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Ane Marte Heggedal: Investment in new transmission capacity between Estonia and Finland - effects on the electricity market and welfare, Master's thesis,  Norwegian University of Life Sciences, 2006.

Executive summary

The Estlink, an electric cable under construction in the Baltic Sea, will interconnect the electricity market in Estonia and Finland. The Estlink will have a capacity of 350 MW. The construction of the cable started in 2005 and it will be finished by the end of 2006. The financial lifetime of the Estlink is 25 years. In this thesis, the effects the Estlink will have on the electricity market in Finland and the Baltic States in the period 2006-2031 have been studied.

When two regions interact in trade, prices and quantities produced will change. The theoretical basis for evaluating the effects from trade between the Nordic and Baltic electricity market is a basic market model. The model can be extended to include restrictions in transmission, capacities and other limitations. The model is formalized in the Balmorel model. The Balmorel model is a linear bottom up model which includes regional and national differences in demand, capacities etc. The model predicts prices, production, demand, exports and imports in each country for every year in the analysis.

The following problem statements are researched in this paper:

  1. How will transfer capacity between Finland and Estonia affect the electricity market in Finland and the Baltic States?
  1. How will the Estlink affect the producer- and consumer surpluses and hence social welfare in the countries surrounding the Baltic Sea during the financial lifetime of the cable?

When analysing the effects the Estlink will have on the electricity market in the Baltic States and Finland, some assumptions are made. Future prices of input, for instance oil and natural gas, is included in the model, and the forecast of the Energy Information Administration is taken into use. Technical information and production capacities installed are included. Prices on CO2 quotas are included, but the incomes to the local governments form CO2 quotas are not included when calculating the net present value of the Estlink. The demand for electricity and heat in the different regions are calibrated using a reference level on demand and a chosen elasticity. The discount rate used is 4%.

First, a base line scenario is presented. The variables studied are price, production, demand, trade and CO2 emissions in addition to welfare. The variables are presented as the change due to the introduction of the Estlink. The model includes variables with great uncertainty. Therefore, a scenario analysis is made where the effect on the results from some variables are studied.

In the base line scenario, the prices increase in Finland and decrease in the Baltic States in the period 2008-2031, due to the Estlink. Production increases in Finland and decreases in the Baltic States while the demand decreases in Finland and increases in the Baltic States. Exports and imports i.e. gross trade increase in both Finland and the Baltic States as the capacity for trade increases. Finland increases its exports more than its imports while Estonia and Lithuania increase their imports more than their exports. Net trade in Latvia will not be affected by the introduction of the Estlink. The CO2 emission increases in Finland and decreases in Estonia and Lithuania, due to the Estlink. This is in accordance to the production changes. In total, the Estlink contributes to reduce CO2 emissions with 19,3 million tons. The producer surplus increases in Finland, Denmark, Germany, Norway and Sweden while it decreases in Latvia and Lithuania. The producer surplus in Estonia is not affected by the Estlink in the base line scenario. The consumer surplus from electricity consumption increases in Estonia, Latvia, Lithuania and Russia while it decreases in Finland, Denmark, Germany, Norway and Sweden. In all the countries except Latvia and Lithuania, the total welfare increases due to the Estlink. The present value of the total change in welfare in the period 2006-2031 in the countries included in the analysis increases by 114,4 million Euro in the period. With an investment cost of 110 million Euro, the Estlink contributes to increase welfare by 4,4 million Euro.

When calibrating the demand curve for electricity in the Baltic States, the level of demand is exposed to great uncertainty. Therefore, a scenario where the level of demand is changed is developed. If the demand for electricity is lower compared to the base line scenario, the difference in price between Finland and the Baltic States will decrease. The trade will be reduced and the effects of the Estlink will be reduced due to less price differences between the countries when the level of demand is reduced. When the level of demand is lower compared to the base line scenario, the welfare in Estonia, Finland, Latvia and Lithuania increases due to the Estlink, but not to the same extent as in the base line scenario. The welfare in Norway and Sweden however decreases due to the Estlink. In total, the Estlink contributes to increase the total welfare in the Baltic Sea region by 10,8 million Euro in the period 2006-2031. With an investment cost of 110 million Euro, the total change in welfare when the Estlink is installed is a reduction of 99,2 million Euro and hence the Estlink is not profitable.

When the level of demand is increased compared to the base line scenario, the difference in price, production and demand increases compared to the base line scenario. All the countries in the analysis, except Latvia and Lithuania, will benefit from the Estlink and the present value of the total change in welfare in the period 2006-2031 is 293,2 million Euro. With an investment cost of 110 million Euro, the Estlink will contribute to increase total welfare in the Baltic Sea region by 183,2 million Euro.

The Baltic States are considering getting together to build a new nuclear power plant when the Ignalina power plant in Lithuania is closed down. If a new power plant is installed in Lithuania, the effect on price, production, demand and trade as a consequence of the Estlink will be reduced. The consumer surplus in the Baltic States will be reduced due to increased prices when exports to Finland are possible while the consumer surplus will increase in Finland. The producer surplus in Estonia stays unchanged, it decreases in Finland and increases in Latvia and Lithuania. All the countries except Estonia, Norway and Sweden benefit from the Estlink when new production capacity is installed in Lithuania. In total, throughout 2006-2031, the Estlink will contribute to increase the present value of welfare by 666,3 million Euro. The total welfare increases as a consequence of the Estlink increases even tough trade between the Baltic States and Finland decreases. This is due to more exports both from Finland and the Baltic States to Russia. Consumer surplus in Russia increases and hence the total welfare in Russia increases. With an investment cost of 110 million Euro, the Estlink contributes to increase welfare in the region by 556,3 million Euro.

There is uncertainty connected to the price of the CO2 quota in the future. Great parts the installed capacity in the Baltic States contributes to CO2 emissions, and the profitability of the production in the future depends on quota price. The Kyoto agreement is valid until 2012. After 2012, nobody knows what direction the CO2 quota price will take. If the Kyoto agreement is not prolonged and the quota price drops to zero Euro/ton, the change in price and demand due to the Estlink will decrease compared to the base line scenario. The welfare in Denmark, Finland, Norway and Russia increases due to the Estlink, but not to the same extent as in the base line scenario. Total welfare decreases in Estonia, Lithuania and Sweden but the change in welfare is reduced compared with the base line scenario. This is due to reduced price differences. When the price difference is reduced, trade with Russia is reduced and hence the increase in welfare in Russia compared to the base line scenario is reduced. Total welfare in the countries surrounding the Baltic Sea decreases more than it increases compared to the base line scenario. The present value of the total welfare will increase by 73,9 million Euro in the period 2006-2031. With an investment cost of 110 million Euro, the net change in welfare due to the Estlink is a reduction of 36,1 million Euro. Hence, the Estlink will not increase welfare in the Baltic Sea region when the quota price is zero.

If the Kyoto agreement is prolonged, the quota price might increase. If the CO2 quota Price increases to 50 Euro/ton, the change in price and demand due to the Estlink will increase compared to the base line scenario. Emission of CO2 will decrease by 15,5 million ton. The total change in welfare in the period 2006-2031 has a present value of 12,2 million Euro. With an investment cost of 110 million Euro, the Estlink will contribute to decrease social welfare by 97,8 million Euro. Hence, when the quota price increases or decreases, the Estlink will not contribute to increase total welfare in the Baltic Sea region.