Network Expansion to Mitigate Market Power: How Increased Integration Fosters Welfare

Lack of transmission capacity hampers the integration of the European electricity market, and thereby precludes reaping the full benefits of competition. We investigate the extent to which transmission grid expansion promotes competition, efficiency and welfare. This work proposes a three-stage model for grid investment: a benevolent planner decides on network upgrades, considering welfare benefits of investments through a reduction of market power exertion by strategic generators. These firms anticipate their impact on market clearing, in particular when lines are congested. To this end, we provide the first model effectively endogenizing the trade-off between costs of grid investment and benefits by reduced market power potential. In a three-node network, we illustrate three distinct strategic effects: firstly, by reducing market power exertion, network expansion can promote welfare beyond pure efficiency gains: optimally accounting for strategic generator behavior can push welfare close to a first-best competitive benchmark. Secondly, network upgrades entail a relative shift of rents from producers to consumers, and thirdly, they may yield suboptimal or even disequilibrium outcomes when strategic behavior is neglected.