Real Options and Transmission Investment: the New Zealand Grid Investment TestGlenn Boyle, Graeme Guthrie and Richard Meade

EPOC Winter WorkshopUniversity of Auckland7 September 2006

Richard Meade

Research Principal, ISCR

Principal, Cognitus Advisory Services Limited

Teaching Fellow, Victoria University SEF and Management School

richard.meade@cognitus.co.nz

• Electricity Commission (EC) now approves Transpower’s grid investments

• EC has developed a grid investment test (GIT) for proposing, reviewing and approving grid investments

• GIT has three steps:– Identify market development scenarios– Estimate “net market benefit” (NMB) of investment under each

scenario:• “Market benefit” = PV of benefits to users and suppliers over 20 years• Cost = PV of investment’s cost to users and suppliers over 20 years

– Calculate E(NMB) as probability-weighted average across scenarios

• Investment satisfies GIT if:– E(NMB)>0 AND– E(NMB of proposed investment) > E(NMB of feasible alternatives)

Background

• GIT permits the use of ROA, without being prescriptive

• ROA values the flexibility inherent in many investments to change plans in response to new future information, i.e. to either:– Improve returns– Reduce losses

• It thus extends/complements standard NPV analysis

• ROA is useful when:– Investments are irreversible– Key future decision variables are uncertain– That uncertainty is financially material– Investment is flexible

• See (e.g.) Dixit and Pindyck, Investment Under Uncertainty, 1994

Real Options Analysis (ROA) – cont’d

Simple ROA – Invest Big or Small?

Investment Possibility Project NPV

(a) Single 400 kV now

(b) Single 220 kV now

(c) Two 220 kV’s in a row

(d) Single 220 kV now + possibly another later

Consider a two period investment (220 kV or 400 kV), discount rate r:

400N

1 220stN

2 220

1 220 1nd

st

E

r

NN

2 220

1 220

max ,

1

0 nd

st

E

r

NN

Invest Big or Small? – cont’d

Investment Possibility Project NPV

(a) Single 400 kV now

(b) Single 220 kV now

(c) Two 220 kV’s in a row

(d) Single 220 kV now + possibly another later

Consider a two period investment (220 kV or 400 kV), discount rate r:

400N

1 220stN

2 220

1 220 1nd

st

E

r

NN

2 220

1 220

max ,

1

0 nd

st

E

r

NN

Value of expansion option (≥0)

Invest Big or Small? – cont’d

2 220

1 220

max ,

1

0 nd

st

E

r

NN

Now the NPV of “220 kV now and maybe one later” can be rewritten as:

2 2202 220

1 220

max ,

1 1

0 ndnd

st

EE

r r

NNN

NPV of two 220kV’s in a row

Value of abandonment option re 2nd 220 kV (≥0)

Hence only sensible to compare immediate 400 kV investment (i.e. a) with immediate 220 kV investment and possibility of a second (i.e. d), allowing for the possibility of the second line’s abandonment

Invest Big or Small? – cont’d

Rearranging the RHS, immediate 400 kV investment is preferred iff:

2 2202 220

400 1 220

max ,

1 1

0 ndnd

st

EE

r r

NNN N

Value of scale economies

Value of abandonment option that is destroyed by a larger

(rather than staged) investment

Thus a simple ROA identifies a trade-off between earlier receipt of scale economies, and investment flexibility

• Any decision to delay transmission investment is affected by:– Availability of alternatives, and – Speed of resolution of uncertainty

• Suppose that if no line is built now, either a 400 kV or a 220 kV line must be built later

Strategy Strategy NPV

Do nothing now and invest in grid later

Invest in transmission alternative now (with NPV=G) and grid later

An Extension – Transmission Alternatives

400 1 220max ,

01

stE

rN N

400 1 220max ,

1st

EG

rN N

• Any decision to delay transmission investment is affected by:– Availability of alternatives, and – Speed of resolution of uncertainty

• Suppose that if no line is built now, either a 400 kV or a 220 kV line must be built later

Strategy Strategy NPV

Do nothing now and invest in grid later

Invest in transmission alternative now (with NPV=G) and grid later

An Extension – Transmission Alternatives

400 1 220max ,

01

stE

rN N

400 1 220max ,

1st

EG

rN N

Assuming G>0

Transmission Alternatives – cont’d

Immediate 400 kV investment is preferred to this strategy iff:

Net benefit of committing to 400 kV now versus grid

alternative now + 400 kV later

Value of switching option (i.e. to 220 kV from 400 kV) that is lost

by committing to 400 kV now

400 1 220

400

max ,

1st

EG

rN N

N

1 220 400

400

max ,4001 1

0 stE

Gr r

E N N NN

Transmission Alternatives – cont’d

Similarly, immediate 220 kV investment is preferred to this strategy iff:

Net benefit of committing to 220 kV now versus grid

alternative now + 220 kV later

Value of switching option (i.e. to 400 kV from 220 kV) that is lost by committing to

220 kV now, net of value of expansion option re second 220 kV line

2 220 400 1 220

1 220

max , max ,

1 1

0 nd st

st

E EG

r r

N N NN

400 1 220 2 2201 220

1 220

max , max ,

1 1 1

0 0st ndst

st

E EEG

r r r

N N NNN

• Time to build – decision complicated by uncertainty in planning and construction times:– Waiting defers expenditure and allows investment

decisions to be based on further information– BUT waiting risks loss of option to choose projects

having long or uncertain lead times

• Uncertainty in planning times also increases value of planning for multiple projects (to be measured net of incremental planning costs)

More Extensions

• Using this simplified ROA framework (e.g. ignoring generation and transmission coordination):

If there is significant uncertainty in future grid demand, incremental investments (or investments that defer grid investments), are to be preferred over larger committed investments

• This result can obtain even though there are economies of scale in grid investment

• It must be tempered, however, when there are uncertainties in planning and construction times, which:– Reduce the value of the option to defer investment, and– Encourage parallel planning for multiple investments

Conclusions