A Simple Regulatory Incentive Mechanism Applied to Electricity Transmission Pricing and Investment

34 Pages Posted: 14 Nov 2017 Last revised: 10 Jul 2018

See all articles by Mohammad Reza Hesamzadeh

Mohammad Reza Hesamzadeh

Royal Institute of Technology (KTH) - Electricity Market Research Group (EMReG)

Juan Rosellon

Centro de Investigacion y Docencia Economicas

Steven Gabriel

Department of Mechanical Engineering and Applied Mathematics, Statistics, and Scientific Computation Program, University of Maryland

Ingo Vogelsang

Boston University - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Date Written: October 1, 2017

Abstract

The informationally simple approach to incentive regulation applies mechanisms that translate the regulator’s objective function into the firm’s profit-maximizing objective. These mechanisms come in two forms, one based on subsidies/taxes, the other based on constraints/price caps. In spite of a number of improvements and a good empirical track record simple approaches so far remain imperfect. The current paper comes up with a new proposal, called H-R-G-V, which blends the two traditions and is shown to apply well to electricity transmission pricing and investment. In particular, it induces immediately optimal pricing/investment but is not based on subsidies. In the transmission application, the H-RG-V approach is based on a bilevel optimization with the transmission company (Transco) at the top and the independent system operator (ISO) at the bottom level. We show that HR-G-V, while not perfect, marks an improvement over the other simple mechanisms and a convergence of the two traditions. We suggest ways to deal with remaining practical issues of demand and cost functions changing over time.

Keywords: Electricity Transmission, Incentive Regulation, Multi-Level Optimization

JEL Classification: D24, L51, L94, Q40

Suggested Citation

Hesamzadeh, Mohammad Reza and Rosellon, Juan and Gabriel, Steven and Vogelsang, Ingo, A Simple Regulatory Incentive Mechanism Applied to Electricity Transmission Pricing and Investment (October 1, 2017). DIW Berlin Discussion Paper No. 1696, Available at SSRN: https://ssrn.com/abstract=3070064 or http://dx.doi.org/10.2139/ssrn.3070064

Mohammad Reza Hesamzadeh

Royal Institute of Technology (KTH) - Electricity Market Research Group (EMReG) ( email )

Lindstedtsvägen 30-100 44
Stockholm, SE-100 44
Sweden

Juan Rosellon (Contact Author)

Centro de Investigacion y Docencia Economicas ( email )

Carretera Mexico Toluca 3655
01210 Mexico, D.F.
Mexico

Steven Gabriel

Department of Mechanical Engineering and Applied Mathematics, Statistics, and Scientific Computation Program, University of Maryland ( email )

1143 Glenn L. Martin Hall
College Park, MD 20742-3021
United States

Ingo Vogelsang

Boston University - Department of Economics ( email )

270 Bay State Road
Boston, MA 02215
United States

CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Poschinger Str. 5
Munich, DE-81679
Germany

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