Does Market Integration Help to Expand Renewable Energy?

ITO Koichiro
Visiting Fellow, RIETI

Effective and economical expansion of renewable energy is one of the most urgent and important challenges for addressing climate change. The electricity sector generates one of the largest shares of global greenhouse gas emissions along with the transportation sector. In addition, a significant part of the transportation sector is expected to be electrified in the near future. Decarbonizing electricity generation is therefore critical to addressing climate change.

Many countries are facing a challenge

However, many countries are facing a challenge in expanding renewable energy because existing network infrastructures (i.e., transmission networks) were not originally built to accommodate renewables. Conventional power plants, such as thermal plants, were able to be placed reasonably close to demand centers (e.g. large cities), and therefore, minimal transmission networks were required to connect supply and demand. However, renewable energy, such as solar and wind, are often best generated at locations that are far from demand centers.

Two problems arise from the lack of market integration between renewable-intensive regions and demand centers. First, when renewable supply exceeds local demand, electricity system operators have to curtail electricity generation from renewables to avoid system breakdowns, even though this means that operators need to discard the zero-marginal cost electricity produced from renewables. This curtailment indeed occurs in many electricity markets. Second, because the marginal cost of renewable electricity is near zero, local market prices in renewable-intensive regions tend to be low and often become negative when it cannot be exported to demand centers. These two problems discourage both new entries and investment in renewable power plants. Indeed, many countries have started to realize these problems are among the first-order policy questions. For example, the Biden administration in the United States considers investment in transmission lines and renewable energy to be a key part of the infrastructure bill, currently proposed to be 1.75 trillion US dollars.

Evidence from Economic Theory and Data from Chile

My coauthors, Luis E. Gonzales at Pontificia Universidad Catolica de Chile, Mar Reguant at Northwestern University and I examine this question by providing theoretical and empirical analyses on the impacts of market integration on renewable expansion and allocative efficiency in wholesale electricity markets (Gonzales, Ito, and Reguant, 2022). We begin by developing a simple theoretical model that characterizes the static and dynamic impacts of market integration. In the static scenario, we assume that market integration does not affect producers' entry decisions. In this case, the value of market integration can be summarized by a conventional definition of gains from trade. Market integration allows lower-cost power plants to export and replace production from higher-cost power plants, which results in an improvement in allocative efficiency.

However, this conventional approach does not incorporate the potential dynamic impact of market integration. When producers can anticipate market integration, they have incentives to invest in new production capacity that will be profitable in the integrated market. This investment effect changes the supply curve of production, which results in an equilibrium that is different from the static case. Our model shows that this dynamic impact of market integration can be substantial, and ignoring this impact would understate the impact of market integration.

With this insight, we empirically quantify these theoretical predictions by exploiting two large changes that recently occurred in the Chilean electricity market. Until 2017, two major electricity markets in Chile---Sistema Interconectado Norte Grande (SING) and Sistema Interconectado Central (SIC)---were completely separated with no interconnection between them. Recently, this separation has been recognized as an obstacle to expanding renewable energy because renewable-intensive regions (near Atacama desert) are located far north from demand-centered regions (near Santiago, the capital city). To address this problem, the Chilean government completed a new interconnection between these two markets in November 2017, and an additional extension transmission line in June 2019 (see Figure 1).

Figure 1. Market Integration in the Chilean Electricity Markets
Figure 1. Market Integration in the Chilean Electricity Markets

Not only do these expansions provide a unique research environment for applying our theoretical and empirical framework to study the impact of market integration, but the Chilean electricity market also offers another unique advantage in the comprehensiveness of its data. We are able to collect nearly all of the data relevant to market transactions, including hourly unit-level marginal cost, hourly node-level demand, hourly node-level market clearing prices, hourly unit-level electricity generation, and plant characteristics such as capacity, technology, year built, and investment.

Market Integration Helped Renewable Expansion and Cost Reductions

We begin by presenting visual and statistical evidence of the static impacts of market integration on wholesale electricity prices, production, and cost. First, we show that the market integration in Chile resulted in price convergence across regions. Before the market integration, we observed that SING and SIC often had substantially different market clearing prices. In addition, within SIC, the Atacama desert region often became an isolated local market when its solar production exceeded the local demand and the region had limited transmission capacity to other regions. We show that the market integration substantially reduced this spatial price dispersion by increasing prices in renewable-intensive regions and decreasing prices in demand centers (see Figure 2).

Figure 2. Impacts of Market Integration on Spatial Variation in Electricity Prices
Figure 2. Impacts of Market Integration on Spatial Variation in Electricity Prices
[Click to enlarge]

Second, we investigate the static impacts of market integration on electricity production and cost. Consistent with our theoretical prediction from gains from trade, we find that the market integration allowed lower-cost power plants, including renewables, to increase their production, which replaced production from higher-cost plants. We find that the market integration resulted in a decrease in the cost of electricity generation per megawatt hour.

Third, we examine how the market integration affected new entries of renewable capacity. We find that a rapid growth in renewable capacity started right around the first announcement of the market integration in 2015, which was two years before the completion of the transmission line construction in 2017. In addition, we find that the node prices in renewable-intensive regions were near zero during this rapid increase in renewable capacity and increased to a profitable level for renewables only after the market integration. This evidence suggests that renewable investors made their investment decisions based on the anticipation of the market integration. This evidence also suggests that the static analysis, which ignores the potential impact on investment in new generation capacity, could understate the impact of market integration, as it is suggested by our theory.

To investigate the potential dynamic impacts of market integration, we build a structural model of power plant entries. In the model, investors consider investment for a new power plant based on the expected value of long-run profit from the investment. The net present value of investment depends on profit from subsequent years. A key element to the future expected profit is transmission constraints from its local region to other regions. The attractiveness of the Chilean market is that its simple geography makes the network model tractable and makes it feasible to conduct counterfactual analysis. We simulate a few counterfactual policies on transmission capacity expansion to examine each policy’s impact on capacity investment in renewables, node prices, profits, and consumer surplus.

Our counterfactual simulations reveal several findings. First, our static result suggests that the market integration of solar generation in Chile increased 17% relative to the counterfactual case with no market integration. This is because in the absence of market integration, the system operator would have had to curtail excessive amounts of power from solar due to transmission constraints. Second, this number still understates the impact on solar investment because a substantial amount of solar investment would have become unprofitable without market integration due to low market prices. We simulate the market equilibrium to find the maximum level of solar capacity investment that could be positive in the net present value, given the discounted rate and duration of investment used by the Chilean government's public infrastructure projects. Our dynamic result suggests that the full impact of market integration on solar generation was a 45% increase in solar generation, as opposed to the 17% increase if we ignore this dynamic impact.

Our results indicate that both the static and dynamic impacts of market integration are important factors in the evaluation of transmission investment. In our context, we find that the static effect itself resulted in 10.1% and 4.9% reductions in electricity generation cost per megawatt hour in hour 12 (a solar-intensive hour) and all hours, respectively. If we incorporate the dynamic effect on solar investment, these reductions in generation cost are 13.6% and 6.3%. Our simulation results also indicate that both the static and dynamic impacts play key roles in the price convergence across regions (see Table 1).

Table 1. Counterfactual Simulation Results
Table 1. Counterfactual Simulation Results

Our findings provide important implications for energy policy in many countries. For example, the Biden administration in the United States considers the investment in transmission lines and renewable energy to be a key part of the infrastructure bill, currently proposed to be 1.75 trillion US dollars. Our theoretical model and empirical evidence from Chile provide several key implications related to the design of the new transmission infrastructures in the US electricity markets.

  • Gonzales, Luis, Koichiro Ito, and Mar Reguant. 2022. "The Value of Infrastructure and Market Integration: Evidence from Renewable Expansion in Chile." Working Paper.

February 15, 2022