Congestion Risk, Transmission Rights, and Investment Equilibria in Electricity Markets

Abstract

Financial instruments that help provide revenue certainty are fundamental for project finance in liberalized electricity markets. Nodal markets have financial transmission rights (FTRs), which enable participants to manage locational risk caused by network congestion. Despite the industry's concern for locational risk, there is no evidence that FTRs are used to support project finance. Through a stochastic equilibrium model in which market participants invest in production assets and trade risk, we show that long-term FTRs promote surplus-maximizing investments and reduce the cost of capital. Investors pair them with energy price hedges and thus protect themselves against both types of risk. Our results suggest that altering the tenor and auction design for long-term FTRs to match the needs of project finance could help ensure a complete risk market and encourage surplus-maximizing investments. Improved management of locational risk is becoming increasingly important with a growing share of production from geographically remote renewable resources.

Keywords: financial transmission rights (FTRs), locational risk, project finance, stochastic equilibrium, electricity markets, risk trading