What is the value of the option to defer an investment in Transmission Expansion Planning? An estimation using Real Options

Abstract

In deregulated markets, Transmission Expansion Planning (TEP) is usually performed by a central network planner seeking to maximize social welfare. In doing that, the network planner commonly follows a traditional project valuation, considering a discounted cash flow (DCF) methodology, although incorporating uncertainty and reliability considerations. Accordingly, once the optimal transmission expansion plan is determined, the network planner frequently auctions the needed investments, obligating the investor to execute the expansion in the fixed (inflexible) terms defined in the bidding process. A key problem is that DCF does not take into account the responses of the planner when uncertainties are resolved because DCF evaluates the project with the information available today. In TEP, managerial flexibility may be valuable because optimal decisions may change over time with the release of new information. Transmission investors may want to defer or expand according to such information. The aim of this article is to estimate the value of adding some flexibility in TEP through real options. In particular, by means of using a real-option approach with binomial trees, we study the benefits for a social network planner of having the option to defer some transmission investments. Our results suggest that incorporating flexibility in TEP may increase social welfare.