Real option valuation of power transmission investments by stochastic simulation

• Published in: Energy economics Vol. 47; pp. 215 - 226
• Main Authors: Pringles, Rolando, Olsina, Fernando, Garcés, Francisco
• Format: Journal Article
• Language: English
• Published: Kidlington Elsevier B.V 01.01.2015; Elsevier Science Ltd
• Subjects: Capital; Capital costs; Cash flow; Classification; Computer simulation; Cost; Decision making models; Decisions; Dynamic programming; Economics; Electricity distribution; Energy economics; Energy market; Flexibility; Investment; Investments; Investors; Least squares method; Markets; Monte Carlo; Monte Carlo simulation; Power network; Power transmission; Real options; Real options analysis; Revenue; Sensitivity analysis; Stochasticity; Studies; Uncertainty; Valuation; C530; Power network; Uncertainty; Monte Carlo; O220; Investments; E220; D810; Real options; Flexibility; C630; C520
• ISSN: 0140-9883; 1873-6181
• DOI: 10.1016/j.eneco.2014.11.011

Network expansions in power markets usually lead to investment decisions subject to substantial irreversibility and uncertainty. Hence, investors need valuing the flexibility to change decisions as uncertainty unfolds progressively. Real option analysis is an advanced valuation technique that enables planners to take advantage of market opportunities while preventing or mitigating losses if future conditions evolve unfavorably. In the past, many approaches for valuing real options have been developed. However, applying these methods to value transmission projects is often inappropriate as revenue cash flows are path-dependent and affected by a myriad of uncertain variables. In this work, a valuation technique based on stochastic simulation and recursive dynamic programming, called Least-Square Monte Carlo, is applied to properly value the deferral option in a transmission investment. The effect of option's maturity, the initial outlay and the capital cost upon the value of the postponement option is investigated. Finally, sensitivity analysis determines optimal decision regions to execute, postpone or reject the investment projects. •A modern investment appraisal method is applied to value power transmission projects.•The value of the option to postpone decision to invest in transmission projects is assessed.•Simulation methods are best suited for valuing real options in transmission investments.