In a new policy brief, the Regulatory Assistance Project (RAP) proposes a new approach to financing crucial interconnection projects at the pace needed to meet European policy goals. A Contestable Approach to Financing Critical Interconnection Across Europe at the Scale and Pace Needed proposes a contestable approach to interconnector investment aimed at introducing new sources of capital to ensure a robust and secure transmission network. Greater interconnection capacity also will help to meet Europe’s renewable targets more cost-effectively through the exploitation of areas of high-quality renewable resources and reduced curtailment, while the ability to balance energy and demand over wider areas will ease the integration of renewable capacity.

To achieve these goals, the European Commission estimates that EUR 105 billion in new interconnector capacity will be needed by 2020, while available funding is a small fraction of the amount needed. RAP’s proposed approach aims to fill this gap by allowing both incumbent transmission system operators and private investors to compete in reverse auctions to develop transmission projects identified as ‘projects of common interest’ by the Commission.

“The contestable approach delivers the lowest-cost solution, encourages innovation, and, most importantly, brings new sources of capital into the market,” said Phil Baker, senior advisor at RAP and author of the policy brief. “A similar approach in Brazil delivered savings up to 44 percent below the expected price.”

Baker outlines the current approaches to funding interconnectors, both of which present challenges. Transmission system operators normally develop interconnection resources on a fully regulated basis, with investment costs allocated between the coupled Member States and recovered via national transmission tariffs. However, due to regulatory differences between Member States, the creation of clear ‘winners’ and ‘losers’, and the fact that returns are often not sufficient given the additional difficulties associated with developing cross-border projects, transmission system operators tend to focus their limited resources on internal projects rather than interconnectors.

In the alternate merchant-exempt approach, investors fund interconnection projects in return for the rights to the revenues arising from the energy price differentials across the interconnection. Unlike regulated projects, cost recovery risks lie entirely with investors. Merchant investment suffers from a significant disadvantage in that projects are generally undersized. Investors aim to maximise returns from congestion rents and don’t account for the social value of additional interconnector capacity such as enhanced security and resilience, increased competition and liquidity, as well as further reductions in congestion.

Developing interconnection projects on a contestable basis combines the advantages of the regulated and merchant approaches and avoids some of the disadvantages. Projects can be sized to maximise welfare, while the prospect of regulated returns over the lifetime of a project reduces the cost of capital. Competition between potential providers encourages innovation and gives regulatory authorities comfort that projects will be delivered at the lowest cost to consumers. Importantly, a contestable approach also allows infrastructure investors an additional route to investing in Europe’s transmission system at a time when investment requirements are at an all-time high.