Designing regulatory frameworks for merchant transmission investments by real options analysis

Abstract

In deregulated electricity markets, the transmission network is a key infrastructure for enabling competition in the generation sector. A deficient expansion of the transmission grid prevents the realization of the benefits in terms of efficiency associated with market mechanisms. Consequently, it is essential to provide clear investment policies and economic signals to attract timely and efficient transmission in order to be developed at minimum cost, with adequate levels of service quality and reliability, and adapted to the requirements of generators and consumers. This paper proposes a modern tool of economic evaluation based on Real Options Analysis that provides the regulator the ability to assess various incentives that allow transmission investors to make efficient decisions in highly uncertain environments. Real Options properly values partially irreversible investment decisions, such as to defer, modify or abandon an investment project in response to the arrival of new information or as uncertainties are resolved. Decisions are evaluated from the point of view of an agent trying to maximize its own profits in the time period set to recover the capital invested. The results of this paper allow the study of the behavior of transmission investors regarding their decision making when they have the possibility to manage the option to defer, under different regulatory schemes that encourage the expansion of the transmission system