How to Determine whether Regional Markets are Integrated? Theory and Evidence from European Electricity Markets

Prices may differ between regional markets if transport capacities are limited. We develop a new approach to determine to which extent such differences stem from limited participation in cross-border trader, i.e. lack of integration, rather than from bottlenecks. This approach considers both sets of prices (transport and spot prices). We derive a theoretical integration benchmark for the typical case where transportation markets clear before the product markets, using Grossman’s (1976) notion of a rational expectations equilibrium. We compare the benchmark to data from European electricity markets, where spot prices differ between coun-tries and interconnection capacities between national markets are scarce. The data reject the integration hypothesis: Capacity prices contain too little infor-mation about the price differential; this indicates that well informed traders, e.g. large national incumbents, do not engage in cross-border trade. While unprof-itable in the short run, this behavior may result from anti-competitive long run strategies