Integrating Thermal and Hydro Electricity Markets: Economic and Environmental Costs of not Harmonizing Pricing Rules

The electricity sector is the largest source of GHG emissions in the world, and reducing these emissions would often be costly. However, because electricity markets remain often only integrated at a shallow level (with different pricing regulations), many gains from deeper integration (adoption of marginal cost pricing everywhere) are yet to capture. This paper assesses the benefits of such deep integration between a "hydro" jurisdiction and a "thermal" one. It also underscores the inefficiency of trade when pricing rules differ. Our detailed hourly model, calibrated with real data (from the provinces of Ontario and Quebec, Canada), estimates price, consumption, emissions and welfare changes associated to fully integrating electricity markets, under transmission constraints. A negative abatement cost of $37/tonne of CO2 is found (for more than 1 million tonnes), cleary illustrating the untapped potential of wealth creation in carbon reduction initiatives. Furthermore, given the inefficiency of shallow integration between markets, we find that removing interconnections between markets is a relatively affordable CO2-reduction opportunity, at $21.5/tonne. J.E.L. Classification: F14, F15, L50, L94, Q52, Q56.