The Dynamic Impact of Market Integration: Evidence from renewable energy expansion in Chile

Author Name Luis E. GONZALES (Pontificia Universidad Catolica de Chile and CLAPES UC) / ITO Koichiro (Visiting Fellow, RIETI) / Mar REGUANT (Northwestern, BSE, CEPR, and NBER)
Creation Date/NO. May 2022 22-E-050
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Effective and economical expansion of renewable energy is one of the most urgent and important challenges in addressing climate change. However, many countries are facing a problem because existing network infrastructures (i.e., transmission networks) were not originally built to accommodate renewables, which creates disconnected networks between demand centers and renewable supply sources. In this paper, we study the static and dynamic impacts of market integration on renewable energy expansion. Our theory highlights that statically, market integration improves allocative efficiency through gains from trade, and dynamically, it incentivizes new entry of renewable power plants. Using two recent grid expansions in the Chilean electricity market, we empirically test our theoretical predictions and show that the commonly-used event study estimation underestimates the dynamic benefits if renewable investments occur in anticipation of market integration. We build a structural model of power plant entry and show how to correct for such bias. We find that market integration resulted in price convergence across regions, increases in renewable generation, and decreases in generation cost and emission of pollutants. Furthermore, a substantial amount of renewable entry would not have occurred in the absence of market integration. We show that ignoring this dynamic effect would substantially understate the benefits of transmission investments.