On economic inefficiency of European Inter-TSO compensation mechanism

•European Inter-TSO compensation mechanism (ITC) is economically inefficient.•ITC mechanism has serious technical issues; yet in principle they can be improved.•EU power sector regulatory rules are the main barrier for efficiency of ITC.•A change of rules on congestion management may lead to efficiency of compensation.

Economic inefficiency of European Inter-Transmission System Operator (ITC) mechanism is demonstrated by means of statistical analysis of a time series of natural quantities (production, consumption, and exchange of energy), as well as by devising a simple model that shows that the current system misallocates relevant costs between transmission system operators (TSOs) involved. Then, the reasons for this apparent inefficiency are discussed. It is concluded that under existing EU policy rules in electricity sector it is not possible to construct a compensation mechanism that would perform a correct reallocation of external costs incurred by energy transits among interconnected networks operated by different TSOs. Then, simple microeconomic models that exhibit a correct compensation of costs, with rules of the game set differently than by today's EU regulatory framework, are presented.