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 countries and interconnection capacities between national markets are scarce. The data reject the integration hypothesis: Capacity prices contain too little information about the price differential; this indicates that well informed traders, e.g. large national incumbents, do not engage in cross-border trade. While unprofitable in the short run, this behavior may result from anti-competitive long run strategies.