Zonal pricing in a deregulated electricity market

In the deregulated Norwegian electricity market a zonal transmission pricin g system is used to cope with network capacity problems. In this paper we i llustrate some of the problems with the zonal pricing system as it is imple mented in Norway. Using small network examples we illustrate the difficulti es involved in defining the zones, the redistribution effects of the surplu s that a zonal pricing system has, as well as the conflicting interests con cerning zone boundaries that are present among the various market participa nts. We also show that a zone allocation mechanism based on nodal prices do es not necessarily lead to a zone system with maximal social surplus. Final ly, we formulate an optimization model that when solved yields the zone sys tem that maximizes social surplus given a pre-specification of the number o f zones to be used.