Network Expansion to Mitigate Market Power

Abstract

Constrained transmission capacity in electricity networks may give generators the possibility to game the market by specifically causing congestion and thereby appropriating excessive rents. Investment in network capacity can ameliorate such behavior by reducing the potential for strategic behavior. However, modeling Nash equilibria between generators, which explicitly account for their impact on the network, is mathematically and computationally challenging. We propose a three-stage model to describe how network investment can reduce market power exertion: a benevolent planner decides on network upgrades for existing lines anticipating the gaming opportunities by strategic generators. These firms, in turn, anticipate their impact on market-clearing prices and grid congestion. In this respect, we provide the first model endogenizing the trade-off between the costs of grid investment and benefits from reduced market power potential in short-run market clearing. In a numerical example using a three-node network, we illustrate three distinct effects: firstly, by reducing market power exertion, network expansion can yield welfare gains beyond pure efficiency increases. Anticipating gaming possibilities when planning network expansion can push welfare close to a first-best competitive benchmark. Secondly, network upgrades entail a relative shift of rents from producers to consumers when congestion rents were excessive. Thirdly, investment may yield suboptimal or even disequilibrium outcomes when strategic behavior of certain market participants is neglected in network planning.