Economics of electricity grid interconnections: A heterogeneous markets’ design context

In electricity markets, a heterogeneous market design context arises when grid interconnections link a regulated market to a liberalised one. This paper reviews how these “heterogeneous interconnections” operate, identifies their currently prevailing capacity allocation mechanisms, and investigates the economics of grid interconnections with a special focus on the heterogeneous context. Our results reveal significant diversity in how heterogeneous interconnections function and allocate their capacity. The capacity allocation mechanisms often appear to be adaptations of those utilised in homogeneous market design contexts, without accounting for the unique challenges of heterogeneous contexts. We develop a conceptual framework illustrating how social welfare in interconnected markets evolves with cross-border exchange. We highlight that achieving the efficient outcome, fully utilising the cross-border capacity up to full arbitrage, is unlikely to occur when individual markets behave strategically as incentives to hinder electricity flow exist. These inefficiencies are amplified in the heterogeneous context due to information asymmetry in favour of the regulated market, and its utility’s monopoly over arbitrage decisions. We conclude by briefly discussing possible approaches to mitigate these inefficiencies. This paper therefore provides one of the first comprehensive analyses of heterogeneous interconnections, offering policy insights for regulators and market operators alike.