Regulation of Electricity Interconnectors in the EU: Providing Efficient Investment Incentives for Project Developers Through the Lens of the “Real Options” Approach

Electricity interconnectors are key to integrating adjacent electricity markets. They can play a vital role in the continuing deployment of renewable energy sources, because they make flexibility sources, e.g., pump storage, available to a larger number of network users. The European Commission has promoted the European single market in electricity since at least 1996. In the EU and the UK, interconnectors have already had an impact on reshaping cross-border electricity trade. In the EU, there are two polar cases of incentivizing investments in new interconnector capacity: (i) under the standard EU regulatory framework for transmission system operators (TSOs) or (ii) under an exemption regime. The former is designed for TSOs who are assumed to have market power and may underwrite grid investments by revenues charged from network users. The latter recognizes the increased risk under which interconnectors may operate. Here, the amortization of the investment depends on realized congestion rents. The regulators of UK and Belgium have developed a hybrid “cap & floor” model, which includes elements of both polar cases. We present a survey of interconnectors in Europe and find that several of them, both regulated and exempted, operate under regimes which include cap-type elements. Setting return caps for interconnectors exposes regulators to a whole new challenge: at what threshold level should returns be capped (or shared with network users) so that – in expectation – the interconnector recovers its costs, including an adequate rate of return. This chapter shows that the widely used capital asset pricing model (CAPM) in isolation is not suitable to provide a meaningful answer to this question. We show that the economics of real options analysis can answer the question of setting the “right” return threshold. The real options framework may also be applied to other regulated infrastructure facing demand uncertainty and limited market power.