The Limits of Direct Cross-Border Participation in Capacity Markets of Weakly Interconnected Systems

Antón García Díaz, Albert Riera, and Alberto Martin Cedillo recently authored an article assessing direct cross-border participation in European Capacity Remuneration Mechanisms and its implications for electricity market design.

The views expressed in this article are the sole responsibility of the authors and cannot be attributed to Compass Lexecon or any other parties.

Executive Summary

Capacity Remuneration Mechanisms (“CRMs”) have become an increasingly important feature of European electricity markets as Member States seek to address growing adequacy concerns associated with the energy transition. While CRM designs differ across jurisdictions, there is a clear trend, particularly among larger electricity systems, towards market-wide mechanisms in which capacity is procured competitively through centralized auctions.[1]

At the same time, the European regulatory framework has progressively strengthened the requirement that national CRMs allow the participation of foreign capacity providers. In particular, Regulation (EU) 2019/943 requires Member States operating CRMs to enable direct cross-border (“XB”) participation, while recent European Commission guidance establishes such participation as a prerequisite for fast-track State aid approval of market-wide mechanisms.

The case for direct cross-border participation appears simple: if foreign resources can compete in domestic capacity auctions, countries may be able to rely on a wider pool of adequacy resources and reduce the cost of securing supply.

However, this logic only holds where foreign resources can actually increase their contribution during domestic scarcity events. Whether this condition holds can be assessed through a simple test: are imports constrained by the availability of foreign capacity, or by the interconnector itself? If imports are limited by the availability of foreign generation, direct XB participation may create value by improving incentives for investment, availability or delayed retirement abroad. In those circumstances, direct XB participation can be an efficient way of procuring adequacy across borders. But if imports are limited by the interconnector itself, paying foreign generators is unlikely to increase the effective contribution of foreign resources.

This test is particularly important for weakly interconnected systems. When interconnection capacity between two countries is limited relative to the size of the neighbouring system, scarcity events in the importing country are likely to coincide with full utilisation of the interconnection. In such circumstances, the scarce resource is not generation capacity in the neighbouring market, but the interconnection itself. Under these conditions, direct XB participation may primarily result in transfers from domestic consumers to foreign generators, while adding substantial implementation complexity and administrative burden.

Our analysis also highlights an often-overlooked consequence of cross-border interactions: their effect on Member States’ incentives to introduce CRMs. Because CRMs generate adequacy benefits that spill across borders, smaller countries connected to larger neighbouring systems may have an incentive to free-ride on the capacity procured by those neighbours rather than implement their own mechanisms. Direct XB participation can reinforce these incentives. For smaller systems, allowing foreign participation may significantly increase the volume of capacity contracts that must be procured and financed, while delivering limited additional adequacy benefits when interconnection capacity is small relative to the neighbouring market. As a result, mandatory direct XB participation may in some cases increase the relative cost of introducing a CRM for smaller countries, further reinforcing their incentive to free-ride on their neighbours.

We illustrate these issues through the case of the Spanish capacity market, recently approved by the European Commission.[2] Spain provides a useful empirical illustration with broader relevance for European CRM design because it has two borders with similar absolute import capacity, but very different neighbouring systems.

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