Cross-border Effects of Capacity Remuneration Schemes in Interconnected Markets: Who is Free-riding?

We study the welfare impacts of domestic support schemes for generation capacity when energy markets are interconnected. We find that if transmission system operators (TSOs) can't reduce export capacity and neighbors stay energy-only, a capacity market is ineffective unless transmission capacity is small. If TSOs can reduce export capacity, the capacity market attracts investments and Security of Supply (SoS) of non-domestic markets shrink. A neighboring energy-only or strategic reserve market will thus be prejudiced in the long-run and may have to implement a capacity market as well in order to meet its SoS standard. Hence, capacity markets may spread in Europe thanks to their negative cross-border effect on investment incentives. This is in sharp contrast with the conventional wisdom, based on short-term arguments, that energy-only markets will free-ride the SoS provided by neighboring capacity markets. Our conclusions urge for the harmonization of capacity remuneration schemes across Europe.