Abstract: The paper examines efficient mechanisms to allocate scarce transmission capacity when the upstream generation market is not competitive. I analyze an environment in which the regulator owns the transmission infrastructure. The regulator cannot directly intervene in the generation market. However, through the allocation mechanism, it can affect incentives of the upstream generators, thereby modisying the outcome of the generation market.
I find that, when the allocation is related to the generated output, the mechanism can partly correct the standard production externality intrinsic in the transmission market (determined by the fact that the constraint on the transmission capacity is on the net, rather than on the gross, flow of energy).