Transmission constraints and imperfect markets for power

This article argues that, while most of the economic gains from the restructuring of the power industry will be achieved in electricity generation, trading and retailing, the transmission grid holds the keys to an important share of the economic value created by the process. Using a simple three-node network, this article shows that an increase in transmission capacity has two effects: (1) cheaper power can be used, and (2) competition among generators is increased. This carries three policy implications: first, policy makers can and should use transmission expansion to increase competition in generation. Second, generators will not necessarily finance nor advocate optimal transmission expansion: they may prefer to keep the rents derived from local market power, rather than gain better access to markets, even if they receive transmission payments corresponding to their investment, as suggested in parts of the United States. Finally, this work provides support for the vertical separation between generation and transmission, beyond the traditional foreclosure argument.