AEMC (2011)). It has been suggested that some of these issues could be
dealt with by devices such as constrained on/off payments, or network support
contracts, which are already provided for in the NEM code, but seldom used. Another

31
Quadratic losses imply that rents will only cover half the (loss-induced) inter-regional
differentials on the actual flow, when flow is unconstrained. This may not matter much because
differentials are typically low in such situations. Unlike the congested situation, though, flow
volume in such periods is essentially what participants, in aggregate, have decided they want it to
be. Thus the ratio reported here will be under-stated because true “hedging requirements” may be
significantly less than nominal interconnector capacity, and maybe close to actual flows.
324 E.G. Read and P.R. Jackson

possibility is that all of these problems could be resolved, using FTRs in a nodal pricing
framework. In fact, the original NEM design included a rule that required new regions
to be created once congestion on any constraint reached some quite low threshold. If
applied, this would have progressively moved the market toward something like nodal
pricing. It never has been applied, though, partly because it was shown that a large
number of regions might have to be created to capture the pricing impacts of a single
constraint arising in a loop. Thus, in a study conducted for the Ministerial Council on
Energy (MCE), CRA (2004a, c) considered a range of alternative proposals, including
full nodal pricing, and “generator nodal pricing” (GNP), under which nodal prices
would be averaged into zones for loads.
Naturally, such proposals will always be opposed by generators whose price is
expected to drop, and by loads whose prices are expected to rise. But it should also be
said that successive studies referenced in AEMC (2008) suggest that intra-regional
congestion has only had a modest impact on efficiency (perhaps 0.5 %), making it
difficult to justify radical change. In that context CRA (2004c) proposed an intermedi-
ate alternative, which allowed participants to be selectively exposed to a form of nodal
pricing, but provided with FTR-like instruments to hedge the risk implied by that
exposure. That framework was based on the earlier proposal of CRA (2003b) for
NEMMCO, to use a combination of price and contract mechanisms to incentivise
participants to support an agreed level of interconnector flow, while, at the same time,
firming up the corresponding IRSR account. Read (2008) later generalised the frame-
work for the AEMC so as to include load, network capacity, and ancillary service
providers, as well as interconnectors and generators. Before discussing its potential
application to various NEM situations, we will describe the framework in this general
form.
In NEMDE, only the generator and interconnector terms appear on the LHS of any
generic constraint, with load, ancillary service and intra-regional network capacity
terms combining to form the RHS constant, as in (1).32 The generalised framework
accepts that formulation, but introduces a conceptual distinction between terms (and
hence parties) that are “exposed” to the price impact of the constraint, and therefore
face price risk, and terms that are “protected” by an implicitly assigned “dispatch
matching” hedge. In general, there is no reason why variable terms may not be
“protected”, or fixed terms “exposed”. So, denoting “protected RHS capacity” as
PRHSC, we can re-arrange equation (13.1) as:
X X
CPFik  xi  PRHSCk ¼
CPFik  xi (13.2)
i2EXPOSEDk i2PROTECTEDk

Given a Constraint Shadow Price (CSP) for each NEMDE equation, each market
design can be expressed in terms of exposing a particular subset of the parties
represented in constraint form (13.1) to the CSP on a particular subset of constraints.

32
In reality, other terms, such as the inertia of generating units assumed or observed to be running,
may affect the RHS, but that complication will be ignored.
13 Experience with FTRs and Related Concepts in Australia and New Zealand 325

For example, if we expose a participant (generator or load) at node i to the pricing

impact of constraints k ¼ 1,. . .K, they will pay, or be paid, this CSP component in
addition to the regional reference price they already face for their net injection. This
effectively creates an Adjusted Nodal Price (ANP) of:
X
ANPi ¼ RRP
CPFik  CSPk (13.3)
k

Charging these prices to affected participants thus creates a limited form of nodal
pricing, in the context of a zonal market. It provides affected participants with the same
price signals they would see in a nodal market, at least with respect to adjusting
operations so as to respect the limits implied by key constraints. But it also creates a
hedging problem for those participants, if they wish to trade power with other parties
facing the regional reference price. If only generators are exposed, that would include
all intra-regional loads, since they are implicitly hedged to the regional reference node,
and inter-regional parties who purchase (IRSR based) inter-regional FTRs, to transport
power away from that node. So we introduce a Constraint Rental Right (CRR) which
gives the holder the right to call on the rents generated by a portion of the PRHSC of the
corresponding constraint, in form (13.2). Before accounting for any energy contracts,
the net market exposure of a participant injecting INJi, while holding a bundle of CRRs
for constraints k ¼ 1,. . .K, would be33:
X X
NetExpi ¼ INJi  ðRRP
ðCPFik  CSPk ÞÞ þ ðCRRik  CSPk Þ (13.4)
k k

If all parties, including transmission and ancillary service providers, were exposed
to CSP, all would appear on the LHS, and PRHSC ¼ 0, implying a net rental pool of
zero. In fact the total pool of rent available to support hedging is zero in all cases. But
each market design partitions that total pool differently, between implicit and explicit
hedging pools. The rental pool available for explicit hedging of exposed participants is
always determined by the PRHSC. But we can think of the protected terms making up
PRHSC, as being implicitly hedged, by what Read (2008) called Implicit Dispatch
Matching Allocation (IDMA). The market does not work this way, but it is as if
protected participants are always assigned, ex post, a CRR that exactly matches their
dispatch position, and so face no exposure to the pricing impact of this constraint at all.
But, since the entire hedging pool sums to zero, this hedging cannot have positive
value, in aggregate, to both “protected” and “exposed” parties. The aggregate rent
available to be paid to (or paid by) exposed parties is just the net available after
protecting the protected parties from constraint pricing effects. For example, in a nodal
market, both load and generation terms are exposed to the pricing impact of all
constraints, and the ANP defined above is just the nodal price. Transmission line

33
We have also defined them in fixed MW capacity terms, but assume that revenue adequacy is
dealt with by scaling, thus creating a problem with “firmness”.
326 E.G. Read and P.R. Jackson

capacity terms, on the other hand, are typically protected, in the sense that the
transmission service provider does not ultimately receive the rents generated on
those constraints, and so is not exposed to variability in the rent. This protection,
which has a negative expected value for the transmission service provider, allows the
rents to be used to support FTR hedging which is as firm as the transmission capacity
limits themselves.
CRR is defined in terms of constraint RHS units, but dividing by CPFik gives an
equivalent Participant Rental Right (PRR) defined in terms of MW injection at
node i. If a participant holds the same PRR quantity for each constraint in which
it is exposed, then minor re-arrangement shows that the PRR quantity is effectively
sold at RRP, with the remainder sold at ANP. That is:

NetExpi ¼ PRRi  RRP þ ðINJi
PRRi Þ ANPi (13.5)

In other words, the bundle of CRRs for all constraints in which a nodal injection is
involved effectively forms an FTR (for PRR MW) from that node to its reference node.
Similarly, a consistent bundle of CRRs for all constraints in which an interconnector
flow is involved effectively forms an FTR from its source to its sink. Together, these
FTRs form a complete hedging structure for the system, but how firm can they be?
In its simplest form, classic FTR theory states that the rental pool available for
hedging is just the rents on transmission capacity constraints, including any weighted
sum of line limits. If transmission is not exposed to CSP then these appear as part of the
PRHSC, and the rent available for generator/load hedging is just the rents generated by
the transmission system. So the FTR pool is as firm as the PRHSC defined by the
transmission system capacity. But ancillary service terms may appear in transmission
constraints, too, if ancillary service support can allow increased interconnector flows.
This may be implicit in the calculation of the constraint RHS, or explicit in the kind of
co-optimised market discussed by Read (2010). If those services are paid for by some
other means, e.g. as part of a regulated transmission system cost recovery regime, they
can be considered protected, and thus provide part of the PRHSC from which rent is
available for hedging by exposed participants. This will typically increase the FTR
hedging pool, but that pool will then be only as firm as the transmission capacity,
adjusted for whatever ancillary service support happens to be provided.
In a zonal market, by way of contrast, load and generation terms are not exposed to
the pricing impact of constraints, but are implicitly hedged to their own regional
reference prices. This means that the firmness of hedging available for interconnector
flows, which are the only terms exposed to CSP in that market design, is significantly
compromised. The PRHSC of each constraint in which an interconnector is involved
will depend on the pattern of load, generation and ancillary service levels, for each
party involved in that constraint, irrespective of whether these are treated as constants
determining the RHS of that LP constraint in each NEMDE LP run, or variables to be
optimised on the LHS. And this gives rise to what has been described in Australia as
“disorderly bidding”. For example, generators involved in binding constraints which
would, in a nodal market, imply a low nodal price, will bid very low so as to be
13 Experience with FTRs and Related Concepts in Australia and New Zealand 327

dispatched at a high level, knowing that they will be paid their own regional reference
price for whatever quantity they can be dispatched for. Equivalently, they know that,
simply by being dispatched, they will implicitly be granted (retrospective) CRR
transmission rights to cover that dispatch quantity. This obviously creates a conflict
with inter-regional flows, which do not share that privilege, but must instead purchase
what are effectively bundles of CRRs, representing whatever constraint capacity has
not been taken up by protected parties, from the IRSR pool.
These effects contribute significantly to the “lack of firmness” discussed in the
previous section, and can be characterised as creating a need for “interconnector
support”. In that context, CRA (2003b) proposed to selectively expose participants
in key constraints to the pricing impact of those constraints, and then contract with then
for “support” services. CSP was referred to then as a Constraint Support Price, while
CRRs were expressed in the form of Constraint Support Contracts (CSCs). CSCs could
be thought of as equivalent to a (financial) FGR with respect to a particular constraint.
As with any such right, a generator facing the CSP, in addition to its regional reference
price, would have first order incentives to increase or decrease generation in ways that
reduce congestion on that constraint. Risk aversion, and localised market power,34
mean that a party holding a CSC also has second order incentives to move dispatch
toward the CSC level.35 If the CSC level is set appropriately, this has the physical effect
of “supporting” interconnector flows, as well as the financial effect of creating a firmer
inter-regional settlement pool for hedging purposes. Effectively, the CSC quantity
becomes protected, and becomes part of the PRSHC. Similar incentives apply if other
parties, including transmission and/or ancillary service providers, are exposed to
congestion pricing, and contracted in a similar way.
In this context, it was envisaged that the overall deal required to induce parties to
behave in ways which increased net interconnector capacity would generally have
negative expected value for those parties, relative to the status quo, and so would need
to be paid for. In some cases exposure to CSP would have a negative impact, while the
CSC had a positive value. In other cases it could be the other way around. But increased
revenue should be available to make such payments, to the extent that parties buying
IRSR bundles value the increase in firm interconnector capacity. And generators
contracted in this way would also receive “firm access”, to deliver the CSC quantities
through the constraints to which they are exposed to the regional reference node. Thus
CSCs are effectively financial FGRs with respect to particular constraints. If all
generators were exposed to CSP for all constraints, though, we would effectively
have GNP.
CSCs would have positive or negative value to a generator, depending on whether
its ANP was typically above or below the regional reference price. But their firmness

34
Which can be very important in some of these constrained situations where a single generator
may act as a “gatekeeper” determining effective interconnector flow capacity.
35
CSCs held with respect to various constraints might imply different preferred generation levels,
and conflicting second order incentives, if those constraints bind simultaneously. But participants
are free to target a dispatch level that makes an appropriate trade-off, given the relative prices
involved on any occasion.
328 E.G. Read and P.R. Jackson

would still be limited, so long as loads were not exposed to constraint pricing. Thus, in
a GNP regime, the rents available to support hedging with respect to a transmission
constraint are not as firm as the transmission capacity of that constraint, but as variable
as the transmission capacity minus the weighted sum of load levels defining the
PRHSC. Although that may not be very firm, it is really the upper limit on firm hedging
that can be provided for generators in such a market. Firmer hedging can be provided to
generators, but only at the expense of exposing loads to constraint pricing, and
requiring them, too, to protect themselves explicitly with FGRs or FTRs.
Exposing loads to constraint pricing effects has not found general favour in
Australia, but the framework has been extended to deal with issues arising out of
interactions between interconnector flows. In reality, power does not flow from one
region to another over a single piece of wire. Cross border flows may occur at several
points, and interconnector flows between several regions may be involved in some of
the same loop flow constraints. Under the status quo, the IRSR pool available for each
notional interconnector is effectively determined by the flow NEMDE dispatches on
that interconnector, which is determined by the dispatch position generators using that
interconnector are able to achieve. Conversely, the rental pool available to support
hedging on each interconnector, with respect to a constraint, is the RHS of that
constraint minus all ancillary service, load, generation, and other interconnector
terms involved in that constraint, at whatever dispatch level they happen to achieve.
Understandably, that can imply significant variability in the IRSR bundle available to
each interconnector.
CRA (2004b) proposed to resolve this problem by assigning each interconnector a
CSC corresponding to a defined share of the constraint RHS capacity. Suppose CSCs
were assigned to proportionally partition PRHSC capacity between multiple
interconnectors involved in a common constraint. Then rents collected on any
interconnector from flows above its CSC level would be paid into a common pool,
and re-assigned to interconnectors whose flows were below their CSC levels. The
effect would be to make the IRSR pool available to each interconnector involved as
firm as the PRHSC. Under the status quo, generator terms are protected, so the PRHSC
available for interconnector hedging would still vary significantly, as generator
dispatch varied. But if all generator terms were exposed to constraint pricing effects
the joint hedging pool available for interconnector and generator hedging would be as
firm as the RHS capacity of the NEMDE constraint (i.e. the transmission capacity
adjusted for load and ancillary service terms.)
Biggar (2006) proposed a more comprehensive framework in which CRRs would
be defined, and traded, for every possible constraint. Read (2008) describes that
approach in terms of the CSP/CRR framework, but argues that it would be impractical
since there were, at that time, over 12,500 possible constraints in the NEM.36 Thus an
FNP/FTR framework was considered preferable, if a comprehensive NEM wide
locational pricing/hedging regime was thought to be worthwhile. What CRA

36
In an appendix, CRA also argues that there are conceptual errors in the Biggar paper, and in its
critique of earlier work by CRA.
13 Experience with FTRs and Related Concepts in Australia and New Zealand 329

(2004c) actually recommended, though, was to leave the NEM regional market
structure largely intact, while using the CSP/CRR approach to deal with situations
arising around congestion on critical constraints which might not be severe enough, or
expected to persist for long enough, to justify a change to regional boundaries. When
applied in this way, the CSP/CRR framework can be compared with a “financial”
(rather than physical) application of the FGR framework of Chao et al. (2000). But it
was developed in the context of a zonal market, and thus relates to an old proposal of
Stoft (1998). When applied to inter-regional flows, it is similar to the approach adopted
in the Texas market before introduction of full nodal pricing, as described by Baldick
(2003), or the regime proposed for Europe by Pérez-Arriaga and Olmos (2005).
If generator terms are included, as above, it deals with the kind of situation identified
by Baldick, in which generators classified as being in a particular region may actually
have significantly different participation factors in particular constraints.
In reality, while these proposals received a reasonable level of support, and similar
proposals are again under discussion, none of these applications is current in the NEM.
The major problem identified by CRA (2004c) was the need to determine how capacity
on congested flow gates would be allocated between generation and interconnector
flows, between different generators or interconnector flows, and between new
participants and old. This has proved a significant barrier to widespread implementa-
tion of the regime, given the many vested interests involved. From 2005, though
(an approximation to) the CSP/CSC approach was employed in a large scale trial to
deal with constraint problems around the former SNY market region.37 While gener-
ally successful, the trial was eventually discontinued when the SNY market region was
amalgamated into the NSW market region, thus “resolving” the boundary flow issues
by moving the market design in the opposite direction from the gradual proliferation of
regions envisaged in the initial rules. In 2009, a rule was introduced to deal with one of
the most obvious mis-pricing problems by simply truncating any negative IRSR at a
low positive value, should it persist, on average, for more than a week. 38
But it would be fair to say that, in practice, the inter-related problems of inter-
regional boundary definition, firm inter-regional hedging, and firm intra-regional
access, remain unresolved. The situation is again being reviewed but, so far, one can
only conclude that the acknowledged deficiencies of the current framework are not
(yet) causing enough economic inefficiency to justify the transaction costs of
establishing a consensus in favour of any particular proposal for a better regime. In
that context, though, the CSP/CRR approach at least provides a consistent general

37
The constraints involve a trade-off between generation in the SNY region and both VIC-SNY,
SNY-NSW interconnector flows. Initially, the trial did not involve the VIC-SNY interconnector,
so CSP/CSC transfers were only made between SNY generation and the SNY-NSW
interconnector, within an aggregate rental pool that was less firm than the transmission capacity.
This was subsequently modified to eliminate negative residues on the VIC-SNY interconnector.
38
This may be seen as a very limited application of the CSP/CRR framework, in which the
transmission system provider, who ultimately receives the SRA proceeds, effectively guarantees
that the net interconnector capacity available to support flows in each direction will at least be
non-negative.
330 E.G. Read and P.R. Jackson

framework within which a wide variety of market designs, involving elements of both
FGR and FTR paradigms, can be described, compared, and potentially implemented.

13.7 Conclusions

Experience with FTRs, and related concepts, has been mixed, and success limited, in
both Australia and New Zealand. These two markets are actually very different in
structure, with one pricing power at every node, and the other over quite broad regions.
In both cases, the industry has evolved to accommodate itself to the lack of effective
hedging arrangements. And that means that there can be significant resistance to
change from participants whose modus operandi has been developed to exploit some
particular aspects of the status quo arrangements. Thus the pressure for change has
often come more from regulatory institutions, which have only gradually gained
strength over the years.
While the SRA process has been moderately successful in providing inter-regional
hedging for Australia, the mismatch between the market architecture and the physical
network configuration makes this hedging less firm than it could be, and it seems the
market participants do not value it highly. Those problems might be overcome by
applying some version of the CSP/CRR framework, or perhaps by moving to full nodal
pricing, but it is far from universally accepted that the NPV benefits of introducing
either regime would be positive. For New Zealand, the “inter-island” FTR regime now
planned will provide a level of inter-regional hedging comparable to that in Australia.
But participants there will still face significant intra-regional price risk. Thus, although
recent studies have not predicted overwhelmingly positive NPV benefits, further
development may be expected. On the other hand, we might suggest that, in both
cases, the cost incurred by all concerned in continuing a debate which has already
lasted for more than a decade may account for a significant part of the projected
“implementation cost”.

Acknowledgement The authors wish to thank the EA (New Zealand) and AEMO (Australia) for
provision of data, and permission to publish.

References 39

AEMC (2008) Congestion management review: final report (on AEMC website)
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www.aemc.gov.au/Market-Reviews/Open/Transmission-Frameworks-Review.html

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results.html
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management. Electr J 13(8):38–58
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proposal/
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transmission rights auction: proposal and properties. IEEE Trans Power Syst 17(4):1058–1067
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Chapter 14
Transmission Rights in the European Market
Coupling System: An Analysis of Current
Proposals

Gauthier de Maere d’Aertrycke and Yves Smeers

14.1 Introduction

Regulation EC No714/2009 on “. . . conditions for access to the network for cross-

border exchanges in electricity . . .” (see European Commission 2009) and the Frame-
work Guidelines on Capacity Allocation and Congestion Management (ACER 2011)
formally introduced transmission rights in the European Electricity System. None of
these documents really explain what these transmission rights should be but the
Framework Guidelines are slightly more explicit than the Regulation: transmission
rights can be physical or financial; physical rights should be options subject to a use it
or sell it clause (UIOSI1); and financial rights can be options or obligations. Further
details will come with the grid codes that Transmission System Operators (TSOs) are
preparing. The Framework Guidelines do not really elaborate on the market design that
must accommodate these rights. They simply mention that “TSOs implement capacity
allocation in the day-ahead market on the basis of implicit auctions . . . based on the
marginal pricing principle”. Both Market Splitting (MS), which is now well
established in the Nordic power market and Market Coupling (MC), which is emerging
as the European reference system outside of the Nordic countries satisfy these
conditions. The US experience shows that the transmission rights and market design
are closely intertwined and that one cannot discuss the former without referring to the
latter. We follow suit and discuss the extent to which transmission rights can
be meaningfully implemented in Market Coupling. Market Coupling can be seen

1
Physical rights must be nominated (“Use It”) before the opening of the day-ahead market in order
to be used. Otherwise (“Or Sell It”) they are automatically sold back to the day-ahead market at the
price that will come out from that market.
G. de Maere d’Aertrycke
FEEM, Corso Magenta 63, Milan 20123, Italy
Y. Smeers (*)
CORE, Voie du Roman Pays 34, L1.03.01, Louvain-la-Neuve 1348, Belgium
e-mail: [email protected]

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 333

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9_14,
# Springer-Verlag London 2013
334 G. de Maere d’Aertrycke and Y. Smeers

as a very simplified version of nodal pricing (replacing nodes by zones and hoping that
the rest applies). It is thus convenient to discuss transmission rights in Market Coupling
keeping the nodal system in background. Chapter 3 of this book (Oren 2012) offers an
in depth discussion of transmission rights in the nodal pricing model: we continuously
(most often implicitly) refer to this chapter during the discussion. Much of the analysis
of congestion management in nodal pricing was constructed on examples of two and
three nodes grids. It is thus also reasonable to follow that approach and reason on two
and three zone (not node) systems that we construct from a six node (not zone)
network. The rest of this introduction gives a brief survey of the literature on Market
Coupling and the structure of the paper.
Nodal pricing has been elaborated during the restructuring of the US electricity
system (see HEPG website (http://www.hks.harvard.edu/hepg/) and the list of research
papers thereof). A summary is presented in Chap. 1 of the book to which we refer the
reader. Market Coupling has been extensively discussed in the so-called “Florence
Forum” that is driving the thinking on the completion of the internal electricity market
in Europe (see the website of the Directorate General Energy at http://ec.europa.eu/
energy/gas_electricity/electricity/forum_electricity_florence_en.htm). The Forum
produced many informal presentations that can be found on its website. Transmission
System Operators (TSOs) (see the website of ENTSO-E, formerly ETSO at https://
www.entsoe.eu/resources/publications/) and regulators (see the website of ACER at
http://www.acer.europa.eu/portal/page/ACER_HOME/Public_Docs) also produced
many papers on the subject. More technical documents are available in studies initiated
by the Commission (see the website of the Directorate General Energy under the
heading “Studies” at http://ec.europa.eu/energy/studies/index_en.htm). In contrast,
the academic literature on Market Coupling is more limited. Buglione et al. (2009)
offers an extensive and very pedagogical presentation of many aspects of the problems
posed by the internal electricity market including a discussion of transmission rights
and market coupling. The paper also contains an extensive list of academic and non
academic literature. Glachant (2010) provides a quite readable paper that summarizes
the important ideas underlying Market Coupling and gives references. Van Vyve
(2011) offers a rigorous formal presentation of Market Coupling and its relation to
nodal pricing. Janssen et al. (2011) and Wobben (2009) analyze European transmis-
sion rights as financial instruments. The improved efficiency of the power system and
the resulting price convergence that it entailed attracted a lot of attention (De Jong et al.
2007; Dijkgraaf and Janssen 2009; Huisman and Kilic 2011; Kurziden 2010; Parisio
and Bosco 2008; Pellini 2011; Zachmann 2008).
Most of these academic presentations refer to the current implementation that
makes the assumption that the electricity grid can be described by a set of zones
(today countries) connected by interconnections described by their sole transfer
capacities (the Transfer Capacity or TC model). Neglecting bloc bids (which represent
machine indivisibilities) for the sake of brevity in this paper, Market Coupling
determines the price in the different zones by solving a welfare maximization problem
subject to these transfer capacities. The success of Market Coupling in bringing about a
closer integration of European electricity markets is remarkable given the simplicity
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 335

and very approximate nature of the underpunning model. This success is also
recognized in the reports of the European Commission on the progress in the internal
electricity and gas markets (e.g. European Commission 2011).
The representation of an interconnection by its sole transfer capacity requires two
simplifications: one can neglect Kirchhoff’s second law and one can aggregate lines
between different pairs of nodes connecting two zones into one interconnection
between these zones. TSOs who introduced that model had advised very early
(ETSO 2001) about its strange properties. They explain that transfer capacities have
none of the usual algebraic properties of day-to-day life (adding and subtracting),
which also rule flows on individual lines (adding and netting). These difficulties
induced the search for a new model, named as “flow based” (FB) that was first
proposed in ETSO-EuroPEX (2004) and later elaborated more extensively in ETSO-
EuroPEX (2009). The flow-based version of Market Coupling also solves a welfare
maximization problem but it replaces the TC representation of the grid by PTDF like
relations: these are common in the nodal system but are here applied to a zone-to-
zone representation of the grid. The FB model is more technical than its TC
predecessor and less developed in the literature or in the slides of the Florence
Forum. TSOs have produced important documents on that system (Amprion et al.
2011a, b) that we refer to in this paper. As for the TC model, academic studies have
examined the efficiency gains accruing from the FB model. They generally adopt a
simplified view of the FB representation of the grid that they assume to be pure
flowgate (see Oren 2012). This contrasts with the real FB model that goes through
an aggregation of the real network to construct the PTDFs of the zone-to-zone
model. This aggregation is one of the themes of this paper.
The demand for transmission rights originated from stakeholders, whether traders
or large industrial consumers. Papers from the Florence Forum on the subject are
mainly descriptive and do not go into technical discussions of feasibility (e.g. ETSO
2006; EFET 2008). Duthaler and Finger (2008) seem to be the first ones to look at the
problem from a more formal point of view. A recent in depth study by Booz & Co
(2012) recommends going to the nodal system for granting transmission rights. This
chapter falls into this more analytical category: it explores the feasibility of
constructing firm transmission rights on the basis of the TC and FB models.
In conclusion, the literature on Market Coupling is more limited and much more
informal than the one that drove the discussions of the nodal and flowgate systems in
the USA. It is also more limited and less technical than the literature of market splitting
that is an older sibling of Market Coupling. We contribute to that literature in the
following way. Following the tradition in congestion management we analyze the
principles of transmission rights discussed in EU regulatory and legal European texts
on the basis of two and three zone models that we construct in Sect. 14.2. We examine
the properties of transfer capacities in these models with reference to a “superposition
property” that has been important for creating portfolios of tradable transmission rights
in the nodal system and underlies legal requirements such as netting (Sect. 14.3). We
show that these basic properties are not verified in general (as was already recognized
in ESTO 2001). Our analysis goes into some depth in the notion of Generation Shift
Key (GSK) that is crucial in the FB model but remains largely ignored in the literature
336 G. de Maere d’Aertrycke and Y. Smeers

(except by TSOs who introduce the notion but do not explore its properties). We then
explain how congestion charges in the day-ahead market of Market Coupling (there is
no real-time market in Market Coupling) increase transmission risk compared to a
nodal system and are more difficult to hedge with transmission rights (Sect. 14.4). We
then go more in detail in that discussion and explain that these shortcomings dramati-
cally complicate the “simultaneous feasibility” requirement that is central to firmness
in the Financial Transmission Rights of the nodal system. We finally come back to the
description of the transmission rights proposed by the Framework Guidelines
(Sect. 14.5) and show that financial rights would not satisfy the “simultaneous
feasibility”2 criterion and that physical rights suffer from well known shortcomings
that justified the abandonment of the contract path model. Whether financial or
physical, the rights foreseen by the Framework Guidelines are thus unlikely to be
firm or if so will be unduly restricted. We conclude with a pessimistic view on
development of a liquid market of transmission rights.

14.2 A Primer on Market Coupling

Market Coupling is a zonal model that assigns responsibilities on energy and trans-
mission to different entities while organizing some interaction between them. As in
many implementations of nodal pricing, the energy market in Market Coupling is a
combination of a centralized market organized around Power Exchanges (PXs) and a
decentralized market of bilateral contracts. PXs receive energy bids in each zone and
clear their respective intra-zonal market in day-ahead assuming that it is free from
transmission constraints. Bilateral contracts, whether domestic or international are
concluded outside of the PXs and are thus not part of this market clearing.
Transmission System Operators (TSOs) deal with the transport of electricity.
Transmission is conventionally unlimited inside a zone (physical limitations need to
be handled by counter-trading) but zones are linked by capacitated interconnections.
Market Coupling adopts the EU common but contestable (Duthaler et al. 2008 and
Duthaler and Finger 2009) assumption that transmission limitations occur at the border
between countries. TSOs therefore provide a simplified view of the grid consisting of
zones (today identical to countries) connected by capacitated interconnections. PXs
(more specifically EpexSpot and Apx Belpex) clear this inter-zone market in day-
ahead on behalf of the PXs using the interconnections and taking account of the
clearing of the domestic market already achieved by the PXs. These intra- and inter-
zone clearings of the energy market take place in day-ahead; there is no real-time
energy market in Market Coupling but intraday markets (between day-ahead and real-
time) are in development inspired by the Nordic ELBAS market. It is recognized that a

2
Simultaneous feasibility is a property that requires that the set of transmission rights, whether
financial or physical (but this notion was introduced for financial rights), be physically feasible
(that is satisfy Kirchoff’s first and second laws) for the real grid. We come back to that question
later.
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 337

grid composed of infinite intra-zone capacities and limited inter-zone interconnections

cannot represent the real physical system; TSOs may therefore have to proceed to intra
and inter-zonal counter-trading3 in order to restore the feasibility of the grid after the
clearing of the energy market. Counter-trading does not give rise to tradable transmis-
sion rights and is therefore not discussed in this paper. Our focus here is the extent to
which a zonal system based on this organization of the day-ahead market can provide
the background for firm and tradable transmission rights.
Transmission rights mainly developed in the restructured US systems in the form of
hedges of congestion charges (Financial Transmission Right). Congestion charges in
the nodal system, whether computed from node-to-node transactions or on particular
links (flowgate), are intimately related to the solution of an Optimal Power Flow (OPF)
that simultaneously clears the real-time energy and transmission markets. Market
Coupling does not rely on an OPF to clear a real-time energy market but the algorithm
(Djabali et al. 2010) used in the day-ahead market has a flavor of a simplified OPF at
least if we exclude technically difficult issues such as “bloc bids”. It thus makes sense
to reason on transmission rights allowed by Market Coupling in the EU market by
analogy to those offered in the restructured nodal systems.
As mentioned above, Market Coupling does not have a real-time market but is in the
process of implementing an intraday market. All our discussion refers to the existing
day-ahead market. This implies that we implicitly transpose considerations made for
the real-time US markets to the day-ahead European market. The real-time market is
seen as the real spot market in several electricity organizations but Market Coupling
does not comply with that philosophy and considers (so far and before the full
deployment of intraday markets) the day-ahead market as the spot market.

14.2.1 From Nodal to Zonal Models

Market Coupling is based on a zonal decomposition of the electricity market. It was

first implemented in November 2006 on the so-called “trilateral market” consisting of
Belgium, France and The Netherlands and it expanded to include Germany in Novem-
ber 2010. Further linkage with the Nordic system (known as Nordpool and consisting
of Denmark, Finland, Norway and Sweden) is in progress and extensions to the
Southern Peninsulas (Iberia and Italy) are foreseen. We reason in this paper on the
basis of two and three zone illustrative examples that we construct on the basis of Chao
and Peck (1998) six-node example (see Fig. 14.1). This test problem can be
summarized as follows:

3
Counter-trading is an operation whereby TSOs buy adjustment injections and withdrawals of
power at different nodes to generate counter-flows on congested line. A counter-trading operation
may require an expensive plant to ramp up and a cheap plant to ramp down. These operations are
also called “out of merit” because they violate the economic order of plant operations. Counter-
trading is the responsibility of the TSOs and does not involve PXs; it must be planned on the basis
of the real characteristics of the grid and not of the simplified model provided by the TSOs to the
PXs.
338 G. de Maere d’Aertrycke and Y. Smeers

Fig. 14.1 The six nodes,

eight lines, test problem

Table 14.1 Demand and Node Function type Function

cost functions
1 Marginal cost 10 þ 0.05q
2 Marginal cost 15 þ 0.05q
3 Inverse demand 37.5  0.05q
4 Marginal cost 42.5 þ 0.025q
5 Inverse demand 75  0.1q
6 Inverse demand 80  0.1q
Source: Chao and Peck (1998)

Table 14.2 PTDFs in the six node example

Power flow on link Power flow on link
Power (1 MW) injected at node 1 ! 6 (MW) 2 ! 5 (MW)
1 0.625 0.375
2 0.5 0.5
3 0.5625 0.4375
4 0.0625 0.0625
5 0.125 0.125
6 (hub) 0 0

There are three generators respectively located at nodes 1, 2 and 4 with linear
(affine) marginal cost curves. Three demand nodes with linear (affine) demand
functions are located at nodes 3, 5 and 6. Two lines, namely 1–6 and 2–5 of impedance
2 are capacity constrained respectively at 200 and 250 MW. The other lines are
unconstrained and their impedances are 1. The marginal cost curves and demand
functions are documented in Table 14.1. The PTDFs of lines 1–6 and 2–5 are given in
Table 14.2. Real time nodal prices are obtained by solving an OPF and reported in
Table 14.3. The difference of nodal prices between two nodes (e.g. nodes 1 and 6) is the
congestion charge of a node-to-node transmission service. The dual variable of the line
constraint (e.g. line 1–6) in the solution of the OPF is the congestion charge on the
“flowgate” (see Oren 2012) defined by these lines. Differences of nodal prices can be
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 339

Table 14.3 Demand, generation and power prices of the nodal pricing model
Node Demand (MWh) Generation (MWh) Prices (€/MWh)
1 300 25
2 300 30
3 200 27.5
4 200 47.5
5 300 45
6 300 50

Fig. 14.2 The two zone example

constructed as PTDF weighted sums of the dual variables of constrained lines (which
are the real-time market prices of line services in the US flowgate system). We use the
six node example to construct two zonal models respectively with two and three zones.

14.2.2 A Two Zone Model

Consider Fig. 14.2 where nodes 1, 2 and 3 have been aggregated into a Northern
zone, the three other nodes 4, 5 and 6 being aggregated in a Southern zone.
The two lines 1–6 and 2–5 form the single interconnector between the zones. This
two zone grid can be viewed as part of the 2006 trilateral market between Belgium,
France and the Netherlands after grouping Belgium and the Netherlands (see
Fig. 14.3). The cost and demand data of the example reported in Table 14.3 are
obviously unrelated to these countries but the radial topology of Fig. 14.2 offers
some resemblance to the trilateral market of Fig. 14.3 that can be useful.
Market Coupling organizes trading between the Northern and Southern zones
through a market-clearing model whose principle is as follows (we describe a very
simplified version of Market Coupling and refer the to Djabali et al. (2010) and Van
Vyve (2011) for further details).
340 G. de Maere d’Aertrycke and Y. Smeers

Fig. 14.3 The two zone

network as a reduction of the
trilateral B-F-NL market

Table 14.4 Intra zonal equilibrium before cross border trade

Northern zone
Global supply (horizontal addition of supply functions at nodes 1 and 2)
pN ¼ 12.5 þ 0.025 QN
Global demand
pN ¼ 37.5  0.05 QN
Equilibrium
pN ¼ 20.83, q1 ¼ 216.6, q2 ¼ 116.6
q1 þ q2 ¼ qN ¼ q3 ¼ 333.3
Southern zone
Global supply (node 4)
pS ¼ 42.5 þ 0.025 QS
Global demand (horizontal addition of demand functions at node 5 and 6)
pS ¼ 77.5  0.05 QS
Equilibrium
pS ¼ 54.16, q5 ¼ 258.33, q6 ¼ 208.33
q5 þ q6 ¼ qS ¼ q4 ¼ 466.6

14.2.2.1 Clearing Zonal Markets

Recalling the Market Coupling assumption that intra-zonal transmission systems are
unconstrained, we suppose that there is one Power Exchange in each zone (here
Northern and Southern PXs) that clears the energy market and finds the equilibrium
between supply and demand in that zone. One can verify that all generators are active
and that nodal demands are positive at the intra-zone equilibrium. Equilibrium prices
and quantities in that equilibrium are given in Table 14.4.
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 341

Table 14.5 Impact of a unit Northern zone

export from North to South on
Global supply with export
the intra-zone equilibria
pN ¼ 12.5 þ 0.025 (QN þ Ex)
Global demand
pN ¼ 37.5  0.05 QN
Start from Ex ¼ 0 and suppose a unit export ΔEx ¼ 1
ΔpN ¼ 0.0166, Δq1 þ ΔEx1 ¼ 0.33, Δq2 þ ΔEx2 ¼ 0.33
ΔQN þ ΔEx ¼ 0.66, ΔQN þ Δq3 ¼ 0.33
Note that one cannot separate ΔQi þ ΔExi, i ¼ 1, 2
Southern zone
Global supply (node 4)
pS ¼ 42.5 þ 0.025 QS
Global demand
pS ¼ 77.5  0.05(QS þ Ex)
Variation of the equilibrium for ΔEx ¼ 1
ΔpS ¼ 0.0166, Δq4 ¼ 0.666
ΔqS þ ΔEx ¼ 0.333
Note that one cannot separate ΔQi þ ΔExi, i ¼ 5, 6

Table 14.6 Import and Northern zone

export functions of the
Global supply
Northern and Southern zones
pN ¼ 12.5 þ 0.025 (QN þ Ex)
Global demand
pN ¼ 37.5  0.05 QN
Eliminating QN we get
pN ¼ 13 ð62:5 þ 0:05ExÞ
Southern zone
Global supply
pS ¼ 42.5 þ 0.025 QS
Global demand
pS ¼ 77.5  0.05(QS þ Ex)
Eliminating QS we get
pS ¼ 13 ð162:5  0:05ExÞ

The price difference between the two zones (of the order of 35.5) suggests that
trading should take place from North to South. This is what Market Coupling organizes
using a model that bears some resemblance to an OPF as we discuss now.

14.2.2.2 Coupling the Northern and Southern Markets

Consider a unit export from North to South. The principle of Market Coupling is to
consider the export as a parameterized demand (here noted Ex for Export) in the
Northern zone and as a parameterized supply (the same Ex) in the Southern zone.
The equilibrium in each zone is then modified as stated in Table 14.5 that also reports
the price and generation changes in the two zones. Because marginal cost and demand
curves are linear in this example, these coefficients can be used to construct linear
342 G. de Maere d’Aertrycke and Y. Smeers

Table 14.7 The “OPF” like Ð

Ex Ð
Ex
model of the inter zone Max pS ðeÞdE  pN ðeÞde
market clearing of the two 0 0
zone model s.t. “E is feasible for the interconnection”

Fig. 14.4 The three zone

model

export/import curves in both zones as depicted in Table 14.6. It is then possible to set
up a welfare maximization problem very similar to an OPF on a two zone grid provided
we have a representation of that grid. This is done in a stylized way in Table 14.7 where
the grid is provisionally represented by the statement “Ex is feasible for the intercon-
nection”. We discuss the construction of the grid and the implied transmission services
after the presentation of the three zone model.

14.2.3 Three-Zone Model

Three node models have been instrumental in analysis of congestion management;

Oren (2012) uses a three-node model in his chapter on Financial Transmission
Rights. The following constructs a three zone model using the six node example.
Suppose a partitioning of the nodes in three zones respectively noted East (E)
consisting of nodes 2 and 5, North West (NW) comprising nodes 1 and 3, and South
West (SW) formed by nodes 4 and 5. This is depicted in Fig. 14.4. Each zone
contains one generator and one customer so that one can clear each intra-zone
energy market. In contrast with the two zone model, zone E now also contains a
domestic transmission constraint namely line 2–5. This will require some particular
treatment as explained below. Last the three zones are linked by interconnections
composed of one or two lines. The interconnection between the two Western zones
is limited to the sole capacity constrained line (1–6). The other interconnections
consist of unconstrained lines: NW-E is formed by lines 3–2 and 1–2 while SW-E
consists of lines 6–5 and 4–5. This three zone model can again be viewed as a
simplified representation of the Pentalateral market that went live in November
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 343

Table 14.8 Intra-zone NW zone

equilibrium in the three zone
Supply (node 1): pNW ¼ 10 þ 0.05 qNW
model before cross border
Demand (node 3): pNW ¼ 37.5  0.05 qNW
trade
Equilibrium: pNW ¼ 23.75, qNW ¼ 275
SW zone
Supply (node 4): pSW ¼ 42.5 þ 0.025 qSW
Demand (node 6): pSW ¼ 80  0.1 qSW
Equilibrium: pS ¼ 50, qSW ¼ 300
E zone
Supply (node 2): pE ¼ 15 þ 0.05 qE
Demand (node 5): pE ¼ 75  0.1 qE
Equilibrium: pE ¼ 35, qE ¼ 400

Table 14.9 Impact of a unit NW zone

export from each zone on the
Supply: pNW ¼ 10 þ 0.05 (qNW þ ExNW)
intra-zone equilibrium
Demand: pNW ¼ 37.5  0.05 qNW
Unit export: ΔExNW ¼ 1
ΔpNW ¼ 0.025, ΔqNW þ ΔExNW ¼ 0.5, ΔqNW ¼ 0.5
Generation increase: 0.5, demand decrease: 0.5
SW zone
Supply: pSW ¼ 42.5 þ 0.025 (qSW þ ExSW)
Demand: pSW ¼ 80  0.1 qSW
Unit export: ΔExSW ¼ 1
ΔpSW ¼ 0.02, ΔqSW þ ΔExSW ¼ 0.8, ΔqSW ¼ 2
Generation increase: 0.8, demand decrease: 0.2
Equilibrium: pS ¼ 50, qSW ¼ 300
E zone
Supply: pE ¼ 15 þ 0.05 (qE þ ExE)
Demand: pE ¼ 75  0.1 qE
Unit export: ΔExE ¼ 1
ΔpE ¼ 0.0333, ΔqE þ ΔExE ¼ 0.666, ΔqE ¼ 0.0333
Generation increase: 0.8, demand decrease: 0.2

2010 where SW and E respectively represent France and Germany while NW

integrates Belgium, Luxemburg and The Netherlands. As in the two zone model
the cost and demand data of the example are unrelated to those of the Pentalateral
market but the topology of Fig. 14.4 offers some resemblance with the real system
that can usefully be kept in mind.
Proceeding as in the two node grid and neglecting the domestic transmission
constraint in zone E for the time being, we find market clearing quantities and prices
in each zone as depicted in Table 14.8.
Supposing a unit export from each zone, we can again compute the price
variations and the changes of generation and demand that result from that export
in the three zones. These are listed in Table 14.9. As before the linearity of the
supply and demand curves allows one to use these coefficients to construct linear
import/export curves in each zone. These are listed in Table 14.10. Assuming a grid
model to represent export/import between zones the clearing of the cross border
344 G. de Maere d’Aertrycke and Y. Smeers

Table 14.10 Impact of a unit NW zone

export from each zone on the
Supply: pNW ¼ 10 þ 0.05 (qNW þ ExNW)
intra-zone equilibrium
Demand: pNW ¼ 37.5
Eliminating qNW we get pNW (ExNW) ¼ 23.75  0.025 ExNW
SW zone
Supply: pSW ¼ 42.5 þ 0.025 (qSW þ ExSW)
Demand: pSW ¼ 80  0.1 qSW
Eliminating qSW we get pSW (ExSW) ¼ 50  0.02 ExSW
E zone
Supply: pE ¼ 15 þ 0.05 (qE þ ExE)
Demand: pE ¼ 75  0.1 qE
Eliminating QE we get pE(ExE) ¼ 35  0.033 ExE

Table 14.11 The “OPF” like ExR;NW ExR;SW RE

Ex
model of inter-zone market Min pNW ðeNW ÞdeNW þ pSW ðeSW ÞdeSW þ pE ðeE ÞdeE
clearing of the three zone 0 0 0
model s.t. ExNW þ ExSW þ ExE ¼ 0
ðExNW ; ExSW ; ExE Þ is feasible for the grid

market can be obtained by an OPF like model that is given in Table 14.11 where
we have left the detail of the grid for the next section.

14.3 Transmission Services in Market Coupling

Market Coupling is a zonal system where zones are today identical to countries.
In contrast with the USA, energy and transmission markets remain separated in
the EU: PXs clear the energy market in each zone and provide the import/export
curve of the zones; TSOs remove intrazonal congestion and provide the represen-
tation of the grid used for clearing the inter-zone energy market. Two
representations of the grid are relevant for the discussion: the so-called Transfer
Capacity model (TC) is currently in operation; a new Flow Based model (FB) is
being developed. Whatever the model, representing the grid by zones and
interconnections between them can only approximate reality. TSOs may thus
need to conduct both inter and intra-zone counter trading services to remove
overflows that result from these simplifications. Counter-trading adds to the
balancing operations that take place in real-time and are not part of the day-
ahead energy market. None of these involve tradable transmission rights relevant
for the energy market; they are thus not discussed in this paper.
Transmission services offered on this zonal model will differ from those in nodal
systems. We first consider the TC model that is implemented today and then turn to
the FB model that is meant to be the reference system for the future. We conduct the
discussion on the two and three zone examples.
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 345

14.3.1 The Two Zone Model

Consider first the two-zone model depicted in Fig. 14.1. Section 14.2.2.1 shows that
exports should normally flow from North to South. A single interconnection links
the Northern and Southern zones. We examine how this interconnection compares
to the standard flowgate (line) of the nodal model.

14.3.1.1 The TC Model

Computing Interconnection Characteristics

The PTDF of the Northern zone to the interconnection is obviously equal to 1: all
exports from North must go through this single interconnection and similarly for
exports from South. The only remaining relevant question is the capacity of this
interconnection.
TSOs publish interconnection capacities but do not guarantee them before day-
ahead. TSOs also do not explain today their method of calculation but will have to
do so in the network code as required by the Framework Guidelines. One should not
expect too much from this publication though: transfer capacities of interconnectors
composed of several lines cannot be determined unambiguously in a meshed
network and are always conventional figures obtained by some heuristics. Rious
et al. (2008) illustrate a possible approach: they provide a “worst case” analysis that
we apply as follows.
Suppose a unit export from North to South. First assume that domestic
transactions have no impact on the flows on the interconnection (this is corrected
later in the section). The most effective use of the interconnection occurs for a
transaction between nodes 3 and 4 where Kirchoff’s laws equally separate the
physical flow between the two lines 1–6 and 2–5. The maximal export is then
400 MW. In contrast the minimal use of the interconnection lines occurs for a
transaction between nodes 1 and 6. Most of the flow (1/0.625 where 0.625 is the
PTDF of node 1 on line (1–6)) is directed to the 200 MW line 1–6 while the rest
flows on line 2–5 of capacity 250. Because the distribution of transactions between
North and South is not known beforehand, the TC is obtained by selecting the most
unfavorable pattern, which is the transaction from 1 to 6. This gives a flow of 200/
0.625 or 320 MW. The interconnection can accommodate all flow patterns resulting
from an export of 320 from North into South.
The 320 MW value must be corrected for the impact of pre cross-border trade on
the interconnection lines. Following Rious et al. (2008) we suppose that zonal TSOs
rely on some intra-zone trade scenarios to compute the flow on the interconnection
lines before cross-border trade. In order to fix ideas we assume that the flows at
equilibrium before cross-border trade described in Table 14.4 reflect this practice.
Taking node 6 as a hub, it is easy to verify (see Appendix 14.1) that these domestic
transactions imply net (rounded) flows of 3 MW and 3 MW on lines 1–6 and 2–5
346 G. de Maere d’Aertrycke and Y. Smeers

respectively. The TC available for North South commercial transactions is then

reduced by that amount and becomes 317 (320  3).
TCs differ by direction. Consider now the TC from South to North. The TSOs
can realistically assume that only transactions from 4 (the generator in South) to 3
(the demand node in North) are possible. Flows then distribute equally on lines 1–6
and 2–5, which gives the most efficient use of the interconnection. The TC from
South to North is then 403 (400 þ 3) when there is no contingency.
Contingency analysis is important for determining firm transmission services.
Suppose a failure of one of these two lines, for instance 1–6. The capacity of the
interconnection is then 250, which is the capacity of the remaining line (2–5). The
transmission capacity drops to zero when both lines are down.

Superposing Transactions in the TC Model

The capability to superpose transactions in the representation of the grid is a key

element for developing portfolios of tradable transmission rights in the nodal
system (Oren 2012). Note that Regulation EC No. 714/009 also requires some
sort of superposition property when stating “nominations of transmission rights in
the opposite direction shall be netted” (Annex 1, paragraph 4.2). We analyze
whether a superposition property also holds in the zonal system. We first examine
whether transactions of opposite directions on the N-S interconnection can be
netted (as requested by the Regulation) to determine the utilization of the intercon-
nection. We then explore whether transactions can be added for determining the
utilization of the interconnection. The conclusion is that these operations are not
guaranteed in the TC model (see ETSO 2001 for a more extensive discussion).

Subtracting (Netting) Transactions

Assume two inter-zonal transactions of equal amount (e.g. 400 MW) but opposite
direction. Suppose that the N to S transaction is between nodes 1 and 6 and the S to N
transaction between nodes 4 and 3. Using the PTDFs one checks that the combination
of these transactions leaves a residual flow of 400 * 0.125 ¼ 50 MW on line 1–6 and
400 * 0.125 ¼ 50 MW on line 2–5. While the sum of the inter-zonal transactions
is algebraically zero, the flows on the lines are not zero. The two transactions would
have netted to zero line flows if they had taken place between the same nodes. We
find that, in contrast with node-to-node transactions, zone-to-zone transactions cannot
be netted on interconnections (aggregate flowgates) when their entry and exit points
differ.
The lack of netting is inconsequential for the interconnection lines of 200 and
250 MW that can accommodate the residual flows of 50 and 50 MW. This is no
longer true if the capacities of these lines were respectively 49 MW for line 1–6
(changed from 200 to 49) and 250 MW for line 2–5 (unchanged). Netting the two
transactions to zero implies that the interconnection is not saturated while it is
effectively saturated by line (1–6). This misjudgment can be corrected in two ways.
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 347

One is to permit some violation of the physical capacities of the lines in the day-
ahead market and to correct that violation by counter-trading in real-time. The other
possibility is not to allow netting and to only work with single direction transmis-
sion rights. There are then two TCs, one from North to South and the other from
South to North. Transactions are then allocated according to the directional TCs.
This excludes the N to S 400 MW transaction but permits the one from S to N. This
is the solution adopted in the EU system where transmission rights are directional
(see Djabali et al. 2010) for day-ahead transactions and EnBW (undated) for yearly
and monthly transmission rights. This implies that trade can be restricted because of
the sole market design without physical capacities or generators’ market power
having any responsibility for this restriction.

Adding Transmission Rights

A similar reasoning applies to the adding of transactions. Consider two N to S
transactions of 200 MW from node 1 to node 6 and from node 2 to node 5
respectively. Their combination entails flows of 200 MW on lines 1–6 and 2–5
respectively or globally 400 MW. These two transactions are feasible for the real
network but exceed the TC of the interconnection. One transaction will then be
rejected. Here again trade is limited by the market design without physical capacities
or generators’ market power having any responsibility with this limitation.

Long and Short Term TC

The Framework Guidelines require that long and short term computations of
capacities be compatible. This seems difficult to achieve. A worst-case analysis
indeed depends on the set of flow patterns that it considers. The larger this set, the
lower the TC value. Long term transmission rights are based on a long term view of
the TCs for which the set of plausible transactions is probably larger than in the day-
ahead. TSOs are aware of that and will therefore restrict the computed long term TC
through some rule of thumb in the hope of making it compatible with the short-term
one. Long term and short term TCs are thus bound to be assessed differently even
though the network and hence its physical possibilities in different contingencies
are identical. Besides the difficulty of satisfying the compatibility requirement of
the Framework Guidelines, this raises the question of how to maximize TCs while
at the same time insuring the firmness of transmission rights. This is the central
question addressed later in the paper.

Conclusion

Transactions can be netted or added on lines (flowgates) in the nodal system: they
satisfy the superposition property, at least if we assume constant PTDFs. This is not
true for interconnections in the zonal grid. Node-to-node services in the nodal
348 G. de Maere d’Aertrycke and Y. Smeers

system are constructed from portfolio of flowgate services where adding and netting
play a fundamental role. Because superposition of transactions on interconnection
does not hold in the zonal system, it will also be missing on interconnections and
hence in zone-to-zone services. The implication is that one cannot construct
portfolios of transmission rights in the sense that one cannot verify that a set of
zone-to-zone services that is found to be feasible for the zonal grid is effectively
feasible for the real grid. If this verification cannot be done in day-ahead, it is
unlikely that it can be done for transmission rights in the forward market.

14.3.1.2 The Flow Based Model

The Flow-Based (FB) model is meant to offer a better representation of the grid for
clearing the inter-zone energy market in day-ahead. It can alternatively also be used
to increase the TCs in today inter-zone market-clearing as explained by TSOs in
Amprion et al. (2011a, b). The FB model crucially relies on so-called “Generation
Shift Keys” (GSK). The importance of these factors is generally overlooked in
academic studies of the FB models even though they are essential elements of the
model. According to TSOs “It is the Generation Shift Key (GSK) that defines how a
change in net position is mapped to the generation units in a bidding area”
(Amprion et al. 2011a). Section 5.7 of Amprion et al. 2011b describes the way
different TSOs compute GSK: “RTE puts its best effort to anticipate the best
generation pattern for France in D þ 2”. The German TSOs only mention that
they include “power plants in GSK that are very quick and flexible”. Elia gives the
same type of information. Tennet’s approach is still less informative: “Tennet has
no access to the merit order of units, however the list of units that appear in the GSK
is evaluated by the operators on a daily basis for known outages”. We come back to
these statements when discussing the forward market. In the meantime and because
these quotations of TSOs do not really constitute a description of how they compute
GSKs, we introduce a notion of “perfect” GSKs that leads to an exact representation
of the real grid. We then explain that real GSKs and hence the FB model can
necessarily be “imperfect”. We conclude with the implications for long term
transmission rights.
TSOs usually describe the FB model in terms of bilateral transactions between
PXs. Appendices of their reports (e.g. Amprion et al. 2011a, b) explain that it is
more logical to conduct the discussion in terms of net positions of PXs (the outcome
of market clearing). We adopt this more logical presentation and analyze the
situation in terms of net positions on the exchanges.

“Perfect” GSK

Beginning with the clearing of the intra-zone energy markets before cross-border
trade depicted in Table 14.4, we consider changes of generation and demand
resulting from a 1 MW export from North to South (Table 14.5). Using the
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 349

PTDFs we compute the incremental utilization of lines (1–6) and (2–5) due to this
export. Generator 4 originally produces 466.6 (Table 14.4) and decreases its output
by 0.66 for each MW export. It will stop generating when the export is 700 MW.
Demand at node 3 decreases by 0.33 for each 1 MW incremental export and is still
positive (100 MW) at the 700 MW export level. The other generation and demand
levels increase with export and hence remain positive. Because supply and demand
curves are linear, the incremental generations and demands with respect to the no
cross-border trade equilibrium are proportional to the export as long as it remains
lower than 700 MW. Using the PTDFs one infers per unit incremental line flows as
shown in Appendix 14.2: 1 MW export respectively leads to 0.5 MW and 0.5 MW
additional flows on lines 1–6 and 2–5. We refer to these values as “zonal PTDFs”
(ZPTDFs) of lines (1–6) and (2–5) because they represent the impact of a zonal
export on these lines. The ZPTDFs assume that the energy markets clear in the two
zones for these different export levels as in the philosophy of Market Coupling (see
Djabali et al. 2010). One can easily verify that these ZPTDFs remain valid as long
as the set of active generators and demands does not change, which is the case here
for any export level not exceeding 700 MW.
Taking into account residual loop flows before cross-border trade (3 MW from
North to South on line 1–6 and 3 MW in the opposite direction on line 2–5) one
obtains that the 700 MW export from North to South leads to an utilization of lines
1–6 and 2–5 equal to 353 MW and 347 MW respectively. These flows are larger
than the capacities of the lines of respectively 200 and 250 MW and hence are not
feasible for the grid. Applying a standard reasoning in terms of DC load flow
approximation, this suggests introducing two “ZPTDF” inequality constraints as
in Table 14.11 to express the real limitation of export implied by the grid. These
constraints have the usual PTDF form of the DC load flow approximation, but use
ZPTDFs.
ZPTDFs are computed on the basis of both the original PTDFs (using node 6 as
the hub) and of incremental demands and supplies induced by export as computed
in Table 14.5. These are the GSKs mentioned in TSOs’ documents: they indicate
how generation (and here also demand) is modified as a result of the unit export
from the Northern to the Southern zone. Because we also deal with demand in this
computation we refer to these coefficients as Generation and Demand Shift Keys
(GDSKs). Line capacities in the grid constraints of Table 14.12 are based the
original data taking into account the flows on line (1–6) and (2–5) before cross-
border trade.
One can alternatively consider an import from the Southern to the Northern
zone. This transaction requires the expensive generator in node 4 to increase
production to displace the cheap generators at nodes 1 and 2 and hence is unlikely
to take place. This should not be of concern for the TSOs in charge of modeling the
network. Using the same reasoning as before one can write the ZPTDF constraints
of Table 14.13 that express the limitation of the export from the Southern zone.
Taking export from the Northern to the Southern zone while adapting the
clearing of the zonal markets, one finds that the capacity of the N-S interconnection
without contingencies ranges from 406 (203/0.5) to 396 (197/0.5) where the
350 G. de Maere d’Aertrycke and Y. Smeers

Table 14.12 ZPTD 0.5 Ex  197

constraints on lines (1–6) and
0.5 Ex  253
(2–5) in the two zone model
in the North South direction

Table 14.13 ZPTD 203  0.5 Ex

constraints on lines (1–6) and
247  0.5 Ex
(2–5) in the two zone model
in the South–North South

two bounds are reached because of saturation of line 1–6. Capacity in both
directions is higher than the one computed with TCs. This improves cross-border
trade compared to the TC model as announced by the proponents of the FB model
(Amprion et al. 2011b).

Superposing Transactions in the FB Model

Because the superposition of transactions is essential for the construction of

portfolios of transmission rights, we again successively consider netting and adding
transactions.

Subtracting (Netting) Transactions

Assume again two transactions of equal amount (e.g. 400 MW) but opposite
direction. Because they are inter-zonal, their impact is accounted for through the
PXs. This implies that their impact on lines (1–6) and (2–5) is computed using the
GDSKs determined from market clearing. These coefficients are identical in the
two directions (at least locally as we shall explain), which implies that these line
flows cancel out. The two transactions can thus effectively be netted in the sense
that N-S and S-N transactions that algebraically add up to zero imply flows on the
interconnecting lines that are also zero.

Adding Transmission Rights

It is easy to verify that the same result applies when adding two N-S transactions of
197 MW (twice 197 MW or 394 is the maximal export capacity found in
Table 14.11 in Sect. 14.2.1.1). The flows on the interconnection lines implied by
the two transactions are twice the flows implied by one of these transactions. This
suggests that adding and netting are both allowed, meaning that transactions are
superposable and hence that the FB model meets at least in the day-ahead market
the property of superposition mentioned in Oren (2012). The following shows that
this conclusion is unfortunately too optimistic.
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 351

Table 14.14 Impact of an

Northern zone
incremental N-S export when
plant 2 is at capacity Global supply: pN ¼ 10 þ 0.05 (qN þ Ex  200)
Global demand: pN ¼ 37.5  0.05 qN
Suppose a unit incremental export ΔEx ¼ 1
ΔpN ¼ 0.025, ΔqN þ ΔEx ¼ 0.5
Δq1 þ ΔqN þ ΔEx ¼ 0.5, þ Δq2 ¼ 0.5
Southern zone
Global supply: pS ¼ 42.5 þ 0.025 QS
Global demand: pS ¼ 77.5  0.05 (QS þ Ex)
Suppose a unit import ΔEx ¼ 1
ΔpS ¼ 0.01666, Δq4 ¼ 0.666
Δq5 þ ΔEx5 ¼ 0.1666, Δq6 þ ΔEx6 ¼ 0.166
ΔqS þ ΔExS ¼ 0.333

Non-linear GDSK

TSOs insist on the “linearity” of GSKs (Amprion et al. 2011b). The perfect GDSKs
are constant, which in the terminology of Amprion et al. means that the effect of
exports on generation (and demand in our case) is a linear function of these exports.
The wording is different (constant vs. linear) but our “perfect GDSKs” meet the
requirements of Amprion et al. (2011b). The real situation is more complex (even in
this extremely simplified six node example) as we explain. Suppose the same data
as before except that the plant located at node 2 has a limited generation capacity of
200 MW. This is larger than the generation of 183 MW of this plant when export is
198 MW. It is not possible for this plant to ramp up sufficiently to accommodate
twice that export level. The plant will keep generating at its 200 MW limit when
export becomes sufficiently large and plant 1 as well as demand at node 3 will adapt
to increase export. This requires recomputing the GDSKs to reflect to the new
generation pattern where plant 2 is at capacity. Table 14.14 reports the marginal
impact of a unit export when machine 2 is at capacity.
Appendix 14.3 shows the computation of the new GDSKs that respectively
amount to 0.8 and 0.2 for the lines (1–6) and (2–5). Computations show that an
export of 250 MW leads to a generation of plant 2 just below 200 and to ZPTDFs of
0.5 and 0.5 for both lines; in contrast ZPTDFs become 0.8 and 0.2 for the fraction of
the export exceeding 250 MW. The two 198 transactions are therefore not super-
posable because their combination implies a change of ZPTDFs.
The example shows that the model of the aggregate grid is ambiguous because
the ZPTDFs change with export. This conclusion obviously extends to the case
when the supply and demand curves are non-linear as happens if one introduces
further constraints on the capacities, or non-linear marginal cost curves (the usual
case) or demand, or a mixture of both. GDSKs will thus in general be non-constant,
with the implication that the ZPTDFs of the aggregate network become non-linear.
Non-linear ZPTDFs imply that transaction cannot be superposed. TSOs assume
constant GSKs (Amprion et al. 2011b) but do not justify that assumption.
352 G. de Maere d’Aertrycke and Y. Smeers

Table 14.15 Impact of zonal NW zone

exports in the three zone
Supply: pNW ¼ 10 þ 0.05 (qNW þ ExNW)
model (GDSK)
Demand: pNW ¼ 37.5  0.05 qNW
Variation of the equilibrium for ΔExNW ¼ 1
ΔpNW ¼ 0.025, ΔqNW þ ΔExNW ¼ 0.5, ΔqNW ¼ 0.5
Generation increase: 0.5, demand decrease: 0.5
Δq1 þ ΔqN þ ΔEx ¼ 0.5, þ Δq2 ¼ 0.5
SW zone
Supply: pSW ¼ 42.5 þ 0.025 (qSW þ ExSW)
Demand: pSW ¼ 80  0.1 qSW
Variation of the equilibrium for ΔExSW ¼ 1
ΔpSW ¼ 0.02, ΔqSW þ ΔExSW ¼ 0.8, ΔqSW ¼ 0.2
Generation increase: 0.8, demand decrease: 0.2
E zone
Supply: pEx ¼ 15 þ 0.05 (qEx þ ExE)
Demand: pEx ¼ 75  0.1 qEx
Variation of the equilibrium for ΔEEx ¼ 1
ΔpE ¼ 0.033, ΔqEx þ ΔEEx ¼ 0.666, ΔqEx ¼ 0.333
Generation increase: 0.666, demand decrease: 0.333

Imperfect FB Models

The superposition property of transactions in the FB model justified calling the

GDSKs “perfect” in Sect. 14.3.1.2.1. This was unexpected good news: it is indeed
known that the aggregation of a meshed grid by a reduction of the number of nodes
or lines is never perfect. It is thus relevant to identify what entails this welcome but
unexpected “perfection”. Two linearity assumptions guarantee the result in the
example. One is the linearity of the supply and demand functions of the six-node
model. The second assumption comes from keeping the same set of active
generators and demand as export increases until hitting the capacity constraints.
These two linearity conditions imply that constant GDSKs measure the changes of
generation and demand resulting from an export/import deviation from the intra-
zonal equilibrium. These together with the PTDFs of the original grid give the
changes of flows (ZPTDF) on the lines resulting from these exports and imports.
ZPTDFs are true PTDFs of the aggregate network operating under Market Coupling
but they are only valid locally and the range of this validity is a matter of empirical
analysis. The scant information on the computation of GSKs provided by TSOs
(Sect. 5.7 in Amprion et al. 2011b as recalled in Sect. 14.3.1.2) gives little evidence
that GSKs are effectively constant in practice. Some additional comments of TSOs
cast additional doubt on the matter. In Sect. 5.7.1 of the above report RTE states
“in order to avoid unwanted behavior of the GSK on major critical branches,
RTE excludes some generating units from the GSK”. The statement has a flavor
of discrimination that will probably be unnoticed by competition authorities. From
the perspective of this paper, it signals that GSKs can be subject to ad hoc
manipulation by TSOs of the type already mentioned for TCs.
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 353

Long and Short Term TC Model

ZPTDFs are constructed on the basis of GDSKs that are provided by the clearing of
the day-ahead market. This raises the question as to how construct ZPTDFs
representing the grid in the forward market. This relates to the distinction between
implicit and explicit auctions in the EU language. Market Coupling is an implemen-
tation of implicit auctions where transmission rights are allocated implicitly by the
double clearing of the intra-zonal and inter-zonal energy markets. This determines
ZPTDFs that are locally valid in the day-ahead market or non-linear ZPTDFs that are
valid everywhere but do not allow for superposing transactions by adding and netting.
TSOs exclude non-linear GDSKs (Sect. 5.7 in Amprion et al. 2011b). These
constructions may look a bit complicated but are well under control when the
information from market clearing is on hand, that is in implicit auctions.
The situation is quite different in the forward market where transmission rights
are allocated by so-called “explicit auctions”, without reference to any energy
market clearing. It is again useful to recall here that the Framework Guidelines
require that the short and long term descriptions of the grid be compatible. This
raises the question of computing compatible GDSKs for both the long and short
terms, or in other words to reconcile the explicit and implicit auctions. This worry
does not appear in the nodal system that relies on a single physical description of
the grid both for the long and short terms without reference to the energy market.
But Market Coupling requires adapting the method for computing daily GDSKs to
monthly and yearly GDSKs. Transposing RTE statement recalled in Sect. 14.3.1.2
(which is the most explicit among TSOs quotes on the determination of GSKs), this
would imply “the best effort to anticipate the best generation pattern for France in
one month/one year”. This is certainly more difficult than making the same antici-
pation “in D þ 2” as in the day-ahead market. Tennet’s statement (recalled in
Sect. 14.3.1.2) is the most deceptive in that respect: how can one construct a year
ahead merit order without even the knowledge of it in day-ahead?

A Final Note: Do Perfect GDSKs Lead to the Nodal System?

It is easy to verify that the clearing of the inter-zone model by Market Coupling
using the computed transmission capacities between North and South is not identi-
cal to the result of the nodal system, reported in Table 14.3. Market coupling indeed
imposes that all transactions in a zone clear at a single price. This constraint is
absent from nodal pricing. The FB model therefore improves on the TC model but
remains less efficient than the nodal system.

14.3.2 The Three Zone Model

The discussion of the two zone network easily extends to three zones at the cost of
additional complications for the TC model.
354 G. de Maere d’Aertrycke and Y. Smeers

14.3.2.1 The TC Model

TSOs will publish the details on the computation of transfer capacities in the grid
codes. In the meantime we only mention in passing the difficulty of applying the
worst-case analysis but do not elaborate. Consider computing TCs between the NW
and SW zones. These are linked by an interconnection composed of a single line of
capacity 200 MW. But 200 MW is not the TC between the two zones! The available
capacity for transaction between NW and SW is indeed influenced by both
the domestic transactions of zone E as well as by the transactions between the E
and the NW and SW zones. TSOs must thus make worst-case assumptions both
about the transactions that are completely external to their operations and about the
transactions between domestic and other zones.

14.3.2.2 The FB Model

ZPTDF for the Tree Zone Model

In contrast with the TC model, the analysis of the FB model for the two zone system
easily extends to the three zone case. Table 14.15 reports the change of generations
and demands resulting from a unit export in each zone while maintaining intra-
zonal market clearing. These figures can then be used with the PTDFs to compute
the ZPTDFs of lines 1–6 and 2–5 (keeping node 6 as the hub). These are
documented in Appendix 14.4 and the results reported in Table 14.16.
The clearing of the energy market before cross-border trade implies flows on the
interconnections. These are computed in Appendix 14.5 and respectively amount to
186 and 214 MW on lines 1–6 and 2–5. They are feasible for the grid (where
capacities of these lines are respectively 200 and 250) but leave little additional
room for cross-border trade.
Combining the GDSK and PTDFs one obtains a representation of the grid model
in three relations. Two ZPTDF inequalities express constraints on line flows, a third
balance equation sums zonal export to zero. These are stated in Table 14.17. This
model has the same form as the PTDF representation of a three node system. The
only difference is the use of ZPTDFs.

The Role of the Line 2–5 Constraint

The three-zone model comprises two capacitated lines but only one capacitated
interconnection. The jurisprudence of European Institutions concentrates on
limitations to cross-border trade caused by insufficient interconnections even
though the impact of domestic limitations is progressively recognized as a factor
for determining cross-border capacities (Duthaler et al. 2008; Duthaler and Finger
2008, 2009; ACER 2011). This raises the question of the treatment of the
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 355

Table 14.16 ZPTDs of the (1–6) (2–5)

three zone model
NW 0.6 0.4
SW 0.05 0.05
E 0.375 0.291

Table 14.17 The FB model of the three zone grid

386 (200  186)  0.594 ENW þ 0.05 ESW þ 0.375 EE  14 (200  86)
464 (250  214)  0.406 ENW  0.05 ESW þ 0.292 EE  36 (250  214)
ENW þ ESW þ EE ¼ 0

Table 14.18 Two 386  0.544 ENW þ 0.325 EE  14

dimensional view of the FB
464  0.456 ENW þ 0.342 EE  36
model in the three zone grid

constrained line 2–5 in the model of Table 14.17. We first neglect this question and
briefly discuss the proposal to use the FB model to construct improved Transfer
Capacities (Amprion et al. 2011b).

From the FB the TC Model?

The three zone model of Table 14.17 contains two ZPTDF inequality constraints
and one balance equation each involving the PXs’ export variables. Because export
variables are unconstrained, the balance equation can be used to express one of the
export variables as a function of the other two. Table 14.18 reports the model
obtained after elimination of the SW export.
Amprion et al. (2011a, b) suggest using this reduced formulation to obtain
improved (larger) TCs compared to the classic method. We illustrate the approach
in Fig. 14.5 on a FB model consisting of the sole constraint on the interconnection
NW-SW (line 1–6). The principle is to select a rectangle inside the space deter-
mined by the FB constraint. The advantage compared to the standard method is to
avoid any “worst case” analysis and hence to increase the TCs.
The reasoning is certainly useful to determine transfer capacities for the day-
ahead market. But other elements should come into play when discussing transmis-
sion rights. The selection of a rectangle (the TCs) inside the domain defined by the
ZPTDF constraints reintroduces the discretion of the TSOs for constructing TCs. It
again illustrates the conventional character of TCs whatever the method to deter-
mine them. Starting from ZPTDF constraints obtained with perfect GDSKs as we
have done here, we first need to select the export variable to eliminate when going
from the three-dimensional to the two-dimensional model. This implies that the
TCs that represent access to different zones may have no relation with the physical
356 G. de Maere d’Aertrycke and Y. Smeers

Fig. 14.5 Construction of TC

from ZPTDF constraints

capacities between these zones. We have here chosen to eliminate the SW export
and obtained a graph in the sole NW and E exports. This gives a TC to and from
zone E, which is in reality connected to the two other zones by unconstrained
interconnection. This is in sharp variance with the common discourse of European
and national authorities that systematically refer to the insufficient physical
capacities between the zones to justify their conclusion of national relevant geo-
graphic markets. There is here no physical limitation between zone E and its
neighbors but the physical limitation between NW and NS creates transfer
capacities on zone E. Given this arbitrary selection of the eliminated export
variable, there is also an infinite number of choices for allocating the possibilities
given by the FB constraints into the two transfer capacities. The authors of the FB
model explain that TSOs can take advantage of that flexibility to allocate the overall
constraint between the two PX exports. This is certainly true but it also introduces
ambiguity in the definition of the TCs that as we shall see later spoils any hope of
producing the necessary mechanisms to guarantee firmness of transmission rights,
or alternatively drastically reduces the scope of transmission rights for which
firmness can be guaranteed.

Long and Short Term TC Model

Previous comments on possible discrepancies between day-ahead and the long term
TC model equally apply to the FB model. The model of Table 14.18 embeds GDSK
information collected from the clearing of the day-ahead market. There is no such
information in the explicit auction of transmission rights in the forward market.
Except for resorting to past observation, there is no objective rationale to select
GDSKs for constructing the long-term possibilities of the grid.
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 357

14.4 Congestion in Market Coupling

14.4.1 Generalities

The three node network has been the reference example in most discussions on
congestion management in the nodal model. It is also used in Oren (2012) to present
the fundamental notions of transmission rights in the nodal system. We similarly
use a three zone model to analyze inter-zonal congestion in Market Coupling. By
analogy with the nodal system, congestion charges can be measured as difference
between zonal prices or as congestion charges on interconnections. These charges
are the risks that one wishes to hedge through transmission rights and hence are the
underlying of these rights. A first question is what influences this underlying. We
successively discuss the question on the TC and FB models.

14.4.2 Congestion Charges in the TC Model

Congestion can occur on line 1–6 which is the single capacitated interconnection in
the three zone model. It can also occur on the 2–5 domestic capacitated line, which
is not part of the interconnection. The implicit principle in the EU is that zonal
TSOs handle domestic congestion by counter-trading or other remedies and that
these congestion costs are socialized in access charges. Market clearing then
consists in maximizing welfare computed on the PX import/export curves subject
to the sole constraints on interconnections. We treat this case first and then turn to
domestic congestion (here on line 2–5).

14.4.2.1 Case 1: Market Coupling Does Not Recognize Domestic Congestion

Suppose that Market Coupling only recognizes congestion on interconnections, or

in this example on line 1–6 between zones NW and SW. It may be surprising to note
that this implies a single price for the three zones and zero congestion cost. Prices
and quantities are identical to those occurring when there is no line limitation.
The reason is that the TC model allows MC to redirect flows so as to avoid
saturating the interconnection. Table 14.19 gives a TC feasible solution of Market
Coupling. The reported flows are incompatible with Kirchhoff’s law and hence with
the possibilities of the real grid, but they are feasible for the TC representation of
the grid.
These price and flow patterns differ from those of nodal pricing where a single
constrained line implies three different prices in a network three node network.
Dropping the PTDFs of the nodal model to arrive at the TC model therefore implies
going from three to one price. The property is general: a single constrained line
induces as many different prices as the number of nodes in the nodal system but
358 G. de Maere d’Aertrycke and Y. Smeers

Table 14.19 A TC feasible Generation (þ)

solution with one capacitated
line (1–6) Price Demand () Line flows in a TC solution
1 35 þ500
2 35 þ400 1–2 450
3 35 50 1–3 50
4 35 0 2–5 850
5 35 400 450
6 35 450 0

only one “copper plate” (obtained without congestion) price in the TC model. More
surprisingly any single capacity located anywhere in the three zone network gives
the same single price in the TC model! The constraint and its value are irrelevant to
the outcome of Market Coupling in the TC model! There is no congestion cost and
hence nothing to hedge. In contrast nodal prices are node specific and their pattern
depends on the location and value of the constraint as one could expect. There is a
congestion cost in the nodal model as there is in reality.
This paradoxical result sheds doubts on the TC model. Indeed combining the
common assumptions that intra-zonal congestion does not interfere with inter-zonal
congestion, with the principle that one can represent the interconnection by its sole
capacity leads in this example to the patently absurd result that one can do away
with congestion altogether. The TC model is wrong in this simple example and is
thus unlikely to be right in the complexity of the real world. The following
elaborates on this paradox by turning to the constrained domestic line 2–5.

14.4.2.2 Case 2: Market Coupling Recognizes Domestic Congestion

The implicit assumption of the EU zonal system is that TSOs can manage domestic
congestion to arrive at a single price in each zone. To do this in the three zone
example, the E-TSO first checks whether the outcome of Market Coupling violates
the possibilities of its grid. This is the case with the results of Table 14.19 where the
flow on line 2–5 is equal to 416 MW and thus exceeds the 250 MW capacity of the
line. The TSO then remedies the situation by counter-trading, that is, by reducing
the flow from 416 to 250 by a counter flow from node 5 to 2. This counter flow
would here amount to 166, which is significant and would cost a lot in access
charges to the clients (generator and consumer) of the E zone. The TSO may thus
want to find an alternative approach more acceptable for its jurisdiction.
This is what the Swedish TSO is reputed to have done in 2006 (DG Competition
2009 and Chauve et al. 2010). Because it could not accommodate the combination
of domestic (to Swedish customers) and international (to Denmark) demands on its
grid, it introduced a TC on the interconnection to Denmark. The TC was not a
physical reality of the interconnection but a conventional number aimed at
preventing domestic congestion by reducing the global use of the Swedish grid. It
was a transfer from domestic to international congestion. Bjørndal et al. (2003) had
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 359

mentioned the possibility of this practice well before 2006. We can adopt a similar
approach here and introduce a TC of 250 MW (the capacity of line 2–5) on the NW-
E interconnection; note that we introduce this fictitious capacity notwithstanding
the fact that this interconnection is composed of non congested lines 1–2 and 3–2
(the congestion is domestic to zone E and has nothing to do with the interconnec-
tion)! The problem becomes feasible for the E-TSO and the new TC creates two-
zonal prices in the system.
The Danes and the Swedes belong to the Nordpool system and both understand
its functioning; the Danes found out and complained to European Competition
Authorities (European Commission 2010). The practice has since been declared
illegal and is also prohibited by the Framework Guidelines: TSO cannot move
domestic congestion to the border by introducing fictitious TCs. The problem is that
the practice is difficult to detect in a complex meshed network. The Swedish TSO
denied any wrong doing but has since created domestic zones that will in any case
prevent any misbehavior. Applying the same remedy in the three zone example
implies creating subzones of the E zone, that is, separating the zone (2, 5) into two
subzones (2) and (5). The impact of this separation is considerable. Market coupling
of the three zone model now gives the same result as the North–South model (see
Table 14.4) where generators 1 and 2 receive the same low price 20.83, which is
also the price paid by consumer 3. In contrast, consumer 5, which was located in the
same zone as generator 2 before the separation but is now in a different subzone,
pays the much higher price 54.16 induced by generator 4. This solution better
represents the physics and economics of the system but its application maybe
controversial for the E zone.

14.4.2.3 Summing Up

This discussion reveals that the TC model is largely conventional at least in a

meshed network where TSOs need to remove domestic congestion to arrive at a
single zonal price: whatever the value set for the TC on line 1–6, the outcome of
Market Coupling is the same as if this value had been set at zero! This solution can
also create domestic difficulties in zone E. One way out it to introduce a purely
artificial TC; the other solution is to create additional zones, possibly with dramatic
consequences for the operators of the initial zones. All this seems somewhat ad hoc
and may explain that TSOs have so far limited the description of the TC calculation
to very general considerations. This will be remedied with the publication of the
grid codes but the clarification can only be in terms of procedures as nothing
substantive can be said about the physical and economic reality of TCs. The result
is that the congestion cost in the TC model is fundamentally arbitrary and impor-
tantly when it comes to transmission right subject to discretionary manipulation by
TSOs. The question is then whether this constitutes a good underlying for hedging
instruments.
360 G. de Maere d’Aertrycke and Y. Smeers

The possibility to hedge congestion costs is necessary to conclude long-term

contracts.4 TSO announce TCs but not fully guarantee them before day-ahead.
Congestion charges in the TC model therefore depend not only on the characteristic
of the grid and on commercial activities but also on its management by TSOs.
Dependence on short term ad hoc decisions cannot be avoided in the real time
management of the electricity grid. But long term ad hoc decisions should be
excluded at the design stage of the system. We shall formally argue in the next
section that the very nature of TCs makes it impossible for TSOs to guarantee the
firmness of the rights except by drastically reducing their scope.
The Nordic system, which is more radial than the one of Central West Europe,
should be less vulnerable to this problem. But as the Denmark-Sweden event of
2006 revealed, even that system can suffer from meddling congestion management
with grid physical characteristics. Changing zones in response to congestion is a
congestion management technique that tries to rationalize TCs to better represent
the use of capacitated lines. But it also mixes congestion management with grid
physical realities and hence create the ambiguity of the TC signal that impacts on
zonal prices and their difference (Bjørndal and Jørnsten 2001). The Nordic system
responded to the problem by creating a decentralized market of Contracts for
Differences (CfD) on zonal prices (Hagman and Bjorndalen 2011). The system
does not involve the TSOs and hence dispenses them from providing firmness. This
is probably unavoidable as changing zones modifies the topology of the grid on
which zonal prices are computed and hence prevents firmness or reduces the scope
of transmission rights. This CfD market is active but not very liquid in contrast with
the Nordic energy market that is very liquid (NordREG 2010).

14.4.3 Congestion in the FB Model

Turning to the FB model we examine whether it offers a more solid basis to

congestion charges and their use as underlying of transmission rights. There is indeed
an improvement, but its extent depends on the capability to determine constant
GDSKs in the day-ahead and forward markets. The FB model effectively offers a
realistic (possibly non-linear) representation of the capabilities of the grid in the day-
ahead market when bidding information is available. But it fails to do so in the
forward market when transmission rights need to be allocated. Moreover the practice
of the TSOs referred to in Amprion et al. 2011a and 2011b, Sect. 5.7 suggests a
somewhat ad hoc determination of GSKs. We discuss the day-ahead market in this

4
There is a guarantee before day-ahead but it only holds if the security of the grid is not
endangered. Needless to say the security of the grid in real-time depends on the set of transmission
rights that have been allocated, as well as on the real-time conditions of the grid. A guarantee of
transmission right that can be waived because of an initial misallocation of transmission rights by
the TSO is not a guarantee. There is however an incentive not to unduly curtail transmission rights
as TSOs are not sure to recover the compensation in their tariffs.
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 361

Table 14.20 Market coupling in the FB model with congestion limited to

interconnection
ER
NW ERSW ERE
Min PNW ðENW ÞdENW þ PSW ðESW ÞdESW þ PE ðEE ÞdEE
0 0 0
s.t. ENW þ ESW þ EE ¼ 0
386 (200  186)  APTDFNW;16 ENW þ APTDFSW;16 ESW þ þAPTDFE;16 EE
 24 (200  186)

section and treat the forward market in the next one. We successively take up the
cases where Market Coupling only encompasses the single capacitated interconnec-
tion (1–6) and the one where it also treats the domestic line 2–5. These are referred to
“critical branch” in the FB literature and we shall sometimes use that expression. We
do not discuss the case where the FB model is used to construct improved TC models
as this per se reintroduces discretionary decisions of the TSOs that spoil any hope of
creating an adequate underlying for transmission rights.

14.4.3.1 Case 1: Market Coupling Does Not Recognize Domestic Congestion

Applying the reasoning of Sects. 14.2.2.2 and 14.2.3, one sees that Market Coupling
solves a problem analytically similar to the standard three node problem of the
nodal system (see Oren 2012). This problem is restated in full in Table 14.20. It
involves the ZPTDF constraint expressing the limitation on line (1–6) and the
balance equation.
The solution is also structurally similar to the one of the nodal system in the
sense that it consists of three different zonal prices. The situation is thus analogous
to the one of a standard three-node grid provided the ZPTDFs are interpreted as
ordinary PTDFs. We have seen that is this is the case as long as the GDSKs
extracted from the clearing of the energy market remain constant.5
The congestion costs to be hedged are well defined in the sense that they depend
on the technological characteristics of the grid and of the GDSKs, which in
principle are only functions of the bids and offers in the day-ahead market. In
more technical language zonal prices are “measurable” with the state of the system
if one includes the GDSK in that state. The advantage compared to the TC model is
that the discretionary decisions of the TSOs (which are not “measurable” with the
state of the system) have now disappeared at least in “perfect” GDSKs. But the
drawback compared to the nodal system is that the representation of the grid now
also depends on commercial operations.

5
The solution obviously differs from the nodal prices of the six-node system as MC imposes that
the number of prices is at most equal to the number of zones. But this is taken for granted (and even
desired) at the outset.
362 G. de Maere d’Aertrycke and Y. Smeers

Table 14.21 Market coupling in the FB model with congestions on lines (1–6) and (2–5) node
explicit
ExRNW ExRSW RE
Ex
Min PNW ðEeNW ÞdEeNW þ PSW ðeSW ÞdeSW þ PE ðeE ÞdeE
0 0 0
ExNW þ ExSW þ ExE ¼ 0
386 (200  186)  APTDFNW,1  6 ExNW þ APTDFSW,1  6 ExSW þ APTDFE,1  6 Ex1  6
 14 (200  186)
464 (250  214)  APTDFNW,2  5 ExNW þ APTDFSW,2  5 ExSW þ APTDFE,2  5 Ex2  5
 36 (250  214)

Table 14.22 Solution of the model 21

Net positions Equilibrium prices Equilibrium quantities
NW 32.37 24.56 258.81
SW 21.27 49.6 304.2
E 11.11 34.63 403.70

14.4.3.2 Case 2: Market Coupling Recognizes Domestic Congestion

Accommodating the sole interconnection (1–6) leaves the congestion of the domes-
tic line (2–5) untreated. In the interest of brevity, we skip the discussion of counter-
trading for treating this domestic congestion and immediately move to a FB model
that recognizes domestic congestion as proposed in Sect. 14.4.2.2. The market
clearing problem solved by Market Coupling is stated in Table 14.21.
The solution of the model is given in Table 14.22. It leaves the domestic line
unconstrained and implies a transfer from the low demand zone (NW) to the two
other zones. Note that this is not a general outcome. Increasing the capacity of line
1–6 and decreasing the one of 2–5 will congest the sole domestic line, and not the
interconnection. Whatever line is congested, there could be three zonal prices. It
will thus be necessary to explain to stakeholders that there are three zonal prices
even though there may be no congestion on the interconnections.

14.4.3.3 Implication for Hedging

In contrast with the TC model the FB model does not meddle congestion manage-
ment with the physical realities of the grid. It thus give unambiguous congestion
charges when GDSKs are constant (commercial transactions that determine the
GDSKs are observable). The result extends to non-linear GDSK but this is not
considered by TSOs and hence not discussed here. The suggestion of the authors of
the FB-model to use the PTDF constraints of the import/export possibilities to
derive TC constraints would reintroduce arbitrariness in the process and hence be
counterproductive for guaranteeing firmness of transmission rights. These good
properties depend on whether GDKs are determined in a proper manner (constant,
obtained from the PXs and without meddling of the TSOs). It remains to see
whether these advantages of the FB model carry through to the forward market.
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 363

14.5 Hedging Congestion by Transmission Rights

in Market Coupling

14.5.1 Problem Statement

Consider a long term cross border bilateral transaction that one wants to financially
hedge against congestion charges between the two zones; alternatively suppose that
one wants to physically guarantee access of this transaction to the relevant zones.
The question is whether the TC and FB models can provide adequate underlying for
transmission rights. The preceding section elaborates on the better properties of the
FB model. We therefore begin by discussing the extent to which transmission rights
can be constructed on that model. A small subsection later adapts the discussion to
the TC model.
The discussion of the preceding sections indicates that the FB zonal model
completed with appropriate GDSKs (constant GDSK or export/imports dependent
DGSKs determined from the PXs’ clearings) gives a realistic representation of the
possibilities of the grid and hence well-defined congestion charges in the day-ahead
market. The model is also formally very close to the nodal model presented in Oren
(2012). This suggests adapting the financial transmission rights of the nodal model
to the zonal case. The preceding discussion also shows that this can be done under
two conditions: first transaction should be superposable, second GDSKs should be
available in the forward market: alternatively TSOs should be willing to bear the
risk of changing GDSKs and ZPTDFs as North American ISOs bear the risk of
changing PTDFs. Both conditions are important. First, superposition is important
for agents to constitute portfolios of tradable rights. Second, TSOs are regulated
companies and hence should not be forced to take on risks that the market design
does not allow them to control. Specifically, while one can argue that ISOs in the
nodal system can be responsible for the risk induced by varying PTDFs because
these are characteristics of the grid (and hence ISOs should have some capital at risk
for doing so), it seems more difficult to demand that TSOs should also be responsi-
ble for GDSKs that are essentially outcomes of the energy market and hence the
result of PX operations at the border between the bilateral and organized markets.
We explore the impact of these caveats to assess differences between Financial
Transmission Rights in the nodal and zonal systems.
Transmission rights of the nodal system can be of the point-to-point or link
(flowgate) type. The relative advantages of the two rights have been the subject of
intense and deep discussions during several years in the USA. Oren (2012) briefly
presents the two types of rights and summarizes these discussions. The US debate
concluded in favor of point-to-point services. Oren (2012) analysis can be formally
transposed from the nodal to the FB model but the question is whether a formal
transposition is justified in substance. One can think of two criteria to assess the
validity of this transposition. One criterion deals with the relation between node-to-
node (zone-to-zone in FB parlance) and portfolios of flowgates (critical branch rights
364 G. de Maere d’Aertrycke and Y. Smeers

in FB parlance). It is possible under certain conditions to assemble flowgate rights

to arrive at point-to-point rights in the nodal model; the criterion is whether one can
similarly assemble critical branch rights into zone-to-zone rights. The second
criterion is about firmness. One can under “simultaneous feasibility” guarantee
the firmness of node-to-node rights in the nodal system. The question is whether a
similar property holds in the zonal system.
We first show that an equivalence between zone-to-zone rights and a portfolio of
rights on critical branches also holds in the zonal system, but note that the property
diverges from what is stated in the Framework Guidelines. One can indeed in
principle hedge zone-to-zone congestion costs by a portfolio of hedges on critical
infrastructures even when GDSKs are significantly non-linear. Coming to the
second criterion, we then explain that the main weakness of the transposition
from nodal to zonal is the difficulty of foreseeing GDSKs in the forward market.
Last, we show that the default makes it unlikely that firmness of transmission rights
can be guaranteed for the different rights presented in Framework Guidelines, or
alternatively that the set of rights that can be guaranteed will be a small fraction of
what the grid allows.

14.5.2 Financial Rights in the Nodal and Zonal Systems

14.5.2.1 On the Relation Between Zone-to-Zone and Critical Branch Rights

The relation between node-to-node congestion charge and flowgate value in the
nodal system is well known. The difference of nodal prices is equal to a PTDF
weighted sum of the value of the saturated lines. Both nodal prices and values of
saturated flowgates are determined by the solution of the OPF. A hedge on point-to-
point congestion can thus be obtained as a portfolio of hedges on the flowgate
values. Different portfolios of hedging instruments can be offered in the nodal
context and Oren (2012) discusses their respective advantages and drawbacks.
This relation can be formally transposed to the zonal system. Consider an
adaptation of the model of Table 14.22 where the dependence of the ZPTDFs on
import/export is made explicit (see Table 14.23).
The optimality conditions of that problem show that zonal prices are weighted
sums of the values of the lines. This is similar to the nodal system except for one
major difference. The weights are now a sum of ZPTDFs and derivatives of
ZPTDFs with respect to export variables. The relation between zone-to-zone prices
and critical line valuations thus follows the same principle as in the nodal system
when GDSKs are constant. It is more complex when GDSKs are non-linear.
Whether the non-linearities are significant enough to be taken into account is an
empirical question that we cannot address here. We thus conclude that this equiva-
lence is still warranted but is more complex to implement in practice. Oren (2012)
comments on the advantages of node-to-node versus portfolio of flowgate rights
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 365

Table 14.23 Market coupling in the FB model with congestions on lines (1–6) and (2–5) node
explicit
ExRNW ExRSW RE
Ex
Min PNW ðeNW ÞdExNW þ PSW ðeSW ÞdeSW þ PE ðeE ÞdeE
0 0 0
ExNW þ ExSW þ ExE ¼ 0
386 (200  186)  ZPTDFNW,1  6 (ExNW, ExSW, ExE)ExNW þ
ZPTDFSW,1  6 (ExNW, ExSW, ExE)ESW þ ZPTDFE,1  6 (ExNW, ExSW, ExE)EE  14 (200  186)
464 (250  214)  APTDFNW,2  5 (ExNW, ExSW, ExE)ExNW þ
ZPTDFSW,2  5 (ExNW, ExSW, ExE)ESW þ ZPTDFE,2  5 (ExNW, ExSW, ExE)ExE  36 (250  214)

would be reinforced in a comparison of zone-to-zone and portfolios of critical

branch rights.
It is useful to note that the Framework Guidelines adopt a TC oriented but FB
incompatible view on that question. Suppose congestion for zone-to-zone services
is defined as the difference between zonal prices (which is effectively what cross-
border transactions pay). The Framework Guidelines define the value of an
interconnection between these zones as the difference between the two zonal
prices. This definition is correct for the TC model but incorrect in the FB case
where the zone-to-zone congestion cost is a weighted sum of the value of all
critical branches of the zone-to-zone network. Applying the Framework
Guidelines definition to the nodal system would conclude that the value of a
link is the difference of the prices of the nodes connected by that line, which is
definitely erroneous.

14.5.2.2 On Firmness of Zonal Financial Transmission Rights

The long-term (year-ahead and month-ahead) auctioning of node to node Financial

Transmission Rights under constraints of “simultaneous feasibility” is central to the
firmness of these rights in the nodal system (see Oren 2012). The question is
whether such a central auctioning can be transposed to the zone-to-zone system.

Back to Superposition: In the Day Ahead and Forward Markets

Transmission rights should be feasible for the grid. The verification of the property
both in the forward and day-ahead markets is an obvious necessary condition for
firmness. The DC representation of the load flows, which implies the linearity of the
PTDF relations describing the use of the lines simplifies this verification in the nodal
system: transactions can be added and subtracted and the use of the lines by a
portfolio of transactions can be derived from the use of the lines by individual
transactions. We have seen that this superposition property only holds in the FB
model for constant GDSKs. One can infer that the failure to satisfy the superposition
366 G. de Maere d’Aertrycke and Y. Smeers

property in real time in the zonal Market Coupling also implies its failure in the
forward market. In other words, supposing that one knows the dependence of
ZPTDFs on import/export in the real time market and assuming that this depen-
dence carries through to the forward market, the nonlinearity of ZPTDFs
complicates the construction of portfolio of hedging instruments of congestion
charges in the forward market even if it does not make it strictly impossible
(composing transmission rights using non-linear ZPTDFs is effectively possible).
TSOs do not consider non-linear GDSKs. The capability to construct portfolios of
hedging instruments by adding and subtracting individual instruments therefore
depends on whether their assumption of constant GDSKs is valid in practice. This is
an empirical question that only TSOS can respond. But the response to the question
is crucial: the constitution of portfolios of hedging instruments may be impossible if
the assumption of constant GDSKs is seriously violated.

Simultaneous Feasibility in the Real Time and Forward Market

Assume that GDSKs are constant and hence that ZPTDFs are also constant.
Simultaneous feasibility requires that the portfolio of transmission rights in the
forward market be physically feasible for the grid in real time. This is an obvious
necessary condition for firmness. Hogan (1992) also shows that it is a sufficient
condition in the sense that the congestion costs collected by the ISO in real-time
(day-ahead for Market Coupling) suffice to refund the congestion costs paid by the
holders of transmission contracts. Holders of transmission rights are thus protected
from congestion costs by an adequate portfolio of contracts. Because the real time
conditions of the grid are not known at the contract time, simultaneous feasibility at
the time of auctioning of transmission rights is imposed in nodal pricing by a set of
scenarios of the grid topology that likely embed the real-time grid scenario.
Firmness is thus not guaranteed if real-time grid conditions differ from what has
been assumed when granting transmission rights. This is reported to be infrequent
and not to cause solvency questions for ISOs. The question is whether this
reasoning applies to FB transmission rights.
Simultaneous feasibility condition in the FB model would require that the set of
transmission rights is feasible for day-ahead ZPTDFs. This is a drastic strengthening
of the simultaneous feasibility condition of the nodal system that only involves grid
characteristics. Simultaneous feasibility in the FB model would involve both several
topologies of the grid (the PTDFs) and several GDSKs in day-ahead. This latter
information is first inexistent in the forward market but were it known it is in principle
entirely under the responsibility of the PXs or becomes a joint responsibility of PXs
and TSOs if the latter manipulate GSKs as described in EnBW (undated) Sect. 5.7.
The TSOs would thus take on risk created by PX operations. This is unlikely to be
acceptable in practice and would raise problems of asymmetry of information
between TSOs and PXs in theory. By construction the FB model makes it at best
very difficult and possibly impossible for the TSOs to extend the simultaneous
feasibility condition of the nodal system to the zonal Market Coupling.
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 367

The Central Auctioning of Transmission Rights

Notwithstanding the already negative above remarks, central auctioning of all

transmission rights remains a central part of the simultaneous feasibility constraint
and hence another necessary condition to guarantee firmness. Long-term transmis-
sion rights are also auctioned in the European Market Coupling (see EnBW undated
for a description of the current platform). The existing European platform offers
coordinated auction services on different interconnection but this coordination is
purely administrative and deals with procedure. It does not offer anything like a
central auctioning under simultaneous feasibility.

Conclusion

The above discussion shows that none of the condition that are considered neces-
sary or sufficient to guarantee firmness in the nodal model can be transposed in
substance to the FB model of Market Coupling.

14.5.2.3 Firmness in the TC System

As has often been mentioned the TC model is mainly conventional and does not
reproduce fundamental properties of the DC load flow model used in nodal pricing.
The superposition of transactions is violated to the point that even netting is not
possible. It is thus impossible to construct portfolios of transmission rights. TSOs had
cautioned very early (ETSO 2001) against the very strange properties of TCs.
Because TCs also depend on discretionary decision of TSOs, “simultaneous feasibil-
ity” becomes impossible to implement in practice except by drastically reducing the
scope of offered transmission rights. The sole idea of a auctioning a large portfolio of
rights that satisfy simultaneous feasibility is thus incompatible with the TC model.

14.5.3 Transmission Rights in the Framework Guidelines

14.5.3.1 Problem Statement

The Framework Guidelines allow for physical (PTR) and financial (FTR) transmis-
sion rights. Their description is brief: PTRs must be options subject to the “Use-It
Or Sell it” (UIOSI) clause6; FTRs are options or obligations. Mixes of PTRs and

6
Rights that have not been nominated before the opening of the energy market in day-ahead are
released to the implicit auction of Market Coupling and the former owner of these rights receives
the price determined in the auction.
368 G. de Maere d’Aertrycke and Y. Smeers

FTRs are permitted in the internal market but not on one zonal border where
transmission rights must be of only one type. PTRs should be harmonized in the
internal market; similarly FTRs should also be harmonized. This harmonization is
not described any further.
The Framework Guidelines provide scant additional comments. PTRs or FTRs
are not necessary if a cross-border financial market already exists on both sides of
the interconnector. This probably takes care of Nordpool that developed a market of
Contract for Differences (NordREG 2010), even if Nordic regulators acknowledge
that this market is no really liquid. The Framework Guidelines also provide for a
common platform for the allocation of long-term transmission rights. Such a
platform already exists (EnBW undated) and it is not clear whether the Framework
Guidelines want to go beyond what is in place. The reference to the FTRs is thus the
real novelty of the Framework Guidelines even if guidance is missing on how these
could be organized.
Physical transmission rights are currently allocated on a yearly and monthly
basis through explicit auctions. They are allocated year-ahead for a fraction of what
is expected to be the capacity with additional tranches being released as one moves
on and information on plausible transactions accumulates. They must be nominated
before play-ahead to be used or will be sold back to the day-ahead market because
of the UIOSI clause. Traders require firmness of transmission rights (e.g. EFET
2008). The Framework Guidelines also impose firmness but do not say on which
horizon it should be guaranteed. TSOs have interpreted the requirement for firm-
ness in a very restrictive way: they guarantee it (that is they compensate an
interruption at the difference of zonal prices) after nomination in the day-ahead
market but may restrict it for reason of grid security before that. This is certainly
much less than what traders desire but is possibly the best one can do in the TC
system. There is a common platform with uniform rules for acquiring these long-
term rights. The description of that platform does not suggest anything like a
simultaneous feasibility constraint. There is also no indication of a combinatorial
auction that would allow traders to express a preference for bundles of rights to
construct a portfolio. Rights are thus for individual links offered in a platform that
essentially harmonizes procedures.
The contrast with the US FTR experience could not be more striking. The EU
has so far reasoned in terms of congestion on interconnections and the Framework
Guidelines retain that tradition. This could suggest a view more akin to the flowgate
approach discussed in Oren (2012) and now abandoned in the USA. But even this
resemblance is superficial. There is no notion of portfolio of interconnection rights
to hedge zone-to-zone congestion and as we have seen, even the definition of
congestion on a line as the difference between zonal prices in the Framework
Guidelines is incompatible with the zone-to-zone definition in a FB model. The
absence of theory of these rights, the disqualification of the TCs and contract path
approach in meshed systems, the fact that the FB model has never been
implemented anywhere so far and that the related flowgate model has been aban-
doned where it has been implemented, all this makes it difficult to comment on the
effectiveness of current proposals. But the demand for firmness and the way
firmness is handled in the US system can provide a beginning of discussion.
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 369

14.5.3.2 Firmness of Financial Rights

The notion of simultaneous feasibility is central to the firmness of financial rights

and the possibility to implement it might be the yardstick to assess the TC and FB
models. Simultaneous feasibility requires that transmission rights allocated in the
forward market be physically feasible in day-ahead (recall that we refer to day
ahead and not real time in Market Coupling). This can never be totally guaranteed
(just think of the extreme case of a collapse of the grid), but there are degrees in the
extent to which one can get close to the objective. The nodal system guarantees
simultaneous feasibility on the sole basis of the physical characteristics of the grid.
The N-1 criterion allows one to define a grid topology in the forward market that
should remain valid in the day-ahead in most circumstances. We have seen that the
FB model would require simultaneously feasibility with respect to topologies
constructed from a combination of grid characteristics and market information
(the GDSKs). This combination makes it much more difficult to find a topology
in the forward market that remains valid in the day-ahead market. Simultaneous
feasibility thus requires enlarging the set of possible FB topologies, which implies
restricting the set of guaranteed transmission rights. The situation is worsened if
TSOs manipulate GDSKs to introduce congestion management considerations. The
TC model goes one step further and requires simultaneous feasibility with respect to
a set of topologies constructed from grid characteristics, market information (the
worst case analysis) and congestion management decisions such as zone splitting in
the Nordic system (continental TSOs mention remedies in their documents but do
not provide information). This again increases the set of topologies in the feasibility
constraints of the forward market and as a direct consequence reduces the set of
guaranteed transmission rights offered to the market.

14.5.3.3 Firmness of Physical Rights

Transmission rights are currently physical; they are equipped with the Use It Or Sell
It (UIOSI) clause, which makes them equivalent to options. These rights seem to
have the preference of all stakeholders except for large industrial consumers.
Physical rights will thus probably prevail. Can they be made firm? It is here useful
to recall that the nodal system created financial rights because it turned out to be
impossible to make physical rights firm. The reason was that combination of rights
allocated in the forward market could induce difficulties of dispatch in the spot
market that could only be relieved by cancelling some of the allocated rights.
In contrast financial rights do not impose dispatch constraints in real-time because
it suffices to satisfy the simultaneous feasibility conditions in the forward market to
guarantee the hedging of congestion costs in real-time. TSOs argue that real-time
remedies will solve the problem of coordination in real-time (Amprion et al. 2011b).
This maybe possible but reserving remedies for real-time amounts to restricting the
set of transmission contracts allocated in the forward market. As the discussion of
370 G. de Maere d’Aertrycke and Y. Smeers

simultaneously feasibility with financial transmission rights shows optional rights

further complicate coordination problem with the effect that they also reduce
transmission possibilities. In short, besides the undocumented recourse to remedies,
existing proposals do not suggest any reason to believe in the firmness of the
proposed transmission rights.

14.6 Conclusion

Market Coupling is currently implemented in the so-called “Central West Europe”

region that includes Belgium, France, Germany and The Netherlands. It is intended
to expand to the whole of Europe. CWE is today larger than the combined US PJM
and MISO system. Market coupling is conceptually a significant simplification of
the nodal system (which does not mean that its operational implementation is
simpler than nodal pricing) that underlies PJM and MISO. A natural question is
how a conceptually less sophisticated organization can cope with a larger power
system. A possible response is that it can’t and that flaws will be revealed under
stress (as was the case in California) if and when demand picks up again and wind
power penetrates. This paper concentrates on one question of Market Coupling
namely its potential to provide a working market of firm and tradable transmission
rights.
Transmission rights seem to be a hard part of the design of the short term
electricity markets. The physical rights of the US OASIS system were abandoned
after they revealed difficult coordination problems. Financial rights on flowgates
were tried in Texas and abandoned because of the considerable costs that they
implied. Financial rights for node-to-node models are today the best solution.
Contract for Differences that substitute FTRs in the Nordic system remain rela-
tively illiquid in contrast with the financial energy market, but there is effectively
less demand for congestion hedges than financial contracts and demand is mainly in
Finland, Sweden and Denmark. In short, because transmission is a difficult prob-
lem, financial markets on congestion charges due to transmission bottleneck remain
particularly challenging. ACER (2011) proposals allow for optional physical rights
and financial rights on interconnections. The first have generally failed and the
second proved costly.
Traders require firmness but provide no hint on how to get it. TSOs offer
firmness under restricted conditions that make it useless for long term contracts.
The Nordic system offers a bilateral market for hedging transmission. The US
restructuring offers a concept of “simultaneous feasibility” that has proved opera-
tional for providing firmness of Financial Transmission Rights. The Framework
Guidelines do not offer much hope of technically implementing simultaneous
feasibility except by drastically reducing these rights and hence making their
market illiquid. The joint implication of TSOs and PXs in these rights add problems
of asymmetry of information that will further restrict liquidity. Illiquid markets of
transmission rights will segment the geographic market, and hence hamper the long
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 371

waited completion of the internal electricity market. The European power system is
currently subject to a flurry of changing regulations that degrade the investment
climate. The possibility of contracting long term on transmission would help. It is
not clear how the Framework Guidelines will enhance the scope for long term
contracts and hence how they will help.

Appendix 14.1: Flows on the Interconnection in the Two-Node

Model Before Cross-Border Trade

Table 14.24 PTDF

Node Line 1–6 Line 2–5
1 0.625 0.375
2 0.5 0.5
3 0.5625 0.4375
4 0.0625 0.0625
5 0.125 0.125
6 (hub) 0 0

Table 14.25 Flows

Node Injection Line 1–6 Line 2–5
1 216.6 135.4 81.2
2 116.6 58.3 58.3
3 333.3 187.5 145.8
4 466.6 29.1 29.2
5 258.3 32.3 32.3
6 208.3 0 0
Total 0 3.1 3.1

Appendix 14.2: Incremental Flows Due to Exports

in the North–South Model

Table 14.26 PTDF Node Line 1–6 Line 2–5

1 0.625 0.375
2 0.5 0.5
3 0.5625 0.4375
4 0.0625 0.0625
5 0.125 0.125
6 (hub) 0 0
372 G. de Maere d’Aertrycke and Y. Smeers

Table 14.27 Flows Node Injection Line 1–6 Line 2–5

1 0.3 0.2 0.1
2 0.3 0.2 0.1
3 0.3 0.2 0.1
4 0.6 0.0 0.0
5 0.2 0.2 0.2
6 0.2 0 0
Total 0.5 0.5 1

Appendix 14.3: Change of ZPTDF Due to a Limitation

of Generation Capacity

Table 14.28 PTDF Node Line 1–6 Line 2–5

1 0.625 0.375
2 0.5 0.5
3 0.5625 0.4375
4 0.0625 0.0625
5 0.125 0.125
6 (hub) 0 0

Table 14.29 Flows Node Injection Line 1–6 Line 2–5

1 0.5 0.31 0.19
2 0 0 0
3 0.5 0.28 0.22
4 0 0 0
5 1.6 0.2 0.21
6 1.6 0 0
Total 4.3 0.80 0.20

Appendix 14.4: Computation of ZPTDF in the Three Zone Model

Table 14.30 PTDF Node Line 1–6 Line 2–5

1 0.625 0.375
2 0.5 0.5
3 0.5625 0.4375
4 0.0625 0.0625
5 0.125 0.125
6 (hub) 0 0
14 Transmission Rights in the European Market Coupling System: An Analysis. . . 373

Table 14.31 Flows Node Inflow Line 1–6 Line 2–5

NW 1 0.5 0.3 0.1875
2 0 0 0
3 0.5 0.28125 0.21875
4 0 0 0
5 0 0 0
6 0 0 0
Total 1 0.59375 0.40625
SW 1 0 0 0
2 0 0 0
3 0 0 0
4 0.8 0.05 0.05
5 0 0 0
6 0.2 0 0
Total 1 0.05 0.05
E1 0 0 0
2 0.66 0.33 0.33
3 0 0 0
4 0 0 0
5 0.3 0.04 0.04
6 0 0 0
Total 1 0.375 0.29

Appendix 14.5: Flows on Interconnection Due to Intra-zone

Market Clearing in the Three-Zone Model

Table 14.32 PTDF Node Line 1–6 Line 2–5

1 0.625 0.375
2 0.5 0.5
3 0.5625 0.4375
4 0.0625 0.0625
5 0.125 0.125
6 (hub) 0 0

Table 14.33 Flows Node Injection Line 1–6 Line 2–5

1 275 171.9 103.1
2 400 200 200
3 275 154.7 120.3
4 300 19 18.7
5 400 50 50
6 300 0 0
Total 0 186.9 214.0
374 G. de Maere d’Aertrycke and Y. Smeers

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Chapter 15
Incentives for Transmission Investment
in the PJM Electricity Market: FTRs
or Regulation (or Both?)

Juan Rosellón, Zdeňka Myslı́ková, and Eric Zenón

15.1 Introduction

Government led reforms of the electric industry have taken place in the United
States of America (USA) since the 1990s. The restructuring of the industry was
concerned with changing the system historically treated as a natural monopoly to a
free market industry. The generation and the distribution segments of the system
were opened to competition. Transmission services, because of its characteristics,
stayed as a monopoly under regulation. While the generation and distribution
sectors were thus flourishing under the reforms, the transmission sector experienced
a shortfall in necessary investment because it lacked incentives for development.
The system has become congested in various areas as growth in electricity demand

This paper was originally published as: Rosellón, J., Mysı́ková, Z., and E. Zenón (2011),
Incentives for transmission investment in the PJM electricity market: FTRs or regulation
(or both?). Utilities Policy January 2011, 3–13. We thank Jeff Pavlovic for valuable help with data
processing, and Hannes Weigt for helpful comments. Juan Rosellón acknowledges support from
Pieran_Colegio de México, the Alexander von Humboldt Foundation, and Conacyt (p. 60334).
The usual disclaimer applies.
J. Rosellón (*)
División de Economı́a, Centro de Investigación y Docencia Económicas (CIDE), and German
Institute for Economic Research (DIW-Berlin), Carretera México-Toluca 3655, Mexico, DF
01210, Mexico
e-mail: [email protected]
Z. Myslı́ková
Centro de Investigación y Docencia Económicas (CIDE), Carretera México-Toluca 3655, Mexico,
DF 01210, Mexico
E. Zenón
Facultad de Ingenierı́a, Universidad Nacional Autónoma de México (UNAM), Mexico, Mexico

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 377

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9_15,
# Springer-Verlag London 2013
378 J. Rosellón et al.

and investment in new generation facilities have not been matched by investment in
new transmission facilities.1
The transmission network is a critical part of the system, and in the last decade
transmission expansion became a crucial issue for the Federal Energy Regulatory
Commission (FERC) and the US Department of Energy (US Department of Energy
2002, 2006). It was then understood that without efficient transmission expansion,
the electric grid in the near future would be stretched far beyond its capacity
increasing dramatically the final cost of electric energy, and negatively affecting
the entire economy. Present-day reforms are searching for optimal mechanisms that
would provide adequate transmission investment incentives to guarantee expanding
the capacity of the network and relieve congestion problems. One area with
congestion problems in its electricity networks is the US region known as PJM.2
Our paper proposes and applies a mechanism that provides adequate incentives to
promote expansion of the network in this area.
This chapter is organized as follows. In Sect. 15.2, we review the literature on
incentive mechanisms for the expansion of electric transmission networks.
Section 15.3 reviews the features of the PJM electricity transmission market, its
current transmission pricing and investment policies. Section 15.4 provides descrip-
tion of the mechanism used in this paper for transmission expansion in the PJM
region. It is an application of a merchant-regulatory mechanism where the optimi-
zation problem is treated as a two-level (or bi-level) programming problem of a
Transmission Company (Transco), and an Independent System Operator (ISO). The
Transco maximizes its benefit subject to a regulatory constraint (upper level
problem). The ISO solves an optimal dispatching problem maximizing the social
welfare (lower level problem). The two levels are solved simultaneously. In
Sect. 15.5, the details of the simulation of the model are explained. The mechanism
is tested for 17-node geographical coverage area of PJM, divided into zones
according to the historical utilities control areas. The analysis addresses market
efficiency and changes in social welfare caused by changes in nodal prices (an
extension of the analysis for a modified region is provided in the appendix).
Section 15.6 concludes.

1
For a detailed analysis see the National Transmission Grid Study (NTGS) from US Department
of Energy (2002) or Joskow (2005a).
2
PJM is an abbreviation for the region operated by PJM Interconnection. The letters P-J-M
represent names of its three original principal member states: Pennsylvania, New Jersey and
Maryland.
15 Incentives for Transmission Investment in the PJM Electricity Market: FTRs. . . 379

15.2 Review of Literature: Incentive Mechanisms in Electricity

Transmission

This section presents a survey of current research paths on transmission expansion

mechanisms. We survey three approaches according to basic assumptions about
whether the transmission sector can sustain competition, and according to the
tools – regulatory, merchant and combined merchant-regulatory tools – employed
by the mechanism.3
There are two basic regulatory approaches suggested in the literature. First, there
is a regulatory mechanism based on price regulation (Vogelsang 2001). This mech-
anism relies on the rebalancing of the two (fixed and variable) parts of a price-
capped tariff. The fixed part of the tariff is an instrument through which long-term
costs are recuperated (i.e., it is a complementary charge). The variable part can be
understood as a nodal price difference in the sense of the financial transmission right
(FTR) literature (Rosellón 2003). The Transco rebalances over time the two parts of
the tariff while meeting the price cap established by the regulator, and efficiently
expands the network. The expansion process takes place so that incentives to keep
the network congested are broken and, under certain conditions, there will be
convergence to a steady-state Ramsey-type of equilibrium.4 However, a critical
aspect of the regulatory mechanism is its definition of the transmission output as the
capacity flow between two points, and also that its reliance on assumed smoothly
behaved properties of production and cost functions of transmission services
which –both in theory and practice – are difficult to establish. Hogan (2002) argues
that the properties of these functions are not well known (the functions are consid-
ered not linear), and are suspected to be generally non-differentiable and even
discontinuous. Also, the definition of transmission output in meshed networks is a
difficult issue. Under the definition of transmission output that he uses, the
Vogelsang (2001) mechanism can typically be applied to radial lines only.
The second regulatory approach is based on a measure of welfare loss with respect
to the Transco’s performance. The basic approach used in Léautier (2000) and
similarly in Joskow and Tirole (2002) is that the regulator rewards the Transco

3
Apart from the three main approaches, usually one more is mentioned in the literature. This
approach defines optimal expansion of the transmission network according to the strategic
behavior of generators, and considers conjectures made by each generator on other generators’
marginal costs due to the expansion. It explicitly models the existing interdependence of genera-
tion investment and transmission investment. However, it also relies on a transportation model
with no network loop flows.
4
The model reconciles allocative, productive and even distributive efficiencies as well as
promotes convergence to Ramsey prices. Likewise, the expansion process is incentivated since,
with the use of the mechanism, the expected revenues from expanding the network become greater
than or equal to the revenues from keeping the network congested. Convergence to a “congestion”
equilibrium –where the marginal cost of expanding the network equals the congestion cost of not
adding an additional unit of capacity – is also achieved (see Crew et al. 1995; Vogelsang 2001;
Hogan et al. 2010).
380 J. Rosellón et al.

when the capacity of the network is increased so that congestion rents are decreased.
On the other hand, the regulator can punish the Transco for taking advantage of a
congested network by charging increasing fees, and accumulating higher congestion
rents. Another variation is an “out-turn” based regulation. The out-turn is defined as
the difference between the price for electricity actually paid to generators and the
price that would have been paid absent congestion (Léautier 2000). The Transco is
made responsible for the full cost of out-turn, plus any transmission losses.
The merchant approach to transmission expansion aims to bring competition
into the transmission expansion process through the assignment of property rights
specified as FTRs. An FTR is a financial instrument that allows the value of
increased transmission capacity to be security and auction competitive, facilitating
the entry of the private sector into transmission expansion investment (Hogan
2002). FTRs are defined according to transmission capacity between nodes with
different prices, and grant their owner the right to collect the difference between the
nodal prices. This process motivates investment. The assignment of FTRs is
managed by the ISO. Under loop flows within a meshed transmission network,
negative externalities might arise on property-right holders since the expansion of
one link in the network might affect the capacities of other links. Kristiansen and
Rosellón (2006) suggest a solution to this issue where the ISO retains some
“unallocated FTRs” to use in case that negative externalities arise during the
expansion process. They argue that using unallocated FTRs prevents a gaming-
behavior of investors.
The last approach to transmission expansion aims to bring together the main tools
of both the merchant and regulatory mechanisms. Hogan et al. (2010) design a
combined model where price-cap regulation is merged with a redefinition of trans-
mission output in terms of FTRs. This allows that FTR auctions inherit the regulatory
logic in Vogelsang (2001). Conversely, the combined approach upgrades the
Vogelsang model into a bi-level programming model where an ISO maximizes
dispatch through a power-flow model providing the optimal loads and nodal prices
needed to achieve expansion in meshed networks according to the rebalancing of each
part of the two-part tariff. Rosellón and Weigt (2008) further combine the merchant
and regulatory price-cap mechanisms with an engineering approach to calculating
locational marginal prices (LMPs). They prove that this approach is effective in
incentivizing investment in a real transmission network in Northwestern Europe.

15.3 The PJM Electricity Market

The US transmission network is a part of the North American electricity transmission

system which consists of three interconnected systems – the Western Interconnect,
the Eastern Interconnect, and the Electric Reliability Council of Texas (ERCOT).
Together they comprise the bulk power system in the USA, much of Canada and a
small portion of Mexico. Each system is coordinated independently within its power
grid and the three systems are not synchronized together (electricity cannot flow
15 Incentives for Transmission Investment in the PJM Electricity Market: FTRs. . . 381

between them except through the use of asynchronous tie lines). The current day
organization of the electric industry in the USA differs across the states. In general
there is no agreement or policies (or mechanism employed) that would establish how
appropriate transmission investments should be identified, who bears the responsi-
bility for making the investments, and who pays for the associated costs (Joskow
2005b). While in some states (or regions)5 the operation via wholesale competitive
market was accepted, other regions keep the industry under a completely regulated
system without any marks of competitive market. No pure merchant system exists in
any state. Even if FERC maintains the function of the regulator of “last instance”
(exercising principal regulatory authority over interstate wholesale trade, and the
associated transmission interconnection) the electric power industry in the USA has
historically been regulated primarily by the states.6 The legal responsibilities for
important aspects of transmission policy are split between the federal government
and the states. Each state or region has unique circumstances and organization of the
transmission sector, and applied transmission investment policies.
Investor-owned utilities (IOUs) own 73 % of the transmission lines, federally
owned utilities own 13 %, and public utilities and cooperative utilities own 14 %.7
On one hand, in regions with wholesale markets (such as PJM, New York and New
England), LMPs are widely used and FTRs could be used as a risk hedging tool.8
Considering the investment to the transmission network, it is not always clear who
should pay for it. When a new generator is included to the interconnection,
reliability of the grid could be threatened, and new investment could be necessary
to upgrade the grid. The new transmission investment costs could be projected into
the basic charges for the transmission service reflected in their tariffs, or generators
bear the costs. The exact policies differ from one market to another. On the other
hand, in regions with pure regulation, transmission pricing and retail electricity
power prices are usually calculated based on cost of service or a utility’s embedded
costs plus a negotiated rate of return on their investments, and the transmission
network expansion policy is planned by state. From the point of view of expansion
of interconnection capacity between control area operators, there is no process in
place that would systematically evaluate opportunities to expand transmission
capacity on both sides of the borders between them (Joskow 2005b).

5
For example in PJM area, New England, New York or California.
6
Joskow (2005b) argues that states in the USA have a variety of different views on the desirability
of transitioning to competitive wholesale and retail electricity markets, and that there are has no
clear and coherent national laws that adopt a competitive wholesale and retail market model as
national policy.
7
The values correspond to the year 2000 (Department of Energy, Energy Information Adminis-
tration 1).
8
In the New York Independent System Operator (NYISO)’s region FTRs are also known as long-
term transmission rights or firm transmission rights.
382 J. Rosellón et al.

PJM Interconnection is a part of the eastern-interconnect grid nowadays manag-

ing high-voltage electric networks as well as the wholesale electricity market in
which 13 states9 and the District of Columbia were included in 2008. It provides
service to a population of approximately 51 million.10 PJM is a Regional Transmis-
sion Organization (RTO). It is federally regulated, with the service in the area
provided by IOUs and Public Owned Utilities (POUs).
As an RTO, PJM coordinates the movement of power within its region and is
responsible for the operational and planning functions of the PJM bulk power
system on behalf of participant members.11 It also administers an open access
transmission tariff that establishes prices for various categories of transmission
services available to the third party transmission users, and defines how the
associated revenues are distributed to the transmission owners (Joskow 2005b). It
is not engaged in wholesale or retail marketing, and does not own generation,
transmission or distribution assets. PJM actually operates four major product
markets: energy,12 capacity, FTRs, and the ancillary services markets. The price
of transmission service offered by PJM is based on traditional regulatory cost-of-
service (rate-of-return) formulas applied to one or more transmission owners.
The main features characterizing PJM markets are the use of LMPs and the
existence of FTRs as a tool for hedging against the congestion costs.13 LMPs in
PJM are defined as “the cost to serve the next MW of load at a specific location,
using the lowest production costs of all available generation while observing all
transmission limits” (PJM Member Training Department 2007). In this way, the
LMP reflects an equilibrium price including not only the value of available genera-
tion but the marginal losses and marginal cost of transmission congestion at each
location as well. The LMPs in PJM are collected from 10 main hubs.14 The FTRs
market provides the market participants an opportunity to hedge themselves against
congestion in the energy market. FTRs are obtained through annual and monthly
auctions and bilateral trading.15 It has a form of a financial contract which enables

9
All or parts of Delaware, Illinois, Indiana, Kentucky, Maryland, Michigan, New Jersey, North
Carolina, Ohio, Pennsylvania, Tennessee, Virginia, West Virginia.
10
After establishing competition in wholesale markets in the USA, PJM was the first largest
wholesale competitive operating market in the world. Currently it is one of the biggest Operators in
the USA together with NYISO, New England ISO, California ISO, and the Midwest ISO (MISO).
11
It is also responsible for maintaining the integrity of the regional power grid and for managing a
regional planning process for generation expansion needed to ensure the reliability of the electric
system (PJM Interconnection).
12
The administrated energy markets consist of real time and day-ahead markets.
13
Also the financial trading hubs, bilateral markets, day-ahead markets, real-time markets, ancil-
lary services and installed capacity.
14
The ten hubs for which PJM posts prices are: AEP Gen (all generator buses in AEP), AEP-
Dayton (all buses in AEP and Dayton), Chicago Gen, Chicago, Eastern, N Illinois, New Jersey,
Ohio, West Int., and Western.
15
Parallel to FTRs, another tool exists on FTR markets – it is called an Auction Revenue Right
(ARR). ARRs are allocated annually and provide their holders with revenue based on locational
15 Incentives for Transmission Investment in the PJM Electricity Market: FTRs. . . 383

the holder to receive revenues based on the day-ahead hourly energy price
differences across a specified transmission path, and so give their holders the
right to a proportionate share of annual congestion charges.
The transmission expansion planning is prepared by the RTO. There are several
categories of transmission investments in PJM. When a new generating unit seeks
to connect to the PJM network, the reliability criteria could be violated and an
investment to the new transmission capacity could be needed. Also “merchant
investment projects” (motivated by appearance of FTRs when a project is
implemented) or “economic transmission projects” (which are investments whose
expected economic benefits are associated with reductions in congestion costs)
exist (Joskow 2005b). In general, PJM develops an annual regional transmission
expansion plan that identifies transmission system enhancement requirements. The
transmission companies propose their plans about the construction of new trans-
mission lines or capacity increase to the RTO, FERC and the Department of Energy
(DOE). When a transmission expansion plan is approved, FERC can offer
incentive-rate treatment to reduce regulatory risk. The costs for investment made
in order to reestablish reliability after connecting a new generation unit are
generally paid by the generation unit.
According to the US Department of Energy (2006), the congested zones were
identified in both Eastern and Western interconnected systems. PJM is one of the
regions where one of the two principal critical congestion areas within the Eastern
Interconnect Grid has been identified.16 The area includes the eastern coast of the
PJM region – beginning at metropolitan New York continuing southwards through
Washington D.C. to Northern Virginia. Historically, the concern has always been
how to move the electric energy from the lower-cost western part of the market to
the eastern part of the market where the major load far away from the low cost
generation is situated. The congestion in the PJM region is caused mainly because
of the growing load together with plant retirements. Limited new generation
investment near loads is another cause of congestion there. Even if there is a
low-cost coal and nuclear power generation in Midwest, the east parts of PJM
cannot use it because the capacity of the transmission network does not allow it.17
The installed capacity of PJM at the end of 2006 was 162,143 MW. Table 15.1
provides an overview of the generation plants in PJM, installed capacities

price difference between ARR sources and sink determined in the annual FTR auction (see Frayer
et al. 2007).
16
The critical congestion area is defined as a place where it is critically important to remedy
existing or growing congestion problems because the current and/or projected effects of the
congestion are severe. In these locations of the network it has frequently been necessary to
interrupt electric transactions or redirect electricity flows because the existing transmission
capacity was insufficient to deliver the desired energy without compromising grid reliability
(US Department of Energy 2006, p. 21).
17
The nodal prices reflect the described congestion problem for the west-east deliveries. For
instance, at the western AEP-Dayton hub the nodal price in given moment in 2005 was $46/MWh
while at PJM Eastern Hub it was $66/MWh at the same time (PJM Interconnection 2006, and PJM
Summer 2007, Reliability Assessment).
384 J. Rosellón et al.

Table 15.1 Plant characteristics and price structure in PJM

% of total installed Part of total average weighted % of total
Plant type capacity in PJM LMP PJM price in the 2006 generation
Coal 41 % 38.7 % 56.8 %
Nuclear 18.5 % 0% 34.6 %
Natural gas 29 % 32.3 % 5.5 %
Oil 6.6 % 5% 0.3 %
Hydroelectric 4.4 % 0% 2%
Solid waste 0.4 % NA 0.7 %
Wind 0.19 % 0% 0.1 %
Source: Own calculations with from the PJM Interconnection (2006)

(in percentage terms), structure of average weighted LMP18 (how the fuel prices
influence the final LMP, in percentage terms), and percentage of total real genera-
tion. The PJM region could also be a power source for the neighboring regions
(especially the New York metropolitan area) as long as transmission cross-border
constraints are relieved.19

15.4 The Model

The model of transmission expansion that we apply to the PJM transmission

network integrates the key concepts of incentive mechanisms presented in
Sect. 15.2 of this paper, and relies on the modeling logic in Vogelsang (2001),
Hogan et al. (2010), and Rosellón and Weigt (2008). The approach is then a
combination of the merchant and regulatory mechanisms with an engineering
approach – it merges the tools of the two main models for the adequate transmission
expansion problem: a welfare optimization dispatch power-flow problem (lower-
level problem) with a two-part tariff cap regulatory model (upper level). The way it
is constructed simulates the real transmission operation and planning issues faced
by an ISO, and a Transco. It has power to model many crucial aspects of practical
cases where (1) a central authority applies certain kind of regulation, imposing a
regulation constraint, (2) the Transco, subject to the regulation constraint, charges a
fee for the transmission service and plans the transmission expansion, and (3) the
ISO, operating the wholesale market, manages the electric dispatch, subject to
the characteristics and capacity limitations of the transmission network. Its goal is
to dispatch electric power in an efficient way.

18
The other components of the average weighted nodal price are the price corresponding to
generating NOx, SO2, VOM and markup.
19
Figure 15.3 in the Sect. 15.5 shows some of the transmission links within the PJM region subject
to congestion.
15 Incentives for Transmission Investment in the PJM Electricity Market: FTRs. . . 385

The combination of the last three concepts is modeled in the following way:
1. The merchant mechanism is introduced via system of nodal pricing and FTRs.
Transmission expansion is carried out through the sale of FTRs. FTRs are
defined according to node pairs that suffer congestion, and are commercialized
via auctions where the participants enter voluntarily.
2. The regulatory part of the mechanism is based on Vogelsang (2001) regulatory
mechanism – a cap constraint is intertemporally applied over a two-part tariff.
3. Dispatching is modeled through a welfare optimization program, subject to the
engineering restrictions reflecting the transmission network’s technical
limitations. It defines the wholesale market prices in each short-run period.
The crucial step which enables the combination of the merchant and the regu-
latory approach is the definition of the transmission output in terms of FTRs. It is an
approach originally introduced by Hogan et al. (2010), and solves the shortcoming
of Vogelsang (2001) with an exact and convenient measure of transmission output
as point-to-point transactions or FTR obligations. Hogan et al. (2010) show that,
under certain conditions, convergence to Ramsey prices might be reached. In the
case of PJM, the transmission sector bears parts of regulation as well as merchant
elements. The structure in PJM region is similar to a theoretic “centralized ISO”
structure.20 The features of our model are in general compatible with the institu-
tional setup in the PJM region. In particular, the existence of a competitive
wholesale market with FTRs in PJM facilitates the application of our model.
Mathematically, the model is divided into two levels of optimization. The upper
level represents a dynamic profit maximization problem solved by a Transco when
considering transmission expansion. It reflects the opposite incentives that the
Transco faces – to expand the transmission network which releases congestion
and produces long term benefits for the society (given the growing demand for
electricity and need for higher capacity), or to keep congestion in the network and
get high congestion rents. The lower level problem reflects the optimization prob-
lem faced by an ISO operating the wholesale market, and dispatching the genera-
tion and transmission optimally. The lower problem, hence, defines the wholesale
market outcome. The two-part tariff maximization forms a dynamic optimization
problem running thru T periods, subject to complementarity constraints. The two
levels of the optimization are solved simultaneously.

15.4.1 Upper Level Problem

The Transco maximizes its objective function (the intertemporal flow of profits)
subject to a price cap constraint:

20
Wilson (2002) defines two possible structures for an ISO: a centralized structure and a
decentralized structure. Generally speaking, in the former structure the ISO coordinates the
equilibrium of the various electricity markets as a central planner, while the latter approach
would reach such equilibrium in a sequential way through the free participation of economic
agents. No electricity market has been proven to work in practice under a decentralized ISO.
386 J. Rosellón et al.

" #
X
T X X  
max p¼ tij ðk Þqij ðk Þ þ F N 
t t t t t
c kij i 6¼ j
t t
(15.1)
k;F
t ij i;j
s.t.:
P
ttij ðkt Þqwij þ Ft N t
ij
P  1 þ RPI þ X (15.2)
tt1
ij
qwij þ Ft1 N t
ij

The profit function allows for two basic sources of revenue – the first term of the
profit function represents the congestion rent. In the FTR literature the congestion
rent is generally defined as point-to-point FTRs, qBijB, between two nodes i and j,
multiplied by the FTR price, tBij B, which is set on the FTR auction. The congestion
rent is only charged in the lines that generate “space” for new FTRs. If the limit of
the overall capacity of a line is not reached during the transmission process in the
period t, there are no FTRs generated on the line in t, and no congestion rent
charged by the Transco.21 The second term is a fixed fee F charged to each of N
users of the transmission grid. It represents a fixed payment for the access to the
transmission network. The last term in the maximization problem is the cost
function, c(k), which represents the costs of transmission-line capacity expansion
between the nodes i and j incurred by Transco.
The restriction on revenue is the regulatory constraint set by the regulatory
authority. The constraint is built as a two part tariff cap. The opportunity to
rebalance the parts of the tariff guarantees that the Transco will not lose income
through the diminishing of the congestion rent when the transmission network is
expanded. A lower congestion rent will in turn decrease profits. This is offset as the
Transco counters the diminishing congestion rent by increasing the fixed fee.
The weights w used in the price tariff are the Laspeyres weights. According to
Rosellón (2007), the Laspeyres weights applied to the Vogelsang (2001) two-part
tariff mechanism grant a solution that will converge to an optimum under stable
cost and demand functions. The price cap also adjusts for an efficiency factor, X,
and an inflation factor, RPI. The Transco maximizes its profit subject to the
regulatory restriction, through T periods, considering the transmission lines
between all the nodes i and j within the grid. Perfect information is assumed and
there is no uncertainty about demand and generation capacity.22

21
The idea that the throughput has to reach the capacity upper limit of the line to be congested is
simplified. In reality, an important factor in congestion is also the susceptance of the transmission
lines. Certain susceptance of a line can cause the line to be a source of congestion even though the
throughput in the line has not reached the upper limit capacity of the line. This is considered in the
constraints of the lower level problem.
22
The model relaxes from an auction FTR price setting and the distribution of FTRs to the specific
market participants.
15 Incentives for Transmission Investment in the PJM Electricity Market: FTRs. . . 387

In order to find the first-order optimality conditions, ignoring inflation and the
efficiency factors, the derivative of the objective function (15.1) subject to the
constraint (15.2) is:

rqtij ttij ðkt Þ  rc ¼ ðqwij  qtij ðkt ÞÞrttij (15.3)

In order to simplify the application of this model to actual electricity networks

Rosellón and Weigt (2008) avoid the FTR. They redefine the system of (15.1) and
(15.2), so that the profit maximization problem can be rewritten as:
" #
X T X X  
max p ¼ ðpi di  pi gi Þ þ F N 
t t t t t t t
c kij i 6¼ j (15.4)
k;F
t i i;j

s.t.
P
ðpti diw pti gwi Þ þ Ft N t
P i
 1 þ RPI þ X (15.5)
ðpt1
i di pi gi Þ þ F
w t1 w t1 N t
i

The first term of (15.4) represents an alternative way to define the congestion
rent. Instead of a congestion rent expressed in terms of FTRs multiplied by their
price corresponding to each part of the grid, this is now defined in terms of the
market clearing prices, demand and generation at every node. More exactly, it is
defined as the difference between the payments from the loads, pi di , and the
payments to the generators, pi gi . When the loads pay the generators precisely the
price that energy costs at the place it was generated, no congestion and congestion
rent exists. The relationship between the market clearing prices, pi, and the FTR
prices used in the original maximization problem is tBij B ¼ pBj B  pBiB . The
regulation constraint is written in the same manner. It substitutes the FTR revenue
with congestion rents arising from the differences in nodal market clearing prices.

15.4.2 Lower Level Problem

This is a welfare maximization problem, and determines the wholesale market

outcome. The optimization of electric dispatch undertaken by the ISO is subject
to the technical restrictions of the network and power flows. There is a perfectly
competitive environment assumed where the ISO maximizes social welfare
W. Following Rosellón and Weigt (2008), the social welfare is defined as a
difference between the gross consumer surplus and the total generation costs23:

23
Rosellón and Weigt (2008) use this approach in order to obtain a more straightforward
expression of the consumer rent and generators’ rent.
388 J. Rosellón et al.

0 1
ðdi
t

XB C X
max W¼ @ pi ðdit Þddit A  mci gti (15.6)
d;g
i;t i;t
0

s.t.:

gti  gt;max
i 8i; t (15.7)
 
 t
pfij   kijt 8ij (15.8)

gti þ qti ¼ dit 8i; t (15.9)

The first restriction to the welfare optimization, (15.7), is a capacity constraint

that does not let any generation in any node i exceed its generation capacity.
Equation (15.8) reflects the restriction that the power flow pfBijB between the
nodes i and j cannot exceed the transmission capacity kBij B of the line. The
constraint described by (15.9) imposes that demand at each node is satisfied by
local generation or by a net injection kBi .
Then, in the same manner as in Hogan et al. (2010) and Rosellón and Weigt
(2008), a DC-Load-Flow approach is applied in order to get the power flow within
the meshed network. Simulation of the optimization of both levels simultaneously
leads to iteration of efficient solution values. From the lower level optimization
process, the vectors of optimal values of d and g, as well as nodal prices p, are
obtained and substituted into the upper level problem. Then the optimal values of
capacity k and fixed fee F are in turn obtained.

15.5 Transmission-Expansion Simulation for the PJM Network

The data used for the simulation are obtained from a “snap shot” of a power flow
during a non-peak demand period in the USA in 2006. The database information is
organized according to the transmission operators of six main regions within the
Eastern Interconnection in the USA, and a part of Canada. A more detailed
subdivision of the data is presented according to the historic control areas in each
region. In the system modeling for PJM, each of the historic control areas is called a
zone. Every zone is characterized by number of generators, total generation poten-
tial, transmission lines and instantaneous demand of load centers within the zone.
The total area operated by PJM (and included in the database) is divided into
15 Incentives for Transmission Investment in the PJM Electricity Market: FTRs. . . 389

17 zones.24 For the purpose of modeling the PJM network topology, one node is
assigned to each zone.25
Since the region that PJM operates has expanded significantly during various
years, there are two data sets considered for the simulation. The first data set covers
a region operated by PJM until 2006. The topology corresponding to this area is
tested for original non-peak demand obtained from the database. The second data
set is reduced to a region known as PJM-Classic which is an area operated by PJM
until 2001. This data set is tested for peak demand. The basic difference in peak and
non-peak demands will be reflected in the level of congestion within the network,
and in the level of the nodal prices. When peak demand has to be satisfied, higher
levels of energy are being transported among the nodes, and there is a higher load
for some lines in the grid. Hence, the lines are more prone to congestion. Moreover,
to satisfy higher demand it is more probable that higher cost generators would have
to be turned on. Together with higher congestion levels in the network, this is a
cause for higher peak-demand LMPs in comparison with the LMPs during the non-
peak demand periods. Details of the PJM Classic topology – and the corresponding
results for peak-demand data simulation – are included in the first part of the
appendix.

15.5.1 Topology of the Network

The first data set includes the area of PJM until 2006.26 Figure 15.1 represents the
simplified topology of its Transmission Network. There are 17 nodes in total, where
thirteen nodes are connected with more than two other nodes and the rest is
connected to one or two other nodes. In two cases, where a single historic control
area is divided in two parts without a common border, the topology follows this
division and two sub-zones per one control zone are considered. Each sub-zone has
its own node assigned in the model (nodes N11, N12 and N4, N5).

24
The analysis assumes a closed area with a closed system of transmission lines. While in reality
PJM trades energy to NYISO to the north, MISO to the west, and also to states in the south,
congestion linked to these exchanges is not considered in the topology.
25
The decision to assign one node to each zone comes from the fact that each utility owner within
the region of PJM is given monopoly over the zone where it operates.
26
The original PJM-West region was modified for the purpose of the simulation. First, it excludes
the territory nowadays corresponding to Virginia Electric and Power Company which was added
to PJM Interconnection in 2004 under the name of “Dominion Power”. This territory is considered
neither in the topology (and consequently nor in the simulation) because the data base does not
include it. Second, given that the analysis is for a closed area only (so as to preserve integrity of the
topology and avoid bias of results), the zone corresponding to Commonwealth Edison Company –
which is a part of PJM-West situated in the state Illinois – is excluded from the data set. The
exclusion was made because the zone has stronger transmission connections and commerce with
zones which are parts of different ISOs’ regions, and does not have common frontiers with any part
of the remainder area of PJM.
390 J. Rosellón et al.

Fig. 15.1 Topology of PJM (An explication of the abbreviations and precise location
corresponding to the nodes is shown in Fig. 15.7 in the Appendix). (Source: Own elaboration
with information from PJM Interconnection)

Fig. 15.2 Detailed scheme of transmission network (Source: Own elaboration)

The transmission lines between the connected zones were aggregated in a way to
obtain the total maximum capacity that can be transmitted between each two
connected zones. These total connected capacities are represented in the model as
single lines between the two zones. Because of the scale of aggregation, each
aggregated area is considerably large, and consists both of load and generator
centers. All nodes but node N14 (which has zero demand in the moment the
snapshot was taken) are considered to be load nodes.
A detail of the transmission network topology is shown in Fig. 15.2. It is a
scheme of variables, and their concrete values that are needed for the simulation.
Each node in the topology has associated its maximum generation capacities, a
reference (starting) demand, the cost of generation per MW, and the capacity of the
transmission lines that connect it with other nodes.
The distinction and the assignation of the fuel type used by the generation units
were made according to the maximum generation limit of the plant. This way the
distribution and classification of the generation units in PJM – the types of
generating plants and marginal cost of generating MWh corresponding to each
kind – were obtained, and are shown in Table 15.2. An equal marginal cost level is
assumed for each type of generation unit.
15 Incentives for Transmission Investment in the PJM Electricity Market: FTRs. . . 391

Table 15.2 Generation plant characteristicsa

Assumed technology MW cap for the generation plant Fuel Price for MWh
Internal combustion 1–20 MW Diesel $137.5
Turbine simple cycle 21–199 MW Natural gas $72.5
Turbine combined cycle 200–499 MW Natural gas $45
Coal 500–800 MW Coal $20
Nuclear 801–9,999 MW Uranium $12.5
Source: Own elaboration with information from PJM Interconnection
a
The fuel prices were obtained as an average cost reported in PJM Interconnection (2007) and
Edison Electric Institute data reviews (www.eei.org).

15.5.2 Initial Conditions

Our simulator works in such a way that, given the technical restrictions of the
network, the demand is satisfied employing the low cost generators first. On the
other hand, the total demand has to be satisfied completely (see (15.9) in
Sect. 15.4.2) even if the last activated generator produces energy for double, triple
or even higher costs compared to the first generator employed.27 The functional
forms – and if necessary also starting values of the parameters used in the
simulation – are assumed according to the values in Table 15.3.
The demand function for each node is derived from the load level for each node,
a reference price derived from the weighted average marginal cost28 corresponding
to every zone, and an assumed price elasticity of 0.25 at the reference point. The
demands are assumed to be linear. Uniform reactance values x0ij ¼ 42:5 for all the
lines are assumed in t ¼ 0 and individually change according to the expansion of
each line. A depreciation factor of 8 % is assumed.29
The tariff cap is formed using a Laspeyres index in the regulatory tariff where
the weights are the (t  1) period amounts. In the simulation there are 20 periods of
time considered. The derived market results for one time period represent 1 h.30
Even if the analysis of the transmission-network power flow is based on various
simplifying assumptions, in a simulation with three-node network simplifying
assumptions will not influence the general properties of the mechanism outcome.
When relaxing simplifying constraints, the robustness of the mechanism is not
affected – there is no effect on the desired properties of the mechanism. This result

27
We only consider in this paper the case where new capacity can only be added to already
existing transmission lines.
28
Weights for each level of marginal cost are settled according to the proportion of the maximum
generating potential of each plant type within the node.
29
The value of the depreciation factor is taken from Rosellón and Weigt (2008). Twenty years are
supposed to represent the depreciation time of assets in electricity markets and 8% represent an
investment with rather low risk. For simplification, we do not account for inflation or efficiency
factors within the Transco’s price cap.
30
As the values are obtained in hours, the Transco’s revenue is multiplied by 8,760 for each period
so as to represent yearly income.
392 J. Rosellón et al.

Table 15.3 Simulation values

Simulation values
Number of periods 20
Costs Linear
Cost function ctij ¼ c0  ðkijt  kijt1 Þ
C0 (line expansion cost) 130 $/MW
Demand Linear
Assumed elasticity 0.25
Reactance in t ¼ 0 x0ij ¼ 42:5
Source: Own elaboration with information from PJM Interconnection

Fig. 15.3 Potentially congested lines (Source: Own elaboration with information from PJM
Interconnection)

can be extended to a more complicated transmission network topology (see

Rosellón and Weigt 2008).
As mentioned in Sect. 15.3, there is an extended part of PJM that suffers high
grade of congestion. 12 “zones” suffering from congestion were identified (US
Department of Energy 2006). These congested paths within the PJM topology are
shown in Fig. 15.3 as the thicker lines connecting the nodes. Because of the scale of
aggregation, some of the congested parts inside the zones do not appear separately
but will be identified during the simulation in aggregation in a particular line.
The highest nodal prices correspond to the nodes on the eastern part of the
topology. These nodes correspond to an area that historically has high demand
given by high population density and – compared to the generation situated in the
west part of the region – with high cost electricity generation. Due to transmission
bottlenecks, it is not possible to transport cheap energy from the west to the eastern
part. The simulation will show if an application of the incentive mechanism would
lead to price arbitrage, and decrease of nodal prices.
15 Incentives for Transmission Investment in the PJM Electricity Market: FTRs. . . 393

Fig. 15.4 Price development for the PJM region (Source: Own elaboration)

15.5.3 Results: Price Development and Welfare Properties

The mechanism seeks to promote for capacity increase of the transmission lines,
which should then permit transmission of lower cost energy from the western part
of the region to the eastern-coast area. To test scope of the mechanism, the
development of nodal prices and welfare properties are considered as well.
Figure 15.4 shows price development in the PJM nodes over 20 periods. In the
first period the nodal prices differ substantially as they are subject to a high level of
congestion. Eastern node N2 has the highest nodal price ($100). The average price
of the nodal prices in the first period is $53.64. However, convergence towards a
common price level occurs fast within the first nine periods. The average price after
the first nine periods is 17 % lower compared to the average nodal price at the
beginning of the simulation. If the average level of the five highest nodal prices at
the beginning of the simulation is compared to the average price of the same nodes
after the first six periods of simulation, a decrease of 32 % can be observed. During
the rest of the periods, most of the nodal nodal prices change only marginally.
The extension of the grid follows similar dynamics – the grid is expanded exten-
sively during the first nine periods, and after the ninth period the grid expansion is
relatively small. The striking fall of the prices is visible mainly for the nodes N2, N4,
and N8. All of them are situated in the eastern area of PJM. This reflects the current
problem mentioned in the Sect. 15.3. Transmission congestion separates the eastern
part of the market from the remainder of the grid, and electricity prices on the east
coast are higher compared to the rest of the region. Transmission congestion does not
allow bringing cheaper energy produced in the western part of the region to the east.
394 J. Rosellón et al.

If the grid is expanded, cheap nuclear and carbon energy that can be produced
and transported mainly from nodes N10 and N12 is utilized to satisfy demand at
other nodes, and nodal prices in nodes N10 and N12 increase. The average nodal
price at the end of the simulation decreases to $43.11, which is 20 % lower than at
the beginning of the simulation. An arbitrage of nodal prices occurs and the former
difference of $87.5 between the highest and the lowest price at the beginning of the
simulation is reduced to $19.22 after the 20 periods.

15.5.4 Welfare Properties

The nodal price development brings about welfare changes. The purpose of the
mechanism is to permit arbitrage of prices, and an increase in social welfare, through
transmission expansion. When comparing social welfare, only changes that are
caused by nodal prices changes are considered. As argued in Vogelsang (2001),
the fixed fee acts as a lump-sum tax. The major concern is centered on the develop-
ment of the nodal prices which converge to marginal costs. Figure 15.8 in the
appendix shows the general development of the fixed fee when nodal prices increase.
In order to assess the performance of the mechanism (“Regulatory Approach”),
the results from the simulation are compared to the benchmark case without
network extension, and to a benevolent ISO case31 (“Welfare Maximization”).
Table 15.4 shows the welfare characteristics of the mechanism. The basis for the
estimation of the corresponding rents are the demand function of each node, the
congestion rent (first part in (15.4)), and consumer and producer surpluses (15.6).
An increase in consumer rent is observed after the mechanism is applied.
Consumers pay lower congestion costs. Even if the nodal prices increase in two
cases, the consumer surplus reduction is offset by a price decrease in the other 15
nodes. Note that the sum of the demands in the two nodes that experienced price
increase is not higher than the sum of the demands in the remainder part of the
system. Since, after the adjustment, prices lie above its marginal cost the producer
surplus increases as well as a significant part of total generation that corresponds to
nuclear and carbon generation.
The new installed capacity is 42 % higher than the capacity at the beginning of
the simulation. As expected, the congestion rent is not equal to zero but its level
decreases substantially. The original level of the congestion rent is reduced to 15 %
within the 20 periods. The regulatory approach then produces results that are
relatively close to a pure welfare-maximizing outcome, and suggest convergence
to the welfare optimum levels. Comparing the results for the European model tested
by Rosellón and Weigt (2008), the results for PJM show a similar tendency.

31
The benevolent ISO case is obtained from the maximization problem:
 
P d Ð P P  
max W ¼ pi ðdit Þddit  mci gti  c kijt , subject to the restrictions in the lower
d;g i;t 0 i;t i; j
level problem.
15 Incentives for Transmission Investment in the PJM Electricity Market: FTRs. . . 395

Table 15.4 Comparison of the regulatory and benevolent ISO approach for PJM region
No grid extension Regulatory approach Welfare maximization
Consumer rent (MioUSD/h) 6.53 6.63 6.67
Producer rent (MioUSD/h) 0.36 0.59 0.64
Congestion rent (MioUSD/h) 0.067 0.01 0.006
Total welfare (MioUSD/h) 6.95 7.23 7.32
Total grid capacity (GW) 35.8 50.83 52.83
Average price (USD/MWh) 53.64 43.11 42.97
Source: Own elaboration

Table 15.5 Comparison of the non-peak and peak demand nodal prices for the 17-and 14-node
topology
Non-peak demand (17 node
topology) Peak demand (14 node topology)
Number of the 1. Period nodal Final nodal 1. Period nodal Final nodal
node price price price price
1 $72.5 $47.23 $137 $49.70
2 $100 $53.84 $137 $59.30
3 $72.5 $47.23 $72.50 $46.20
4 $88.53 $49.01 $137 $51.97
5 $72.50 $47.23 $72.50 $46.76
6 $45.00 $38.16 $45.00 $46.70
7 $45.00 $43.04 $72.50 $46.15
8 $72.50 $47.43 $137 $59.30
9 $35.27 $35.33 $20.00 $39.60
10 $20.00 $36.86 $20.00 $39.30
11 $60.33 $47.36 $72.50 $46.80
12 $12.50 $34.62 $45.00 $42.70
13 $35.27 $38.12 $20.00 $39.40
14 $45.00 $37.72 $20.00 $39.70
15 $45.00 $43.21 – –
16 $45.00 $43.21 – –
17 $45.00 $43.21 – –
Source: Own elaboration

As mentioned at the beginning of this section, even more pronounced fall of the
nodal prices and bigger increase of the rents could be experienced if the demand
tested in the simulation were a peak one. In Table 15.5, results from the non-peak
demand and peak demand testing are compared. Details of peak-demand testing
within the smaller region of PJM called PJM-Classic are presented in the appendix.
The first period nodal prices for the peak demand testing are in several nodes higher
than in the case of non-peak demand. In general, this is given so as to satisfy the
peak demand. Apart from the cheapest generators that provide energy when
satisfying non-peak demand, more expensive generators have to be turned on.
Another factor that increases the total cost of providing energy for peak demand
is higher congestion. For the majority of the nodes, the final level of the nodal prices
is higher when peak demand is satisfied. For example, in the case of nodesN13 and
396 J. Rosellón et al.

N14, even if the first period nodal prices were higher for the non-peak demand, at
the end of the simulation their nodal prices are higher when the peak demand is
satisfied. However, when comparing the nodal price levels for the peak and
non-peak demand situations, it has to be taken into account that differences in
topologies influence the differences in the nodal prices as well.

15.6 Conclusions

This paper presents an application of a merchant-regulatory mechanism for transmis-

sion grid expansion to the transmission network in the PJM region. The theoretical
model is based on a structure with regulated profit-maximizing Transco, and a
competitive wholesale market with nodal price setting and FTRs. Regulation is
applied through a price cap imposed on a two-part price tariff that the Transco can
charge to users of the transmission network. The regulatory constraint allows for the
rebalancing of the variable and fixed parts of the fee in order to let the Transco preserve
its benefits when congestion rents decrease due to the increased transmission-grid
capacity. The Laspeyres weights are used in the two-part tariff mechanism. The
wholesale market is operated by an ISO that coordinates generation and transmission,
maximizing the social welfare. FTRs signal the need for new transmission capacity.
The purpose of the mechanism used for the simulation is to arbitrage nodal
prices and to foster their convergence to an steady-state equilibrium state with
lower congestion rents and higher total welfare. The capacity increases of the
transmission lines permit transmission of lower-cost energy to the zones with
higher demand and more expensive energy generation. The mechanism is
applied to the region that suffers critical levels of congestion combined with
growing demand. To date, no coherent mechanism that promotes adequate
expansion of the PJM transmission network exists. Moreover, the PJM network
is a complicated system of loads and generators covering a considerably large
part of the US area. Transmission services are getting unreliable in PJM, and the
congestion costs are a significant part of the energy price charged in the region.
A 17-node and 14-node network topology was designed for PJM, and the
mechanism is tested for both non-peak and peak demands. Starting with a grid
that suffers critical levels of congestion in various zones, the simulation of the
mechanism proves that after first nine periods the congestion is relieved, nodal
prices converge to a common lower average level resembling the marginal cost of
energy generation, the consumers pay lower congestion costs and both consumer
and producers surplus increase. In general, the nodal prices for peak-demand
periods are higher than for the non-peak period, given that more of the high-cost
generators are turned on and also because the higher demand could cause higher
congestion in the transmission lines. The simulation proves that the mechanism
works for a quite complicated meshed topology such as the PJM one. The installed
capacity of the 17-node transmission network after the simulation is 42 % higher
than the capacity of the original grid, and the congestion rent decreases to 15 % of
its original level. Total welfare increases. Given that the various composing
15 Incentives for Transmission Investment in the PJM Electricity Market: FTRs. . . 397

elements of our mechanism and its features are compatible with the FTR-based
competitive wholesale market in PJM region, we believe that our mechanism holds
promise for being applied in practice.
Next steps in modeling the PJM electric transmission system would implement
some new elements to the model. The purpose of future research would improve on
the engineering – lower level problem – part of the optimization, and focus in a
more detailed geographical division of the PJM region. The intention would be to
create different zonal divisions which could reflect the set of zonal areas that is
actually used in the internal PJM modeling. Additionally, we would also like to
improve on the data set on marginal costs. In the actual operation of markets,
marginal costs can be much higher due to imperfect competition.

Appendix

PJM Classic: Peak Demand Testing

The second data set includes the zones which comprised PJM prior to 2006, referred
to by the term “PJM Classic”. It takes account of the PJM region after the
establishment of a competitive wholesale power market and before it expanded,
when its operating territory consisted of eastern Pennsylvania, New Jersey, and part
of Maryland, Delaware and District of Columbia. Figure 15.5 represents the
simplified topology of the transmission network of PJM-Classic which has 14
nodes, and 26 transmission lines connecting the nodes.
Compared to the 17-node PJM region, this data sample excludes the zones
corresponding to nodes 15, 16 and 17. The PJM Classic topology is used in order
to test the mechanism facing a peak demand conditions.32 If not specified differ-
ently, the starting conditions and all the details of the simulation are the same as in
the case of simulation of the mechanism for 17-node PJM topology.
The results of nodal price development are shown in Fig. 15.6. In Table 15.6, the
welfare properties results are specified.
The general results are the same for both topologies – the nodal prices converge
to an equilibrium level after the first six periods of the transmission network
expansion. However, when comparing the welfare properties of the mechanism
for the simulation of the peak demand, the results are more pronounced, highlighting
the power of the mechanism. The average nodal price is almost 36 % lower after the
mechanism is applied, the transmission network capacity is doubled compared to the
first period, and both consumer and producer surplus increase. The price fall is
steeper and, given that the demand is higher, the consumers’ surplus increase is

32
The peak demand values were obtained adjusting the original demand data according to the
February 2006 peak values reported in “PJM Summer 2007 Reliability Assessment (2007)” for the
zones at PJM Classic.
398 J. Rosellón et al.

Fig. 15.5 Topology of PJM Classic region (Source: Own elaboration with information from PJM
Interconnection)

Fig. 15.6 Price development for PJM Classic region (Source: Own elaboration)

higher than in the case of 17-node PJM case.33 The congestion rent after the
20 periods of simulation decreases to 16 % of its original level.
In general, the welfare properties in case of higher demand are expected to be
more pronounced as the need for transmission network expansion in the network
that suffers high levels of congestion could be higher.

33
However, a comparison with the results for 17-node PJM topology should be made with
precaution as there are some significant differences between the cases. The PJM Classic topology
does not include three nodes with quite high demands and generation potential. Another important
detail is that it is tested for demand in different periods of the year and day.
15 Incentives for Transmission Investment in the PJM Electricity Market: FTRs. . . 399

Table 15.6 Comparison of the regulatory and benevolent ISO approach for PJM Classic region
No grid extension Regulatory approach Welfare maximization
Consumer rent (MioUSD/h) 8.01 8.13 8.17
Producer rent (MioUSD/h) 0.44 0.68 0.73
Congestion rent (MioUSD/h) 0.076 0.012 0.0076
Total welfare (MioUSD/h) 8.53 8.82 8.91
Total grid capacity (GW) 26.91 49.88 52.63
Average price (USD/MWh) 72.0 46.63 46.21
Source: Own elaboration

PJM Zones

Fig. 15.7 Map of PJM region and the utilities operating in each zone in the year 2008 (The map
was obtained from PJM Interconnection (http://www.pjm.com). The correspondence with the
abbreviations used in the topology are the following: AE Atlantic City Electric, BC Baltimore
Gas and Electric Company, DELM Delmarva Light and Power Company, JC_N Jersey Central
Power and Light Company (North), JC_S Jersey Central Power and Light Company (South), ME
Metropolitan Edison Company, PE PECO Energy Company, PEP Potomac Electric Power
Company, PL and PN Pennsylvania Electric Company, PS_N Pennsylvania Electric Company
(North), PS_S Pennsylvania Electric Company (South), UGI Public Service Electric and Gas
Company.) (Source: PJM Interconnection)
400 J. Rosellón et al.

7 40

6 35

30
5
25
4
20
3
15
2
10
1 5

0 0
0 2 3 4 5 6 7 8 9 10
Periods
Fixed Fee
Nodal price

Fig. 15.8 Fixed fee development (Source: Own elaboration)

References

Department of Energy, Energy Information Administration 1. (http://www.eia.doe.gov), consulted

in January 2009
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marginal prices in the PJM market and estimated short-run marginal sosts: 2003–2006. London
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Hogan W (2002) Financial transmission right formulations. JFK School of Government: Harvard
Electricity Policy Group Harvard University, Mimeo
Hogan W, Rosellón J, Vogelsang I (2010) Toward a combined merchant-regulatory mechanism
for electricity transmission expansion. J Regul Econ 38(2):113–143
Joskow P (2005a) The difficult transition to competitive electricity markets in the U.S. In: Griffin
J, Puller S (eds) Electricity regulation: choices and challenges. University of Chicago Press,
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Joskow P, Tirole J (2002) Transmission investment: alternative institutional frameworks. J Ind
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Kristiansen T, Rosellón J (2006) A merchant mechanism for electricity transmission expansion.
J Regul Econ 29:167–193
Léautier T (2000) Regulation of an electric power transmission company. Energy J 21:61–92
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Concluding Remarks

This book analyzed a variety of detailed concepts, theories and practical

experiences on FTRs. It should have provided its readers with an overview of
financial transmission rights, and their advantages and disadvantages. The theoretical
part of the book addressed the formal definition of FTRs and their different
modalities, going through the various mathematical formulations discussed by
Hogan (Chap. 1). Transmission pricing was studied as a basis for the derivation
of FTRs from nodal-price differences. Likewise, issues such as FGRs, forward and
spot auction markets, market power, FTR-based merchant and combined merchant-
regulatory mechanisms for transmission expansion, and FTRs in an experimental
economics framework were also covered in detail. The practical part of the book
dealt with issues such as real-world revenue adequacy in markets using LMPs,
practical aspects regarding bidding of FTRs, financial hedging and risk manage-
ment strategies. Likewise, it presented a comprehensive update on the most recent
status in countries implementing FTRs
The experience with FTRs the last decade has evolved substantially with more
markets to trade and more sophisticated FTR operations. FTRs have served their
purpose as transmission congestion hedging instruments. Additionally FTRs have
provided revenue sufficiency for contracts for differences, distributed the
merchandizing surplus an ISO or RTO accrues in market operations, and provided
a price signal for transmission developers. Moreover, as discussed by Arce (Chap. 11),
FTRs have become a very appealing financial instrument both to financial
institutions as well as to investors. Likewise, as described by Adamson and Parker
(Chap. 12), the experience with implementation of FTRs in the NYISO over the
period 2000–2010 shows that the market quickly reduced the transmission
congestion spreads between forward and spot prices after a relative inefficiency at
inception. However, FTRs may not always serve as a perfect hedge against
congestion charges, as alerted by Benjamin (Chap. 9).
Outside the US FTRs are still in their infancy. As claimed by Read and Jackson
(Chap. 13), in New Zealand and Australia FTR proposals have been mainly used to
hedge LMP risk. New Zealand has designed FTRs so as to deal with locational price
differentials resulting from losses and ancillary service requirements. Australia has

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 403

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9,
# Springer-Verlag London 2013
404 Concluding Remarks

issued FTRs between zones, but they are not as firm as the underlying capacity.
Likewise Europe discusses proposals similar to those of Australia including linking
FTRs to market coupling. However, Aertrycke and Smeers argue (Chap. 14) that
the organization of both transfer capacity and flow-based European models makes it
unlikely that firmness of FTRs can be guaranteed without restricting the
possibilities of the transmission grid.
Revenue adequacy is important for guaranteeing the firmness of FTR payments.
Yet, Bautista Alderete points out (Chap. 10) that attaining revenue adequacy is
difficult in practice due to the changing nature of the variables (such as derates and
outages) that impact both the issue of FTRs and funds gathered in the energy
market. The research by Oren (Chap. 3) demonstrated that in FTR/FGR markets
potential short positions by FGR owners might capture some of the FTR auction
revenues in exchange for assuming liability in the FTR market revenue shortfalls.
Moreover improvements in line ratings would be a way to reduce revenue
shortfalls.
One common allocation method for FTRs is auctions. O’Neill et al. propose
(Chap. 4) that the auction design might be improved by implementing a non-linear
model including forward auctions for FTRs in an AC load flow model, with reactive
power as well as auctions for FTRs on a DC load flow model with hedging for
losses. FTRs are also in principle enhancing social welfare. Henze et al. show
(Chap. 8) that introducing FTRs in an appropriate manner may reduce the physical
capacity needed for the full benefits of competition. The experimental-economics
analysis by Henze et al. on FTRs measures spot and LTFTR prices, capacity, and
welfare, and compares it to a simulated benchmark. These results demonstrate that,
overall, LTFTRs perform well, though showing some heterogeneity.
The main area where FTRs demonstrate some shortfall is transmission
investments. In PJM, the welfare efficient expansion of the network might be
achieved through a combined merchant-regulatory mechanism that includes the
FTR biddings. To mitigate these shortfalls Perez-Arriaga et al. propose (Chap. 2)
that transmission charges are to be calculated according to transmission investor
responsibilities. Furthermore independency from short-run commercial
transactions is required. Complimentary charges are to be calculated once and for
all in advance of construction of new transmission capacity. This further provides
solid ground for the further calculation and trading of FTRs. Kristiansen and
Rosellón propose (Chap. 6) a merchant mechanism for transmission investment
depending on investor preferences and simultaneous feasibility. Such a model
considers existing FTRs and FTR reserves for possible negative externalities.
Rosellón (Chap. 7) and Rosellón et al. (Chap. 15) suggest a combined FTR based
merchant-regulatory mechanisms to incentivize transmission expansion which can
be implemented as a price cap on the two-part tariffs of the transmission owner.
Such a mechanism converges over time to an efficient steady state Ramsey equilib-
rium. However, a potential weakness might be the way FTRs are allocated for the
existing network and their impact on retail rates, as discussed by Benjamin.
Furthermore, generators’ ownership of FTRs may influence the effects of transmis-
sion lines on competition. Joung et al. (Chap. 5) show that introducing FTR options
Concluding Remarks 405

or FTR obligations in an appropriate manner may reduce the physical capacity

needed for the full benefits of competition.
To sum up, we feel that the overall overview, both of the theory and practice of
FTRs, is however an optimistic one. FTRs contribute to reduce the transmission
congestion spreads between forward and spot prices, generally implying welfare
improvements. However, as discussed in Chaps. 2, 6, 7, and 15, FTRs alone are not
enough to provide sufficient incentives for efficient expansion of transmission
capacity. They need to be combined with adequate regulation. But again, the
introduction of FTRs together with LMPs in the framework of a competitive
electricity market provide adequate hedging of transmission price risk, grant reve-
nue adequacy for contracts for differences, efficiently redistributes congestion rents
that the system operator collects, and provides efficient price signals for transmis-
sion and generation investors. Of course, the further practical implementation of
FTRs faces the variety of challenges discussed throughout the book. We hope that
our text contributes in overcoming such challenges, as well as in inspiring future
research on FTRs.
Index

A gradient, 40–41
ARR. See Auction revenue right (ARR) linear approximations, 41–42
Asymmetric markets, 146, 147 objective function derivatives, 41
ATC. See Available transmission capacity optimal-value function, 39–40
(ATC) relaxation solution procedure, 42–43
Auction, FTRs sequential approximation approach,
data 38–39
base and dynamic models, 300, 301 violated constraint, 41
expected spot–forward prices, 301–302 real, reactive and complex power,
spot congestion prices, 298 45–46
transaction profits, 299, 300 resistance and reactance, 45
transmission system, 298 Auction model
design, 3 binding constraint, 170
execution, 3 derive prices, 166
formulation, 3 electric grid, 180
line capacitance, 45 nonlinear and non-convex problem, 170
LTFTR, 217–218 nonlinear optimization problem, 167
New York proxy award mechanism, 176
awards, 293–295 proxy award mechanisms, 180
banks and funds, 293 transmission capacity constraint, 179
day-ahead locational transmission expansion, 177
congestion prices, 296 Auction revenue right (ARR), 308
econometric models, 296–297 Australian market system
financial sector firms, 295 calculation, markets prices, 316
generators/marketers, 292 congestion, 323, 324
LMP, 296 constraints, 316–317
market participation, 294, 295 cross border flows, 328
POI/POW, 292 CRR, 325–326
retailers, 293 CSCs, 327–328
spot and forward prices, 296 CSP, 324–325
utilities, 292 FNP/FTR framework, 328–329
notation translation, 46 framework, CSP/CRR, 329
PTP, 30–31 GNP, 324
PTP-FTR interconnector support, 327
AC auction model, 38 locational hedging framework
DC-load approximation, 39 (see Locational hedging framework,
extension, 37–38 Australian market system)

J. Rosellón and T. Kristiansen (eds.), Financial Transmission Rights, 407

Lecture Notes in Energy 7, DOI 10.1007/978-1-4471-4787-9,
# Springer-Verlag London 2013
408 Index

Australian market system (cont.) operating costs, RTO, 241, 242

national electricity market (NEM), overhedging and underhedging, 243–244
315–316 RTO level, net costs, 241
NEM design and code, 323–324 CRR. See Congestion revenue right (CRR)
nodal pricing, 325 CSCs. See Constraint support contracts (CSCs)
PRHSC, 326–327 CSP. See Constraint shadow price (CSP)
proposals, 329–330 CVaR. See Conditional value at risk (CVaR)
protection, RHS capacity, 324
PRR quantity, 326
transmission capacity adjust, load and D
ancillary service, 328 Day-ahead and real-time markets, 99–100
Available transmission capacity (ATC), 78 DC-load approximations
assumptions, 21–22
calculations, 23
B determination, real power flows, 21
BCs. See Binding constraints (BCs) formulation, 22
Binding constraints (BCs) implications, 24
congestion, 275, 309 inversion and topology, 24
generators, 326 net loads balancing losses, 26
lower level problem, 170 non-linear properties, 25
transmission, 14, 275 optimization algorithms, 22–23
restatement, security-constrained economic
dispatch, 23–24
C small angle differences and line losses,
Competitive market 25–26
duopoly and monopoly quantity, 146–147 DC optimal power flow (DC OPF), 261–262
FTR Dispatch and forward markets
obligation model, 149 energy and transmission auctions,
option model, 149 112
Joskow and Tirole’s model, 148 ISO auction markets, 111–112
reference model, 146 multi-settlement system
Conditional value at risk (CVaR), 281 nodal price, 114
Congestion. See also Hedging pre-day-ahead forward energy
European market coupling system transactions, 114
charges, 357 uniform clearing price rule, 112, 113
FB model (see Flow based (FB) model) revenue adequacy, auction sequence,
hedging (see Hedging, congestion) 114–116
nodal model, 357
TC model (see Transfer capacity (TC)
model) E
PTP-FTR Electricity markets and forward contracting,
losses, 31–32 214–215
loss prices and loss rentals, 32–33 Electricity transmission expansion
payments cost, 31–32 auction model (see Auction model)
PJM implementation, DC-Load competition assumptions, 160–161
dispatch model, 31 complementary charge, 161
Congestion revenue right (CRR), 325–326 economic analysis, 158
Constraint shadow price (CSP), 324–325 institutional structure, industry, 162
Constraint support contracts (CSCs), 327–328 Kuhn-Tucker conditions, 181–182
Cost inflation, FTR long-run nodal price fluctuations, 181
distributional impacts, 243 “loop flows”, 157
factors, 241, 242 LTFTR, 158, 162–163
insufficient revenue, NYISO, 241–242 “merchant”, 160
Index 409

normalization and non-negativity guidelines framework, 333

conditions, 183–184 implementation, 370
potential expansion, 180 incremental exports flows, North-South
power costs and transmission costs, 157 model, 371–372
power flow model and proxy awards (see interconnection, two-node model cross-
Power flow model) border trade, 371
power-market structure, 159 intra-zone market clearing, three-zone
proxy awards, 163 model, 373
radial line, 170–172 literature, 335
security-constrained dispatch, 161 market splitting (MS), 333
three-node network, two links nodal system, 333–334
feasible expansion, 172, 173 nodal to zonal models, 337–339
FTRs, 173 and Nordic power market, 333
Kuhn-Tucker multiplier and OPF, US, 337
transmission capacity multiplier, 175 power exchanges (PXs), 336
Lagrange multiplier, 174 three-zone model, 342–344
power flows, 176 transmission services (see Transmission
proxy preferences and pre-existing services, market coupling)
amount, FTRs, 174 TSO and regulation, 334
“Transco”, 159 two zone model, 339–342
two-part tariff cap, 159 ZPTDF (see Zonal power flow distribution
welfare effects, 158 factors (ZPTDF))
Electricity transmission networks
costs, 192
economics, 193 F
EU markets, 208 FACTS. See Flexible AC transmission system
externalities, 191–192 (FACTS)
grid expansion and pricing, 191 FB model. See Flow based (FB) model
incentive-regulation (see Performance- Federal Energy Regulatory Commission
based-regulation (PBR) and (FERC), 96, 130
merchant mechanisms) FERC. See Federal Energy Regulatory
incentives analysis, 192 Commission (FERC)
institutional structure, 192 FGRs. See Flow gate rights (FGRs)
liberalization processes, 208 Financial transmission rights (FTRs). See also
literature, 208–209 New York FTR markets
LTFTR and PBR, 193 analytical expressions, 133
market power increases, 191 asymmetric markets, 146, 147
merchant-regulatory approach (see competitive market, 146–149
Merchant-regulatory approach, congested situations, 150
electricity transmission networks) Cournot best response output, 153
merchant transmission investment, directions, 133
198–203 economic benefits, 130
European market coupling system electricity markets, 129
congestion (see Congestion, European FERC, 130
market coupling system) Game theory, 129, 131
cross-border exchanges, electricity, 331 market system
definition, 336 Australia (see Australian market
design, 370 system)
electricity grid, 334–335 FNP, 305
electricity transports, TSOs, 336–337 inter-regional hedging, 305–306
ETSO-EuroPEX, 335 New Zealand (see New Zealand market
flow based (FB) model, 335 system)
410 Index

reforms and developments, 305 three-node load model, 237

obligation model (see Obligation model, two-node model, 230–231
FTRs) wholesale price electricity regulation,
optimal aggressive and passive outputs, 234
134, 153 long-term transmission capacity rights, 230
option model, 136–140 obligation vs. option, 230
profit, firm, 153–155 short-run incentives, 229
profit function, 151, 152 tradeoff, 229
PTP (see Point-to-point (PTP) FTR properties
formulations) allocation (see FTR allocation)
reference model cost inflation
best response curves, 135, 136 distributional impacts, 243
competition-promoting effects, 135 factors, 241, 242
Cournot best response output, 134 insufficient revenue, NYISO, 241–242
electricity market, 134 operating costs, RTO, 241, 242
symmetric two-firm model, 135 overhedging and underhedging,
two market model, 132–133 243–244
Firmness RTO level, net costs, 241
financial rights, 369 data sources
physical rights, 369–370 administration charges, 246
TC system, 367 congestion costs, 246
Flexible AC transmission system (FACTS), 4 ISO-NE’s annual markets report lists,
Flow based (FB) model 246–247
congestion charges legal settlements and FTR defaults, 248
GDSK, day-ahead and forward markets, long-term FTRs, 248
361–362 market report 2008, NYISO, 247
hedging, 362 differences, 245–246
non recognize domestic congestion, 361 functions
recognize domestic congestion, 362 distributing, merchandizing surplus, 244
three zone, 354–356 hedging, 244
two zone (see Two zone model, FB) price signal, 244–245
Flow gate rights (FGRs) grid expansion, incremental FTRs
feasible region, FTRs, 92–94 allocation, 227–228
FTRs, 78 hedging (see Hedging)
lines capacities, 87 LMP, 228
LMPs (see Locational marginal prices LSE, 245
(LMPs)) market imperfections, 245
Forward and spot market, 218–219 price risk exposures, 227, 228
Forward prices, 222–223 settlements, wholesale electricity market,
FTR allocation 228
differences, grid expansions and extant transmission pricing, 228–229
grid, 230 Full nodal pricing (FNP), 305
distribution
assumptions, energy and capacity
markets, 235–236 G
electricity cost, 232 Generation and demand and shift key
impacts, 234–235 (GDSK), 363
long-run equilibrium, 232–233 Generation shift key (GSK)
LSEs pay congestion charges, 234 capacity, incremental N-S export, 351
market place, 230 intra-zone energy markets, 340, 348–349
power settlement, 231–232 unit export, intra-zone equilibrium,
retail-rate impacts, FTR revenues, 234 341, 348
RTO, 231 and ZPTD constraints, 349
Index 411

Generation weighted average price (GWAP), J

307 JETRA. See Joint energy and transmission
Generator nodal pricing (GNP), 324 rights auction (JETRA)
Generic transmission line analysis JETRA-NL model, 106, 123–124
representation, 44 Joint energy and transmission rights auction
and transformer, 44 (JETRA)
GNP. See Generator nodal pricing (GNP) day-ahead and real-time energy markets,
GSK. See Generation shift key (GSK) 102
GWAP. See Generation weighted average price dispatch and forward markets (see Dispatch
(GWAP) and forward markets)
FERC, 96
forward and spot market designs
H characterization, 97, 98
Hedging day-ahead and real-time markets,
bilateral trade revenues, 239–240 99–100
characteristics, load aggregation ISO and non-ISO, 97–98
impacts, 238–239 pre-day-ahead markets, 98–99
non-contract power settlements, 238 ISO markets, 95–96
three-node network, 237–238 LMP, 96, 123
congestion network models, 102
description, 363–364 nonlinear constraints (see Nonlinear
FB and TC model, 363 constraints, auction)
financial rights, nodal and zonal non-linear transmission network
systems, 364–367 constraints, 100–101
firmness, financial rights, 369–370 products
GDSK, 363 electricity products, 102
nodal system, transmission rights, 363 energy, 102–103
PTRs and FTRs, 367–368 point-to-point transmission rights,
interpretations, 240–241 104–105
managing electricity market risks, 239 simple transmission capacity rights and
market imperfections, 240 portfolio combinations, 103–104
supply revenue, FTRs, 239 quadratic losses
bidders, 118
current and voltage laws, 116
I dispatch model, 122
Independent system operator (ISO) financial right holders, awards, 121
auction markets, 112 formulation, 118–119
centralized, 192 injection-withdrawal pair, 117
day-ahead energy markets, 99–100 ISO, 119
financial transmission and energy rights, iteration, 120
121 nodal and flowgate prices, 119–120
forward markets, 97 three node network, 117
JETRA-NL, 119, 120 violating revenue adequacy, 122
NYISO (see New York Independent withdrawals and LMPs, 121
System Operator (NYISO)) revenue adequacy, 123–125
pre-day-ahead, 98–99 wholesale market design process, 96
unhedged congestion, 242 Joskow and Tirole’s model, 148
Inter-regional settlements residue (IRSR), 318
Investor-owned utilities (IOUs), 381
IRSR. See Inter-regional settlements residue L
(IRSR) Line shadow price (SP), 80
ISO. See Independent system operator (ISO) LMPs. See Locational marginal prices (LMPs)
Load weighted average price (LWAP), 307
412 Index

Locational energy pricing schemes forward auction, 217–218

classification, 64 forward contracts, 212
management, 63 laboratory experimentation, 213
nodal differentiation, energy prices, 64–65 “merchant” mechanism, 158
power system dispatch, 63 network
single pricing, 67–69 access, 216
zonal differentiation, 65–67 infrastructure, 211
Locational hedging framework, Australian operators, 216–217
market system regulator, 216
firm access problem, 317 parameters, 216, 217
inter-regional flows, 319 regulation, gas pipelines and electricity
intra-regional congestion, 317 grids, 212
IRSR, 318 regulator, 216
market settlements surplus, 317–318 timing of activity, 216, 217
MNSPs, 318 LRA. See Locational rental allocation (LRA)
payout ratio distribution, interconnectors, LTFTR. See Long term financial transportation
321, 322 rights (LTFTR)
performance and firmness, interconnectors, LWAP. See Load weighted average price
321–323 (LWAP)
SRA process and statistics, 319–321
Victoria-South Australia (VIC-SA)
interconnector, 323 M
Locational marginal prices (LMPs) Market-clearing model
congestion price component, 290 intra-zonal transmission systems, 340
day-ahead market LMPs, 99 price difference, 341
description, 80 Market coupling system. See European market
FTR, 81–82 coupling system
JETRA-NL, 120, 122 Market equilibrium, PTP optimal power flow
NYISO, 296 benefit function, 16
OPF, 78 consumers, 16–17
optimal dispatch, 80 description, 16
PTDF, 79 economic dispatch problem, 18
quantities, 80 framework, 16
shadow price, 81 profits, 17
Locational rental allocation (LRA), 308, 310 properties, 17–18
Long term financial transportation rights service transmission, 17
(LTFTR) Market network service providers (MNSPs), 318
demand and cost functions, 212 Market splitting (MS), 333
description, 212 Mega-Volt-Amperes-Reactive (MVARs), 3
electricity markets and forward contracting, Megawatt (MW) award, 253
214–215 Merchant and regulatory mechanisms,
environment, 216 384–385, 396
experimental data Merchant-regulatory approach, electricity
differences, spot and forward prices, transmission networks
222–224 DC load approximation model, 205–206
efficiency measure, 221 definition, price-cap model, 204
forward prices, 222, 223 HRV mechanism, 206–207
spot prices, 222, 223 ISO environment, 203–204
static and dynamic efficiency, 221, 222 loop-flows, 204
time path capacity, 219 non-Bayesian mechanisms, 203
time path welfare, 220–221 price cap index, 206
feasibility rule, 162–163 price-taking generators and loads, 204
forward and spot market, 218–219 properties, transmission cost and demand
functions, 204
Index 413

MNSPs. See Market network service providers hybrid proposal, 310–311

(MNSPs) hydro dominated system, 311
MVARs. See Mega-Volt-Amperes-Reactive inter-island HVDC flows, 312
(MVARs) loss cost/rentals, 311
LRA, 308, 310
market-clearing auction, 313–314
N nodal pricing proposal, 306
Network cost recovery re-allocate assets, 308
allocation, grid and users requirements, hedging, 310
agents responsibility, 71–72 retailer, 310
construction, 71 revenue adequacy, 313, 314
expensive lines, 71 shareholding, 304
regulators, 71 transmission charges, 306
connection charges and UoS, 70–71 Nodal prices
differences, energy price, 69–70 computation
grid constraints, 70 consumer surplus, 55
incentive regulation, 69 impacts, 56
revenues, 70 line capacities, 54
short-term economic signals, 70 ohmic losses, 55
UoS charges design, 72–73 reference node, 56
Network infrastructure, 211 system economic dispatch, 54
Network losses, 50–51 transmission losses, 56
Network operators, 216–217 definition, 53
New York FTR markets description, 53
auction (see Auction, FTRs) locational energy pricing schemes (see
congestion price difference, 291 Locational energy pricing schemes)
congestion prices, 291 properties
electric power system, 289 allocation, network losses and
POI and POW, 291, 302 redispatch costs, 57–58
spot market pricing system, 291 contribution, network investment and
TCCs, 291 maintenance costs, 58–60
test efficiency and learning, 297 decomposition, energy, losses and
transmission congestion pricing, 289–290 congestion components, 60–61
New York Independent System Operator sensitivity line flows, power injections,
(NYISO) 62–63
auctions, 292 short-term energy prices, 57
congestion prices, 291 short and long term marginal costs,
FTR markets, 289 53–54
zones and zone names, 290 Nodal to zonal models, market coupling
New Zealand market system demand and cost functions, 338
AC transmission system, 307 PTDFs, 338–339
code changes and market manager, 315 six-nodes and eight lines, test problems,
congestion rents increases, 308 337–338
differential components, OTA-BEN price, trilateral market, 337
311–313 Nonlinear constraints, auction
early 1989, 305 energy and transmission rights, 110–111
electricity market and connection assets, mathematical statement
306–307 index sets, 107
FGR, 306 JETRA-NL model, 106
FTR market gaming, 310 parameters and functions, 108–110
FTR support grid, 314 variables, 107
GWAP and LWAP hub prices, 308–309 NYISO. See New York Independent System
hedging and economic signalling, 309–310 Operator (NYISO)
414 Index

O P
Obligation model, FTRs Participant rental right (PRR) quantity, 326
firms’ strategic behaviors, 141 PBR. See Performance-based-regulation (PBR)
negative obligations, Cournot equilibrium, Peak demand testing, PJM classic region
144, 145 price development, 397, 398
obligation-type rights, 139 regulatory and benevolent ISO approach,
positive and negative price difference, 139 397, 399
positive obligations, Cournot equilibrium, typology, 397, 398
142–144 Performance-based-regulation (PBR) and
unconstrained Cournot equilibrium, 141, 142 merchant mechanisms
OPF. See Optimal power flow (OPF) incentive regulation
Optimal power flow (OPF) capital and operating costs, 193–194
abstract benefit and cost functions, 9 England and Australia, 194
DC-Load approximations (see DC-Load ISS, 198
approximations) Laspeyres index, 196
DC-load approximations, 21–26 price level and structure regulation, 195
economic dispatch, 10–13 price periods and calculation, 197
benefit function, net loads, 11 pure price-cap approach, 197
guarantee, 12 Transco’s performance, 194
MVA, 10 transmission cost and demand
non-linear and non-convex problem, 11 functions, 195–196
real power bus loads, 10 Vogelsang model, 195
shadow and locational prices, 12–13 transmission investment
transmission constraints, 10 asymmetries information, 201
various control parameters, 11 European Union, 202–203
economic interpretations, 9 expansion, FTR auctions, 198–199
linear approximation, constraints, 19–21 long-term and short-term models,
first order conditions, 19 FTRs, 200
local, 19 loop flows, 201
relaxation solution procedure, 20–21 LTFTR mechanism, 199, 202
Taylor approximation, 19 New York ISO’s, 199
market equilibrium (see Market equilibrium, proxy awards, 201–202
PTP optimal power flow) PTP-FTRs, 199
real power, 9–10 returns and lumpiness, 200
security constrained, 84 trilateral market coupling (TLC), 203
security-constrained economic dispatch, Physical transmission rights (PTRs)
13–15 firmness, 369–370
congestion cost, 15 guidelines, 367–368
description, 14 PoI. See Point of injection (PoI)
limits, transmission system, 13–14 Point of injection (PoI), 291, 302
monitored elements, overloads, 15 Point of withdrawal (PoW), 291, 302
net loads, 14 Point-to-point (PTP) formulations
standard procedure, 13 approximation, 2
Option model, FTRs auction (see Auction, FTRs)
best response curves, 137, 138 definition, 2, 26
equilibrium forms, 137 design, 2
nodal price difference, 136 generic transmission line (see Generic
optimal aggressive, passive, and Cournot transmission line analysis)
responses, 137 obligations
ownership, 137 balanced mix and unbalanced rights, 27
passive/aggressive equilibrium, 139 congestion, 31–33
unconstrained Cournot equilibrium, forward, 27–28
138–140 FTR auction, 30–31
Index 415

hedging, 28 PRR quantity. See Participant rental right

market clearing prices, 27 (PRR) quantity
payments, 28 PTDF. See Power transfer distribution factors
revenue adequacy (see Revenue (PTDF)
adequacy) PTP. See Point-to-point (PTP) formulations
optimal power flow (see Optimal power PTP and flow-based FTR
flow) allocation, revenue shortfalls, 91–92
options ATC, 78
description, 33–34 description, 78
FTR auction, 37–44 dispatch and transmission rights ownership, 77
revenue adequacy, 34–37 energy transactions, 94
physical interpretation, transmission rights, feasible region, FGRs, 92–94
1–2 line deration and topology changes
requirement, electricity markets, 1 feasible region, 88, 89
revenue adequacy (see Revenue adequacy) flowgate capacity, 88, 89
spot market, 26–27 optimal dispatch, 89–91
transmission line, AC load flow model ratings, flowgate capacity, 85, 88
AC electric network revenue adequacy, 88–90
FACTS, 4 settlements, 90, 91
generic, 4–7 SFT, 88
individual flows, 7 LMPs and FGRs, 78–82
Kirchoff’s laws, 9 managing congestion risk
literature, 4 central coordination, 84
measure, MWs and MVARs, 3–4 day ahead market, 82
MVA, 4 lines and flow limits, 82, 83
and net loads, 8–9 nodal prices and shadow prices, 82
real power losses, 8 portfolio protects, 83
transformer ratios and phase angle PTDFs, 83
changes, 7–8 quantities, 77
PoW. See Point of withdrawal (PoW) revenue adequacy and SFT, 84–87
Power flow distribution factors (PTDFs), PTRs. See Physical transmission rights (PTRs)
338–339
Power flow model
economic dispatch model, 163 R
FTRs, 166 Radial line, electricity transmission expansion
LTFTRs, 166 maximization problem, 171
point-to-point obligations, 164 optimization problem, 170–171
proxy awards, 165 transmission capacity, 172
revenue adequacy, 165 Regional transmission operator (RTO). See
transmission congestion, 164 Independent system operator (ISO)
Power transfer distribution factors (PTDF) Revenue adequacy
LMP, 80 acronyms, 254–255
transmission investment, 186–188 allocation gaps, 259–260
transmission lines, 79 calculation, market-wise metric, 260
Pre-day-ahead markets, 98–99, 114 California ISO market, 264–265
PRHSC. See Protected right hand side capacity causes, 258–259
(PRHSC) DC OPF, 261–262
Price development, PJM electricity market, definition, 2–3
393–394 description, 253–254
Profit and Loss (PL) report, 281 feasibility test, 255–257
Protected right hand side capacity (PRHSC), FTRs hedge, 254
326–327 interpretation, 263–264
416 Index

Revenue adequacy (cont.) description, 342

locational marginal price, 262–263 impact, unit export, 343–344
measure, 257–258 intra-zone equilibrium, 343
megawatt (MW) award, 253 OPF, inter-zone market clearing, 344
net nodal injections, 263, 264 FB model
neutrality, 265–267 grid, 355
prices impact, 260 long and short term TC model, 356
PTP-FTRs TC construction, 355–356
obligations, 29–30 ZPTDF, 354
options, 34–37 TC model, 354
shadow prices, 264 transmission services, market coupling
surpluses and deficiencies, 264 flow based (see Flow based model (FB))
symbols, 255 TC (see Transfer capacity (TC) model)
transmission ZPTDF, 372–373
constraint, 260–261 TLC. See Trilateral market coupling (TLC)
gap, 265 Trading FTRs
limits, markets, 264 analysis, 273–275, 287
variations auction, 280
auction rents, 269 characteristics, 282
congestion vs. losses, 268 data
day-ahead market vs. real-time market, art software, 272
268 dimensionality, 273
hourly basis over an accounting period, dispersion, 273
268 ISOs, 272, 273
reimbursements, FTR payments, 269 mapping, 273
Revenue neutrality, 265–267 third parties, 272, 274
description, 271
global financial markets, 286
S interaction
Settlement residue auction (SRA) process and back office roles, 283, 284
statistics, 319–321 diverse interests, 284
SFT. See Simultaneous feasibility test (SFT) management, researchers/analysts, and
Simultaneous feasibility test (SFT) risk takers roles, 283
convex polyhedron, 85 transmission system, 282
feasible dispatch, 86 long-term auction, 282
FTR market, 84 managing current exposure, 278–279, 287
LMPs, 86 market risk assessment, 280–281
obligation, FTR, 85, 86 metrics, 281
revenue surplus, 87 PL, 281
Spot prices, 221–222 portfolio construction, 275–277, 287
System operation costs potential evolution
constraints, networks, 51–52 consolidation, 286
energy prices and network charges, 50 Quant desks, 286
network losses, 50–51 underfunding and liquidity, 285
physical limitations, network profile requires, 284–285, 288
transmission, 50 risk management process, 280
quality, electricity supply service, 52 trade execution, 277–278, 287
Transfer capacity (TC) model
congestion charges
T hedging, 367
TCCs. See Transmission congestion contracts non recognize domestic congestion,
(TCCs) 357–358
TC model. See Transfer capacity (TC) model Nordic system, 360
Three-zone model recognize domestic congestion,
European market coupling system 358–359
Index 417

TSO calculations and guarantee, profit function, 386

359–360 regulation, 387
three zone model, 354 tariff guarantees, 386–387
two zone model, 345–348 welfare properties (see Welfare properties,
Transmission congestion contracts (TCCs), PJM electricity market)
291 zones, 399
Transmission congestion pricing, New York Transmission pricing See also Transmission
LMP markets, 289–290 congestion pricing, New York
NYISO, 290 economic impact, 49
zones and zone names, 290 effect, system operation costs (see System
Transmission investment, PJM electricity operation costs)
market energy prices, 74
characteristics and capacity limitations, grid, electric power systems, 49
network, 384 net revenues, 74
congestion, 383 nodal prices (see Nodal prices)
description, 376 recovery, network cost (see Network cost
eastern-interconnect grid, 382 recovery)
electric grid, 376 service, 74
expansion planning, 383 Transmission services, market coupling
expansion simulation counter-trading, 344
congested lines, 392 description, 344
database information, 388 EU, 344
generation plant characteristics, 391 three zone model
generators, 388–389 flow based (see Flow based model (FB))
topology, 389–390 TC (see Transfer capacity (TC) model)
values, 391–392 two zone model
features, 382–383 flow based (see Flow based model (FB))
implementation, 397 Northern and Southern zones, 345
incentive mechanisms, 377–378 TC (see Transfer capacity (TC) model)
industrial reforms, USA, 375–376 USA, 344
installed capacity, 383 Transmission system operators (TSO) and
interconnections, US transmission network, regulation, 334
380–381 Trilateral market coupling (TLC), 203
investor-owned utilities (IOUs), 381 Two zone model
Laspeyres weights, 396 European market coupling system
literature review, incentive mechanisms, demand, generation and power prices,
379–380 339
LMPs, 381 market clearing, 340–341
lower level optimization problem, 387–388 northern and southern markets, 341–342
merchant and regulatory mechanisms, radial topology, 339
384–385, 396 trilateral B-F-NL market, 339–340
peak demand testing (see Peak demand FB
testing, PJM classic region) adding transmission rights, 350
plant characteristics and price structure, description, 348
383–384 GSK (see Generation shift key (GSK))
price development, 393–394 imperfects, 352
purposes, 396 long and short term TC model, 353
regional transmission organization, 382 meaning, 348
upper level dynamic profit maximization netting, 350
problem non-linear GDSK, 351
congestion rent, 387 TSO, 348
price cap constraint, 385–386 TC model
418 Index

adding transactions, 347 fixed fee development, 394, 400

characteristics, computing non-peak and peak demand nodal prices,
interconnection, 345–346 395–396
grid, 346 and price development, 394
long and short term TC, 347
netting, 346–347
N-S interconnection, 346 Z
property, 346 Zonal financial transmission rights
central auctioning, 367
forward markets
U and day-ahead markets, 365–366
UoS. See Use of the system (UoS) real time, 366
Use of the system (UoS) Zonal power flow distribution factors (ZPTDF)
and connection charges, 70–71 computation, three zone model, 372–373
design, 72–73 limitation, generation capacity, 372
three zone, FB model, 354
Zone-to-zone and critical branch rights,
W 364–365
Welfare properties, PJM electricity market ZPTDF. See Zonal power flow distribution
characteristics, 394, 395 factors (ZPTDF)
consumer and congestion rent, 394